As energy companies focus more on balance-sheet strength and less on maximising growth, the sector is likely to become more attractive to credit investors.
Back when commodity prices were peaking, production volumes were arguably the key drivers of Exploration & Production (E&P) companies’ equity valuations. The underlying logic was simple: the faster the company grew production, the more barrels of oil it could sell at high prices. Expansion strategies were justified by high internal rates of return, exceeding those of returning capital to shareholders.
But this quest for growth weakened cash flows and stretched balance sheets. Seeking ever-more barrels, E&P companies borrowed frequently and heavily, leading to the energy sector becoming the largest constituent in the Global High Yield Index. As of November 2017, it accounted for about 15% of notional market capitalisation and about 22% of the market in terms of duration-times-spread.
Today, with oil and gas prices being lower, pump-priming growth provides less upside for E&P companies. Equity investors, disappointed with the diminishing returns from energy companies (see figure 1), now seem to favour capital discipline and free cash flow generation, which is rare among E&P businesses.
Figure 1. After a strong 2016, energy stocks have been lethargic this year
Source: Bloomberg as at November 2017.
Executive pay schemes typically incentivised absolute production growth as an explicit goal for E&P companies, which also explains why it dominated corporate strategies in the past. According to Goldman Sachs, of the 39 US upstream E&P companies covered by its equity research team, only seven had profitability metrics – such as growth per share adjusted for debt, or corporate return – in the management incentives disclosed in the 2016 proxy filings. This number dropped to four in 2017.
But this is beginning to change. Recently, some US E&P companies have taken steps to address compensation and profitability related concerns by introducing compensation metrics that do not incentivise absolute production growth at all costs. Instead, they focus on cash flows, which is welcome news for credit investors. These companies include:
- Range Resources, in addition to setting compensation metrics tied to debt-adjusted production-growth per share for a period of at least 10 years, the company recently introduced the measure of drilling rate of return. This metric is designed to compensate management for the actual return a well generates versus what it is expected to deliver before the start of the project. Producing returns at the wellhead should lead to higher gains at the corporate level, as well as stronger cash flows.
- Marathon Oil, whose management team noted in the company’s Q3 2017 earnings call that it fully expects to integrate cash returns into its compensation structure and focus on funding profitable growth through cash flows rather than turning to the capital markets. The management team also acknowledged that debt-adjusted cash flow per share growth is one of the highest correlated metrics to the equity performance of E&P companies.
This highlights the importance of governance on a company’s financial performance. We assess governance considerations into our credit analysis, and as a result some of our holdings include issuers whose incentives for executives are focused on improving profitability. These companies include Range Resources, Hess, Antero Resources and Marathon Oil.
Natural gas producers lead the way
This focus on cash flow and profitability is not only evident in revised incentives but also in the behaviour of companies. The 2018 guidance commentaries – especially those from natural gas producers – clearly show that cash flow is a priority. For example:
- In its Q3 earnings release, Range Resources provided preliminary soft guidance for 2018 that involves lower production growth (10% growth versus 30% in 2017); spending levels below cash flow; a focus on paying down debt and a willingness to eventually consider returning cash to shareholders.
- This shift from growth to value can be partly explained by the following: first, growth in excess of cash flow is not necessarily desirable given structurally lower and rather volatile natural gas prices in the US; second, equity investors prefer the company to deleverage its balance sheet to below 3x; and third, lower natural gas prices mean that shareholders are likely favour the prospect of returns sooner rather than later.
- Antero Resources announced that over the four-year period to 2020 it will target a production-growth rate of 20% compared with 20-25% in 2017. This suggests a slowdown. Importantly, the company reduced its lender commitments by $1.5bn to $2.5bn since it expects its drilling and completion capital programme to be funded fully by E&P cash flow, rather than drawing on revolving credit facilities.
New cash-focused paradigm is a positive for credit
These announcements signal a change in the behaviour of E&P companies. They reflect the shifting preferences of equity holders from growth to value – which is clearly positive for credit investors.
Companies that spend within the limits of their cash flows typically have less-leveraged balance sheets and therefore lower risk profiles, which ultimately translates into tighter spreads. For example, after Range Resources announced its preliminary guidance for 2018, Moody’s upgraded the company’s Corporate Family Rating by one notch to Ba2. It also moved its outlook on the company to Positive, which drove unsecured bond spreads tighter. Marathon Oil, after announcing the developments described above and its stronger-than-expected results, has also outperformed the investment-grade market (see figure 2).
Figure 2. Range Resources and Marathon Oil: Credit investors like a good cash flow story
Source: BarclaysLive as at November 2017
Credit investors should feel energised
In the current environment of lower oil prices, credit investors should be encouraged by E&P companies’ focus on profitability at the expense of growth, and consequently benefit from greater capital discipline, lower risk profiles, tightening spreads and potentially stronger returns.
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