Buoyed by geopolitical tensions that threaten global commodity supply, oil and gas prices have surged in 2022, boosting E&P corporate fortunes and raising the potential for additional share buybacks and other measures toward shareholder returns.

Both domestic and international E&Ps begin reporting on their second-quarter performances this week, and insiders anticipate a glimpse into their second-half forecasting.

But while commodity prices have popped this year to unexpected highs, the sector faces a list of headwinds. Among them, cost inflation, derivative buy-offs, hedging and workforce shortages each challenge companies operating in the E&P space, analysts say.

Undervalued and Overwrought

E&P share values have pulled back 6% during the last month and underperforming the S&P 500 by 23%. The drop places an increased focus on the potential for buyback programs weighted toward the second-half 2022.

Indeed, some companies began mounting larger buyback programs as the second quarter came to a close. Chesapeake Energy Corp. doubled its buyback program to $2 billion, proffered by the end of next year. And U.S. oil producer Murphy Oil Corp. CEO Roger Jenkins said the firm may increase shareholder returns via buybacks before it reaches its debt reduction targets.

While debt reduction and variable payouts dominated many capital programs during the first part of the year, analysts at Cowen Equity Research anticipate management teams will lean into buybacks in the second half.

Share underperformance makes buybacks a less costly method of returning cash to shareholders, noted Cowen analyst David Deckelbaum.

During the last six weeks, the XOP (the S&P 500’s E&P index) has traded down 24% since June 8 and underperformed the S&P 500 by about 20%. But analysts at Wells Fargo say the sector is due for an uptick by year-end.

“We think the sector is set to outperform again, given 1) discounted valuations versus the market, 2) tight inventory for both oil and gas that should support product prices, and 3) even stronger cash return initiatives,” said Nitin Kumar, a Wells Fargo equity analyst.

Moreover, Kumar said, U.S. E&Ps may continue to benefit from the investor focus shift to “the three Cs—capital discipline, cash margins and cash returns.”

Geopolitical tensions strengthened commodity prices, particularly during the first half of the year, boosting the XOP’s besting of the broader market through most of the first half of 2022.

But recession fears began dragging on the sector in mid-June. Nevertheless, Kumar noted the E&P index has showed up the broader market intermittently. During the week of July 18, the XOP popped 8.4% and outperformed the S&P.

Inflation, Recession Collision

The macroeconomic outlook has deteriorated under the weight of a potential recession and looming inflation increases throughout 2023, but Kumar said Wells Fargo analysts maintain that the global commodity market is structurally undersupplied.

However, the demand outlook is polarized. This summer, the International Energy Agency (IEA) has forecasted profound demand destruction, an assertion that earned widespread criticism.

One headwind that few insiders argue is increasing cost inflation on the industry. At Wells Fargo, Kumar anticipates second-quarter reporting will show capital expenses ticking upward to high side of corporate spending guidance. And, the investment bank is already modeling roughly 15% incremental inflation throughout 2023.

However, he said that while a recession could hit demand, it could also depress inflationary pressure on service costs “if the industry remains disciplined.”

Three of the largest oilfield services (OFS) providers have already reported their second-quarter earnings. Supply chain challenges and a quick drawdown of its operations in Russia pressured Baker Hughes Co.’s costs, said CEO Lorenzo Simonelli.

Year-over-year, margins were up 240 basis points. Excluding Russia, OFS operating margin rate was 10.3% and OFS EBITDA rate was 18%.

Still, underlying energy fundamentals continue to improve, and Simonelli said he expects growth in both international and North American activity, as well as continued price improvements in the third quarter, benefiting both the services and E&P sectors.