With 3rd quarter earnings in full swing, producers are cementing their full-year 2017 financial and operating outlooks and disseminating preliminary 2018 plans. An omnipresent topic in recent years has been “operating within cash flow,” but not many companies actually do. The truth is that overspending is far more common than capital discipline, and investors’ appetites for production growth is helping drive production gains.
The chart below shows how many companies have had positive free cash flow since 2013 out of a sample of 64 independent E&Ps. Less than 20% of companies are on track to finish 2017 with positive free cash flow.
Data like this could be used to support claims that companies chase production growth at the expense of long-term value creation, but as BTU Analytics discussed in an article earlier this month evaluating executive incentives, the data it isn’t that clear cut.
Digging deeper to look at stock returns versus production growth over the last three years after controlling for various factors, including market cap, leverage, oil as a percent of production, and credit rating provides some interesting takeaways. Cutting to the chase, the factor that resulted in the highest correlation to stock returns when tested independently was “oiliness.” For companies whose production was 60% oil or higher, production growth had a stronger correlation to stock performance, but for those with under 60% oil production, it had a very poor correlation.
Like the comparison shown above for oiliness, this analysis also compared the aforementioned variables independently and in combination with each other to understand if production growth and stock returns are related for companies with certain characteristics. The conclusion from this research is that there is some evidence of a positive relationship between production growth and stock returns for companies that are more oil-focused, small or micro caps, or have strong credit ratings.
The pursuit here was not to discover the optimal decision point between focusing on cash flow or focusing on production growth, but to evaluate whether there was a general incentive for companies to pursue production growth, even if that means overspending. In this sample, 50 of the 64 companies had at least one variable that associated with a strong or moderate link between production growth and stock returns.
A takeaway from this finding is that investors might expect overspending to continue even if prices don’t improve any time soon. Especially for oil-focused plays, based on this analysis, there is a strong incentive to grow production, and the market has historically demonstrated that it will provide capital for expenditures not covered by operations for certain types of companies. Media commentary throughout earnings season could suggest that a focus on capital discipline will lead to curtailed activity. However, many of the same commentators believe the oil market outlook is improving. Will growth within cash flow satisfy investors if the tides turn and prices move higher?
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