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

So first, what happened?

The XOP, or S&P Oil & Gas Exploration & Production ETF, slumped by more than 20% in July-August, touching an all-time low on Aug. 27. As pointed out by Simmons Energy, just one of the so-called FANG stocks, Facebook, now has a market cap—$525 billion as of mid-August—larger than the entire E&P sector, from ConocoPhillips Co. at the high-end all the way down to micro-cap E&Ps.

Oh, and by the way, you could add in 90% of Chevron Corp.’s market cap, to top it off, added Simmons.

The sell-off leaves the energy components of the S&P at about 4.4%, down from 5.3% at the end of 2018.

In part, the downward rerating of energy reflects fears of a protracted period of trade tensions or a possible recession. Under these circumstances, “risk-off” or “haven assets” (U.S. Treasuries, gold) do better, while “risk-on” or “growth assets” (energy, copper) perform poorly.

But wasn’t the energy sector making progress toward meeting the market’s mantra of capital discipline and free-cash-flow (FCF) generation?

“E&Ps returned to capital discipline in the second quarter of 2019,” according to Bernstein’s report, “State of the E&P Business.” The report, in which Bernstein aggregated data from 54 E&Ps, showed the sector’s organic capex (ex-acquisitions) fell by 1.4% from the prior quarter, while cash flow from operations rose 27%. This resulted in E&Ps spending just 75% of cash flow (80% with acquisitions).

Second-quarter FCF followed a gain in the oil price realization of slightly over $5 per barrel (bbl) from the first quarter to just shy of $60/bbl, at $59.88. However, the natural gas price realization fell by 36 cents per thousand cubic feet (Mcf) to $2.56/Mcf, pulling down the blended rise in price to $2.54 per barrel of oil equivalent (boe).

In turn, the sector registered increases of 73 cents/boe in EBITDA and 47 cents/boe in net income.

With the marginal cost of oil at close to $60/bbl West Texas Intermediate (WTI), according to Bernstein, the E&P sector is capable of generating FCF. “The key then becomes to return enough of it to shareholders to (a) please them, and (b) not flood the market with production and push down price,” the report said. “That goal is within the reach of the sector.”

So what explains the ongoing deterioration of the sector—described by Bernstein as “more discipline,” but “worse multiples and sentiment”—as price-to-trailing cash-flow multiples fell to about 4 times?

The quarters ahead “look tougher,” with July through August prices of around $56/bbl for WTI and $2.30/Mcf for natural gas, noted the Bernstein report. However, projections of the rig count and frack spreads “suggest capex is down, so discipline should hold,” it said. “A potential test of the sector would be a commodity sell-off into the fall.”

In a second-quarter earnings review, Credit Suisse estimated that organic FCF for the sector (before dividends and ConocoPhillips) could reach $2 billion in 2019, similarly assuming a then prevailing WTI futures strip of $56/bbl. While up from “essentially zero” FCF in 2018, this nonetheless implied a “paltry median FCF yield of 2% for large-cap E&Ps,” observed Credit Suisse.

For 2020, with a WTI strip of about $52/bbl as of its report, Credit Suisse forecast the FCF yield would “fall to 1% for large caps … far off the S&P 500 yield of about 5.5% and highlighting the group really needs WTI of over $60/bbl to generate attractive free cash flow.” And even with lower capex, E&Ps are “limited as to how much they can cut spending given the high PDP decline rates in U.S. shale plays.”

Simmons similarly summed up the “sober realism” aired at its recent European conference, saying “durable investor sponsorship” of energy may remain “challenged.”

“Fifty-dollar oil prices might be high enough to allow companies to generate a small amount of FCF and deliver sub-2% dividend yields,” it said, “but that is not enticing enough for investors, especially with limited conviction on oil prices given recessionary worries and ongoing demand concerns.”

For E&Ps, the focus is on reducing costs, lowering FCF breakevens, bolstering balance sheets, lengthening liquidity runways and returning cash to investors through dividends and share buybacks, said Simmons. “The hope for a V-shaped recovery of cycles past has evaporated.”

Where’s the good news? “Oil markets may be overreacting to the bad news on demand, and seem to have lost focus on the constrained backdrop for supply,” said one source.

Not always right, could an oft-used observation—“It’s the darkest before the dawn”—be right?

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