[Editor's note: A version of this story appears in the January 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

The advent of a New Year brings reflection of old vs. new: What old habits of last year do we discard and which new ideas do we embrace? The upstream industry spent the whole of last year divesting its old grow-at-any-cost model for a new returns-and-cash-flow model. 2019 is the year when investors hold the industry accountable.

ConocoPhillips Co. (NYSE: COP)—not coincidentally the top-ranked company in Oil and Gas Investor’s Top 50 E&P rankings in the January issue—leads the paradigm shift. In December, the Houston producer announced its 2019 spending plan, which it held essentially flat year-over-year. The $6.1 billion capex projection provides for free-cash-flow generation with West Texas Intermediate at $40 and above, $3 billion in share repurchases and a target payout to shareholders of 30% cash from operations, with a modest 5% growth in production.

“We no longer think of our value proposition as merely disciplined; we view it as the new order,” Ryan Lance, CEO, said in a news release. “We are running our business for sustained through-cycle financial returns, which is necessary for attracting investors back to the E&P sector.”

Indeed, the E&P sector is undergoing a massive re-rating by Wall Street. David Deckelbaum, Cowen Inc. managing director of oil and gas equity research, said the evolution is real.

“E&Ps have re-rated from a growth sector to a value sector,” he wrote in a Nov. 29 report, “which we believe is a byproduct of volatile commodity pricing, lack of investor sponsorship and ever-maturing inventory.”

Deckelbaum noted that E&Ps underperformed the S&P by 98% during the previous five years, with shares lagging the broader market by 12% in 2018, “the fourth year in a row that the sector has earned the dubious distinction of being among the worst-performing investable sectors.”

But now the E&P sector has the opportunity to be globally relevant, he added. “The move to free-cash neutrality is not insignificant as expectations for 2.7% free-cash yield, on average, for the sector stacks well against the 1.2% average for S&P sectors.

“… It is our view that E&Ps’ shift in tone away from high production growth and NAV [net asset value] acceleration toward capital discipline, return on capital employed and debt-adjusted returns is resonating with Street analysts and could create the climate for a re-rating going forward.”

Seaport Global Securities LLC has changed its own paradigm in how it rates E&Ps, materially altering its NAV-modeling approach. The sell-side research team now incents full-cycle returns and penalizes “companies that continue to live by Shale Version 1.0 standards,” meaning “growth and pricey undeveloped acreage acquisitions sold on the merits of NAV upside,” wrote Mike Kelly, lead analyst.

“We think our revised framework aligns with how Wall Street will assess U.S. E&P companies going forward.”

Seaport’s seven crucial elements to gauge E&Ps: returns, cash flow, growth, inventory, balance sheet and valuation/NAV upside. All of these can be summed up with management-team quality, which Kelly said has never meant more to investors than now and for which they are willing to pay up.

“As investors place more emphasis on corporate returns, excellence on the capital-efficiency front has become a must-have for many of the clients we speak with,” he wrote. “We don’t think this changes anytime soon in an E&P world where it seems easy to get smoked by potential parent-child type-curve revisions, [midstream/takeaway] tightness, misguided well-spacing assumptions, offset-frack hits, logistically complicated water-sourcing/disposal demands, etc., if you’re not on top of your game.

“We think companies with good rock and a solid management team will increasingly garner a valuation premium and house long-term investors less interested in quarterly results/well-watching, thus taking some of the volatility out of a volatile space.”

With OPEC’s December decision to defend crude prices with production cuts, Kelly believes some of that volatility will level. “… The cartel has resigned itself to the passive role of oil-market balancer. This is outstanding for U.S. producers; the market share war is done and won by U.S. shale.”

That means OPEC will defend an “almost concrete floor” on oil prices “not much lower than we are now” even while U.S. production hums along.

“We think the market dynamics have positively changed,” he wrote, “which finally sets the stage for the outperformance of the E&P group. High-quality E&P companies capable of demonstrating above-average corporate returns and organic growth accompanied by free-cash-flow generation should perform well.”

The battle on Wall Street is not yet done—the campaign to achieve scale, and whether that should be via organic growth or consolidation, remains to be fought. But the shift for E&Ps to look more like a typical S&P company is necessary and in progress. Valuations should follow.

“Despite positive results, the sector sits as cheap as ever,” noted Bernstein Research analyst Bob Brackett in a Nov. 26 report.

Value is the new upside.

Steve Toon can be reached at stoon@hartenergy.com.

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