Refineries may show the way in an environment totally focused on returns

E&P investors are shifting priorities, and are beginning to reject “growth for growth’s sake” in favor of shareholder returns. Cash returns are elusive in a capital-intensive industry, though, and the route to returns is unclear. According to analysts at Cowen, E&Ps would do well to look at another sector in the oil industry, refiners.

Refining companies are typically focused on total shareholder returns, and have several significant similarities to E&Ps. Both have wide cyclicity of margins and volatile returns on heavy growth investment. According to Cowen, refiners that have focused on cash returns have been rewarded by the market, seeing multiples increase.

E&Ps need three things to be able to return cash

E&Ps have several core requirements to transition to a cash return business model, a high-quality long- term inventory, low corporate decline rates, and recognition that supply growth impacts commodity prices.

Without a large inventory, cash returns is a poor use of capital. A company that is on track to run out of drilling locations within a few years is better served by finding new opportunities. The shale revolution, however, has transformed oil and gas operations into something of a manufacturing business, which makes considering cash returns a possibility. In the past, growing production could be very difficult, so the ability to do so was rewarded by investors. Now, massive productive plays like the Permian mean any company can grow production, if they have acreage and capital.

Initial decline rates are high, but there is a way around this problem. After a basin has been active for a significant amount of time, older wells with lower productivity and lower decline make up an increasing share of the overall production. This forces the overall decline rate of the field down, making sustaining production less expensive. According to Cowen, the Marcellus fits this best in the near term. Companies have been active in the field for years, and production growth is slowing.

Increasing shares of new production will be exported

The extensive development of shale production has also led to a change in the effects of further growth. During the early portion of the shale revolution new oil displaced imports, which fell significantly in the past ten years. Today, however, things have changed. Light sweet oil from shale has already displaced most imports of such grades in the U.S., and imports are now dominated by heavy grades not contained in shale formations.

A growing share of new production will be sent overseas, competing in the global market. E&Ps have already begun exporting crude to China, and ports like Corpus Christi are preparing to export oil on massive international tankers. Growing LNG export capacity means natural gas will also see this dynamic, sending new production abroad.

This provides additional incentives against “growth for growth’s sake,” as large production growth will depress commodity prices. This is not easy to address in the U.S., with its numerous competing companies, but should be recognized.

Anadarko, Conoco, others returning cash

Several companies have already begun to focus on cash returns, including Anadarko, ConocoPhillips, Hess and Oxy. Anadarko, for example, has stated that it will not use cash flow beyond $50/bbl to accelerate production growth, focusing on returns instead. The company has already announced a $2.5 billion share repurchase plan. ConocoPhillips continues to focus on its “sustaining price,” and is working to lower this price further. Other companies, pressured by investors weary of growth, may also look to some form of cash returns in the coming months.

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