Oil and Gas Investment Strategies: Probing the Buyside

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We know that 2020 was a firestorm, followed by a big rebound in oil and gas equities since then, with natural gas rising above $4. Fortunately, most executive teams are continuing to show spending discipline, even though commodity prices have recovered. All this begs the question: Have E&P equities finally become more investible?

It seems more optimism is in the air. When recapping results from the second-quarter reporting season this summer, Raymond James E&P analyst John Freeman expressed a positive outlook in his report: “The ‘shift’ in the E&P mindset has established some strong roots.”

He refers to the shift of public E&P companies toward meeting investor expectations by slowing spending or growth strategies, regardless of what oil and gas prices do, to focus on rate of return to shareholders.

Investor Art Smith, founder of Triple Double Advisors LLC after selling his research firm, John S. Herold Inc., in 2007, put it this way: “After the fire, there are some green shoots that pop up in the forest. You know the next cycle is coming, and it’s going to be a doozy.”

True enough, if you look at supply and demand dynamics, but the road to that outcome is always fraught with threats as well as opportunities. In a conversation with Smith, award-winning former energy analyst Tom Petrie, co-founder of Petrie Partners, said this: “Markets dish out humility with regularity.”

And how. The Fidelity Select Energy Portfolio mutual fund, formed in 1981 and now with $1.3 billion under management, has recorded a 10-year, annualized return of negative 2.08%, not exactly inspiring excitement or confidence in the sector. Year-to-date, though, it is up 21%. The fund holds 54 companies, with its top holdings at July 30 being Exxon Mobil Corp., Chevron Corp., Royal Dutch Shell Plc, Cheniere Energy Inc., Pioneer Natural Resources Co. and ConocoPhillips Co.

The biggest institutional investors, such as Fidelity, BlackRock Inc., State Street Corp. and The Vanguard Group Inc., tend to hold the same dozen or so large-cap names, companies that receive the most analyst coverage and pay dividends.

We note that the investor community has been talking about the same themes for at least four years now, with hope: focus on returns, not growth, and no more outspend. We found a report from April 2018 wherein Morgan Stanley analysts were saying capital discipline was being rewarded. At that time, E&Ps were already telling everyone they would not raise their capital budgets even if oil prices rose.

They are still singing that tune today in 2021. In addition, they are initiating or increasing dividends and stock buybacks, all in their quest to deliver higher returns than ever before—to become investible.

Analysts and the buysiders they serve note that if this conservative approach to drilling continues, the industry is setting up the next shortfall of supply and the rise in commodity prices, which should lead to outsize returns ahead.

“Reinvestment rates are shockingly low compared to history as companies remain committed to debt reduction and/or accelerating shareholder returns,” Freeman wrote. “E&Ps remain grossly undervalued compared to the rest of the market as companies search for ways to excite investors, most recently through dividend announcements.”

Grossly undervalued? That sounds like an opportunity waiting around the next bend. We asked a few buysiders or portfolio managers for their latest thinking. After all, the SPDR S&P Oil & Gas Exploration ETF (XOP) has had a great run lately, up about 40% through June.

So, how much does any of this shift matter to investors? KeyBanc Capital Markets studied the 13F filings of 200 top investment managers based on their assets under management and found that as of June 30, money has flowed the most into two industry sectors this year—tech and energy—but tech narrowly beat out energy. (Real estate names were the third most often bought.)

The top net bought stocks in energy were Bonanza Creek Energy Inc., Range Resources Corp., Cabot Oil & Gas Corp., Berry Petroleum Co. LLC, Comstock Resources Inc., SM Energy Co., Magnolia Oil & Gas Corp., PDC Energy Inc., Centennial Resource Development Inc. and Murphy Oil Corp. The top institutional holders of these stocks almost always include the same aforementioned Big Four: Fidelity, Vanguard, State Street and BlackRock.

The energy stocks sold the most, net-net, were some that have seen a good run: EOG Resources Inc., Denbury Inc., Apache Corp., ConocoPhillips and Cimarex Energy Co.

The new paradigm

The new commitment to delivering returns and maintaining capital discipline seems to be having a reassuring effect, most buysiders said.

“Across the board you see management teams mentioning they are doing things to align with shareholders. These parts of the investment narrative are welcome and appreciated,” said Ben Cook, who co-manages two BP Capital Funds (successors to the old T. Boone Pickens energy hedge funds). He joined BP Capital Advisors in 2017 after a career that involved stints at a family office and a hedge fund, but he started as an analyst at Raymond James in 1998.

