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After 2018 thrashing, few Appalachian drillers are planning big spending cuts

With a few exceptions, Appalachian shale gas drillers do not look likely to heed investor calls for more spending restraint and capital discipline despite a clobbering in 2018's stock market, according to an S&P Global Market Intelligence analysis.

While five of the nine large independent producers included in the analysis expect to be cash flow positive in 2019, only two, EQT Corp. and Cabot Oil & Gas Corp., are expected to significantly cut capital spending.

Coincidentally, analysts estimate that EQT and Cabot will have the most positive free cash flow in 2019, money that can be returned to shareholders as dividends or through buybacks.

Investors and analysts have for nearly two years been pleading with U.S. exploration and production companies to slow their drilling and stop flooding the markets with unnecessary hydrocarbons, pleas that were routinely ignored until companies rewrote their executive compensation contracts to swap oil and gas production growth in favor of shareholder returns.

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"The E&Ps have yet to recognize how much the market hates them," Mizuho Securities USA Managing Director Paul Sankey told his clients Jan. 11. "The refiners [cut spending] and can be held up as an example of what E&P could achieve with genuine capital discipline and shareholder friendliness."

"We continue to press the Renaissance concept of higher cash return to shareholders, lower capex, less growth, and a real attempt to compete with any stock in the S&P 500, as opposed to feeble competition and abysmal returns histories," Sankey said. He does not recommend any shale gas stock.

"It's hard to believe that interest in gas equities may be as low as the most out of favor subsectors in the energy space, but that's our sense based on client conversations," analysts at the energy investment bank Tudor Pickering Holt & Co. said Dec. 27, 2018. "Levered balance sheets, limited market caps, and industry participants' current plans to continue to grow have investors continuing to avoid the space. ... [I]nvestors are unlikely to come back to these equities until industry slows the drill bit further."

In addition to saving money, an industrywide reduction in activity would help bring an oversupplied gas market into balance, Tudor Pickering Holt said.

Not all industry analysts are negative on the sector. Guggenheim Securities Managing Director Subash Chandra has been watching the shale revolution for more than a decade, and he said the industry is on a perfectly natural path and getting ready to roll over into "factory" mode after years of exploration.

"We believe stock selection during the final 'development' phase will be based on the ability to generate growth while delivering free cash flows," Chandra said in a Dec. 6, 2018, presentation for clients. "Sustainable FCF [free cash flow] should be a core driver of share performance as it funds share buybacks and dampens commodity-price related volatility."

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Chandra's top pick in Appalachia is Antero Resources Corp., the nation's top NGL producer, which expects to see its revenues and earnings jump in 2019 because Energy Transfer LP's newly opened Mariner East 2 pipeline gives it a new path to export NGLs to high-margin European destinations. Antero also benefits from having 100% of its dry gas hedged at $2.99/Mcf for the full year, Chandra said.

Chandra also likes Antero because it is cheap, having lost 51% of its value in 2018 — a year in which an equally weighted index of Appalachian shale producer stocks lost 33%. None of the 10 shale gas stocks in the index showed any gains in 2018, a year in which E&Ps were among the S&P 500's worst performers.

"If sentiment for E&P is as bad as we've seen since the financial crisis, sentiment for gas E&Ps is worse," Jefferies LLC oil and gas analyst Mark Lear said Jan. 7. However, if prices stay around $3/Mcf, Lear said, the winners are those that kept control of their wallets: Cabot, Gulfport Energy Corp. and Range Resources Corp.

Lear said Cabot "is now our preferred stock for gas exposure, as we see the company as well positioned to generate free cash flow in 2019-plus and believe that [Cabot] can benefit from potential upside to gas prices given its largely unhedged position."

"Too many CEOs and boards abjectly fail to recognize the sense of crisis among equity investors, not least because [investors] have simply sold the sector," Mizuho's Sankey said, even though the Appalachian shale index is up 16% year to date. "Do not let the strong start to 2019 fool you — the stocks are coming off lows from a mass exodus by shareholders over the period 2010-2018."