In search of higher prices, shale oil producers have reined in upstream capex over the last couple of years. Before 2019 they were focused on ever-increasing incremental production growth, and often bragged about their year over year Compound Annual Growth Rate-CAGR, in investor publications. No more. The oil price crash of 2020, having led to near bankruptcy scenarios for some of them, has initiated a much more austere mindset in the boardrooms of many companies. Many are heavily laden with legacy debt from those free-wheeling days of…not very long ago.
Now, thanks to a doubling of oil prices since the first of the year, and sharply reduced Capital Expenditures-Capex, these companies are producing prodigious amounts of operating cash flow-OCF. Capex is now held to what the industry calls “Maintenance Capex.” Enough only to maintain production at levels only sufficient to replace natural field declines, or a low, single-digit growth rate. These companies are now focused on two things. The first is repairing their balance sheets by paying down debt. The second is attracting and retaining investors by rewarding them with a good chunk of the startling amount of excess cash they are generating.
Author’s research, company filings
As you can see in the table above, many of the companies listed are generating huge volumes of cash in excess of what’s required to support their current dividends. This gives rise to the potential for additional capital returns to shareholders in the coming quarters. This excess cash gives a measure of security to yield and income-seeking investors that these increasingly generous programs are funded internally without resort to debt or capital raises. It further insulates them from an investor’s worst fear, capital loss.
In this article, we will discuss how this return of capital is taking place and the relative under-valuation of the traditional energy sector as compared with other sectors.
Under-valuation in traditional energy companies
There are two primary vehicles for these companies to distribute this “wealth” to shareholders. One is through increased dividends, and the other is through advantageous stock repurchases. Many of the first group, in the lightly-gray shaded rows, have been giving increased dividends and share repurchases priority due to a feeling their common stock is undervalued by the market. They have reasons for this suspicion.
If you compare the valuations for the energy sector against the valuations other industries are receiving, there is a substantial disconnect between cash flow and the earnings multiples investors are willing to pay. Valuation methods can vary. Operations Cash Flow or OCF, is one I use frequently as it tells you how much cash the company’s business generated over a period of time. It also tells you about the company’s ability to continue meeting Capital Expenditures-Capex, on a regular basis without resorting to credit lines, or common shareholder diluting capital raises. It also tells you the amount of cash available to meet stockholder expectations of capital returns, or dividends and share repurchases.
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As an example let’s compare the cash generation between Occidental Petroleum, (NYSE: OXY) and NextEra Energy, (NYSE: NEE). One company produces oil and gas primarily, and the other participates in the “Green Energy” sector building windmill farms for electricity generation.
Author’s research/company filings
Investors in NextEra are looking past a mountain of debt to award the company a capitalization of $168 bn at the current share price of ~$85. Some of this is understandable given the figurative, “wind at the back,” of this industry. Windfarms could be the “tulip craze” of the modern era, and are endorsed and sanctioned by local, state, and the Federal government. However, if dividend security is analyzed using conventional metrics in the table above, investors in OXY should be sleeping much better at night, than those holding shares of NEE.
At some point, investors in NEE may have to come to grips with the fact that as attractive as this sector is socially, it is not generating returns sufficient to maintain generous dividends being offered.
Analysts are beginning to take note of the cash generation being seen in the American upstream oil industry. Scott Gruber of Citibank, (NYSE:CITI) recently put out a bullish note on OXY, citing the company’s cash flow yield of ~13% for 2022. His short-term estimate for the stock includes growth to ~$35 per share.
When all of this is considered you can understand why execs at OXY are anxious to finish their deleveraging over the next year. Vicki Hollub, CEO at OXY commented on the coming shift in capital allocation priorities once debt targets are insight-
“We have significantly de-risked our balance sheet with the successful completion of our recent debt tenders, and this marks the next stage of our deleveraging effort as we work to further reduce debt and to lower our breakeven.
While we still have work to do before transitioning to the next stage of our cash flow priorities, including returning additional capital to shareholders, we’re confident that the steps we have completed to date and the strong operational performance that we continue to deliver will accelerate our progress.”
OXY filings
Another company Devon Energy, (NYSE: DVN), has already begun returning capital to shareholders in the form of an innovative dividend policy and share repurchases. Jeff Ritenour, CFO of DVN commented in their recent analyst call about capital allocation-
“I would say the share repurchases is certainly moving up the list of options for us, potential options for us as we move through the back half of this year. We could absolutely supplement it with some incremental variable dividends and potentially some incremental share repurchases. I think the other thing we’ll look at as we get further into the year and probably into 2022 is the potential to increase the fixed dividend as well.”
DVN Company filings
DVN’s newly implemented dividend policy includes a modest regular dividend of $0.44 per share combined with a special dividend that constitutes a plan to return as much as 50% of excess cash to investors.
Your takeaway
Many factors have resulted in the under-valuation of the traditional energy sector. Fluctuating oil and gas prices have annihilated balance sheets in prior years. Now improved products prices have opened a window for these companies to repair-pay down debt, those balance sheets, and return capital to shareholders.
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At present this cash generation potential is under-appreciated by the market. We don’t think this will be the case for long, and investors looking for growth and income should consider if investing in traditional energy producers fits their risk profile. Attractive capital return plans and very shareholder-friendly management could set the table for a very rewarding long-term investment for shareholders in these companies.
It should be noted that these company’s fortunes are directly tied to oil and gas prices which are currently in an uptrend. This trend reverses rapidly and investors should factor this into their individual decisions.
By David Messler for Oilprice.com
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