The Math on E&P Stocks Doesn't Add Up



The Math on E&P Stocks Doesn't Add Up
CEOs and boards are focusing on the wrong metrics. But if they change their ways, the opportunity could be great.

This opinion piece presents the opinions of the author.
It does not necessarily reflect the views of Rigzone.

In my over twenty years of being in the investment business, I have seen many companies and industries lose their focus and discipline for a variety of reasons. Today, the exploration and production (E&P) sector fits squarely into that category. The compensation plans laid out by E&P corporate boards encourage these companies to grow production at almost any cost — which builds the personal net worth of the CEOs, but does nothing for the shareholders for whom they are legally fiduciaries.

There are actions that boards and CEOs can take to rectify this situation, however. In my view, such changes could present a unique opportunity for the E&P sector to generate returns not only above current levels, but higher than their historical norms.

Kevin Holt
Kevin Holt, CIO Value Equities, Invesco
CIO Value Equities, Invesco

As a value investor, I know energy companies have generally not offered a high level of cash flow return on their invested capital (CFROI). The average E&P stock has delivered an annual CFROI of about 3% on average since 1955. That pales in comparison to the average stock in the S&P 500, which has delivered a 9% CFROI on average over the same period. This is an important statistic for stock investors — since 1955, companies with higher CFROIs outperformed those with lower CFROIs.  

Within this long-term trend, there have been times when — at the bottom of an energy cycle — value investors could identify a few E&P stocks that are selling at deep discounts to their reserve values, and could make money for a few years in spite of the industry’s lack of capital discipline. That is, until this cycle. Today, E&P companies have reached a new level of capital irresponsibility, and most are actually generating negative returns and losing money for their shareholders — making that historical 3% return level actually look good in comparison.

Many investors may not realize the extent of the problem. Why? Because companies like to talk about their stellar returns on individual wells, but never want to discuss why their overall corporate returns are so low. One anomaly in the calculation of individual wellhead returns is that E&P companies don’t include the purchase price of the property in their return calculations. They only count the ongoing expenses of running a well, which is how they come up with their high but misleading wellhead returns. How can a company make any investment — such as a house, a business or, in this case, acreage containing oil and gas — and not include the purchase price? Why is this allowed? As they say, it always starts at the top. For E&P companies, that means the boards of directors that are constructing compensation programs to incentivize CEO strategy.

When I dig through the proxies of these companies, I see a distinct pattern of paying senior managements for short-term production growth without regard to the impact of weak cash flows and, in many cases, negative earnings. Within these companies’ long-term incentive plans, which represent at least 70% of most CEOs’ annual compensation, there is a strong focus on how total shareholder return (TSR) compares with that of other E&P stocks. This means that CEOs can attain the long-term goals set by the boards simply by having their stock depreciate less than the other stocks in the E&P sector.

You can see from the chart below that focusing on production growth without regard to corporate-level returns has led the industry to a sustained period of lower CFROIs (and subsequently weaker stock prices) versus the overall market even before oil prices dropped in 2014.

CFROIs chart

The E&P industry is clearly at a crossroads, and boards and management teams need to be held accountable for creating shareholder value over a cycle if they want long-term investors to buy their stocks. As I stated earlier, I believe there is truly a unique opportunity for the E&P sector to generate returns not only above current levels, but higher than their historical norms — if the proper actions are taken by the boards and CEOs of these companies. We all like growth, but it must be profitable growth.

Because of the advent of technologies that have expanded access to shale gas, the E&P industry has visibility into reserves that will allow them to balance production growth and cash flow growth while distributing cash to shareholders in the form of buybacks and dividends. Hopefully in the upcoming year, the boards of these companies will question the value proposition they owe their shareholders and start incentivizing management teams to generate 1) incremental rates of return on total corporate capital, 2) free cash flow, and 3) less issuance of debt and equity. This would lead to lower — but more pragmatic — levels of production growth.

Investors and management teams can all win if these companies start to be managed more responsibly from a capital standpoint. If these steps are taken, I believe this is an industry that can become investable over a full market cycle and offer investors attractive returns.



WHAT DO YOU THINK?


Generated by readers, the comments included herein do not reflect the views and opinions of Rigzone. All comments are subject to editorial review. Off-topic, inappropriate or insulting comments will be removed.

Micah Pingley  |  September 26, 2017
I am empathetic to this economic lookback paradox. Did any of the companies in that table incentivize short term cash flow to firm up existing credit through high ROR incremental projects? If so, wouldnt that be a prudent strategy and also a key message to shareholders?
Clay  |  September 26, 2017
This is essentially the same argument that the Anadarko CEO made to the investment community this past summer. His point was that the investment community rewards putting barrels on the books (proven reserves) and not rewarding efficient, low cost reserves. So whose fault is it? Is it the investment community or the BODs that establish compensation models? There has to be an opportunity for a savvy investor who recognizes this, but unfortunately, I havent yet figured out how to take advantage of it.
John Tan  |  September 26, 2017
The context of this article focuses on American E&P companies that largely produces for American consumption. The revenue from downstream consumption patterns are also heavily constrained by governmental fiscal policies that favor consumers. To wit, people outside America by and large pay much more for their gasoline purchases and other energy usages. The pricing structure is an obvious factor which ties the hands of E&P companies.
LARRY CARPENTER  |  September 25, 2017
Amen! The other cost that is many times not included in the investment efficiency discussion is the G&A cost of the enterprise. Long ago a wise man reminded me that you dont pay off your debt with discounted dollars, you pay it with actual future revenues. That is why one must consider dollar for dollar return on investment as well as rate of return.
Tony Dyson  |  September 25, 2017
One would think that Mr. Holts article would be too basic to be of interest in a discussion of investment decisions. On the contrary, the article is spot on, the industry has lost sight of the endgame which is to provide a profitable vehicle for investor money. It is certainly a changed decision tree that doesnt necessarily include the cost of entry into the return calculations of a new investment prospect. One apparent suggestion is that the upfront costs of entry are more than offset by the cash-out value of the prospect after the initial development has multiplied the core value of the prospect. This is fine if all prospects are routinely profitable, which we dont see to be happening.