Energy Stat of the Week by J. Marshall Adkins

Energy Stat: Why Improved Capital Discipline Makes Sense for E&Ps

January 16, 2018

Given the increased focus on capital discipline in the E&P space from both investors and management teams of late, last week we opened a discussion on the merits of increased capital prudence. We posited that if E&P companies are able to make a true, sustained commitment to a returns focused, FCF generating business model, investors will likely need to change their approach to valuing the group. As the valuation paradigm shifts, we proposed that investors will need to accept higher multiples and lower discount rates (switch from “traditional” E&P discount rate of 10% to “manufacturing” discount rate of ~8%) as independent E&Ps move closer to a “manufacturing” style model (discussed further in Appendix B). This week, we simulate a hypothetical E&P NAV (net asset value) model forward over an eight year horizon period to show why the old approach of continuously outspending cash flows looked so attractive (on the surface) in the past. We then demonstrate why this model is now outdated and how the new paradigm of living within cash flow makes a lot more sense in today’s environment. To examine the impact of increased capital discipline, we simulated changes in valuation for our hypothetical model under scenarios ranging from underspending cash flow by 10% (the new paradigm) to outspending cash flow by 20% (more typical of the traditional E&P model). We tested these scenarios under two commodity price environments. First, we looked at a stable price environment that hearkens back to the early years of the shale boom when crude prices steadily marched upwards. Second, we look at a more unstable price environment that is more indicative of the increased commodity price volatility seen today.