U.S. Exploration and Production Industry, has it learned to be responsible?
The process we employ to manage the Keeley Small-Mid Cap Value Fund focuses on companies undergoing significant corporate restructuring. Sometimes, however, we see clusters of opportunity when entire industries rationalize and become more disciplined. While the Energy industry certainly faces long-term challenges posed by an increasing emphasis on non-fossil-fuel energy sources, the change in the behavior of companies in the industry over the last few years we feel has been profound and, we believe, is underappreciated by investors.
The US exploration and production (“E&P”) industry has transformed itself after an era of rampant dysfunction and poor capital returns to one which focuses on free cash flow generation and operational discipline. There is no shortage of reasons for Energy being the most hated sector in the global economy over the last ten years: 1) Share count grew almost as fast as production, 2) Regulation has been a constant threat, 3) Volatile commodity price swings, and 4) An inability to generate positive full-cycle returns. After getting an earful from shareholders over the last several years, and getting the boom lowered on them by OPEC in early 2020, the US energy landscape has seen consolidation and the surviving participants are perhaps no longer deserving of investor scorn and ridicule.
In the old days, US E&Ps valued production growth over everything else and it did not even matter that these companies were not cash flow positive at any WTI price. If a management team wanted to grow production 20%, all it had to do was pick up the phone and call its investment banker to issue equity. It also had to convince its shareholder base that this time would be the last time and that the balance sheet was now in great shape. Unfortunately, many E&P companies did it again the following year, perhaps this time with the offering funding an acreage acquisition to convince shareholders that the company had significantly increased its drilling inventory and again further shored up the balance sheet. This game worked for many years, but fatigued investors eventually slammed the door on this behavior. The message was clear: start generating free cash, as the market window is now closed. Encouragingly, even during a challenging 2020, many companies were able to live within their means.
Wave of Consolidation
A wave of consolidation kicked off in 2018 as investors started to see a series of all-stock deals done at no premium or a small premium. Pioneer Natural Resources (ticker: PXD, NYSE) CEO Scott Sheffield believes this consolidation will continue until there are only a few companies left outside of the majors. Pioneer has been quite active with a purchase of public competitor Parsley Energy in early 2021 and announced an agreement to acquire large private operator DoublePoint Energy in March 2021. Not to be left out, Diamondback Energy (ticker: FANG, NASDAQ) closed on two acquisitions this year with the purchase of large private operator Guidon Energy and public competitor QEP Resources. Below is a list of the recent public company acquisitions, compiled by KeyBanc Capital Markets.
|Announcement Date||Acquirer||Target||Deal Size Incl Debt ($ in B)||Target Company Production (Boepd)||% Oil||Form of Consideration|
|01/19/18||Cimarex Energy (XEC)||Resolute Energy (RES)||1.60||35,000||45%||Stock & Cash|
|08/14/18||Diamondback Energy (FANG)||Energen (EGN)||9.20||97,400||58%||All-stock|
|11/01/18||Ovintiv (OVV)||Newfield Exploration (NFX)||7.70||202,098||38%||All-stock|
|04/24/19||Occidental Petroleum (OXY)||Anadarko Petroleum (APC)||57.00||701,000||67%||Stock & Cash|
|07/15/19||Callon Petroleum (CPE)||Carrizo Oil & Gas (CRZO)||3.20||65,643||66%||All-stock|
|08/26/19||PDC Energy (PDCE)||SRC Energy (SRCI)||1.70||60,800||44%||All-stock|
|10/14/19||Parsley Energy (PE)||Jagged Peak Energy (JAG)||2.30||38,300||76%||All-stock|
|07/20/20||Chevron Corp. (CVX)||Noble Energy (NBL)||13.00||390,000||36%||All-stock|
|08/12/20||Southwestern Energy (SWN)||Montage Resources (MR)||1.20||96,833||6%||All-stock|
|09/28/20||Devon Energy (DVN)||WPX Energy (WPX)||6.70||207,000||60%||All-stock|
|10/19/20||ConocoPhillips (COP)||Concho Resources (CXO)||13.30||320,000||63%||All-stock|
|10/20/20||Pioneer Natural Resources (PXD)||Parsley Energy (PE)||7.60||183,000||59%||All-stock|
|10/26/20||Contango Oil & Gas (MCF)||Mid-Con Energy Partners (MCEP)||0.18||3,000||91%||All-stock|
|11/09/20||Bonanza Creek Energy (BCEI)||HighPoint Resources (HPR)||0.38||31,500||57%||Stock & Cash|
|12/21/20||Diamondback Energy (FANG)||QEP Resources (QEP)||2.20||76,700||63%||All-stock|
After seeing the light and building scale through consolidation, many of these companies now generate free cash flow. Furthermore, many have initiated or increased regular dividends and some also supplement them with variable dividends which allow for the shareholder to directly participate in rising oil prices. This is a relatively new phenomenon, and it remains to be seen how sustainable the variable dividends will turn out to be but some E&Ps target returning up to 50% of their excess free cash flow to shareholders in the form of a variable dividend.
This shift in emphasis drove a dramatic change in the stance of the E&P industry vis-à-vis dividends. At the end of 2016, there were 44 E&P companies in the Russell 2500 index of small and mid-cap companies and only five of them paid dividends (11%). Today, there are only 33 companies, but nearly 40% of them pay dividends.
Environmental, Social, and Governance
The industry also pays more attention to Environmental, Social, and Governance (“ESG”) considerations. Several companies have accelerated their programs to reduce their methane and greenhouse gas emissions. As an example, Diamondback has led this charge with a target to reduce greenhouse gas emissions by 50% and methane emissions by 70% by 2024 from 2019 levels. These companies can also play a role in carbon reduction as burning natural gas to generate electricity produces only half of the carbon of burning coal on an equivalent megawatt basis.
After a period of significant value destruction and a painful transition, we believe many companies in the E&P industry are now investible. They have become real companies now with attractive yields, good fundamentals, improving ESG scores, and they trade at attractive valuations. In full disclosure, Keeley Funds own PXD, FANG and DVN which were discussed herein. As of March 31, 2021, The Keeley Small-Mid Cap Value Fund owned 1.34% of FANG; The Keeley Mid Cap Dividend Value Fund owned 1.26% of PXD, 0.67% of DVN and 1.38% of FANG; and The Keeley Small Cap Dividend Value Fund owned 0.52% of PXD.