Shareholder Returns May Jump Across Energy Sector As Debt Levels Plunge

• The U.S. oil patch has been exercising better capital discipline, paying down debt and returning excess cash to shareholders in the form of dividends and share buybacks.
• Net debt by companies in the S&P Oil & Gas Exploration & Production Index will have been cut by $100 billion between 2020 and 2022.
• Rising interest rates have increased the cost of borrowing quite dramatically and forced companies to cut down on issuing new bonds.

During the last energy boom, American drillers binged on mountains of readily available debt as they capitalized on investors and financiers willing to gamble on the premise that fracking operations could be significantly cheaper and more efficient than conventional drillers.  Predictably, the bubble finally burst, leaving many like deer in the headlights after saddling themselves with debt to the tune of more than $200 billion. Not surprisingly, hundreds were forced to file for Chapter 11 bankruptcy before the global energy crisis finally came to their rescue.

Unlike during previous oil and gas booms, the U.S. oil patch has been exercising better capital discipline this time around, paying down debt and returning excess cash to shareholders in the form of dividends and share buybacks. In fact, they have become quite adept at it, that they have managed to break out of debtor’s prison: a significant number of energy producers are on track to meeting or surpassing debt reduction targets in the next year and a half.

According to estimates by analysts surveyed by Market Intelligence earlier in the year, net debt by companies in the S&P Oil & Gas Exploration & Production Index will have been cut by $100 billion--or nearly by half--between 2020 and the end of 2022.

Expensive Debt

There’s yet another reason why debt levels in the U.S. oil patch are tumbling: higher interest rates. 

Rising interest rates have increased the cost of borrowing quite dramatically and forced companies to cut down on issuing new bonds. In fact, this has become a global trend, and cuts across various industries:  global corporate debt has fallen for the first time in eight years, with U.S. corporate net debt falling to $8.15 trillion over the past year from a high of $10.5 trillion.

Two years ago at the height of the Covid-19 pandemic, businesses took advantage of low interest rates to borrow enough cash to survive the pandemic. But with the prospect of higher interest rates, businesses have been using their cash flows to pay down debt rather than take on the higher interest charges.  Further, many of those  borrowings will take years to mature. 

For instance, only $1.5 trillion of  corporate debt in developed economies will be maturing over the next two years. Meanwhile, oil and gas drillers have mainly kept spending flat over the past two years as commodity prices rose, leaving them with extra cash to pay down debt and reward shareholders with higher dividends. That kind of discipline has managed to convince investors that oil and gas companies have become stingy stewards of capital despite their history of spending big on production growth when times were good.

Related: What To Expect For Q3 Energy Earnings

This is a good thing because analysts are now predicting that shareholder returns could jump across the energy sector as companies that were previously preoccupied with debt repayment begin plowing more cash into dividends and share buybacks. 

According to a recent report by credit rating giant DBRS Morningstar, oil and gas companies are well positioned to navigate the current inflationary environment, a potential economic slowdown and rising interest rates.

“The primary reason is the fact that they’ve reduced leverage so much over the last two years, the balance sheets are looking better today than they did at any time over the last decade,” Ravikanth Rai, DBRS Morningstar vice president and analyst, said.

Demand for energy stocks to 'dramatically increase' 

According to Truist analyst Neal Dingmann, investors seem ready to start buying energy stocks again as earnings start rolling in, and also because the sector remains cheap. Dingmann says he believes "demand for energy stocks is about to dramatically increase" as earnings reports come in.

Whereas the analyst expects about a third of the companies he covers will report Q3 free cash flow below Q2 levels, he notes that FCF yields will still be among the highest of any group making the sector even more attractive.

The energy sector has enjoyed bumper profits in the current year, with Big Oil companies setting records left, right and center. ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX) and Shell (NYSE: SHEL) together brought in $46 billion in earnings in the second quarter, with all three setting new records for quarterly earnings.

The energy sector is expected to report the highest earnings growth of all 11 U.S. market sectors at 119.4%. Higher year-over-year oil prices are contributing to the year-over-year improvement in earnings for this sector, as the average price of oil in Q3 2022 ($91.43) was 30% above the average price for oil in Q3 2021 ($70.52). 

At the sub-industry level, all five sub-industries in the sector are expected to report a year-over-year increase in earnings of more than 20%. The energy sector is also poised to be the top contributor to S&P 500 earnings growth for the third quarter in a row. If this sector were excluded, the index would be expected to report a decline in earnings of 4.9% rather than growth in earnings of 1.6%.

By Alex Kimani for Oilprice.com

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