He told Oil and Gas Investor that when he started his career, oil was only $10/bbl, and Chesapeake Energy Corp.’s stock was a dollar.

“I’ve seen the ups and downs and seen people come and go. While it’s debatable where hydrocarbons are going to end up, there’s still a lot of opportunity for these companies to regain favor,” Cook said. “Yes, with ESG and all, there’s a risk premium being built in, and how the market deals with that is going to be challenging.

“But I think the appeal of many upstream companies has improved dramatically in recent years. Alignment with shareholders is probably as good as I’ve seen it in my career.”

BP Capital no longer manages its hedge funds and instead serves as a sub-advisor to two energy mutual funds majority owned by Hennessy Fund Advisors in California. The Hennessy BP Energy Transition Fund, started in 2013, is mostly invested in upstream names with the rest in midstream with some in oilfield services, although it can invest across the energy value chain, including renewables. The top five holdings as of June 30 were EOG Resources, Diamondback Energy Inc., PDC Energy, Comstock Resources and ConocoPhillips.

Like many buysiders, Cook strongly believes in the play in natural gas and LNG themes as the world transitions to something else longer term. “Depending on your time frame, depending on your assumptions, the energy transition is not going to happen overnight, so there will be prolonged dependence on traditional energy, especially in developing countries. We’ll see natural gas grow alongside renewables.”

Favorites moving up on his list also include Pioneer Natural Resources, based on the strength of its assets and the management team, especially CEO Scott Sheffield, and natural gas names such as Comstock Resources and Cheniere Energy that will benefit from the call for gas for LNG export and to replace coal.

What factors contribute most to Cook’s investing decisions? This remains a people business, so knowing and trusting the CEO or company president for years makes a difference.

“I’ve known Jay Allison and Roland Burns for years [chairman, CEO and president of Comstock respectively]. They’ve made it through some tough times. At their forecasted rate of production growth, we think the equity could be worth as much as $9 a share, yet it’s trading around $5.

“And I’ve known Scott for a long time. This is a company that combines all the favorable attributes we look for. And I think he’s doing the right thing on addressing the ESG issues.

“But first and foremost, a stock has to have a justifiable valuation, and we assess the upside and downside risks based on commodity prices. The NAV [net asset value] on a risk-adjusted case gives us confidence. We look at discounted cash flow and valuation on a historical basis and versus a company’s peers.”

A BP Capital alum, Billy Bailey grew up in an entrepreneurial family and, having dreams of his own, left a senior position at Boone Pickens’ firm in 2016 to launch his own company, Saltstone Capital Management LLC, in Dallas.

The firm manages a long-short hedge fund but given the opportunities he sees today, Saltstone is net long, Bailey said. He invests in the full energy value chain, from oil and gas to oilfield services, to wind, solar, batteries and renewable gas, believing the energy transition is here to stay, is needed and offers plenty of opportunities. He looks at all market cap sizes and is not opposed to investing in small-cap names. He noted that over 10 years ago while at BP Capital, he visited the largest landfill in the Dallas area in order to analyze gas well drilling there, and now he’s come full circle, looking at similar opportunities today in renewable gas. He recently invested in the Rice brothers’ renewable special purpose acquisition company, for example.

Just as E&Ps have entered the time in their life cycle where they must pay more to their investors, so too will energy transition companies soon be doing the same. “I couldn’t be more excited because now it’s time to return cash to shareholders,” he said.

“But to invest, you have to ask yourself what level of free cash flow yield you need to be able to underwrite before you purchase a specific stock. The single largest variable is the commodity price; the largest headwind is the coronavirus’ effect on demand and the economy, but this too shall pass.

“The opportunity set right now in the near term is vast.”

His current favorites are companies with discipline that ensure that management rewards stem from meeting the same metrics that shareholders will receive. He likes Marathon Oil Corp., Devon Energy Corp. and Occidental Petroleum Corp. He also has invested in some oilfield service names.

Really investible

Another buysider, Josh Young, who runs Bison Interests in Houston, would agree that E&Ps are looking attractive these days.

“ESG, dividends, returns, all these things we’ve been talking about are making the sector really investible, especially when [the stocks] were being sold for almost religious reasons and not for the fundamentals. It’s offering a great opportunity for value investment in some overlooked stocks that are not covered by analysts.”

He noted that although the XOP was up about 40% through June, he thinks there’s more room to outperform by carefully selecting certain E&P stocks and to do so without shorting them or without leverage. Bloomberg recently reported his return year-to-date exceeded 200%, but he would not confirm that and declined to reveal the amount of assets under management. Bison is a private fund invested in public energy equities on both sides of the U.S.-Canada border. He favors a mix, having found opportunities in each country.

