Finding the balance between capital discipline and growth
Chairman, Chief Analyst and author of The Edge
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Capital discipline or growth? It’s THE big question hanging over commodity producers, mining as much as oil and gas.
We touched on the oil Majors’ approach last week. The US Independents' results last week gave another take on how companies are thinking.
US E&P behaviour was challenged a year ago as investors kicked up a fuss about the high investment rate in the tight oil sector. Concerns centred on the ramifications of unchecked spend – there was too much incentive for management to drill, and too much drilling would lead to too much volume for the oil market to absorb and kill the oil price. Capital providers, including shareholders, would be the losers.
It was right then for investors to press for tighter capital discipline, for decisions to be made on value rather than volume, and for money to come back to them. They had leverage, with most tight oil players haemorrhaging cash with WTI at US$50/bbl or lower. This was shareholder activism in action and it was effective, saving the companies from themselves.
A year on, how are things working out? On the face of it, very well.
Most tight oil companies are adhering to tighter investment budgets. Some have even changed compensation incentives for the CEOs to more value-based metrics. Shareholder returns are on the up, notably a spate of share buy-backs funded mainly by capital raised from non-core asset sales. Few independents want to crank up ordinary dividends, given the inherent volatility of earnings for a producer operating at the marginal cost.
Those companies that have ‘walked the walk’ for investors have enjoyed a better reception by the stock market than others (see chart). Noble, Pioneer, Anadarko, ConocoPhillips, Encana and EOG all gave money back, and all were among the top share price performers in the sector through the results period. In contrast, those that didn’t generally fared worse. Other factors were at play for them, including downgraded expectations for the Anadarko Basin plays to which some are exposed.
These independents are in a glorious cash-generating sweet spot in 2018, much as the Majors are.
Production is rising, fuelled by last year’s drilled uncompleted wells. Investment is still in check. Even with cost inflation expected at 15% in 2018, at US$60/bbl many will generate a fair bit of free cash flow this year. What’s more, there are many more in-the-money wells in their drilling inventory at today’s price.
So if they are no longer capital constrained, shouldn’t they now be drilling more? Maybe. We showed last July that accelerating drilling programmes maximises NPV,10s. Drill more sub-US$60/bbl breakeven wells and make more money all things equal – simple. Except it’s not, of course, that simple or everyone would be doing it. The ramifications of ‘drill, baby, drill’ raised by shareholders last year remain valid.
On the other hand, returning capital to shareholders shouldn’t go so far as to limit any company’s potential to invest in commercial opportunities. Anadarko’s leverage of 45% is above average as it works its way through its US$3billion share buy-back (US$1.9 billion still to go). The company stresses it’s comfortable with its financial ratios.
Institutional investors continue to preach capital discipline, concerned that the upturn will lead again to errant behaviour.
This is good and right, and mining and oil and gas companies need to continue to demonstrate they get the point. But it’s not the be-all and end-all. Merely containing costs and spend whilst returning capital isn’t a strategy.
Mining companies and E&Ps mustn’t be distracted from the longer game by a positive reaction of share prices to one-off shareholder distributions or compromise future investment flexibility by loading up with debt. The winners in the long run will be those who make bold decisions on portfolio and growth in this down cycle.