Wind of Change, Part 3 - Diversified E&Ps Nearly Complete Transitioning; Growth Around the Corner

Defying predictions of widespread bankruptcies and credit defaults, the U.S. exploration and production companies (E&Ps) we track returned to profitability in 2017 through a strategic transformation that featured the “high-grading” of portfolios, impressive capital discipline and an intense focus on operational efficiencies.  However, the road to recovery has been longer and more challenging for some companies, particularly a few of the E&Ps in our Diversified Peer Group, whose output and reserves are more balanced between oil and gas. Their portfolio realignments have been the biggest among our three peer groups — collectively they have shed $36 billion in assets and 3.6 billion barrels of oil equivalent (boe) in proved reserves over the last three years. Today, we continue our review of how rebounding oil prices are affecting E&P cash flow, this time focusing on producers with a rough balance of oil and natural gas assets.

The Diversified Peer Group’s 2017 results and 2018 guidance show that the 17 companies have moved along the same general path to recovery as the overall E&P sector, although the degree of the Diversified companies’ rebound to date has fallen short of that accomplished by the Oil-Weighted and Gas-Weighted peer groups. After bleeding a total of $80 billion in red ink in 2015 and 2016, the Diversified group reported $2.5 billion in pre-tax operating losses on substantial asset impairments from divestitures, compared with a combined $3.4 billion in profits for the remaining E&Ps. Based on 2018 guidance, the group’s annual production has nearly stabilized at just under 1,800 MMboe (red rectangle in Figure 2) after 4% and 5% contractions in 2016 and 2017, respectively. In comparison, the Oil-Weighted group is guiding to 11% output growth and the Gas-Weighted group is expecting 12% growth. Like the rest of the industry, the Diversified producers are maintaining impressive capital spending discipline despite higher oil prices, which will generate a $6.1 billion — or 49% — increase in free cash flow. However, in sharp contrast with the remainder of the E&P sector, the Diversified companies are collectively using all the additional funds (and more) to reward shareholders for their patience during the long transformation process by authorizing $6.4 billion in share buybacks and $136 million in dividend increases.

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By way of review, in Part 1 of this series on E&Ps’ 2018 cash flow allocation, we detailed the new profitability of our total E&P universe — now 44 companies after losing Rice Energy and adding Ultra Petroleum and Gulfport Energy — and the companies’ overall 2018 cash flow and spending plans. As we said then, instead of investing all their cash flow into oil and gas producing assets, the E&Ps in our study group are curbing capital spending and instead dedicating funds to (1) reducing their $184 billion in debt outstanding at the end of 2017 and (2) rewarding shareholders. We pegged incremental capital spending in 2018 at $2.3 billion, leaving over $22 billion in incremental free cash flow. In Part 2, we explained that the 17 Oil-Weighted companies would be the main beneficiaries of $60+/bbl oil prices, raking in 55% of the total increase in cash flow. Altogether, these producers were boosting capital investment by only $2.1 billion, less than one-sixth of the additional cash flow, leaving $11.5 billion in free cash flow to strengthen their balance sheets and boost their equity valuations.

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