Attracting Value Investors

[Editor's note: A version of this story appears in the March 2020 edition of Oil and Gas Investor. Subscribe to the magazine here.]

Say goodbye to growth investors; value investors have risen as the industry’s best opportunity. But to woo this market effectively, energy companies must make some critical changes. And fast.

For an industry with more than 100 years of operating as a growth venture, change can be hard and, oftentimes, unpopular.

Increasingly, investors and banks are re­ducing exposure to oil and gas, forcing com­panies to self-fund or get creative. Many growth-minded investors no longer view the industry as a growth play, yet many companies currently do not operate as a value opportunity to attract the value-minded investor.

To shift from the century-old operating mod­el of a growth stock to the disciplined model of a value stock, oil and gas companies must begin to accept some hard truths about what appeals to investors—and make arguably un­familiar changes.

How investing in energy has changed

At the height of historic oil prices in 2008, the energy sector accounted for about 15% of the S&P 500 index. Ten years later, the indus­try took the title for the worst-performing stock sector and fell to less than 5% of the S&P 500, according to Refinitiv Datastream data. This declining performance caused a notable shift in investor appetite the past few years, reduc­ing available capital and causing concerns for the industry’s continued growth.

Broadly, institutional investors fall within three camps:

1. Growth Investors—Those who bought into oil and gas when the investment the­sis was “peak oil”;

2. Environmental, social and governance (ESG) Investors—Those who recently pulled money out of oil and gas, seek­ing alignment with carbon-neutral objec­tives; and

3. Value Investors—Those who are indus­try-agnostic, seeking low-risk, predict­able and reasonable yield investments.

As oil and gas companies lose growth in­vestor interest and work to appeal to ESG investors, value investors have risen as the industry’s best opportunity. To woo this mar­ket effectively, energy companies must make some critical changes.

Appealing to value investors

So, where to start with this coveted demo­graphic of market participants? An unspoken factor at play is management’s focus and skill­set as it relates to moving from a historically growth-oriented model to a dividend-focused model. With growth as the predominant mind­set of leaders for the past 20 to 30 years, natu­rally, the industry cycle required strategies and skills oriented toward expansion.

However, the current cycle calls for a differ­ent mindset and skills unfamiliar to many in the industry, such as delivering earnings outcomes competitive with the S&P 500 “dividend aris­tocrats”—those S&P 500 companies that have paid and increased their dividend annually for at least 25 years in a row—regardless of the commodity price environment.

To deliver competitive earnings that rise above oil-price swings, the industry must look deeply at total costs and revenue at the most granular level, in ways few in the industry have done previously. Gaining a “high-resolution vision” into the organization entails leverag­ing existing yet enormous amounts of data on all costs and determining whether those activ­ities and assets are accretive or dilutive in a low-commodity price environment.

Anything that does not create a net profit when commodity prices are low suggests two things: the parts of the business that are prof­itable in the low-oil price cycle are effectively subsidizing parts of the business generating net income, putting the dividend at risk; and companies must avoid acquisitions that merely serve to drive top-line growth and instead must selectively pursue only those that will contrib­ute directly to net income.

Additionally, getting such a granular vision can likely enhance management’s ability to take firmer control of financial and operational performance to instill confidence in value in­vestors. The more oil and gas companies feed to the bottom line and unlock greater free cash flow, the more they can feed the dividend.

Matching earnings and return on capital to supply

Along with driving commodity prices down, the supply glut challenges investors’ confi­dence that returns on capital are safe. But in a low- to moderate-price environment, oil and gas companies should consider new modes of efficiency to meet investor expectations.

According to a recent oil and gas survey by PwC that examined the strategic alignment of management and investors, many participants identified cost management as an underper­forming area—but one critical to achieving free cash flow. Indeed, the survey found nearly all business leaders (95%) agree cost management is important to generate greater free cash flow, yet just 16% of respondents grade their organi­zations as being strong in this area.

Cost management assumes different forms, including improving asset management for 100% uptime and supporting the top-perform­ing activities while divesting the average-per­forming ones.

For example, recent advancements in digital technology and analytics, such as the use of ar­tificial intelligence and Big Data, have helped streamline operations and identify new oppor­tunities—but too many oil and gas companies still take a “not invented here” approach to new technology. These technologies are becoming powerful tools to unlock free cash flow, but if it wasn’t created inside their walls, companies are less likely to adopt it and will instead spend capital to invent their own tech, limiting the company’s ability to focus on exceptional areas of the business.

Thus, despite the oil and gas industry’s le­gitimate standing as a vanguard of science and technological innovation in many respects, the industry has been slower to adapt as we’ve en­tered the age of the Fourth Industrial Revolu­tion, or 4IR. In fact, according to PwC’s study, just 7% of oil and gas leaders rate themselves as excellent and 37% as good in terms of digital maturity. By partnering with trusted providers to develop digital solutions, energy companies can stay focused on the core business needs, making their operations and use of capital more efficient.

Increasing the dividend above 5%

While the oil and gas industry has historical­ly based budgets and investments on mid- to peak cycles, value companies have built more resilient plans around low-cycle economics. Therefore, to entice the value investor, oil and gas companies must shift strategy to make the dividend their first principle, targeting a range of 6% to 8% to offer a premium to offset inves­tor concerns. To do this, companies must first generate and maintain enough free cash flow at a breakeven level below $50 a barrel.

Some oil and gas companies have already tak­en this first hard step. In the same survey noted, achieving free cash flow was the top objective for industry leaders by far. However, despite prioritizing free cash flow, a majority of survey participants believe that a dividend below 5% can still attract value investors. This indicates that while many oil and gas companies under­stand the importance of free cash flow, they still haven’t taken the second important step of di­recting that cash flow to increase the dividend above 5% to attract value investors.

Instead, free cash flow is being used for share buybacks or invest in growth. And while that in­vesting pattern aligns with management’s focus on the future, maintaining a desirable dividend in the present ensures that investors provide the much-needed capital for continued growth. Time will tell what investors value most—whether it’s a “pay me now” approach, a bet on the future, or a mix of both. Regardless, the in­creasing importance of the dividend above 5% will challenge many.

Hard changes for a soft landing

Ultimately, oil and gas companies should re­alize some arguably uncomfortable new strate­gies and efficiencies to increase their appeal to value investors. Prioritizing reliable shareholder returns through effective capital deployment in any price environment may position them for continued profitability.

And free cash flow isn’t enough—increas­ing dividends competitive across all industries and shifting managerial focus to a value-driven model communicates confidence to value in­vestors, allowing oil and gas companies to see another day and earn the right to focus on future growth opportunities. M

Reid Morrison is the global energy and U.S. energy and chemicals advisory leader and a principal in PwC’s Houston office. He has more than 25 years of experience in the resources industries across upstream, down­stream, midstream, oilfield services, chemi­cals, mining and bio-fuels both domestically and internationally.