The Golden Age of Oil and Gas Producers

Summary

• Rising global demand for oil and a gradual green transition mean we may be in the early stages of the next oil and gas supercycle.
• Energy equities are undervalued despite the ongoing rally, so substantial upside to oil and gas equities may exist.

Introduction

Business has never been better for oil and gas producers. Profits are booming, commodity prices are rising, and growth at any cost has shifted to investor-friendly debt paydown, share repurchases, and dividend increases.

It does not hurt that the fundamental outlook for oil and gas remains strong. The confluence of uneconomic ESG mandates (which are reducing investment and future supply), years of underinvestment in oilfield services, and low oil and DUC inventories has led to structural supply deficits that may take years to resolve. With rising global demand and a green transition that will take decades to achieve, we may be in the early stages of the next supercycle for oil and gas producers.

Prices Are Attractive Despite Recent Rally

Improving fundamentals have renewed interest in oil and gas equities, and share prices are rising in a sector once left for dead. Yet even with recent outperformance versus the market, oil and gas investments remain extraordinarily attractive. Share prices remain lower than the last time oil and gas prices were at current levels, with potential for significant catch-up to broader market performance. Even as West Texas Intermediate oil prices have rallied back to early 2014 levels, XOP, an ETF that holds oil and gas producers, is still down 72%.

Consistent with this longer-term share performance lag, oil and gas equity valuations have become cheaper as increases in share prices have been eclipsed by even larger increases in profits and cash flow. Rising commodity prices have undeniably been a tailwind for E&Ps. Yet their business models and balance sheets have improved markedly since the last cycle high. This is the product of surviving through a challenging financial and operating environment, while shifting focus away from growth at any cost. As such, cashflows for E&Ps have increased materially from 2014, a time with a similar oil price.

Oil and gas producers are more profitable, per share, than the last time oil prices were this high. These numbers likely indicate broader sector-level cash flow improvements. It is the golden age for oil and gas producers.

Key Changes Led to Improved Profitability for E&Ps

Since commodity prices were roughly the same in 2014 and 2021, differences in profitability may be attributable to fundamental improvements. Structural costs have reduced substantially, and capital efficiency has improved despite services-cost inflation.

Capital is being redirected from 2014-style growth-at-any-cost budgets to 2022-style shareholder returns via debt paydown, buybacks and dividends. And for Canadian companies, the weak local currency is accentuating these factors. These drivers of higher cash flow are discussed below.

Structural Reduction in Costs from Previous Cycle Highs

Higher oil prices have bolstered E&P cashflows. But flows have also benefitted from structural fixed-cost reductions over the years since the 2014 oil price crash. Examples of these include headcount reductions for administrative roles and the integration of new technologies such as remote monitoring, AI facilitated forecasting and budgeting.

Now with leaner cost structures, these businesses are more resilient against another oil price downturn. Meanwhile, they generate more cash flow at higher oil and gas prices.

Capital Efficiency Is Higher

E&P cashflows are also benefitting from increased capital efficiency. Current cycle investment is substantially lower, and associated declines in production have been muted.

Unlike the deluge of capital spending in the years leading up to the 2014 crash, E&Ps are remaining disciplined as prices rise. Higher commodity prices encourage more investment. But E&Ps have remained focused on minimizing expenditures to return capital to shareholders via buybacks and dividends. Consequently, E&P capital efficiency has improved markedly.

Also, despite lower spending, production has not declined meaningfully. That suggests E&Ps are doing better at allocating scarce capital to higher-return projects, while also benefitting from prior investment. And capital expenditure restraint, particularly for new drilling, is self-reinforcing: lower investment today reduces future supply, which perpetuates higher prices.

ESG Difficulties

Historically, institutions would pile into high-cash-flow-yielding oil and gas equities. And they would do so particularly during inflationary periods where the broader market appears to be rolling over.

However, self-imposed ESG mandates have driven many institutions and asset allocators—who would had been the largest investors in this sector—to reduce investments in oil and gas. Meanwhile, some have banned oil and gas investments altogether and/or are actively divesting.

The priorities of institutions and their fiduciaries appear to have shifted away from profit maximization as they continue to sell off their best-performing investments. That has driven down oil and gas equity valuations to historic lows.

The Bottom Line

Despite the ongoing rally in energy equities, they remain meaningfully undervalued. And investor interest remains comparatively low to previous cycle highs. As such, there may be substantial upside to oil equities, even if they were only to revert to their mean composition percentage of the index.

As oil and gas equity cashflows become too costly to ignore and investors begin to re-prioritize returns over moral posturing, capital continues to trickle back into the industry, potentially reflating valuation multiples. Combined with higher and growing cashflows, this could galvanize a significant re-rate in oil equities. And even if institutional capital does not return, continually increasing dividends and equity buybacks could drive strong returns for years to come in the new golden age of oil and gas producers.

About the Author

Josh Young is the Chief Investment Officer and Founder of Bison Interests – an investment firm that focuses on the publicly traded oil and gas sector. He has over 15 years of experience in investment management, 10 of which were focused on publicly traded oil and gas securities. Josh became Chairman of the Board of RMP Energy in 2017. After refreshing the board and management team and rebranding the company (Iron Bridge Resources), it was bought out at a 78% premium in 2018.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)