Things appear to be on the upswing, albeit with cautious optimism, in the exploration and production (“E&P”) space.

Most of the eight E&P operators we tracked reported that operations in the first quarter were relatively stable.  This was in spite of winter storm Uri, which wreaked havoc from New Mexico and Texas northeast through upstate New York and New England.

It may be worth examining the effects of Uri on E&P operators’ Q1 performance more in-depth, with a focus on how natural gas prices may have affected revenues vs. any associated increase in operating expenses or the intangible costs stemming from marketing and sales disruptions.

Regardless of Uri’s net effect on financial performance, the ultimate trending phrase in E&P operators’ earnings calls was “positive free cash flow,” indicating continued upward trajectory out of the crude abyss.

Deleveraging remains a primary goal for many operators.  Several have resumed their dividend programs, while others have announced special (i.e., non-recurring) dividends to project their positive outlook to investors.

In tandem with this bullish perspective, few E&P operators seemed overly concerned with the potential tax implications stemming from regulatory changes brought forth by the Biden Administration.

ESG

Continuing the trend we saw in the 2020 Q3 and Q4 E&P operator earnings calls, the Q1 earnings calls featured increased discussions regarding ESG topics.  For some operators, the commentary covered basic items such as reduced greenhouse gas (“GHG”) emissions and quarter-over-quarter reductions in flaring.  Other operators had more comprehensive talking points related to ESG topics in the context of company operations on a forward-looking basis.

• “In March, we issued a press release announcing changes to our executive compensation program and outlining our new greenhouse gas emissions reductions targets.  Comprehensive changes to our executive compensation program included accountability for achieving both quantitative and qualitative ESG goals in the near and medium term.” – Joe Gatto, President & CEO, Callon Petroleum
• “[This year] we introduced methane-related KPIs into our executive compensation program.  We’ve committed to make a substantial multi-year community investment of $30 million over the next six years to widen the path for the middle class in our local community while growing the local talent pipeline.  We have redoubled our efforts to spend local and hire locally.  100% of our new hires will be from our area of operation and will maintain that – we will maintain at least 90% local contract workforce.” – Yemi Akinkugbe, Chief Excellence Officer, CNX Resources
• “This year will also be an exciting year for Antero’s ESG initiatives as we make progress toward our 2025 best in class goals.  These … include achieving net zero carbon emissions, reducing our industry leading GHG intensity and methane leak loss rates.  We also plan to complete and publish our TCFD analysis with our 2020 ESG performance results later in 2021.” – Glen Warren, CFO, Antero Resources

Return of Capital to Shareholders

In recent earnings calls, many E&P operators suggested that they would resume dividend and share buyback programs when positive free cash flow, and in some cases higher-priority deleveraging initiatives, made it conducive to do so.  As noted in the introduction, this time has come for many operators in Q1.

• “We reinstated a quarterly dividend of $0.11 per share, … this is double our previously issued dividend, which has been temporarily suspended at the onset of the global pandemic.  We believe this is expected to be sustainable given our strong cash flow generation and interest expense savings from our significant debt reduction.” – William Berry, CEO, Continental Resources
• “Going forward, our goal is to continue growing the regular dividend.  We have never called for suspending the dividend and we remain committed to its sustainability. … Now, EOG is positioned to address other free cash flow priorities by returning additional cash to shareholders.  The $1 per share special dividend [announced May 6] follows through these consistent long-tailed priorities.” – Tim Driggers, CFO, EOG Resources
• “So, for the quarter we repurchased 1.5 million shares at an average price of $12.26 per share at a total cost of $18 million.  We still have ample capacity of around $240 million under our existing stock repurchase program…” – Nick Deluliis, CEO, CNX Resources

Proposed Tax Changes

Among the potential energy tax changes under the Biden-Harris Administration, the most prominent talking point discussed by E&P operators in the Q1 earnings calls was the proposed change to disallow the reduction of taxable income stemming from intangible drilling costs (“IDCs”), and the subsequent increase in taxes and reduction in future free cash flow.  The discussion and response to questions about these proposed tax changes overwhelmingly suggest that most of the operators we tracked do not foresee any material tax payments for at least the next four years, due primarily to substantial net operating losses (“NOLs”) that may be used to offset future taxes.

• “We are not a cash taxpayer in the U.S. this year.  And at prevailing commodity prices, we don’t expect to be paying U.S. cash federal income taxes until the latter part of this decade.  This holds true even if the tax rules for IDCs are changed or if the corporate tax rate has increased.  We have significant tax attributes in the form of NOLs in addition to foreign tax credits.  These attributes will be used to offset future taxes.” – Dane Whitehead, CFO, Marathon Oil
• “Our plan through ’26, we’re not material cash taxpayers during that plan.  Most of it’s the way we treat sort of the NOLs and utilize those as regards to the cash taxes that we would have to pay, and managing and optimizing that versus sort of the IDCs and the other attributes that you have on the tax side.  So, the color we’ve given to date is no material cash taxes through 2026 is the current plan.” – Don Rush, CFO, CNX Resources
• “We have substantial NOL carryforwards at a federal and a state level.  So, if you look at it in a current regime, putting off a free cash flow at the level that we are, certainly, you convert to cash taxes at some point.  We see it being five to seven years in the future in a current regime.” – John Hart, CFO, Continental Resources

On the Horizon

While we selected three primary themes among the Q1 E&P operator earnings calls, several other notable topics were also discussed.  Perhaps chief among them, the general consensus is that significant production growth is not desirable at this juncture.  Steady operations is the name of the game at the moment.  Furthermore, operators are seeing inflation in field service provider costs, which are expected to continue growing, though it remains to be seen just how those may affect future margins.

Conclusion

Mercer Capital has its finger on the pulse of the E&P operator space.  With increased volatility in the energy sector these days, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream.  For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.