After more than a decade of excessive spending to grow oil and natural gas production, onshore exploration and production (E&P) companies in 2018 are expected to focus on drilling the sweet spots and continuing operational efficiencies to deliver on promises to exercise more capital discipline and generate positive returns for investors.
While E&Ps have provided similar lip service before, analysts appear relatively confident this time is different as producers are feeling the pressure from shareholders to get capital expenditures (capex) under control as uncertainty continues about the direction of commodity prices.
When oil prices were in the $75-90/bbl band until late 2014, E&Ps generated more cash and could more easily fund deficits, RBC Capital Markets Analyst Scott Hanold told NGI’s Shale Daily. Oil traded in a $45-50 band for a good part of last year, and even though prices are pushing above $60, there is a lack of clarity over their direction.
“Most companies will likely budget oil in the $50-55 range because they are very cognizant of the backwardation in the futures curve,” Hanold said.
Excessive spending by large-cap E&Ps came as companies made the switch from seeking natural gas to seeking oil reserves, said Societe Generale’s John Herrlin, head of oil and gas equity research. Over the last seven to eight years, many E&Ps were buying up tracts of land that in many cases needed to be drilled to hold by production (HBP). In addition, many sold a large portion of their U.S. natural gas reserves.
“The combination of declining natural gas cash flows and oil-oriented expenditures overall, inclusive of acquisitions, caused all the E&P cap groups to materially outspend their production cash flow,” Herrlin said. Furthermore, because the oilfield services technologies for unconventional drilling are agnostic, small- and mid-cap E&Ps outspent their operating cash flows.
“Why? They sold technology/production growth stories, and there weren’t that many initial public offerings of growth-oriented companies,” Herrlin said. “As long as the oil and gas stocks worked, investors didn’t complain about deficit spending for growth. And they rationalized high-priced shale acquisitions as value confirmation of existing holdings.”
Raymond James & Associates analysts agreed that capital discipline hasn’t always been a priority for the market and its investors. The land grab years required years of HBP drilling ahead of lease expirations, and included constant experimenting with countless different drilling and completion (D&C) techniques as horizontal development took hold.
“Combined with management teams that never prioritized a returns-focused approach and had access to cheap debt, it is not hard to see why capital discipline was not top of mind,” said Raymond James analysts. “Even more importantly, while investors may have complained over the years about capital discipline, the market clearly rewarded the outspend approach.”
Now that the great land grab essentially is over and commodity prices are fairly stagnant, the preacher is singing a different tune. E&Ps recognize the need to get their capex into balance and provide positive returns to their investors.
“One must admit there is a certain amount of hypocrisy in the new-found capital discipline,” Herrlin said. “Investors didn’t complain when stocks rose.”
Matching Returns To Compensation
A handful of E&Ps announced their 2018 capex plans in late 2017, and early indications are that U.S. onshore companies will increase their spending by 15% year/year. U.S.-based producers that already have set 2018 tentative budgets include supermajor Chevron Corp., super independents ConocoPhillips and Anadarko Petroleum Corp., as well as onshore-focused Cabot Oil & Gas Corp., CNX Resources Corp., Encana Corp., EQT Corp., Extraction Oil & Gas Inc. and Goodrich Petroleum Corp.
Investors are no doubt eagerly awaiting the avalanche of fourth quarter results and the 2018 outlook that will follow in the weeks ahead. But while investors want to know how much companies plan to spend this year, they also want to know how they are changing their short- and long-term compensation programs to incorporate more return-focused metrics, according to NGI’s Patrick Rau, director of Strategy and Research.
For companies like Devon Energy Corp., the shift in focus to capital discipline and shareholder returns means compensation will likely take the shape of some sort of debt-adjusted per share metric, which the company has said is the most highly correlated with equity returns in the oil and gas space. Marathon Oil Corp. and Anadarko executives have expressed similar sentiments.
In the 3Q2017 earnings call with investors, Devon CFO Jeff Ritenour said two different growth metrics would be considered for 2018. One metric is return on capital employed (ROCE), given the transparency and ease of calculation to those metrics directly off financial statements. The other metric, return on invested capital (ROIC), would incorporate all capital, “not just drilling capital, but all capital split by the company in any given year and then the future cash flow obviously that’s going to be generated from that capital spend,” he said.
