If the U.S. upstream sector of the previous decade was best defined by the shale revolution, the market dynamics of the past three years suggest the current decade will be remembered for the reinvention of the E&P business model itself.
What is driving the change in E&P behavior? Certainly, the sheer magnitude of the 2020 collapse in oil prices and in shares of E&P companies tested the industry’s resolve. Intense shareholder pressure on E&Ps to demonstrate true capital discipline—no longer just a buzzword—has been critical to revitalizing investor sentiment in the sector.
Related, but sometimes overlooked, is the role of executive compensation metrics, in particular the factors that drive annual incentive plan (AIP) compensation. Our analysis of AIP formulas for 20 of the largest publicly traded U.S. E&P companies revealed just how dramatically executive compensation metrics have evolved in recent years, better aligning management incentives with shareholder interests and, in our view, promoting a more sustainable, financially sound and investable domestic oil and gas sector.
First, E&Ps have substantially de-emphasized, and in many cases even eliminated, production based metrics from the formula. Currently, just half of E&Ps still have some component of the AIP tied to production targets, down from 60% in 2020 and more than 80% in 2019. This perhaps best illustrates the fundamental difference versus the shale E&P model of the past, which included incentives to pursue ever higher volume growth—in hindsight, often at the expense of capital efficiency, and in too many cases, detrimental to company balance sheets.
Second, the diminishing emphasis on production growth has been accompanied by a notable increase in targets related to free cash flow generation, mirroring the evolution of the underlying business model. Two-thirds of E&Ps now include an explicit free cash flow metric in the AIP formula, up from 45% last year and just 30% in 2019. For many companies, this is also the factor carrying the heaviest weight, on average nearly 25% of the total formula. This underscores the ongoing push from E&P shareholders for management teams to adopt a less capex-intensive business model with a focus on generating more sustainable free cash flows through commodity price cycles.
For an industry that historically spent far in excess of operating cash flow, reinvestment rates for public E&Ps are tracking to come in at less than 40% this year, and well below 50% for 2023 assuming recent futures strip prices.
Growing scrutiny on free cash flow generation not only serves to enforce capital discipline, but it is also becoming an important mechanism as energy investors shift focus to cash returns—increased shareholder distributions through a combination of fixed and variable dividends along with share buybacks—which most E&P companies are now paying out formulaically, based on a target percentage of quarterly or annual free cash flow.
Many E&Ps are now offering investors a total cash return yield of 10% or higher, considerably above the S&P 500 dividend plus buyback yield, which is near 4%. In our view, this value proposition has been a key driver of E&P share price performance, both intra-sector and relative to the broader market.
Third, ESG-related metrics have become far more prevalent in AIP formulas and have evolved to include specific, measurable emissions reduction targets, which we see as a noteworthy improvement from the more traditional (and oftentimes vague) HSE components.
In 2019, none of the large public E&Ps had an explicit emissions intensity metric in the AIP formula. Today, 85% of those companies include at least one. While the current dialogue is understandably more focused on energy security, it is no less critical for the E&P industry to continue demonstrating improvements and transparency on environmental performance. We expect growing emphasis on these metrics as part of management AIP formulas as a way to encourage progress toward longer-term emissions reduction and net zero targets.
From 2010 through 2019, U.S. E&P stocks underperformed the S&P 500 in seven of 10 years, declining more than 40% over the decade while the broader market was up nearly 200%. Last year the trend reversed; E&P share prices rallied more than 60% compared to the S&P 500, which rose 27%. More than halfway through 2022, E&P stocks are on pace to deliver even greater relative outperformance this year.
To be sure, rising oil and natural gas prices have been a major factor supporting higher E&P stock prices. But equity investors are also sending a clear message to companies that the truly capital disciplined, returns-driven business model is resonating. The economic incentives for E&P management teams to stay laser focused on delivering that value proposition are now catching up.
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