The less attention analysts pay to the sector, the less research coverage it gets, the better the overlooked opportunities are, Young said. “There are some really good opportunities out there. Yes, a lot of that is driven by the recovery of the stocks since COVID last year, but a lot of the opportunity is because people are so negatively biased against the industry.

“I do look at the large caps, but so many analysts follow them, so the opportunities in the small-mid-cap range are what I focus on. These are apt to be the overlooked ideas.” He is invested in about 15 E&Ps at this time.

Being climate competent

The buysiders we spoke with agree that financial matters and valuation matter. Liking the management team, especially the CEO and CFO, may matter even more in the decision to buy or sell. But the topics of returns and ESG policy have gained a lot of attention during the past two years.

Some 83% of public E&Ps have implemented some kind of ESG policy, according to a survey of second-quarter results by law firm Haynes and Boone LLP and EnerCom. “With significantly higher levels of investor scrutiny, companies that ignore ESG are becoming a less desirable investment,” the firms said recently.

However, even though a company institutes or raises its dividend, that isn’t necessarily an automatic Buy signal. For example, analyst Mark Lear of Piper Sandler wrote that Berry Petroleum Co. raised its dividend recently by 50% for an annualized 4% dividend yield, the highest in his coverage universe, but Lear maintained a Neutral rating on the stock and even lowered his price target slightly, based on the company’s second-quarter results and outlook. So, traditional fundamentals still matter.

What about the chilling day in May when activists and a Dutch court pummeled Exxon Mobil, Chevron and Shell about their ESG performance, climate risk and overall profitability? What effect will we see from the dire predictions leveled by the Intergovernmental Panel on Climate Change (IPCC) in August? Does the IPCC report squash all further interest in oil and gas exploration and production themes?

“We expect boards to be climate competent,” said Vanguard in a stern letter to the Exxon Mobil board. Vanguard supported the activist Engine No. 1’s claims and new board members elected as a result. “Particularly for companies where climate change is a material risk to the business, we expect boards to reflect the necessary skill set to independently oversee a company’s risk and strategy related to the energy transition.”

If anyone should care about Exxon Mobil’s performance—and future risk—it’s Vanguard, the company’s largest shareholder at the end of the second quarter, owning 8.34% of the shares outstanding, which were worth more than $22 billion.

Woo the generalists

Yes, a defensive posture means holding the equities of the majors. Does that mean most other E&Ps are still destined to remain wallflowers at the investing dance? Investors playing defense against inflation still favor the majors, followed by large-cap indies such as Pioneer Natural Resources.

For some time, Pioneer has remained one of the more popular, investible E&P companies for portfolio managers. The stock is owned by many of the largest, most savvy institutions, including Vanguard and BlackRock. The latter two own the most, a combined 40.5 million shares worth about $6.5 billion (data as of March 31). Checking recently on Yahoo Finance, among sell-side analysts who follow Pioneer, 11 had Strong Buys on the stock and 24 had a Buy.

Pioneer’s Scott Sheffield, a frequent spokesman for the industry, is well-regarded in investor circles and, importantly, is not afraid to speak his mind. One can safely assume buysiders take his call—and he takes theirs. But all is not so rosy. Sheffield had this to say about the institutional investor mindset these days, when speaking to the Houston Producers Forum in mid-August: “I said before during the downturn that there would probably be only four or five, six companies [left to invest in]. I got quoted on that all across the U.S. and the world.

“And what I was trying to point out is, when you talk to these PMs [portfolio managers] as a public company, they’ve always told me, if they’re going to get into fossil fuels, they’re only going to buy about two companies. They’re not going to go all the way and buy 10 or 15 like they used to,” Sheffield said.

“Energy PMs that I know today are all going into alternative energy. There are no more energy shops in most of these firms, whether that’s Fidelity, Wellington or J.P. Morgan Asset Management. They have no more fossil fuels.

“And so, you have to convince the generalists. For the new group, there’s a lot of money in dividend value funds. We have to go over to the dividend value funds.”

The company recently accelerated its first variable dividend payout from next year to later this year. Tudor, Pickering, Holt & Co. said this has helped investor sentiment, and it sees the variable plus fixed dividend providing an aggregate yield of 10% in 2020.

The next irresistible thing

During the sector’s second-quarter conference calls, similar themes emerged as CEOs spoke of what they aim to become, to keep and attract the picky buyside.

