Offense or defense? North America E&Ps adjust operational plans for 2019

Oil and gas operators showed renewed confidence in 2018 as prices rose through September. Large North American E&P peer group data revealed share repurchases and dividend increases. But, did plunging oil prices in Q4 derail operators investment plans for 2019? Dan Pratt and Andrew Byrne from our companies and transactions team join the podcast to discuss the outlook for North American mergers and acquisition activities.

Jessica Nelson:

In 2018, we saw dividend increases, share buybacks, and increased acquisitions. I'd like to hear from both of you: how do you see the industry's mood shaping up as we enter 2019?

Dan Pratt:

Sure, I'll start. I think the mood is quite different. Coming into 2018 and off the price decline in years prior, there was a strong shift-particularly within the North American E&P sector-by investors for more capital discipline, more focus on returns and returning capital to shareholders. But, there was still that element of growth that the E&P companies needed to achieve. Obviously, 2018 was a higher price environment, and so I think there was a relatively high level of confidence, optimism, and more importantly, higher levels of cash flow. The E&P companies themselves were able to provide both sides of that balance. For example, the high cash flows out of these guys, to not only reach their production targets through their capital expenditures, but also do things like support higher dividend yields and do some share repurchases.

So, going into 2019, given the price volatility we've seen the last couple of months, and I think just broader uncertainty globally. If you look at the volatility in the stock market coming into the year, I think higher geopolitical risk in the US, in Europe with Brexit, and other areas, there's just a broader sense of more uncertainty going forward. Obviously, most pressing is the volatility within the commodity prices we've seen the last several weeks.

At these lower prices we're right around $50 plus, $52 today WTI, and given that uncertainty I think we've seen a lot of caution around the E&Ps, and Andy can talk about that in a little bit more detail. Generally, and at these prices at the $50 where we are today, these capital allocation decisions are going to be a little bit harder. There's going to be less cash flow to satisfy both sides of that balance beam. So, we're seeing a lot of caution, and I think just a general uncertainty right now, and Andy can talk about some of the lack of recent guidance that we've seen from these companies and what that may mean.

Andy Byrne:

Yes, $50 I think is really a key inflection point. Last week, Occidental said it would be cutting its 2019 capex (capital expenditures) if WTI was going to average $50 this year. So, I think $50 is really sort of that inflection point where it really gets to be a difficult decision.

I did a capex report that got posted on November 16th, following the third quarter releases. At that time, the companies were quite confident, quite happy that early releasers were guiding towards a 10% to 15% capex increase at that time. Since then, oil prices have fallen quite a bit, and fewer companies have been giving 2019 guidance, but right now that 10% to 15% capex increase is down to maybe 0% to 5% increase. So, I think really at $50 you're looking at maybe flat capex and below $50 you're looking at capex reductions. Once you get closer to $60 you're looking at getting back into that 10% to 15% capex spending increase. So, going from a 10% to 15% capex increase for 2019 down to flat, that really shows a big shift in the industry's mood just in the last quarter.

And, what was interesting, there were half the companies giving 2019 go-forward year guidance at the third quarter releases as they had the year before. I think companies were cautious about giving 2019 guidance given the volatility that was happening at the time. So, it's very interesting to see how the mood has changed, and that capital allocation decision is going to be very difficult this year between volume growth and returning capital to shareholders. Given people are going to be looking at really that $50 price forecast, as their budget plans, it's going to be there a lot less cashflow available to return to shareholders. So, its big trade off; interesting to see how they make those calls.

Jessica Nelson:

And how about investors? How are investors reacting to some of this uncertainty in the market? Are you seeing that reflected with what you're hearing from them too?

Andy Byrne:

Oh yeah. Investors are not particularly pleased, you could say. Pretty much all our stocks in the North American E&P space are trading at considerable discounts to our net asset value, so not a lot of love going on, I guess.

Jessica Nelson:

North American E&Ps have shown a degree of resilience in the lower oil price environment, led by the Permian Basin investment. I remember one of your reports in late 2018 talking about the sizable disparity in Permian per-acre deal values with large ranges. So, let's talk about the Permian. Do you see the trend of resiliency continuing with Permian specialization into 2019?

Andy Byrne:

2019 is definitely going to be a challenge for the Permian operators given the bottleneck situations, not to mention the lower oil price forecast for the year. I think they'll continue to be resilient. It's a very competitive space, and the E&Ps are very responsive to market conditions. I must give them credit: they're very creative and they'll find solutions.

For the specialization, it's an interesting question. The Permian is widely considered the best play, oil-rich or liquids-rich, in the US onshore, perhaps in the world. So, specialization has been rewarded. Companies that are pure play Permian operators have tended to trade at a premium to companies that might have had a basket of other plays. When you're looking at the quality of the portfolio, being 100% in the best play is going to beat being not 100% in the best play so there is that specialization there.

The risks of specialization are going to be shown this year with the bottleneck situations that we have in the Permian, but that's largely seen as a short-term situation where companies that can will tactically reallocate some capital to plays like the Eagle Ford, where you get premium pricing on their crude, but that is just going to be a sort of a temporary thing for this year with everybody looking for 2020 with resolution to a lot of the bottleneck situations.

Dan Pratt:

Yeah. And you just touched on the resiliency part a little bit. I think one of the things that's a little different this time is the presence of the majors. So, if you look at the Permian where you have Exxon and Chevron, we still see some capex increase within the majors as a whole, kind of in that 5% range for 2019. Because of their diversified business model, you tend to see a steadier cash flow.

So, when you talk about just the overall resiliency, of the activity level, of the investment, it may hold up a little bit stronger this year for different reasons than last time. That one reason could be because of the amount of capital and activity being generated by majors in 2019, versus a few years ago.

Andy Byrne:

Yeah, that's a great point, Dan, because normally we're expecting the E&Ps in the Permian to be reducing or moderating their spending, whereas the majors are going to be drilling through the cycle, and they're not really going to be slowing down. So, normally, if in the Permian absence the presence of the majors you'd see activity levels come down and, with that, the service costs would come down. Well, if the majors are in there, and they're really going to continue to be active, then maybe you're not going to really see that same sort of elasticity on service costs as you would in a normal sort of cycle. So, it'll be an interesting challenge for the resiliency, how much they can keep their margins up.

What else do operators and investors see as potential risks or areas of investment in 2019? Listen to the full podcast for additional insights.

Learn more about our energy company and transaction research.

Posted 25 January 2019

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.