ROIC is the better metric, but it’s more difficult to provide the level of transparency investors would like to see, Ritenour said.
ROCE and ROIC metrics each improve upon the often quoted mid-cycle internal rate of return calculations that only focus on D&C costs by incorporating full-cycle costs, Rau said. They each attempt to measure company returns based on the amount of invested capital, but there are subtle differences between the two, he explained. Calculating ROCE is more straightforward as it requires a series of “quirky” adjustments to include only cash taxes that a company paid. But Rau said those adjustments are vital.
“Each is a valid measurement, but I strongly believe Wall Street will gravitate more toward ROIC, especially for those who have been through the Chartered Financial Analyst (CFA) program,” said Rau, himself a CFA.
Meanwhile, even as E&Ps outline their compensation directive, investors will continue to scrutinize what success actually means, Hanold said. “It has to be defined the same way for every company.”
U.S. tax law changes haven’t been discussed either, but could further affect remuneration, Herrlin said.
Raymond James analysts said the transition in how investors value E&Ps won’t happen overnight but will likely evolve over several years. In addition, the market has to see evidence of E&Ps executing on a successful strategy before the group is valued through a different prism.
Capital ‘Discipline’ Defined Differently
Evercore ISI analysts said the debate continues around the optimal long-term rate of growth to maximize cash flows and returns. Differences in company life-cycle stage, development opportunities and cost of capital mean there is not a one-size fits all solution, analysts said in a note to clients in December.
Indeed, some smaller, faster-growing companies in the earlier stages of their life cycles will likely continue to outspend as they prove up their reserve base. RSP Permian Inc. CEO Steven Gray told analysts during the 3Q2017 earnings call that he’s never been one to buy into the theory that everyone has to drill within cash flow.
“I mean, if you're using leverage to leverage your equity returns, I don't think that's a sin,” he said. “And so, as long as your leverage is at the appropriate level, I don't really get this, ‘you can't spend more than your cash flow.’ For a small growth company like us, I don't see that there's going to be an absolute guarantee that we'll only spend within cash flow, that we'll get our leverage back down where we want it.”
Likewise, for companies that have pledged to spend within cash flow, they undoubtedly will employ a host of tools to improve their balance sheets. Many will focus on high-grading their base assets to focus on the most productive and profitable acreage, thereby boosting their production numbers while at the same time reducing the number of new wells and expenditures.
“It’s really easy for an operator with many years of drilling left to go to focus on hi-grading, since it doesn’t have to worry about replacing its reserves right away,” Rau said. “They aren’t in immediate danger of having their finite reserves whittle down to zero.”
Other producers with lower reserves may have to spend more, everything else being equal, to keep up their reserves, he added.
Herrlin cautioned that while producers may focus on their sweet spots, “as they move to less prospective acreage, and if there aren’t further changes in well completion designs, costs will rise.”
But the fears of runaway service cost inflation of a year ago have largely abated, which supports allocating capital toward short-cycle unconventional projects, according to Evercore.
In addition to focusing on core assets to rein in spending, some E&Ps may continue to sell off noncore assets to generate additional cash flow. Linn Energy Inc., a former onshore heavyweight, has sold off big chunks of the portfolio to concentrate its efforts in the Midcontinent.
Likewise, SM Energy Co. plans to sell nearly all of its Powder River Basin properties to improve the bottom line and lend support for activity in Texas within the Permian Basin and the Eagle Ford Shale. Last month, Ultra Petroleum Corp., an early Marcellus Shale entrant, divested its last assets in the play to focus its efforts elsewhere.
Other ways E&Ps may enhance shareholder value are through share buybacks, lowering working capital requirements by outsourcing, bulking up midstream efforts to reduce transportation costs, refinancing debt to delay maturities and spending less on test projects, analysts said.
“When oil prices were a lot higher, there was more money that could go to discretionary projects,” Hanold said. “In this new time period, with more cash flow due to discipline, the focus for free cash flow will be on returning money to shareholders.”
And with public companies less likely to consolidate acreage as they did in the Permian land rush over the last couple of years, expect E&Ps sponsored by private equity (PE) to continue to be incubators for less mature plays, he added.
