Energy is a commodity business, and it comes as no surprise that significant attention tends to be focused on the level and direction of commodities when evaluating the sector. Metrics like multiples—or, more precisely, comparative multiples versus other market sectors—rise much less frequently to a level that warrants discussion.

But this may be changing as the energy sector continues its transition away from exploration toward what is increasingly viewed as “manufacturing.”

Noting the shift to “manufacturing mode,” a Robert Baird research report says the energy sector “is finally on the verge of harvesting the fruits” of its investments in land, infrastructure build-outs and— the experience of the past several years—in marching up the learning curve in unconventional plays. And in the most economic plays, E&P stocks should be rewarded as they approach or achieve free cash flow and ramp up organic growth rates.

“A better understanding of the sustainability of growth and the magnitude of margins possible in pure manufacturing mode, coupled with a diminished need for outside capital, should over time drive best-in-class E&Ps to trade at multiples beyond their historic ranges,” the report says.

At Wells Fargo, the transition to manufacturing is expected to “dominate the headlines” this year, according to its energy research team led by senior analyst David Tameron. The team notes several key factors expected to support “hydrocarbon manufacturing.” These include optimal field development as well as further efficiency gains on the drilling and completion (D&C) side.

On field development optimization, a shift is likely away from downspacing aimed simply at raising the well location count and instead toward maximizing a field's net present value (NPV).The report says operators are likely to wait longer for more production history before implementing a firm development plan and quotes Lynn Peterson, Kodiak Oil & Gas CEO: “You only get one shot at development.”

As for efficiency gains, data cited from Laredo Petroleum show how pad drilling can place four wells on production some 41 days faster than if four individual wells are drilled.This can result in savings of more than $800,000, or more than $200,000 per well, albeit with significantly increased time to first production, resulting in a lumpier production profile. All else being equal, this will improve NPV per well.

The third, more subjective, factor addresses sector valuation. Energy's steady shift “to a less risky manufacturing stage” could eventually lead to at least some expansion of trading multiples, even as net asset value (NAV) and resource potential continue to drive share price.

Using a multiple of enterprise value (EV) to earnings before interest, tax, depreciation and amortization (EBITDA), the E&P sector's multiple on forward EBITDA has remained roughly unchanged, missing out on the expansion enjoyed by industrial stocks, says the Wells Fargo report. As a result, E&Ps currently trade at a 5.2x multiple, or just 56% of the industrials' 9.3x multiple. A return to an historical average ratio of 69% would bring E&Ps up to 6.5x. Moreover, if a shift to manufacturing mode were to remove one-third of the historical discount, the E&P group multiple would move up to 7.4x, the analysts note.

“This is largely guesswork, as we are not sure how much of the discount the market would be willing to remove, nor do we have a true way to quantify it until the market speaks. But when we think about a lower reinvestment-risk development world, focused more on cost structure, efficiencies, and maximizing NPVs and returns, we believe that argues for eliminating some of the discount,” according to the report.

But does the new opportunity set necessarily augur a more conservative energy sector, building its financial strength as manufacturing mode helps generate cash flow in excess of capex?

This raises a basic question, the Wells Fargo team says. Is there such a thing as free cash flow in the E&P sector? Traditionally, the mindset of managements—facing a naturally depleting asset base—has been that “if they are not growing, they are shrinking.”

E&P managements tend to still be “wildcatters at heart,” according to Wells Fargo. The analysts expect E&Ps to continue to reinvest capital and accelerate and ramp production. "When faced with excess cash flow in prior cycles, E&P management teams have had a history of stepping up the risk curve.”

Will they again?

It's a new world in E&P, but old habits die hard for some.

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