E&Ps’ Siren Song to Investors: Free Cash Flow

FORT WORTH, Texas—Record market performance, billions of dollars’ worth of shareholder returns and consistent fiscal discipline are synthesizing into a siren’s song luring generalist investors back to the E&P space.

“This industry went through a 10-year period that we wouldn’t [have] put our own money into it if we look back on our performance,” said Al Carnrite, CEO of The Carnrite Group and managing director of Alvarez & Marsal.

That was during the early days of the so-called ‘shale gale’ when companies spent fast and loose with any cash on hand to and borrowed prodigiously to grow their footprint and their production. Returns were dismal. Shareholders called for returns quarter-after-quarter, but their demands fell on deaf ears.

Amid increasing sentiment on all things ESG-related, many investors gave up on the sector and took their cash elsewhere. Access to capital closed, and that’s when the C-suite at public E&Ps of all sizes took notice. Incrementally, companies started buying back shares and increasing distributions. A few, including Pioneer Natural Resources, Devon Energy and ConocoPhillips reintroduced a variable dividend to their shareholder returns strategy.

Now that sector is flush with free cash flow (FCF) and, in some quarters, returning most of it to their investors, the question is how open investors and the capital markets will be to E&Ps.  

“I think we're in an environment where it's only going to get better as far as attracting capital, whether that be private or public capital,” Carnrite told an audience last month at Hart Energy’s SUPER DUG presentation, ‘Big Bucks: The Money Panel.’

“But it's going to take time,” he said. “If I'm a long-term investor, I'm saying, ‘OK, are you going to keep that discipline?”

 ‘Super’ bull market

When oil prices increase, investment should, too, and that increases costs, said Muhammad Laghari, senior managing director at Guggenheim Securities.

“It’s a pretty simple equation,” he said.

But while oil prices increased–although they have stabilized this year–and costs based largely on inflation grew, E&P investment remains flat in recent years.

The sector’s capital spending is down roughly 33% from five years ago, said Tim Perry, managing director at Credit Suisse. U.S. producers have dropped their production guidance from double-digits to zero in some instances.

Meanwhile, demand dynamics around the world are in flux, he said.

Per capita demand in the U.S. has dropped from 27 bbl/person to 20 bbl as a desire to cut carbon has captured the interest of the general public, Perry said.

But in China, where the 1.43 billion population is quadruple that of the U.S., the opposite consumption trend is happening. Per capita oil consumption has increased from less than 1 bbl/person to 4 bbl/person.

If capital spending continues to diminish–or if it flattens–while the population in China, India and throughout Asia consumes more oil, the long-term supply/demand dynamic is likely to shift, Carnrite said.

“It’s not hard to draw a line that says we’re going to be at some kind of ‘super’ bull market for crude oil, absent a demand destruction event,” he said. “So I think we’re in an environment where supply is not going to be able to keep up.”

“It’s not hard to draw a line that says we’re going to be at some kind of ‘super’ bull market for crude oil, absent a demand destruction event.”
—Al Carnrite, CEO of The Carnrite Group and managing director of Alvarez & Marsal

‘Returns solve everything’

A key indicator of corporate spending is M&A, and deal flow this year is down 33% by value from last year, said David Deckelbaum, managing director at TD Cowen.

Instead, they are using blockbuster profits to shower shareholders with cash. The top Western oil companies paid out a record $110 billion in dividends and share repurchases to investors in 2022.

Between 2008 and 2009, the industry had a dismal track record as measured by the S&P 500, where it offered a 1% return while accounting for up to 13% of trading. FCF was generally in the red.

During the pandemic, the industry’s representation on the S&P fell to 2%, but has since rebounded to roughly 5%, Perry said.

At the same time, operators’ focus on FCF now puts the E&P sector at the top of the index, generating close to 20% compared to the total index’s 5%.

“It was the worst performing industry on the S&P 500 to [become] the best performing,” he said.

But E&P shares prices remain low, which makes buying back shares more affordable.

Deckelbaum said E&Ps have to decide whether they should buy the shares while they are cheap, further incentivizing investors, or make a deal to grow.

Meanwhile, the industry’s access to capital is finally loosening–to some extent, the panelists said.

"I don't think the capital markets are closed at all, but they're more expensive than they should be," Perry said.

Muhammad Laghari, senior managing director, Guggenheim Securities, said he is seeing new interest from private equity.

“We do expect quite a few folks to raise money,” he said.

Private equity funding will exceed the raises generated in recent years, Deckelbaum said. There may be fewer players, but some of them are newly interested in the space, such as family offices and international players. "The odds of getting the size (of fundraise) that you want are greater" than in recent years, he said.

Financial frameworks have changed, but the panelists said the E&P value proposition via record cash flow and blockbuster shareholder returns makes a strong case for investment by both private equity and public investors.

“I think it’s wide open,” Carnrite said. “But returns solve everything.”