For example, in December, FourPoint Energy LLC completed an Anadarko Basin purchase with more funding from PE giant Quantum Energy Partners. ATX Energy Partners,a successor to Brigham Resources, last month secured funding from Warburg Pincus, Yorktown Partners and Pine Brook to pursue resources in the Permian and Williston basins.
A recent analysis by 1Derrick showed that 15 of the 20 largest U.S. oil and natural gas deals last year were financed by private funding, which also committed more than $11 billion to 63 new energy ventures.
And despite a pullback in deals for the second half of 2017, 1Derrick said stronger industry fundamentals and an analysis of U.S. PE investment and private merger/acquisition trends may suggest “another round of dealmaking and consolidation is on the horizon.”
However, Hanold doesn’t expect “a lot of consolidation” will take place anytime soon. “Maybe at some point in the future, but because companies are becoming more disciplined, mergers and acquisitions won’t be the first avenue for cash flow. It will be more likely later on due to maturation.”
Will Thriftiness Pay Off?
After more than a decade of producing at all cost, is being financially prudent good for the industry and if so, will it last?
“There is a definitely a vibrant debate in regards to how long discipline sticks in the face of higher oil prices,” said Evercore’s Stephen Richardson, senior managing director. “History would suggest not long.” However, with most companies dealing with a known resource opportunity, a modestly higher cost of capital could reinforce more discipline, he said.
Herrlin shared that view, saying one of the reasons that deficit spending has been so high is that the cost of capital has been low, and it occurred at a time in which companies could also access public or PE markets since they were targeting source rocks.
“The issue wasn’t so much identification as in the conventional era, but economic conversion,” he said.
Raymond James analysts added that in the early unconventional development days, the trade-off for quickly de-risking the asset base was the need to “feed the beast” by outspending cash flow, resulting in a large negative cash flow yield.
“In an unstable price environment, this causes severe disruptions as operators are unable to reduce drilling activity quickly enough to respond to price shocks and must access the capital markets at very inopportune moments,” Raymond James analysts said.
As a result, the risk of severe commodity price swings shifts the balance in favor of a disciplined capital approach. In the real world, which is fraught with both macro and company-specific uncertainty, increased capital discipline not only improves line of sight into future cash flow generation and returns (i.e., rewarded with higher multiple), but can also result in a more attractive net asset value.
E&Ps that are bottom-line oriented would be a positive for the industry, but companies continue to move toward harvesting resources through more efficient multi-well pads. That means production growth may be lumpier than when they were in HBP-only mode, Herrlin said.
Thankfully, capital discipline has the added benefit of allowing many E&Ps to back off the multi-year volume growth expectations that were set in 2H2016 across the industry group, Evercore analysts said.
According to Evercore, the market in many instances already is discounting a below longer-term production compound annual growth rate, “and the bar will be if capital efficiency is indeed improved versus previous expectations,” the Evercore team noted.
Evercore’s model assumes a 15% increase in D&C costs in 2018, and for 2019, it is assuming another 10% increase.
Already there are indications of higher D&C costs in the Permian’s Delaware sub-basin specifically, Richardson said, “which suggests that some of the excess cash flow that investors are expecting from a more disciplined industry ends up being absorbed by the service industry.”
Regardless, Hanold said the time has come for the industry to shift to “not one of growth, but one that can deliver returns.”
That’s easier said than done. Managers do the best they can in a volatile business, which has production decline curves and oilfield services/credit default swap pricing, which also is volatile, Herrlin said.
“Investors and analysts always have 20-20 hindsight view, but it is very difficult to balance production growth with returns when commodity prices collapse,” he said.
To make things even more complex, when production cycle times shrink and more companies are doing the same thing operationally, production moves to market more quickly and is disruptive.
“Many believe that companies should be fully hedged, but the futures market doesn’t go out more than 18 months in terms of actual liquidity,” Herrlin said.
Still, it appears most of the industry is on the same page as far as reining in spending and delivering positive returns to shareholders, said Hanold. “There will be some companies that don’t behave the way investors want them to. But overall, there is far more participation in the more disciplined approach to growing business.”