U.S. Oil E&P Companies Executing on ROC

After a full year of executing on the return of capital strategy, oil and gas E&P companies are showing the rewards of this strategy.

As a firm, we have emphasized the disciplined return of capital (ROC) strategy by U.S. oil and gas exploration and production (E&P) companies over the years.¹ 2021 was the first full year the industry executed on the ROC strategy and it has paid dividends. This strategy has gained traction and has increased throughout the year, in terms of number of companies and size of returns.

Average WTI oil prices in 2021 were 26 – 31% lower than the 2012-2014 period, but total returns of capital (base dividend, variable/special dividend, and share repurchases) for the some of the top E&Ps by market cap were 3.5 – 5.3x higher over the same period.² Even with the recent increase in commodity prices, companies have stuck to their investment framework. Each company has a slightly different approach, but one thing is consistent: a disciplined capital allocation process that generates high returns on and of capital.

Oil E&P Companies: Return of Capital

Source: APA Corp., Continental Resources, ConocoPhillips, Coterra Energy, Devon Energy Corp., EOG Resources, Diamondback Energy, Marathon Oil, Pioneer Natural Resources Co., Bloomberg.

Is This ROC Strategy Sustainable?

Skepticism will still remain in the market, as 2021 was the first year the E&Ps have generated a higher free cash flow yield than the broader market. We understand the skepticism as this industry doesn’t have a long track record of high free cash flow yields and may still be remembered as an industry that was previously capital destructive. The trajectory changed in 2020, the first year a company announced a long-term investment framework. We believe that this new model will lead to sustainable returns of capital and will continue getting rewarded as companies execute.

In general, the investment framework includes a reinvestment rate (capex/cash flow from operations) of 50-80% at mid-cycle prices, a strong balance sheet, growth capped at mid-single digits, and a percentage of free cash flow that is returned back to shareholders in the form of base dividends, variable/special dividends, and/or share repurchases. In this current upcycle, public E&Ps have not been chasing higher oil prices with more activity as they have in prior upcycles. As the market sees more quarters of execution, we believe the skepticism will turn to optimism.

E&P Companies Free Cashflow Yield – Trailing 12 Months

^* ConocoPhillips, EOG Resources, Pioneer Natural Resources, Devon Energy, Diamondback Energy, Continental Resources, Coterra Energy, Marathon Oil, and APA Corp.

Source: Bloomberg, VanEck. Data as of 12/31/2022. Free cashflow yield is the free cash flow per share a company is expected to earn compared to its market value per share.

Management Teams Aligned with the Market

In addition to companies evolving their framework on capital allocation, executive compensation continues to evolve to support this framework. One example is Pioneer Natural Resources. Their incentive compensation program has shifted dramatically to a more returns-focused, free cash flow generating, and ESG (environmental, social and governance) & health, safety and environment (HSE) focused program. This is compared to prior plans that were more focused on growth, improving financial metrics, and operations.

For comparison purposes, the 2021 Pioneer Natural Resources’ annual incentive compensation components are 20% weighting on corporate returns (ROCE & CROCI), 20% weighting on free cash flow, 20% weighting on ESG & HSE, 20% weighting on capital spending & cost control, and 20% weighting on annual strategic. The CEO at Pioneer Natural Resources has also changed his long-term incentive components to 100% total stockholder return (TSR) with the S&P 500 Index being added into the peer group. This is a dramatic change from their 2019 components of 12.5% weighting on Permian Basin production per share growth, 12.5% weighting on drilling, completions, and facilities capex, 12.5% weighting on ROCE, 12.5% weighting on net debt to EBITDAX, 10% weighting on Permian Basin base lease operating and corporate general and administrative costs per BOE, 10% weighting on Permian Basin proved reserves per share growth, 10% weighting on health, safety, and environmental, and 20% weighting on certain strategic goals.³ The long-term incentive components are 50% weighting of time-based awards and 50% performance-based awards.

ROC Foundation Is Set

E&P companies started announcing their long-term investment frameworks in late 2020, and this continues to gain traction to this day. Companies had to be capital intensive in the past decade to get to where they are now. The first year of tremendous execution on this new investment framework is in the books, establishing a foundation to grow this track record. Management teams believe in this model, as they are continually evolving their compensation programs to be more aligned with their investment framework and investors.

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