Shale gas E&P stocks expected to keep throwing off cash from Q4'21

Investors want shale gas drillers to report that they held the line on spending in the fourth quarter of 2021 and to detail how windfall profits from high natural gas prices will be delivered: increased dividends, share buybacks or a combination of the two.

After seeing some of the highest commodity prices for natural gas in years, analysts expected U.S. shale gas exploration and production companies, or E&Ps, to have a healthy amount of cash to hand out as their margins increased and spending stayed low at maintenance levels, flatlining production growth.

What the analysts do not want to hear about is any spending increases to grow oil and gas production, although some allowance will be granted for inflation.

"We believe that, given shifts in corporate strategy away from resource capture and growth and towards free cash flow and cash return, E&Ps will be able to retain relatively more of the benefit from the higher commodity price," Vincent Lovaglio, a Mizuho Securities USA LLC analyst, told clients Jan. 25.

The change in spending and production will generate free cash and support gas prices at $3.30/Mcf or higher, Mizuho said.

"EQT Corp. is our top pick in natural gas for forward-thinking management (responsibly sourced gas to drive potential margin enhancements) on top of the leading payout strategy among the gas names," Mizuho said.

Gabriele Sorbara, managing director and senior equity analyst at Siebert Williams Shank & Co. LLC, told clients Jan. 24 that investors will be looking for clues to 2022 spending in the fourth-quarter 2021 results. "We expect E&Ps to stay the course consistent with preliminary discussion around maintenance mode or modest growth programs, despite higher commodity prices," Sorbara said.

Sorbara said the 55% year-over-year gain in oil and gas prices can easily accommodate a 10% to 15% increase in service costs and that E&P stocks are still undervalued. Sorbara's top picks in the shale gas sector are Coterra Energy Inc. and Chesapeake Energy Corp.

With growth in the amount of oil and gas extracted from the ground no longer the tried-and-true metric for evaluating shares of upstream oil and gas producers, analysts have begun using alternative metrics, with one variable in common: free cash flow. Free cash flow, or FCF, refers to free cash remaining from operating profits used to be directed right back down the drill bit by shale producers intent on growing volumes. Now, investors want that cash used to fund dividends and stock buybacks, boosting the cash return to investors.

"Reinvestment rates, currently at historic lows, have led to record profitability. E&P free cash flow yields, something unknown to the sector just five years ago, are now the highest in the market," said John Freeman, Raymond James & Associates' top oil and gas analyst. "Even shareholder returns, previously thought to be extinct in the E&P sector, are commonplace among nearly every company within our coverage (via buybacks and dividends)."

Freeman has started to measure his basket of shale stocks by looking at growth in FCF per share of company stock.

"Much to our delight, cash flow growth per share is the new leader in the clubhouse with the highest correlation to stock outperformance, and by a wide margin," Raymond James said in a note.

Applying the new metric to the shale gas world shows the positive financial effects of bankruptcy reorganizations, which trim the number of shares and eliminate debt. The high FCF per share numbers for Chesapeake and Gulfport Energy Corp., both of which emerged from Chapter 11 in 2021, are tempered by the fact that these shares replaced billions in debt.

"One thing to remember, however, is that this transformed business model is still in its infancy," Raymond James said. "While 2021 marked a breakthrough year for E&Ps, cash flow growth and returns should continue their positive trend which will, we expect, strengthen the correlation for both metrics."

Previewing fourth-quarter 2021 results, Tudor Pickering Holt & Co. analyst Matt Portillo is using the ratio of free cash to enterprise value, the sum of a company's market capitalization and debt. "In the gas space, we continue to like names with liquids exposure including Antero Resources Corp., Coterra and Chesapeake," Portillo told clients Feb. 7. "The equities are averaging 22% FCF/EV, 24% FCF to Equity and 39% upside to our price targets."

"Investor engagement in the space continues to rise with the pool of long investors that are willing to give the sector a glance expanding versus what has been the cold shoulder over the prior few years," Portillo said.