They say patience is a virtue, but it’s been a testing time to watch E&P metrics inch ever so slowly higher as the third quarter concluded.

Typically, the E&P sector has lagged the underlying commodity, and certainly that’s been the rule of late. The West Texas Intermediate (WTI) crude price was up about 48% in the 12-month period through Oct. 1 of this year. Meanwhile, the XOP (S&P Oil & Gas Exploration & Production ETF), for example, was up only about 27.5% during the same period.

In the more recent phases of crude’s recovery, as spot prices moved into the upper $50s and $60s, one explanation put forward for sluggish E&P performance was the sloping commodity curve. But while the earlier forward curve may have pointed to prices in the low-$50s, the December 2019 and December 2020 futures contracts closed at just more than $71.50 per barrel (bbl) and $67.50/bbl, as of Oct. 4.

For some time Credit Suisse has noted that E&P valuations reflected a “discount to normalized oil/gas forecasts.” E&Ps were discounting, it said, a WTI price of about $52/bbl vs. the then-prevailing long-term futures commodity curve of roughly $61/bbl. As WTI touched $75 in early October, the move in E&P stocks allowed the sector to boast a valuation now reflecting $53/bbl—a paltry $1 higher.

But the foundations may be in place for an expansion of valuation metrics. While third-quarter results for some are already out, it’s worth looking back on some of the metrics observed in the prior two quarters.

Bob Brackett, senior research analyst with AllianceBernstein, provides a quarterly “state of the E&P business” by aggregating data from a sample group of E&Ps into an imagined entity as if it were a single E&P business unit. According to Brackett, the first quarter of this year marked the most profitable quarter since the third quarter of 2014, which represented the end of an upcycle for oil and gas.

Regarding the 2018 first quarter, “if all quarters looked like this, we’d have a real business on our hands,” read the Bernstein report’s headline.

The second quarter took sector profitability higher, with E&Ps generating $6.40 per barrel of oil equivalent (boe) of “clean” net income, up from $5.50/boe in the first quarter. (Clean net income is defined as EBIT less interest and financial taxes.) EBITDA and EBITDA margins were helped by higher oil prices, averaging $68.07/bbl vs. the prior quarter’s $62.89/bbl, although results varied between large- and small-cap E&Ps.

Large-cap E&Ps generated about $24.90/boe of EBITDA, representing an EBITDA margin of 69%, in the second quarter. This was up from about $23.00/boe, or a 59% EBITDA margin, in the first quarter. Small caps generated about $16.60/boe of EBITDA, representing a 56% EBITDA margin, in the second quarter. This compared to a slightly higher EBITDA of $18.00/boe, or a 59% EBITDA margin, in the first quarter.

Notably, E&P discipline continued for a third consecutive quarter, with E&Ps spending 88% of cash flow on organic capex, down from 91% in the first quarter, said Bernstein. Production in the U.S. from the 56 E&Ps was up a mere 1.4%. In addition, of the $33 billion of cash from operations and asset sales, $5.5 billion, or some 17%, was returned to investors via dividends and shares in the second quarter.

Ongoing discipline is expected to persist for at least the next four to five quarters—and possibly longer—as “self-imposed and Permian congestion-imposed discipline should reign,” predicted Brackett.

A research note by Tudor, Pickering, Holt & Co. (TPH) in mid-September described the upstream sector as being “materially undervalued,” with new capital being tough to attract until it can compete with other S&P sectors on metrics such as free cash flow (FCF) and return on capital employed. Later that month TPH said that it believed “a number of these metrics are nearing a material inflection.”

The analysts added, “We believe that material FCF generation and EBITDA growth will materialize in the coming years, as shale transitions from a land grab into an industry with the ability to materially return capital to shareholders. Near term, we see a select group of E&Ps able to generate a 20%-plus EBITDA compound annual growth rate over 2018 to 2020 and an approximate 7% FCF yield in 2020 on average.

“And lest we forget,” the TPH note added, “these names trade at a market cap weighted 4.7 times 2020 enterprise value-to-EBITDA, far and away below other S&P sectors which grow at slower rates with lower yields.”

So maybe that 4.7 multiple can—slowly—improve.

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