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Slip Sliding Away - E&Ps Face Tougher Decisions About Allocating Dwindling Free Cash Flow

We’re now in the midst of the summer vacation season, but a recent survey showed that just two out of five Americans are planning a trip that requires a flight and/or hotel stay — the fact is, inflation has whittled away at discretionary income. U.S. E&P companies are in a similar boat. After a brutal decade marked by intense commodity price volatility, oil and gas producers over the past couple of years have won back investors with a new fiscally conservative approach that prioritizes harvesting free cash flow to fund surging shareholder returns. But more recently, lower commodity prices and persistent inflation have significantly eroded the funds available for dividends and share repurchases. In today’s RBN blog, we analyze the increasingly difficult cash allocation decisions oil and gas producers made in Q1 2023 and are likely to face in future quarters.

First, a couple definitions. Discretionary income is what’s left after we pay our taxes and fixed costs like housing, food, and clothing. We can use the remainder to save or invest, treat ourselves to luxuries, donate to charity, indulge in recreation, etc. The equivalent for E&Ps is cash flow from operating activities (CFOA), which is the net income the company generates adjusted for non-cash expenses like depreciation and stock-based compensation, and for changes in working capital. The largest allocation of this cash is investing in replenishing oil and gas reserves and growing production through capital expenditures. What’s left is free cash flow, the funds available to fund acquisitions, pay down debt, and return capital to shareholders through dividends and share buybacks.

Just last summer in Make It Rain, we reported that the 41 U.S. oil and gas producers we monitor were showering cash on shareholders as cash flows rose with soaring commodity prices, with some E&Ps offering double-digit payouts. As we described in Spread It Around, dividends and share repurchases hit record levels in 2022. However, commodity prices headed downhill in late 2022 and early 2023, and cash flows from operations declined 21% in Q4 2022 and another 9% in Q1 2023 to $32.5 billion. Free cash flow decreased at a steeper rate, falling 32% in Q4 2022 and 29% in Q1 2023 because of a combination of rising capital expenditures and lower oil and gas prices.

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