US energy sector can thrive with right policies from Washington

M2 Capital HoldingsAuthor: Patrick McFadden, M2 Global

Covestor model: M2 Global

The upcoming presidential election will clearly affect the stock market, and the positive returns to date are in line with typical election years. However, the continued attacks on the oil and gas industry are worrisome. A recent CNN piece outlines the criticism.

Non-cash expenses such as depreciation, depletion & amortization represent about 3% of Exxon Mobil’s (XOM) revenues and 3-5% would be a typical range for many large oil and gas integrated operators and producers. The Obama administration, in its characterization of oil industry profits and taxes, does not separate out depletion.The argument is difficult to see as more than rhetoric as most industries benefit from such tax reducing expenses.

The real concern is that small- and medium-sized oil and gas companies, the companies that are taking real financial risks and hiring millions of people in the United States, incur depreciation, depletion & amortization expenses in a range from 10% to 30% of revenues in many cases. Such companies typically do not have the access to capital and the strength of balance sheets to withstand losing these deductions.

Today, gas prices average nearly $4 across the country. On the bright side, many analysts believe that the US will become the world’s largest producer of oil and gas within the next few years. A large reason for this is that smaller operators are using new technology to extract oil that was not profitable less than a decade ago. Even so, in many cases these projects still are not profitable enough for the big companies that can make larger margins exploiting resources in Africa and Asia.

The bottom line is that smaller, entrepreneurial oil and gas drilling on state and private land has been one of the biggest net positive job producers for the US economy in the past five years. These are high paying jobs, where a high school graduate with training can make $75,000-100,000 per year within a few years. It makes no sense to talk about killing such jobs when college graduates with tens of thousands in debt and no assets are taking jobs flipping burgers.

Gasoline at the pump is nearly three times as expensive in Europe and the price of natural gas, which heats many US homes, is about five times more expensive in much of Asia. Our economy would be in shambles if Americans were paying such equivalent prices today. It is not fully clear whose interests the government protects by pursuing policy to restrict oil and gas drilling on federal lands, however, the United States could enter an economic renaissance if we pursued all of the oil and gas natural resources at our disposal and created millions of new jobs building the infrastructure to transport and refine these resources for economical use by the cities on the East and West coasts. Today, gasoline refineries are shutting down on the East coast, as they are dependent upon crude oil from Venezuela, Africa, and North Atlantic Brent.

Hopefully the President is pandering to his liberal and green voting base with much of this rhetoric. It is hard to deny that the planet is getting hotter, however, this has been going on for at least a few hundred years now, well before the automobile was invented. The magnitude of human population increase, up nearly 600% since 1800, is a likely partial cause no matter what we burn for heat or fuel. Still, if science clearly proves that we need to cut our carbon emissions, the United States should lead from a position of strength. If we become the world’s largest producer of oil and gas, become energy self sufficient and return our economy to a growth track above 3%, we will clearly be in a better position to develop new technologies and lead the world.

Oil and gas needs are not going away for decades and there will be opportunities in many of the domestic small- to mid-capitalization oil production and service companies. We typically look for companies with less than half a billion in revenues that have fully funded drilling and operations plans for the next 18 months plus. Such companies can typically be bought on weakness if their debt to equity is reasonable and they have a history of producing oil from more than 85% of the wells they drill.