Boone once said that giving capital to an exploration and production (E&P) company is like giving lettuce to a rabbit, they will take every bit of it they can. For decades, this has been the case, but in the new shale era, the tide is finally starting to turn. Investor demand for a more disciplined approach to shale oil investment is being met via debt reductions, share buybacks, corporate dividends and capital allocation to projects that exceed the company’s cost of capital. These initiatives are putting a governor on US oil production growth and at the same time making these companies more investable through the energy cycle.
In light of rising oil prices, there has been much skepticism among investors regarding the US E&P industry’s willingness to follow through on capital discipline in their 2018 budgets. As most E&Ps have now announced their budgets, it is clear that they are positioning to give investors what they want – returns on and of capital, not growth for growth’s sake. Despite the recent increase in oil prices, most E&Ps are basing their production plans on $50-55 oil and, in many cases, are committing to use free cash flow generated at current oil prices of $60+ to pay down debt, and initiate/increase dividends, share buybacks or both. Nearly all US large cap E&Ps are embracing this newfound disciplined approach to growth including Anadarko, Conoco Philips, Hess, Devon, Occidental, and even Permian basin growth engines such as Pioneer Natural Resources. In fact, many E&P’s are now revising compensation structures to include return-based metrics. By making these revisions, management teams are incentivized to be more thoughtful in the deployment of capital and are more appropriately aligned with shareholders’ interest of generating attractive returns on capital.
This is a very positive development for the industry for many reasons as it potentially does the following:
- Provides support to long term WTI oil prices by moderating US shale growth within cash flow;
- Provides shareholders line of sight into getting their money back and confidence that free cash flow and returns optimization are the primary goals;
- Reduces liquidity and solvency risk as debt is paid down and balance sheet strength is restored;
- Reduces pressure on services demand helping to keep cost inflation from getting out of control;
- Reduces reliance on capital markets to fund operations and therefore keeps invested capital low with incremental free cash flow helping to increase corporate returns;
- Attracts investors from other industries as free cash flow yields and return on capital improve on a relative basis;
- Allows companies to maximize long term returns on capital by taking a more measured and optimal approach to development plans without the pressure to “drill baby drill;”
- Extends drilling inventory life by moderating production growth rates at lower levels;
- Increases 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.
While there is no question US shale production is growing and provides ample investment opportunities across the entire energy value chain, it may grow at a more moderate rate than market expectations as producers are walking the talk on capital discipline. It’s an exciting time for the energy industry as positive fundamental changes are occurring. In our view, these changes are leading to energy becoming more investable through the cycle as more shareholder friendly policies are being implemented industry-wide. With proof of these companies focusing on returns and optimal growth rates, we believe the energy space is looking even more attractive amidst a constructive macro backdrop.
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