As the end of the first quarter of 2018 nears, analysts see the trend of E&Ps seeking to return more capital increasing, according to a recent report from Guggenheim Securities LLC. Likewise, a research report from Morgan Stanley energy analysts highlights upstream capital discipline and rising North American energy cash returns. The potential outcome: renewed interest from investors previously turned off by the sector’s practice of outspending cash flow.
Guggenheim analyst Subash Chandra noted in a recent report that rather than continue outspending as oil prices recovered, E&Ps reversed course. “Operators instituted or expanded stock buyback and dividend programs even as oil topped $60,” he said. Another favorable trend, in his view, is managements’ renewed focus on ways to restructure and monetize MLP units to benefit upstream. “The combination of dividend yield and sustained, unlevered NAV growth should invite long-term investor interest repelled by the boom/bust dynamics of the past,” he said.
Chandra termed the momentum behind return-of-capital strategies associated with free cash flows “irreversible.” In a majority of cases, he suggested, companies will need to follow a playbook that “focuses on core basins, divests noncore assets and shifts to liquids from dry gas.” Companies epitomizing this playbook are Anadarko Petroleum Corp. (NYSE: APC) and WPX Energy Inc. (NYSE: WPX), he said.
The analyst expects A&D to thrive this year, as companies seek “inventory renewal and expansion.” Other themes for 2018 on his radar are evolving roles for small and mid-cap companies as they are judged as “businesses rather than real estate trading vehicles or levered plays on the commodity.” On the large-cap front, he thinks those in the Delaware Basin will benefit from years of short-cycle, undrilled inventory. “It is important that independents be able to generate free cash flow at a lower-than-strip price deck.”
Morgan Stanley’s North America Energy research team, led by Benny Wong, noted that “with $16 billion earmarked for payouts in 2018, E&Ps are joining the trend of rising North American energy cash returns.” The analysts noted that this incremental $6 billion directed away from drilling could forestall 1% of U.S. output, or 100 million barrels per day of production. They deduce that if E&Ps followed a similar level of buybacks through 2020, almost $16.5 billion would be diverted from drilling.
Convincing investors of the sustainability of E&Ps’ fast-building focus on capital discipline isn’t easy. “Our U.S. E&P coverage has an estimated sustaining corporate breakeven oil price of $40 to $50 WTI in 2018 compared to $35 to $40 WTI for our integrated coverage, implying higher relative risk to E&P free cash flow if oil prices retrench,” the Morgan Stanley report stated. Still, the analysts credit the E&P industry for its initial step toward “a needed cultural shift to attract investors” with increased cash payouts as well as ongoing changes to executive compensation.
The Morgan Stanley analysts highlight Encana Corp. (NYSE: ECA) and Continental Resources Inc. (NYSE: CLR) as having the greatest rate of change toward higher sustainability. They are balancing growth with a free cash flow profile “that provides the optionality to increase cash returns.”
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