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Oil & Energy Stocks are Just Beginning to Bounce Back – Here’s Why Free Cash Flow (FCF) Yields Matter to Retail Investors

Dear Retail Investor,

Oil stocks to date have had a remarkable run since WTI oil futures were trading as low as -$40.32 per contract for a barrel of oil – a truly bizarre and unprecedented moment in global financial markets. The precipitous drop into negative territory occurred as the pandemic was unfolding, when countries went into lockdown and people were confined to their homes. Demand for crude evaporated in the market and supply became bloated as participants in the oil market sought whatever means to offload inventories of crude.

If you are a disciple of Warren Buffet, you should have bought oil stocks when there was ‘blood in the streets’ – or in this case ‘oil flooding the market’. A once-in-a-generation opportunity to buy the dip emerged because of irrational pessimism as negative sentiment reached new lows.

If one had decided to plunge into purgatory and scoop some oil stocks, the angels of the energy gods (very few are a left) would have lifted you out of the darkest days and back to the light, leaving you a very handsome triple-digit return on almost any stock selection. 

For instance, this writer initially purchased Nuvista Energy Ltd. (TSX: NVA; OTC NUVSF), Whitecap Resources Inc. (TSX: WCP; OTC: SPGYF) and InPlay Oil (TSX: IPO; OTC: IPOOF), all of which have experienced returns of between 300-800% since their April 2020 lows. The run in oil stocks has led to healthy returns for many names since the pandemic began, but I want to stress that this was only during the recovery period, and now that the sector is out of hell, blue skies are ahead. 

In other words, there is still tremendous value in the energy sector going forward because of a new paradigm for oil and gas companies, consisting of capital discipline and a focus on shareholder returns. I am going to leave out the supply and demand backdrop for now, as I want to focus on the financials of these companies, most specifically free cash flow (FCF) – and help you understand why this matters. 

What is Free Cash Flow (FCF) and Why Does it Matter?

The FCF or Free Cash Flow that oil producers are generating at current prices are indicating a healthy turn-around in oil and gas stocks. But the financial ratios and FCF yields from the most recent Q2 2021 financials exhibit how grossly undervalued the sector still is, despite the recent recovery. First let’s break down the FCF yield and what it means for you as an investor. 

Free Cash Flow = Cash Flow From Operations – Capital expenditures

  • The Free Cash Flow can be returned to shareholders.
  • The average FCF yields for most stocks in the S&P 500 (the index of the 500 largest publicly-traded companies in the US) range from 2-6%.  
  • FCF yield is calculated as follows: FCF Yield = Free Cash Flow / Market Capitalization 

The current FCF yields for some energy producers is ranging from 10-60%, and on a forward-looking basis, even higher. It sounds absurd, but it is a financial reality. I think the best way to show the potential for energy stocks going forward is by illustrating an example. I will use one of my winners, Whitecap Resources, a mid-cap light oil producer. 

In Q2 of 2021, Whitecap generated $227 million of FCF for the quarter, which would be an annualized amount of approximately $908 million for 2021, and a Free Cash Flow yield of approximately 26%, or a FCF per share of around $1.44 per share. This is a rather simplistic approach because it does not take into account hedging, but it highlights the glaring reality that energy producers are essentially printing money right now, and the sector is very undervalued. I have illustrated this below:

Now, what does a company do with its FCF?  This is what matters. Companies can either pay down debt, make acquisitions, or return capital to shareholders through dividends and stock buybacks. 

Debt is important to look at first. One of the primary metrics used to measure the financial health of energy

producers is the debt to cash flow ratio (D/CF). Companies with higher D/CF ratios will likely use more of their FCF to pay down debt. 

Companies with higher than average D/CF ratio are leveraged and extremely sensitive to the price of the underlying commodity, in this case oil. Therefore, if you have a bullish outlook for oil then perhaps a leveraged play is appropriate for you. I would suggest looking at names such as Baytex Energy Corp. (TSX: BTE; OTC: BTEGF), Athabasca Oil Corporation (TSX: ATH; OTC: ATHOF) and MEG Energy Corp. (TSX: MEG; OTC: MEGEF). Check out this graph from Ninepoint Partners which compares the D/CF ratios of various oil & gas companies. 

Which Companies will Use FCF to Reward Shareholders?

If their debt situation is under control, a company can use its FCF to acquire new assets or increase capital expenditures, which often requires taking on more debt, but is unlikely to happen any time soon in the oil and gas sector. The oil and gas sector has gone to hell and back twice, first with the 2015 price collapse and then during the pandemic. Most of these companies will likely not want to be burned a third time by over-leveraging their balance sheets. The best oil companies to look at are the ones that are going to maintain capital discipline going forward. 

This new paradigm of capital discipline will have an effect on the future output of crude production, which currently lagging and creating a supply issue. To illustrate what has happened to oil production, US Shale production peaked at 13.1 million boe/d before the pandemic and now it sits at 11.4 million boe/d, with production unlikely to match the peak any time soon as certain basins are facing declines in the United States. Further, a Reuters article recently quoted a top executive at Pioneer Natural Resources Co. stating that many oil and gas companies are now focusing on capital discipline and shareholder returns, which leads into my last and most important point. 

If the oil price maintains a floor of at least US$55 a barrel and companies focus on deleveraging and maintaining capital discipline, then return of capital to shareholders through share buybacks, cash dividends and even special dividends is likely on the horizon within the next year. 

Eric Nuttall, an energy fund manager at Ninepoint Partners, is a purveyor of this narrative too. He emphasizes that a new business model has formed in the energy sector, which is resulting in “maximizing free cash flow to allow for meaningful dividends and share buybacks”. Eric, like Warren Buffett, is a buyer in periods of panic and fear, and believes that because of past traumas due to the oil collapse of 2015 and the 2020 pandemic, the average investor is deathly afraid to touch the sector, despite the compelling case in the fundamentals both macro and company-based.  

I highly recommend following Eric Nuttall on twitter and his articles in the Financial Post, as he provides valuable insight about the energy landscape. 

To conclude, many companies have taken a disciplined approach to capital expenditures and deleveraging their balance sheets from the excessive amounts of debt taken on in the past. Those companies, many of which have successfully managed their debt issues and paved a path forward, are likely to implement share buy-backs and meaningful monthly dividends with the free cash flow generated at depleted oil prices. 

There is a lot of negativity surrounding the energy sector right now, ranging from supply concerns to climate change policies, but I hope the retail investor, even if burned in the past, can sift through the noise and look at the financial realities of the sector right now by looking at the current and potential cash flows. In my opinion, there is still tremendous opportunity. 

Sincerely,

Alex Muir, CFA
Dear Retail contributor

 

Disclosure: This article is not investment advice and the opinions are of the author and may contain forward-looking statements. Please do your due diligence and/or seek professional investment advice for any investment decisions made. This author owns Baytex Energy Corp (TSX:BTE), Nuvista Energy Ltd. (TSX: NVA), Whitecap Resources Inc. (TSX: WCP) and InPlay Oil (TSX: IPO) and may buy or sell at any time.

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