The Shale Party Is Just Getting Started

Oil field workers with Wisco work on pump jack in Tioga, N.D. (Photo by Ken Cedeno/Corbis via Getty … [+]

The shale industry is making it rain for investors, generating record free-cash-flow (FCF) on the back of pandemic-related cost-cutting and rising oil prices. And the party is just getting started.

Oil prices are expected to continue to rise as the year progresses, and the global economy recovers with Covid-19 vaccinations ramping up. Wall Street bank Goldman Sachs now sees Brent prices averaging $75 a barrel in the second quarter and $80 in the third quarter, up from around $70 now.

U.S. benchmark West Texas Intermediate (WTI) typically trades about $5 a barrel below Brent, and recent WTI prices of $65 have most shale plays firmly in the black, generating strong returns.

PROMOTED

This marks a step-change for shale, a sector infamous for its “cash burn” — where capital expenditures exceed cash flow from operations — since its inception a decade ago.

The sector’s newfound profitability has made U.S. exploration and production (E&P) companies darlings with investors in recent months. It could prompt greater access to capital markets if these firms can stay the course and resist the urge to invest in lower-return growth projects. And based on recent Q4 earnings presentations, the leading U.S. shale E&Ps plan to do just that.

The result will be an unprecedented windfall for these companies and their shareholders.

Consultancy Rystad Energy estimates that the U.S. shale industry will generate about $73.6 billion in cash flow from operations this year, up nearly a third over last year, based on a WTI price of $50.

And that forecast looks far too low, given that WTI has already moved to $65. It means that shale firms will be swimming in FCF this year, where cash flow from operations exceeds CAPEX. Most E&Ps budgeted for WTI to average less than $50 this year.

All that FCF will allow them to reduce debt more aggressively or return more cash to stockholders through dividends or share repurchases. That makes shale a very attractive bet in the post-Covid world.

Banks and lenders will also take notice of the sector’s stronger balance sheet and higher oil prices. Smaller independent producers, which rely heavily on reserve-based loans from banks calculated twice a year — in the spring and the fall — will benefit immensely. The spate of bankruptcies that have plagued the shale industry over the past year should subside.

The E&P sector suddenly looks hot, not only against other corners of the energy space but also to the broader market.

The S&P Oil & Gas Exploration & Production ETF (XOP) XOP +2.6% is up nearly 100% since Sep. 1, compared to a 19% gain for the S&P 500. But it’s not too late for investors to get in on the action. The XOP is still trading about 50% below September 2018 levels, when investors were still rewarding shale producers’ growth.

Oil prices are critical to sustaining the momentum. At WTI prices over $55, Morgan Stanley MS -1.2% sees substantial upside for E&Ps in terms of FCF yield — the ratio of FCF against a company’s market value — as well as net asset value (NAV). These are important metrics for pushing stocks higher for investors. At $55-$60, E&Ps would deliver a 12 percent to 15 percent median FCF yield and 60 percent to 100 percent NAV upside, while $65 to $75 WTI would deliver a 15 percent to 17 percent FCF yield and 100 percent to 130 percent NAV upside.

But it’s not all about oil prices. Shale’s much-improved financial performance also shows that the survival actions producers have taken to survive the pandemic, from slashing CAPEX and operating costs to combining through strategic mergers and acquisitions (M&A), have worked to bolster their bottom lines.

The sector is moving toward a smaller, leaner, more profitable model, and producers have vowed to remain on this path and not chase growth despite rising prices. Indeed, top E&Ps are overhauling several metrics that determine executive compensation to strengthen the alignment between their financial interests and those of their shareholders.

Companies like Marathon Oil MRO +3.2%, Pioneer Natural Resources PXD +1% and Devon Energy DVN +1.5% are eliminating growth from their pay scale while pledging to stay focused on returns by introducing free-cash-flow metrics into executive compensation schemes.

That doesn’t mean that real growth in shale production can’t or won’t happen in the future. It just means that healthy returns for investors must accompany it.

Another reason for optimism is that E&Ps are moving rapidly to address environmental, social and governance (ESG) concerns. A growing number of shale producers, including ConocoPhillips COP -1.5%, EOG Resources and Range Resources, are setting net-zero targets for Scope 1 and Scope 2 greenhouse gas emissions (from operations) and vowing to eliminate routine natural gas flaring in coming years. Another, Occidental, has even promised to tackle Scope 3 emissions from the end-use of its oil and gas.

This should make the sector resilient to any climate regulations that the Biden administration may introduce in the coming years, too. So the bulls should keep running in the E&P sector no matter what Washington throws at them.

I am CEO of Canary, one of the largest privately-owned oilfield services companies in the United States. I’ve served as a consultant to the energy industry in North

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