Exploration and Production companies in the United States have faced a host of challenges since 2020, and those that survived bankruptcy that year have largely fared well since. The lessons of fiscal prudence invaded an industry historically known for gambling on the next great acreage play. Smaller U.S. players have joined their larger brethren and exercised sound investment judgment post-COVID, avoiding high-leverage, production in excess of demand, and basin concentration to the benefit of windfalls as prices ran up from historic lows.

But now the survivors of 2020 are split into two camps. The first, the largest, diversified players now weather shareholder interests with respect to investing in renewable projects and reducing fossil fuel reliance, and returning capital to markets through dividends and share buybacks. The strategy has worked, garnering investor interest, so much so that as of the first quarter of 2023 Berkshire Hathaway was the largest shareholder of Chevron and Occidental Petroleum.

The second group, U.S. E&P companies under $1 billion in market capitalization, are neither diversified nor investing broadly in ESG campaigns. They face uncertainty about future oil and gas demand, and don’t have the largesse to return capital to the marketplace like their well-coffered peers. As their Free Cash Flow continues to fall going into the latter half of 2023, they’ll have to outsource inspiration, and quickly.

Unclear conditions for drilling

COVID-19’s onset was a reminder to the Oil & Gas sector that no matter how high one thought the industry rode, it could come crashing down at any time. Unlike previous downturns where interest rates prevented using debt as a drilling catalyst, the industry has trafficked in near-zero interest rate policies (ZIRP) dating to the Great Recession. In two weeks in March 2020, the Fed dropped its target rate range to 0 – 0.25% and left it there for the rest of the year. Faced with plummeting spot prices in 2020, E&P finance teams understandably took advantage, restructuring debt both in and out-of-court.  

Over 2020 and 2021, U.S. E&P companies restructured over $34 billion in term debt out-of-court at rock bottom pricing, placing most maturities in the sector well beyond the midpoint of this decade. Similarly, 2020 saw over $53 billion of U.S. E&P debt restructured in bankruptcies. Such a massive resetting of the capital structure decks gave operators the breathing room they’d craved for decades, and a subsequent runup of demand entering 2021 provided elevated pricing to run in tandem with it.  

In past cycles, operators have taken the opportunity to put low cost of capital funding to work, borrowing to drill and subsequently improve Free Cash Flow margins, providing flexibility for reserve replacement or other strategic transactions. This cycle has been seismically different. January 2020’s U.S. total rig count of 796 represents the high-water mark of activity, and has fallen nearly 13% in the U.S. since, for a number of good reasons.

Demand uncertainty has become pervasive in the last year, and in and of itself has justified the sector’s reluctance to drill. But other macroeconomic factors have weighed on the confidence of operators as concerns of a pending global recession complicate executing drilling programs. Global liquids fuel consumption is projected to rebound by 2.3% by year end 2024, but spot prices remain depressed for oil and outright depressing for gas (down 39% and 57% respectively, from a year ago). The Fed’s campaign to reign in inflation through rate increases casts a pall over global demand which has yet to be realized, and has the added impact of making follow on financing for drilling and acquisitions more difficult.

All of these factors have placed the Upstream sector at an impasse of sorts to grow strategically. That’s not to say that some players haven’t been creative with their capital. On the contrary, headlines for energy investing are now routinely tied to whimsical technologies that could be part of lowering greenhouse gases. But that’s for those who can afford it, and can accept profits wedded to long investment horizons, which may never come at all.

Well-intended climate reduction investment

Renewable energy investing has seemingly rose as a use of capital expenditures in the last five years for companies across all streams and justifiably so. Pressure from investors, subsidies from governments, and aforementioned uncertainty in fossil fuel development conditions have tipped the scales toward increased renewable investment. It’s a trend that has affected the industry globally, and from which U.S. producers are not immune.

Five years ago, for every dollar spent on oil and gas development, a corresponding dollar was spent on technologies like carbon capture, renewable gas, e-NG, green hydrogen, alongside the established channels of infrastructure, storage, wind, and solar. That ratio is now lopsided, with oil and gas projected to comprise just 30% of 2023’s $2.8 trillion in global energy investment8.

