US balancing act
The majors are facing a capital spending conundrum sooner than many in the industry expected
As a flurry of positive quarterly earnings statements marks a return to health for the oil industry, executives are confronted once again with the issue of how best to allocate capital to generate superior total shareholder return (TSR) performance. After nearly four years, during which oil companies kept a tight grip on capital in a "lower-for-longer" oil price environment, some shareholders are clamouring for companies to return cash to investors in the form of special dividends and share buybacks.
But industry executives would be wrong to listen wholly to the call, according to the Boston Consulting Group (BCG). Its inaugural Oil Sector Value Creator Report, to be published later this year, ranks TSR (share price appreciation plus dividends) performance since mid-2014 across 64 oil and gas companies with an enterprise value in excess of $8bn and a free float of more than 20%.
The report examines four factors that determine TSR performance across seven peer groups, including the majors, national oil companies, E&P companies and refiners. These factors comprise earnings growth, changes in net debt, free cash-flow yield and changes in earnings multiples.
"We're entering a period where we're likely to see some of the strongest quarterly figures since 2014, owing to the oil price rebound," says Rebecca Fitz, a senior director at BCG's Center for Energy Impact. "Shareholders understandably want a reward for their loyalty during the downturn. But companies that want to be TSR leaders also need to reinvest in the business."
Companies face a dilemma. Either channel surplus profits back to shareholders by maximising yields or invest in assets that will improve their net income margin. "Finding the right balance between the two will be the key to achieving strong TSR performance," says Fitz.
The report found that all peer groups experienced revenue erosion, causing the oil sector's TSR performance to lag the S&P 500 index over the period. Still, some peer groups fared better than others. For example, North American and international refiners, helped by lower input costs, delivered margin gains that were sufficient to compensate for revenue losses. By comparison, pure play E&P companies, with no downstream operations to mitigate their exposure to falling crude prices, were hit by weak margins and declining revenues.
If higher oil prices are maintained, capacity constraints rather than investment could be the main obstacle to US shale growth
However, BCG's study found sharply different investment drivers within the E&P peer group. Small E&P companies, typically with an investor base oriented to growth, performed better in TSR terms: Midland, Texas-based Diamondback, the only E&P to deliver first-quartile performance, did so due to strong oil production growth. Larger, diversified E&Ps delivered TSR figures in the third and fourth quartile. Their investors are more like those of other larger oil companies and are increasingly focused on value and income.
"Small E&P companies that were able to grow production and revenues during the downturn, and maintained capital discipline, were rewarded by shareholders. While a focus on capital discipline was important, it wasn't sufficient to secure leading TSR status," says Fitz. In a higher-oil-price environment, small E&Ps are likely to prioritise investing for growth (with capital discipline a significant, but secondary factor), with diversified E&Ps focusing on strengthening their balance sheet to maintain a competitive yield. Consequently, if higher oil prices are maintained, capacity constraints rather than investment are likely to be the main obstacle holding back growth in US unconventional oil and gas.
Oil companies that raised capital through share issues or made scrip dividends that diluted their share base during the downturn were heavily penalised by investors. With earnings growing again and investors becoming more focused on distributions, companies that maintain their dividend rather than overly increasing and then diluting it are likely to see better TSR, BCG believes. And as share prices across the board rise, differences in earnings multiples should be less important as a driver of leading TSR performance. In a higher price environment, concerns about net debt levels will also diminish, leaving companies that are still prioritising debt reduction goals at a competitive disadvantage.