By: Grant LacKamp
Over the last decade, no sector has under-performed the broader equity market as much as energy. External market factors and unpredictable oil prices have made things difficult, but the under-performance has more to do with capital allocation decisions. Oil company managers are making different decisions now, and the opportunity for a period of strong returns is ahead.
Oil prices have always been volatile. Oil crossed the $100/barrel threshold twice for an extended period in the last 20yrs. The first occurred leading into the Great Financial Crisis when it reached its all-time high of $145.29 in July 2008. The peak was short-lived as demand plummeted with the crises later that year, resulting in prices back in the $40 range by early 2009.
Triple-digit prices emerged again in 2011. The perfect storm of increasing demand from emerging markets, coupled with the Arab Spring and loss of supply from Libya and Egypt, drove prices higher. Oil hovered around the $100/barrel mark for most of the next four years. Meanwhile, new drilling techniques led to a dramatic increase in shale oil production in the United States. The result was a flood of domestic supply and a resumption of oil exports from the U.S. Prices crashed from more than $100 to less than $50 by Christmas of 2014.
An extended period of $100 oil should have led to exceptional returns for shareholders. It didn’t. During 2011-2014, exploration and production (E&P) companies redeployed operating cash flow back into capital expenditures to grow production further. Development budgets and expenses for new wells increased alongside operating cash flow. Returning capital to shareholders through dividends or share buybacks was a low priority. From 2012 through 2017, E&P companies spent more than 100% of cash flow on capital expenditures to develop new production sources, leaving little extra cash flow for shareholders.
Capital misallocation has been the problem for the energy sector over the last decade. The returns on new production didn’t pan out for the companies or their investors.
That is changing. We believe that we are now at the beginning of a long-term bull market trend forged by the COVID-19 pandemic. The stay-at-home orders of early 2020 preceded a decline of activity on roadways and in the sky, leading to a collapse in energy demand. Simultaneously, the largest oil producers, Russia and Saudi Arabia, engaged in a battle for market share by dumping increasing supply into an already saturated marketplace. It became so bad that front-month spot prices traded into negative territory. In other words, for a short time, there was so much excess oil that traders had to pay others to take it off their hands.
Conditions like this scared the daylights out of E&P operators, nearly bankrupting many. Companies who have experienced the power of OPEC realize they are at the mercy of global supply. Worldwide crude production is 8% lower than 2019 levels and US inventories are significantly lower than before the pandemic. Over the last two years, we’ve witnessed a shift in the mindset of management teams. President Biden’s negative position on oil in favor of renewable energy make it even harder for them to justify new spending to grow.
They reduced debt to restructure balance sheets. They reduced capital expenditures and cut expenses. Simply put, they plan to return cash flow to shareholders. The new priority is generating free cash flow (FCF), defined as operating earnings minus capital expenditures. As we look forward to 2022, FCF distributions to shareholders will be higher than the industry has ever seen in its history.
FCF yields are also at all-time highs. FCF yields are calculated as a percentage of Enterprise Value. We reviewed a group of thirteen E&P operators. In 2021, these companies will produce more than $40B in FCF. By 2022, these companies are projected to generate more than $50B in FCF.
Enterprise value (EV) is calculated as Equity Market Capitalization plus Total Debt less Cash. For these companies, EV is $450B, very near their peak at year-end 2013. The FCF yield for these companies is 11%. 11% is an average, with specific examples ranging from single digits up to 20%, underscoring the importance of picking the right companies. This cannot be replicated in today’s market environment.
Renewable energy and electric vehicles may earn the attention and are growing market share rapidly. But the need for oil will neither change immediately nor disappear over the next decade. The world still runs on oil. With an improved management mindset favoring returns to shareholders over additional production, shareholders can expect more competitive returns moving into 2022 and beyond.