Companies are beginning to put capital to work away from the drill bit, but should they be targeting debt?

Several high-profile share repurchase programs have been announced recently as oil and gas companies look for ways to reinvest their free-cash flow.

Anadarko Petroleum Corp. (ticker: APC) said in September that the company plans to repurchase $2.5 billion of its stock while Phillips 66 (ticker: PSX) reported earlier this month that it would put $3 billion to work through a share repurchase program. Anadarko’s announcement sent the company’s stock up 8% in the course of a day as the company signaled markets that it had cash on hand, and was in a strong enough position that it did not need to put that capital into the drill bit or toward the balance sheet.

Anadarko Petroleum Corp's stock performance indexed to the XOI before and after its share buyback announcement

In EnerCom’s Energy Industry Data & Trends for October, EnerCom Analytics examined why the share buyback deal made sense for APC and identified several other companies which could benefit from similar programs. Through the analysis of more than 60 E&P companies, EnerCom found that, in general, the best use of capital for companies was in paying down debt, but there is a threshold under which other company fundamentals become more important in determining price-to-cash flow metrics than debt.

Markets less concerned with debt when debt-to-market cap is below 1.5x

Comparing price-to-cash flow multiples to debt-to-market cap for the companies in EnerCom’s database, valuation begins to vary widely after companies lower their debt below 150%. Cash-flow multiples become much more variable as markets are focused more on company fundamentals rather than their debt at that point, according to EnerCom.

EnerCom's price-to-cash-flow-per-share comparison with debt-to-market cap shows markets care less about debt below 150% of market cap

Companies with debt-to-market cap ratios greater than 1.5x would benefit the most by lowering their leverage. Companies with debt metrics below that threshold have a greater deal of flexibility in how to deploy capital, said EnerCom. If F&D costs exceed the company’s share price on a EV-to-Reserves basis – as was the case for Anadarko – a share buyback can be an effective use of capital. If F&D costs are lower than the EV-to-Reserves metrics, putting capital back into the drill bit tends to be the most cost-effective use of capital for those low-debt companies.

This is not to say that deleveraging has no effect below a 1.5x debt-to-market cap ratio, however. EnerCom’s analysis found that Anadarko’s share price likely would have gone even higher had the company used the $2.5 billion to pay down debt based on regressions from EnerCom’s Five Factor Model (5FM), but the effect deleveraging has on share price decreases significantly for companies with debt-to-market cap below 1.5x.

For further information on debt ratios, capital allocation and buyback programs, please see EnerCom’s Energy Industry Data & Trends for October.

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