August 6th, 2020
When one thinks of the challenges of capital allocation in the oil and gas business, the biggest factor for View is the extraordinarily demanding scenario in which these companies must make their investment decisions. Oil exploration, field development and extraction are heavily capital intensive and quite impactful to overall national investment activity, yet remain among the most volatile spending streams among all economic sectors. Consider the challenge of capital planning in the energy world:
The time from the start of a project to first production can be years, depending on the location of the resource. This effectively front-end loads expenditure realization compared to cash inflow, the byproduct of which is usually increased debt levels to fund future growth.
While the management of costs and their timing for extremely complex projects is hard enough, the forecasting of the realized price for the resource extracted poses real difficulties. Consider the capital analysis process whereby assumptions into out year revenues demand an accurate projection. For most industries, unit growth and average price variables are estimated, with unit production typically under more control than average prices, which tend to be governed by competitive forces. However, it is hard to find an industry where the average price per unit can vary from a peak to trough increase of well over 100% to a decline of over 70%. Indeed, crude prices to VIEW manifest not as mean reverting, which would actually be helpful in capital budgeting, but as trending.
The difficulty in forecasting trend movements that have an amplitude this extreme while making investment decisions of large size and long duration creates a unique challenge for energy companies seeking to return excess capital to shareholders. We can see this by the challenges these companies have historically had in maintaining stable dividend levels, let alone growing them. Due to the heavy use of financing to fund future growth, along with feeling the market's relentless push to produce it, the end result has been companies with either high debt levels, high payout ratios and intermittent periods of excess cash flow mixed with times of balance sheet strain or high debt levels, low payouts but buybacks and the same intermittent cash flow. While some companies have chosen to repurchase stock in lieu of dividend commitments of any real size, this has exposed companies to buying shares at the highs, which is when oil prices have risen and there is excess cash flow available to repurchase. For those companies primarily exposed to US shale, while the dividend payouts have been far lower than say, the European integrated oils, they have collectively come to be seen as challenged in value creation and more reliant on buybacks to attempt capital return.
VIEW has advocated for some time that a variable dividend structure might make sense for public oil companies, as it would still allow excess capital return in predominately our preferred method, dividends, but enhance capital structure agility that should try to match commodity volatility. It would also insulate the companies from having to be good purchasers of their own stock, something many have found difficult to do. And now, Pioneer Natural Resources has announced their buy-in to this concept on the earnings call yesterday. They join Devon Energy, ConocoPhillips and Concho Resources in either announcing they would consider this arrangement or are planning the mechanism. VIEW has long viewed the capital discipline that accompanies a dividend policy as a positive check against riskier options for capital use such as mergers and acquisitions. In a sector that has earned a reputation for questionable capital allocation and has seen relative valuations de-rate over time as a result, this willingness to think in a fresh way about capital return to shareholders is a positive. To the extent this represents an earnest determination to address the industry's capital return shortcomings, it is welcome news.
Comments