E&P Tightrope: Preserving Free Cash Flow On Maintenance Budgets

Free cash flow continues to absorb the interest of many E&P investors, particularly as commodity prices have come off the higher levels seen at certain points this past year. Though, if the drilling pace must accommodate slower growth in demand, what E&P is likely to be able to generate free cash flow in the New Year under a “maintenance capex?”

A maintenance capex, as defined by analysts with Seaport Global Securities LLC, is a budget that “keeps fourth-quarter 2018 production levels flat throughout 2019.”

The Seaport analysts, led by Mike Kelly, summed up the performance of E&Ps in the firm’s universe in a recent report using its fiscal-year 2019 price deck of $55 oil and $3.18 natural gas, and leaving out hedging gains to further level the playing field. To lend context to the analysis, the Seaport team looked back at a similar report the firm generated in 2015—also an “ugly period for E&P investing.”

In 2015, the average E&P was expected to fall far short—43% below—the level needed to fund maintenance capex (unhedged). Today, the outlook is far rosier for many E&Ps, however.

“We expect that the average company will generate significant positive free cash flow—we see cash flow from operations that’s 24% higher than maintenance capex,” the analysts said.

Efficiency and productivity gains, as wells as Saudi Arabia’s production cuts, have combined to set oil and gas producers up for health in a $50-plus West Texas Intermediate (WTI) world, according to the Seaport Global report.

In the Seaport universe, those having the highest free cash flow as a percentage of maintenance capex include Cabot Oil & Gas Corp. (NYSE: COG), Northern Oil & Gas Inc. (AMEX: NOG), Goodrich Petroleum Corp. (AMEX: GDP), Marathon Oil Corp. (NYSE: MRO), Lonestar Resources Inc. (NASDAQ: LONE), Anadarko Petroleum Corp. (NYSE: APC), Abraxas Petroleum Corp. (NASDAQ: AXAS), Concho Resources Inc. (NYSE: CXO), Continental Resources Inc. (NYSE: CLR) and Gulfport Energy Corp. (NASDAQ: GPOR).

By the firm’s other measure—top stocks on maintenance free cash flow yield on enterprise value, the companies include Goodrich, Abraxas, Northern Oil & Gas, Lonestar, Gulfport, Marathon, Cabot, Anadarko, HighPoint Resources Corp. (NYSE: HPR) and Whiting Petroleum Corp. (NYSE: WLL). Seaport Global notes that there are other companies that could join these groups but likely won’t due to “more aggressive development programs.”

This teeter-totter of achieving a balance of spending that allows free cash flow is top of mind with investors. A recent analyst note from Tudor, Pickering, Holt & Co. (TPH) said that demand concerns aside, “the rampant U.S. supply growth in 2018—TPH estimates oil up 1.75 million barrels per day (bbl/d) exit to exit, total liquids up 2.25 million bbl/d—needs to be reined in under most reasonable scenarios.”

For investors to structurally invest in the industry, the TPH analysts said U.S. oil production will likely need to be closer to 1 million bbl/d. “In our view, this means budgeting between $50-$55 WTI over the near, medium, and long term while flexing down activity .... and capping activity levels above $55 with excess cash flow siphoned off towards shareholder returns.”