U.S. E&P Companies Finally Heeding the Call to ROC

Oil and Gas E&P Industry’s Transformation Coming to Fruition

Over the last several years, we as a firm have emphasized our belief that a disciplined return of capital approach is an appropriate one to pursue for U.S. unconventional oil and gas exploration and production (E&P) companies at this point in their business cycles (see: Natural Resource Companies Focus on Returns in 2018 and ROC & Rolling). Transitions do not happen overnight, and this transformation finally seems to be coming to fruition for some.

All U.S. E&P companies are at different stages, and there will no doubt be winners and losers along the way. However, it is extremely encouraging to see multiple companies executing this framework, as we believe it will likely strengthen the overall investment thesis for the industry moving forward.

The Market Screamed “Show Me the Money!” E&P Companies Heeded the Call.

Source: Bloomberg, VanEck. Data as of August 2021.

E&P Industry’s Pathway to Success

In our view, the U.S. E&P industry has gone through, essentially, four stages to get to where they are now: exploration; discovery; “land grab” (i.e., purchasing or acquiring acreage in prime drilling locations); and delineation. Within those stages, we believe that they have had to develop and use innovative (and, ultimately, highly disruptive) technology, gain scale and deploy massive amounts of early stage capital (at the expense of lower returns to investors). They have also optimized their business models to become what we believe are efficient operators generating robust free cash flow. Now the industry has reached, in our view, its fifth and final stage: harvesting cash flows.

What is most impressive to us is that many E&P companies who offered dividends pre-pandemic have reported – in annual reports and other regulatory filings – that they have not cut their dividend. In fact, companies have started to announce, in these same reports and filings, new, official, long-term, integrated operational and financial returns frameworks or delineated pathways to reaching that point in the very near future.

At a high level, these new strategic goals include:

• Reducing the amount of cash reinvested into business operations from well over 100% (in the early stages of U.S. shale oil development) to only 50-80%.
• Targeting flat- to mid-single-digit production growth (versus mid-teens to mid-double digit growth rates in the earlier years).
• Growing competitive base dividends (from prior insignificant amounts or none at all).
• Roughly 50-75% of free cash flow returned to shareholders either through variable dividends or share repurchases, or else used to pay down debts.

E&P Companies That Set a High Bar

Coming out of the second quarter of 2021, Devon Energy (2.4% of Global Resources Fund net assets) and Pioneer Natural Resources (3.7% of fund net assets) will have one of the best implied dividend yields in the S&P 500³. Corresponding share prices for both companies have also seen a bump since taking a substantial hit during the spring of 2020. In our view, these two companies are the frontrunners of this disciplined return of capital strategy.

Devon Energy (DVN) and Pioneer Natural Resources (PXD): Blueprints for Success?

Source: Chesapeake Energy, VanEck. Data as of July 2021. *Includes only E&P peers reporting estimated payout ratio details for 2022 (8 companies).

• Devon Energy – According to several of Devon’s latest filings, the company’s long-term framework is to provide modest production growth (up to 5% annually), reinvestment rates substantially below cash flow, below-average balance sheet leverage (net debt to earnings before interest, taxes, depreciation, amortization and exploration expense – EBITDAX – ratio of 1x or less), and prioritization of cash returns. The company’s filings indicate that, of the free cash flow generated, first priority is to the base dividend, then 50% of the excess free cash flow is paid out through a variable dividend. Additionally, the company also notes in its filings that once the company reaches their debt target by year-end, they will look at other options of returning more to shareholders.
  
  In Devon’s second quarter earnings call of 2021, the company announced their third consecutive quarter of variable dividends, each higher than the previous quarter. We believe that this strategy will lead to an annualized second half of 2021 dividend yield of greater than 10% (assuming $70 per barrel West Texas Intermediary – WTI – crude oil price and stock price as of July 31, 2021). According to FactSet, as of end-June, this dividend yield is among the highest in the S&P 500.
• Pioneer Natural Resources – According to Pioneer’s latest filings, its long-term framework⁴ is a reinvestment rate of 50-60%, production growth of up to 5%, low balance sheet leverage, and delivery of a stable and growing annual base dividend. In the second quarter of 2021, Pioneer announced the initiation of a variable dividend, which was accelerated by two quarters. The company also increased its variable dividend to 75% of free cash flow after the base dividend, which is 18 months ahead of schedule. The company’s filings indicate that their annualized, second half dividend yield will be around 8%. Pioneer also expects their 2022 – 2026 average dividend yield to be greater than 9%⁵.

E&P Industry ROC: Here to Stay?

As mentioned previously, we believe the progression of the U.S. E&P industry to a disciplined return of capital strategy only strengthens the investment thesis moving forward. According to IEA in its August Oil Market Report, global oil demand has rebounded dramatically over the last year and is on pace to hit record levels in 2022. This robust consumption outlook combined with moderating supply growth worldwide has resulted in oil and natural gas prices well above pre-pandemic levels. While global net-zero carbon targets by 2050 will eventually influence the demand picture for fossil fuels, companies such as Devon, Pioneer, and others have evolved to provide market leading returns today. The strategy is clear and here to stay.