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Private equity firm outlines plan to make oil, gas producers 'investable' again

Exploration and production companies should learn from oil refiners and big tobacco if they are to attract investors, private equity firm Kimmeridge Energy Management Co. LLC said in a Feb. 27 whitepaper.

"Both the refining and tobacco sectors, for different reasons, have entered periods where reinvestment opportunities do not present good return scenarios and where growth is not going to be rewarded," the report said. "The solution for both industries has been lower capital reinvestment rates, higher distributions to shareholders and better alignment."

Kimmeridge said that to attract investors, producers should strive to return 100% of the enterprise value of the company to shareholders within 10 years, reinvest "less than 70% of cash flow at strip pricing," and cap reinvestment rates at 80% of cash flow in better market environments. In addition, companies should strive for, at maximum, a leverage ratio of 1.0 times net debt to EBITDA and align executive compensation with the interests of shareholders.

Kimmeridge also said companies should deploy capital "with an understanding of the environmental impact" by discontinuing the use of freshwater for fracking, adopting alternatives to flaring and committing to carbon neutrality.

"Fixing this will not be easy," the authors wrote. "We believe that a significant proportion of the industry will not be able to achieve these targets." Kimmeridge estimated that 63% of the peer group it analyzed had a recycle ratio of more than 100% at oil prices of $53 per barrel, "which is barely enough to stand still, let alone return cash while running flat or growing." The recycle ratio is the profit from producing a barrel of oil divided by the cost of finding and developing that barrel.

Pegging the value of exploration and production companies at less than 4% of the S&P 500, Kimmeridge said, "[A] decade of poor capital allocation choices made with a mindset of growth for growth's sake" put those companies in their current position.

"Resource scarcity drove capital allocation decisions, executive compensation schemes and valuation methodologies. Instead, the abundant production from shale has turned the notion of scarcity on its head," the report said, faulting incentive programs that rewarded executives on reserve growth, production growth, resource capital and operational efficiency.

"For many of these teams, maximizing their own personal wealth meant spending shareholder money and getting bigger," the report said. "Return on capital or total absolute shareholder return was irrelevant."

Kimmeridge said investors will have to push for these changes. "With management and boards compensated to maintain the status quo, few will embrace the changes needed. … The fight will not be easy but the payoff for investors, industry participants as well as the environment will justify the efforts in making the sector investable again."