Wind of Change, Part 4 - Natural Gas-Weighted E&Ps Continue to Grow Despite Lackluster Prices

Four years ago this month, crude oil was selling for north of $100/bbl and natural gas prices were more than 50% higher than they are now. But while hydrocarbon prices sagged later in 2014 — and through 2015 and early 2016 — the declines didn’t deal a crippling blow to U.S. exploration and production companies. Instead, most of the upstream industry weathered the crisis remarkably well. Amidst that striking recovery, the 10 gas-focused E&Ps we’ve been tracking have engineered the strongest return to profitability. After $40 billion in pre-tax losses in 2015-16, they reported a collective $5.2 billion in pre-tax operating income in 2017, with all 10 producers in the black, as well as a 150% increase in cash flow over 2016, to $11.7 billion. However, gas prices have languished below $3.00/MMBtu since early February 2018 — their lowest level since mid-2016 — which means that the gas producers don’t have the tailwind that higher oil prices have been providing to their oil-focused and diversified competitors. Today, we conclude our blog series on E&Ps’ 2018 profitability outlook and cash flow allocation with a look at companies that focus on natural gas production.

The decline in natural gas prices from $6/MMBtu in February 2014 — and about $4.60/MMBtu in April of that year — to well below $2/MMBtu in February 2016 led to plunging cash flows and massive reserve revisions that threatened the financial stability of gas producers. Pre-tax operating cash flow for the 10 E&P companies in our Gas-Weighted Peer Group fell from $17.5 billion in 2014 to $8.4 billion in 2015 and just $4.6 billion in 2016. Like their Oil-Weighted and Diversified peers, the gas-focused companies slashed capital spending — by 62%, from $17.2 billion in 2014 to $6.5 billion in 2016. They also implemented some of the same strategic transformations as the rest of the U.S. E&P industry, which featured impressive capital discipline and an intense focus on operational efficiencies. However, the Gas-Weighted group was able to achieve financial recovery more quickly than the Oil-Weighted and Diversified producers, which reported relatively small 2017 pre-tax operating losses of $1.8 billion and $2.5 billion, respectively. The 150% cash flow increase by the gas producers significantly exceeded the 58% gain by the oil producers and the 16% rise by the diversified companies. The key difference was that the Gas-Weighted producers, with the notable exception of Chesapeake Energy, already had relatively focused portfolios and did not have to undertake the substantial asset divestiture programs conducted by many companies in the other two peer groups. While the shift to premier plays like the Permian required a surge in merger and acquisition (M&A) activity by oil-focused companies, the portfolios of nine of the 10 gas producers were already heavily weighted toward the Marcellus and Utica, the premier U.S. gas resource plays. Despite sharply reduced capital expenditures and ongoing infrastructure restraints — mostly pipeline takeaway capacity out of Appalachia — production by the peer group increased 5% between 2015 and 2016. With gas prices rebounding beginning in mid-2016, the gas producers we track increased their 2017 drilling and completions budgets by 69%. The subsequent 11% increase in production fueled the impressive profit reversal and cash flow growth. The big question now is, what will be the impact of languishing gas prices on 2018 cash flows and capital allocation?

In Part 1 of this series on E&Ps’ 2018 cash flow allocation, we detailed the overall 2018 cash flow and spending plans of the 40-plus companies we track. 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. In Part 3, we explained that the rebound of the Diversified Peer Group had fallen short of that accomplished by the Oil-Weighted producers because of their massive portfolio realignments, which included $36 billion in asset sales. The result was 4% and 5% production contractions in 2015 and 2016, which limited cash flow regeneration. Although higher oil prices are expected to generate $7.3 billion in increased 2018 cash flow, the diversified producers are budgeting just a 5% increase in capital spending and allocating the $6.1 billion in free cash flow to share buybacks and dividend increases to reward shareholders for their patience during the long transformation process.

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