While U.S. E&P companies are working to re-engineer themselves, the general sentiment in the market is bearish. Putting aside the oil industry’s extreme cyclicality, the companies to look at today are those that have been able to develop an efficient business model that allows them to monetize their resources over 30+ years. It means finding the right corporate structure, balance sheet and free cash flow ratios. The ones that can show good profit margins, solid returns on capital and free cash flow generation are likely to attract investor interest.
As we wrapped up the fourth quarter 2018 earnings season, a number of companies have announced spending cuts in favor of cash generation. In general, these companies have highly economic resources and are shifting to balance the pace of development with cash generation priorities.
Merger and acquisition activity in the sector could also renew investor interest. It’s possible the market could see one or two large deals with the major integrated oil companies looking to expand their footprint in the Permian basin, an oil-rich area in western Texas and southeastern New Mexico. This is the first time in four years where the multiples for the major players are on par with or even higher than the large-cap E&Ps while their business plans have moved to prioritize the Permian basin.
Dimitry Dayen is senior research analyst for energy at ClearBridge Investments, a subsidiary of Legg Mason.