Like a wandering missionary centuries ago, I was on a three-year journey to preach a particular gospel. After years of macroeconomic shocks, oil price crashes and persistent energy ignorance, not so long ago energy stocks were viewed as value traps left by public investors to die. To be revived and trade close to historical valuations, I firmly believed that one thing, and one thing alone, could lead to a recovery: meaningful stock returns in the form of stock buybacks and dividends.
It has been a long pilgrimage for the past three years. What progress has been made during that time? How powerful are shareholder returns in forcing a stock price reassessment? And what is the probability that the energy sector will pay high levels of profits over the next several years?
The difference between a value trap and cheap stock that can make sense in valuation is an identifiable trigger. To awaken the common investor from a state of unbridled apathy, the stimulus in my mind was very simple: a dividend or buy-back programme, funded by free cash flow, that would be so attractive that it would be too difficult to ignore it any longer and force reconsideration from generations’ low valuations.
A little over three years ago, I wrote an open letter to the industry advocating such a measure, saying, “We can sit back and take stock in the hope that something magical will happen to improve feelings or we can do something about it with one simple remedy.”
At the time, this thinking was heretical. Production growth was something that seemed to have been instilled into oil CEOs from their birth. Fascinated by the economics of the half-cycle well level or relieved by sticking to the supposed safety of the status quo, cash flow has always been fully redirected to drilling.
This approach is what has allowed the emergence of shale overgrowth in the United States, a period of time in which capital was burned in pursuit of growth at all costs, leading to numerous price crashes and subsequent criticism of energy stocks.
After three long years of cordial conversations and lobbying at the company and board level, which were interrupted briefly by the price shock of COVID-19, it is gratifying to see that “shareholder return” is the new debt, estimated to be 99 percent of the The industry buys into our plan and we pledge to return at least 50 percent – 100 percent in some cases – of free cash flow to shareholders.
We estimate the average Canadian energy stock that is currently trading at an estimated 2.7 times the enterprise’s cash flow and free cash flow yield of 25 percent at $100. How, with one simple act, can the board of directors force a reassessment of trading back seven or more times closer to historical levels? Keep production steady, cancel debt or at least get down to castle-like power, then use every dollar of your free cash flow to buy back stock.
The reissue timeline is surprisingly short, given that the average Canadian energy company that will approach debt forgiveness status by the first quarter of next year will be able to buy back all of its outstanding shares in just four years with $100 of free cash flow. West Texas Intermediate.
After all, what is the value of the last stake for a debt-free company that has billions of dollars in annual free cash flow and 15 years average of constant production? How can the share price not rise appreciably, assuming constant oil prices, if 25 percent of the shares outstanding each year are cancelled by the use of significant issuer bids?
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Looking ahead to the next several years, if oil remains at current prices and the sector approaches debt-forgiveness status by early next year with enough drilling stock so they don’t have to use free cash flow for mergers and acquisitions, companies face a unique problem: unprecedented free cash flow in ways limited to spend.
My advice to businesses is: If you no longer have any debt to pay, if you have sufficient inventory depth and don’t have to buy more land, given that low valuations cannot justify production growth, there is only one thing left to do with free cash flow.. . Give All Back to the shareholders.
So, it’s not unfathomable that the energy sector could soon pay out the equivalent of 25 percent of dividend yield if oil stays at $100 WTI, and that’s where the strength lies. Will the stock trade with an implied dividend yield of 25 percent if investors see the dividend as sustainable? I would suggest no.
Reconverting to a 10 percent return, which (given the debt forgiveness case and 15 years of identifiable free cash flow) sounds like a reasonable valuation level, would mean a 150 percent rise in energy stocks from current levels. Still think you’re late to the oil party?
Eric Nuttall is Partner and Senior Portfolio Manager at Ninepoint Partners LP.
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