How the oil patch turned itself around and is attracting a whole new group of investors

Published Thu, Sep 16 202112:45 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

There's an old saying in Texas — oil will be found where it was once found before. Now, some investors are saying the same could be true about investing in oil and gas companies. They are once more able to look to them for cash flow and dividend growth. After shunning energy, investors this year have been scooping up names in the sector along with other cyclicals. Oil and gas companies have paid down debt and cleaned up their balance sheets. Importantly, they are holding off on new drilling, even as oil and gas prices rise. Shareholders have demanded frugality from producers for several years now, and analysts say the industry is committed to holding off on new wells until OPEC-plus has returned production to previous levels and demand is comfortably back above 100 million barrels a day. That is not expected until some time towards the middle of next year. That means as oil gushes above $70 a barrel, oil companies are not pouring their cash back into the ground to drill more crude. Instead, there's a better chance more of it goes to shareholders. "Debt is not an issue anymore. They're going to be generating a lot more free cash flow. The decision now for energy companies is what am I going to do with all of my free cash flow?" said Michael Bradley, managing director, capital solutions at Tudor, Pickering, Holt and Co. "They're paying variable dividends, special dividends." Bradley said companies are watching the disparity between $70 oil and their own stocks which reflect about a $50 oil price. "We're going to see more share buybacks," he said. "I think a lot of companies didn't want to go the buyback route because a lot of them got burned on that front and were really going with variable dividends and special dividends. What we're hearing now is it's all of the above. Next year, you're going to have a significant amount of free cash flow." Energy in transition Before the pandemic, energy companies that derive profits from fossil fuels were rejected by investors concerned about ESG values, or environmental, social and governance criteria. Energy stocks were already under selling pressure. Then in March, 2020, the pandemic shut down the world economy, destroyed demand and sent oil prices cratering. At the same time, investors worried about an energy transition in the United States, with the Biden administration aggressively looking to move to more renewable fuels following the Trump administration's pro big oil stance. But with an improving global economy, oil has made a comeback, and so have oil and gas companies. West Texas Intermediate crude oil futures was at $72.20 per barrel Thursday, and natural gas was at $5.25 per million British thermal units, the highest since 2014. Still off its highs of the year, the S & P energy sector is up about 5.2% this week so far, though it is down about 7.7% for the quarter-to-date. The sector was up 3.8% Wednesday, with every company ending the day higher. According to Instinet, the Energy Select Sector SPDR Fund ETF XLE closed back above its 50-day moving average Wednesday for the first time since early July. "At some point, you're going to sit there and say, the free cash flow yields on these things are 12% to 15% on average...I don't think there's additional sellers in these names. The question is when do you have these guys that sold say maybe it's not a bad thing," Bradley said. The free cash flow yield for the S & P overall is about 5%. "Everybody in the energy industry with an over leveraged balance sheet has spent the pandemic repairing their balance sheet," said said Rob Thummel, senior portfolio manager at TortoiseEcofin. " Pioneer and EOG are unique in that they almost have no net debt," he added. Sprucing up The energy industry is paying much more attention to lowering its carbon footprint, also in response to shareholder pressure. Thummel said all companies are making changes, but it's the majors that lead in switching up their energy portfolios to reflect the transition to renewable and cleaner energy. "I think global decarbonization is a mega trend. It's not going away. it's something the whole word is doing , and it's healthy for all businesses. So when you're a big carbon emitter, how do you navigate that world? The way these companies want to participate is by embracing ways they could reduce carbon emissions... and the biggest one right now is to stop flaring," he said. Many companies are working to reduce methane emissions and curb the flaring of gas at wells. Energy companies have been working to make themselves more attractive to ESG investors. "They may not make the first screen, but they can hit the second screen - who is making the most dramatic improvement in their ESG principles," Thummel said. EQT, for instance is focusing on responsibly sourced natural gas to reduce its carbon footprint. Other companies, like Occidental Petroleum , are working on carbon sequestration. Cheniere is working with Pioneer and others to tag the carbon intensity of its liquified natural gas shipments. Shareholder driven Investors have forced energy companies to clean up their balance sheets and increasingly the environment. One of the more high profile efforts has been hedge fund Engine No. 1's successful effort to gain board seats at ExxonMobil. The firm has been speaking with executives at other energy companies, including Chevron. "You can argue that the Engine 1 efforts at Exxon have trickled to Exxon's primary competitors. Chevron, Conoco Phillips, Royal Dutch Shell and BP have already been making progress," he said. On Tuesday, Chevron said it expects to invest more than $10 billion by 2028 to accelerate its lower carbon efforts, triple its previous guidance. Of that, $2 billion will be aimed at lowering the carbon intensity of its own operations. The company intends to increase renewable fuel production, hydrogen production and carbon capture. Chevron also reaffirmed it expects to generate $25 billion of cash flow, above its dividend and capital spending, over the next five years. "There's a lot of cash flow coming out of the energy sector that should end up in shareholders' hands over the next couple of years," said Thummel.

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There's an old saying in Texas — oil will be found where it was once found before.

Now, some investors are saying the same could be true about investing in oil and gas companies. They are once more able to look to them for cash flow and dividend growth.