Many small-cap exploration and production companies have had a good run in recent years, but are now getting whacked given their strong connections to oil prices. But the news is not all bad: Philip Juskowicz of Casimir Capital makes a good case for certain micro-cap names. In this exclusive interview with The Energy Report, Juskowicz discusses three companies with strong narratives, two with defensive assets, and notes that natural gas names could see market love as margins widen.
The Energy Report: Your expertise is in the exploration and production (E&P) space. Please give our readers some key investable ideas among those names.
Philip Juskowicz: We’ve seen a divergence between the micro-cap space and the small-cap space within the oil E&P companies. The micro caps have underperformed substantially versus the small caps over the past couple of years. I attribute that to enthusiasm for shale plays, yet only small-cap companies have the financing necessary to develop those expensive plays. Micro caps missed out on that investor appetite; that’s probably why they’ve underperformed.
Given the current oil price environment—uncertainty, downward pressure—the first companies to get hit were the ones with strong exposure to oil prices, even if it was just headline exposure. In fact, my research shows a 58% correlation between the small-cap universe and oil prices, whereas the micro-cap space only vaguely correlates to oil prices. Most small caps are going to be hit regardless of what hedges those companies have in place, whereas many micro-cap companies are one-off value plays, and those value plays are still intact. There is a good case for micro-cap stocks here.
TER: The predominant oil price theory making the rounds is that surging U.S. oil production from old basins and shale plays has reduced America’s dependence on imported oil and will keep downward pressure on the oil price for the foreseeable future. Is that how you see it?
PJ: I do. At the same time, though, there are at least two different factors that should put something of a floor under falling oil prices. First, the marginal cost to produce a barrel of oil is more than it used to be. About 10 years ago, it cost $30 to produce a barrel of oil. Now it’s $60/barrel ($60/bbl). If the oil price falls to that level, many plays would no longer be economic. Second, we have already seen some producers cut back on drilling in response to lower prices. With lower prices comes lower production, and that would put some sort of floor under pricing, too.
TER: What are your near- and mid-term crude forecasts?
PJ: I’m a little bit below the consensus on The Street. The consensus was $94/bbl for 2015 and $95/bbl for 2016. I’m at $91/bbl in 2015 and $93/bbl in 2016. The drilling curtailments should help lower production.
TER: In mid-November, JPMorgan Chase & Co. downgraded its 2015 Brent price by $33 to $82/bbl, citing pressures in the Atlantic basin and the inability of the Organization of the Petroleum Exporting Countries (OPEC) members to curtail production. It also lowered its 2016 forecast to $87.80 from $120. What are your thoughts on those moves?
PJ: The consensus figures out there are too bullish. It feels good that there’s a major bank that has lowered its pricing forecasts. JPMorgan Chase is not saying it’s going to be an all-out blowout, but that its 2016 price of $120/bbl may have been too high. The company has a lot of quantitative people behind those numbers.
TER: JPMorgan Chase also warned us that if there is not a new OPEC agreement in place, crude could slip as low as $65/bbl in January. Is that likely?
PJ: Over the last three years or so, OPEC has become less relevant, less cohesive and, therefore, less able to dictate world oil prices. If the market thinks that OPEC is falling apart, there could be a psychological impact, but not an actual fundamental impact. I don’t think OPEC is acting on the basis of supply/demand fundamentals.
TER: Do you expect the spread between West Texas Intermediate (WTI) and Brent to continue to contract?
PJ: I definitely don’t see it widening. If anything, it should narrow or remain status quo. The main factor is that the petroleum industry has become more global. You see that with Saudi Arabia dillydallying to U.S. pricing; you see that with the U.S. moving toward exporting oil; and you see that with more infrastructure being built in the U.S., which is lessening the gap between WTI, Cook and other benchmark prices.
TER: It was recently reported that Halliburton Co. (HAL:NYSE) has made a takeover bid for Baker Hughes Inc. (BHI:NYSE) How will this merger impact the energy services sector? Do you project any other major M&A news in the coming months?
PJ: The consolidation of two major oilfield service companies can only result in stronger pricing power, notwithstanding any Hart-Scott-Rodino-mandated divestitures. This would hurt explorers and producers (E&Ps).
“Natural gas has some good pricing momentum behind it.”
I expect further consolidation in the oilfield services sector in an effort to compete with the new Halliburton. Any decrease in activity by the E&P space would put even more pressure on the space to engage in mergers and acquisitions (M&A).
TER: What is your basic investment thesis for the micro caps?
PJ: Number one is that there are value plays in the micro-cap space. These companies have been overlooked in the shale play revolution happening over the past couple of years.
Another item for investors to consider is good old natural gas, because lower oil prices have reduced the oil-and-gas spread. On an energy-equivalent basis, not that long ago oil was five times as valuable as gas. That number is now three times. And natural gas generally costs less to drill for and produce. The margins for natural gas companies are going to widen. That may be another investable theme going into 2015.
TER: Do you think natural gas demand could dramatically increase with the onset of another cold winter?