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.
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)
Oil prices are critical to sustaining the momentum. At WTI prices over $55, Morgan Stanley
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
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
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.