Over the past decade, exploration and production companies (“producers”) have been in a land grab battle as shale oil resources (“shale oil plays”) have emerged across the United States. Starting in 2009, the Bakken Shale in North Dakota emerged, followed by several other oil plays including the Eagle Ford Shale in South Texas, the Denver-Julesburg (DJ) Basin in Colorado, and most prominently the resurgence of the Permian Basin in West Texas and Southeast New Mexico. New technologies have unlocked these vast reserves in the US and some estimates now show the US having more reserves in the ground than the most prolific oil fields in Saudi Arabia. The land grab has led to most producers issuing substantial debt and equity to finance the high-cost of entry into these shale plays. In some cases, producers have spent without restraint on drilling their newly-acquired acreage to hold leases (as required by lease agreements) and grow production rapidly. As a result, at approximately 12 million barrels per day, the US is now the largest oil producing country in the world, surpassing both Saudi Arabia and Russia. However, following years of high-cost acquisitions and production growth, producers are now embracing a more disciplined approach to capital deployment with a manufacturing mindset – a fundamental change in the fabric of the industry.

The most pronounced change in energy companies recently has been the transformational shift to capital discipline. Capital discipline simply means that an energy company spends within its cash flow from operations (“cash flow”) and prioritizes long term returns on and of capital to the shareholder. Historically, most producers have outspent cash flow (see EXHIBIT 1) and relied on capital markets to fuel growth. However, as producers have announced their 2019 capital budgets, they are clearly positioning to meet investor demands to focus on returns on and of capital, not growth at all costs. Despite the recent increase in oil prices, most producers are basing their development plans on $50/barrel oil (WTI), cutting capital expenditures and committing to use free cash flow generated at current oil future prices of $55+/barrel to pay down debt, initiate/increase dividends, and/or commence share buybacks. This structural shift in the underlying business model of producers is leading to a healthier industry through this balanced approach to capital allocation and is serving to make these companies more investable through the commodity cycle as they refrain from chasing growth for growth’s sake.

This newfound discipline is making these companies more attractive as margins have expanded and free cash flow is rising as illustrated in EXHIBIT 2. As shown in the chart on the left, average EBITDA margins are expected to increase from 6% in 2016 to nearly 60% in 2019 through 2021. Along with rising oil prices, most producers have continued to drive down costs through improved drilling and completion technologies, which has led to expanding margins. As producers move from land grab to manufacturing/development mode, they are also benefitting from economies of scale. At the same time, the move to capital discipline is putting a governor on capex, which is leading to increases in free cash flow estimates. EXHIBIT 2 illustrates an improvement in free cash flow from a negative $17 billion in 2016 to an estimated positive $20 billion in 2021.

What are these companies going to do with the free cash flow they are expected to generate? As mentioned, some of them are using it to reduce debt in order to strengthen their balance sheets and others are reinvesting it into high-return projects. Many of these companies have also started to return capital to shareholders through share repurchases and dividends. The table in EXHIBIT 3 shows a sample list of producers that are embracing return of capital policies. Notably, even Pioneer Natural Resources, a high-growth Permian producer once dubbed by David Einhorn as the “Mother of all Frackers,” has embraced returning capital to shareholders through an increased dividend and a share repurchase program in lieu of pursuing accelerated production growth. Other high-growth producers, such as Concho Resources and Diamondback Energy have also moderated growth spending and recently initiated dividends.

We think this move to capital discipline is a very positive development for the industry as it potentially does the following:

    • Provides support to long term oil prices by moderating US shale oil production growth within cash flow (the US has been the primary driver in global oil supply growth in recent years);
    • Reduces liquidity and solvency risk as debt is paid down and balance sheets are strengthened;
    • Reduces reliance on capital markets to fund operations and therefore keeps invested capital low with incremental free cash flow helping to increase corporate returns;
    • Extends drilling inventory life by moderating production growth rates;
    • Encourages divestitures of non-core, low-returning assets with possible uses of proceeds including redeployment in higher return assets, debt reductions, or increases in shareholder-friendly payouts.

Supporting this change, many companies have added corporate level, returns-based metrics into management compensation structures to align themselves with shareholders and as such are “putting their money where their mouth is.”

While we applaud the move to capital discipline, it is important to note that this substantial shift in the fundamental model and DNA of these companies will take time and may not be a smooth transition. While a lower growth, more returns-focused model should lead to a healthier industry and long-term value creation, short term mismatches in expectations are likely to arise as the right combination of growth and returns is optimized for each individual company. However, by spending within cash flow, deleveraging, prioritizing free cash flow generation, and returning capital to shareholders, we believe investors will ultimately be rewarded in the long run. With the land grab phase largely over and a disciplined manufacturing phase beginning, we believe many of these companies are well-positioned to deliver improved corporate level returns through the commodity cycle.



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