The perception in the public and across the industry is that energy companies by and large are a major part of the push to meet net zero ambitions by 2050. They’re not. While large projects splash the home pages of the trades and garner coverage across media for justifiably admirable contributions to greenhouse gas reductions, they’re undertaken by majors with discretionary income to make such commitments. To be clear, diversified energy companies are well, and perhaps even best-suited, to undertake clean energy development. They are well-funded, organized, staffed with best-in-class engineering talent, and able to navigate the increasingly complex incentive paradigms that are a part of large-scale technological development. But, that speaks to a small cohort of industry players. There are approximately 9,000 independent producers in the United States of substantially less means.

Operators are projected to invest over $500 billion globally this year, a 7% annual increase, but only Middle Eastern National Oil Companies will spend over pre-pandemic levels. Domestic producers will continue to show declining support for oil and gas development. Of those capital expenditures, low carbon investing has comprised 1% of total O&G investment for the last two years globally. Over fifty times that amount was spent on debt repayments, share buybacks, and dividends in 2022.

The amount of investment spent on low carbon technologies by the energy industry are not trivial. But their proportion of total expenditures speaks volumes about the perceived viability of such endeavors. A for-profit enterprise can invest in renewables, but with unproven technology, protracted investment horizons, and uncertain returns, those expenditures mask nebulous strategies, and are only for the wealthiest of industry players in the US.

Returning capital isn’t necessarily a bad thing

All of the factors previously described have led to operators who are flush with cash without a place that compels them to invest it. Uncertainty for the E&P sector can be most simply seen in diverging views of the future: a price forecast in contango while strips are backwardated for oil. Gas offers a bit more clarity in optimistic economic projections that match its strip, but the decline in spot pricing has placed gas-heavy operators on less-solid free cash flow footing than their oil-weighted brethren.

Understandably, dividends are up and increasing year over year for E&Ps after 2020. Companies with market capitalizations over $750 million have seen dramatic increases in their dividends, with those over $5 billion on skyrocketing trajectories (see Figure 1). As stated previously, dividend issuance and buying back shares represent a defensible fiscal strategy for large U.S. companies. Those producers provide sound returns through dividends and provide a floor for share price appreciation, which among other benefits is a great way to retain talent who receive options as part of their compensation. But not all U.S. players in the oil patch can protect their capitalizations by returning capital to the market.

Figure 1: Dividend per share ($) by market capitalization segments

Free cash flow has customarily been a reliable way to gauge an E&P company’s health. A company that can’t clear its capital expenditures with its operating cash flow has an unsustainable drilling profile. Management teams at an FCF deficit ride a cycle where they transact, selling assets to fund the acquisition of new stock for exploitation or development, then enjoy the profit of executing a successful drilling program until income wanes and the sequence repeats. Debt issuance exacerbates risk for a company operating at a FCF deficit, and aforementioned financial responsibility post-COVID has led to less reliance by U.S. smaller producers on it.

For most of this century, only the largest companies in the sector trafficked in sustained FCF surpluses.  However, the economic conditions for operators has been extremely robust since 2020, when the entire sector by market cap classification saw enormous FCF surpluses (see Figure 2). As volatile as Upstream is, it's only natural that FCF is shifting, but the fact that the sector en masse is over 100% entering 2023 presents potentially temporary options for those operators whose FCF is declining.

Figure 2: Operating cash flow / CAPEX (%) by market capitalization segments

The tools that smaller U.S. companies can use in their current state of profitability are the same ones AlixPartners has historically used for clients of all sizes, and they go beyond dividends and share buybacks, buying optionality for management teams before they face FCF deficits. Clients in this climate can benefit from improving their financial operations, supply chains and operational efficiencies (including workforce improvements). They can also utilize the strategic benefits of ESG / renewable investing where accretive to profitability, and M&A transactions as appropriate, to include consolidation.

The largest operators have the benefit of massive profitability in an uncertain time.  Those companies can more easily utilize dividend and share buyback programs, which are designed to be suspended if needed, and pursue non-fossil fuel technology investing as a part of a long-term strategy. Their smaller peers in the US, though, should invest in optimization now, so those efforts can bring financial flexibility before the next downturn hits the Upstream sector.