Stephens Inc. analyst and banker Jim Wicklund likened trying to attract the market to gambling. “After some of the recent consolidation values and so few Permian players left of scale to consolidate, lots of companies are trying to quickly become the next irresistible thing in the market. It is a bet that goes higher up the risk curve, and the biggest risk is market timing and preference. But then, we are an industry of gamblers.”

Many company managements continue to pledge that they will not increase production much or at all. They will wait for global market signals to indicate that oil demand is at least back to 2019 levels, and crude inventories are manageable, not spilling over. In the meantime, the focus remains on financial performance.

Marathon Oil said its goal is to return 40% of operating cash flow to investors and pay down debt as well. Devon Energy is paying investors through its fixed and variable dividend, but it is returning capital after making capital investments.

Subash Chandra of Northland Capital Markets said this in a research note: “Marathon is the ‘cleanest’ return-of-capital case yet. Devon is the nearest comp, in our view, but their ROC [return of capital] calculation is after capital investment.”

Other analysts noted similar improvements in E&P performance regarding returns to investors, although they observe continued skepticism from those investors as well.

“Return of capital to shareholders is accelerating with more attractive frameworks unveiled; however, the market appears skeptical of this cyclical industry based on stock performance,” wrote Gabriele Sorbara, analyst for Siebert Williams Shank & Co., after the second-quarter results.

“We may need a few quarters of execution on the variable dividend front for investors to become believers that the models are sustainable. Buybacks are becoming more compelling for some companies given stock valuations,” Sorbara said.

The catch-up trade

“E&P returns year-to-date are not particularly correlated to return-of-capital or FCF [free cash flow] yields. Perhaps that will change in 2022 when checks are actually cashed, as cash flows are unencumbered by costly hedges and inflation is mostly in-check,” he said.

After the rush of the second-quarter reporting season was done, the E&P mantra heard through the upstream jungle was loud and clear: “Our earnings beat, we will raise our dividend, net debt is falling and we cut spending.”

Morgan Stanley analyst Devin McDermott also noted the improved E&P results, yet he believes the equities have more room to run. “Now, capital discipline, rising shareholder returns and another solid earnings season have helped E&Ps outperform crude oil. That said, the sector has still lagged the commodity by about 20% since the beginning of 2020, creating room for a further catch-up trade. With 2Q [second-quarter] earnings nearly finished, oil-weighted E&Ps have beat consensus on EBITDAX by 10% and CFPS (cash flow per share) by 9% on average.”

So, when does the catch-up trade begin in full force? Alas, although some big investor groups such as Fidelity reportedly no longer have energy teams, they’ll hold onto a couple majors and a couple large-caps and call it a day.

One may have to look at the true meaning of investment, as Jim Murchie always has. The co-founder in 2003 of the $4.5 billion Energy Income Partners made this distinction: “To me, the upstream business is a lot more attractive today as a trade than at any time in the last 25 years, but it will never be a long-term investment, by my definition.

“There’s trading, and there’s investing. To me, an investment grows its earnings per share over time, and it pays something back to the investor. I need to see per-share earnings growth.”

With these criteria in mind, Murchie is one of the largest investors in the so-called midstream sector. He focuses on non-cyclical infrastructure themes: poles, wires, pipes and tanks, as he says. He looks for quality, not deep value, with competitive returns over the long term in cost-plus, regulated or monopoly-like businesses. Enterprise Products Partners is his largest pipeline holding; Magellan Midstream Partners the second. His funds are the fourth-largest holder of NextEra Energy Partners, which owns Florida Power & Light.

Why not oil and gas companies? He calls the upstream “a lousy investment” as he sees declining revenues in a highly variable industry, with poor capital discipline and outsize executive compensation that is not tied to shareholder returns, he said. “For 25 years the capital allocation in this industry has been horrible. But now they’re getting religion again and ESG-oriented investors are leaning on them.

“They have always been brilliant technically, and the shale revolution has been extraordinary. They have saved the American consumer billions of dollars. But the shareholders have not made money. There is no financial metric you can look at that is positive,” he said.

Indeed, since 2014, the upstream industry has grown production by 7% and lowered costs by 40%, noted Evercore ISI analyst James West in a presentation last January. But that track record is not sustainable because the operating margins of oilfield service companies have fallen by a similar magnitude, he said.

Murchie’s No. 1 criteria for pulling the trigger to buy an equity? “The people who run the company.”

Obviously, he said, he looks at the numbers, the margins, the long-term contracts a pipeline has, whether discipline is in effect on capital spending and whether growth is occurring.

“But all the other metrics come down to the people.”