Cash is an Asset: But What the Heck Do You Do with It?

Expand drilling? Wipe away debt? Take shares out of the market?

There have been nearly $60 billion in equity and debt offerings from the industry in 2017, and more than $105 billion in M&A deals. This means companies have received $160 billion in capital above and beyond the cash being generated by their operations.

For all these reasons, oil and gas companies sometimes find themselves in the position of holding or generating a significant amount of cash that needs a productive home. For example, Anadarko (ticker: APC) received $2.3 billion earlier this year for its Eagle Ford assets in a sale to Sanchez Energy (ticker: SN) and Blackstone Energy (ticker: BX).

Investors seldom look favorably on an energy company that simply hoards cash, but companies have several options for investing capital that shareowners can relate to. A company may invest its excess capital in a share buyback program, pay down debt, or reinvest it into acquiring reserves.

Share buybacks can send positive or negative messages

The ramifications from share buybacks was recently illustrated by Anadarko, (ticker: APC) which announced such a program in late September. In that case, Anadarko chose to invest $2.5 billion in repurchasing shares, buying back nearly 10% of its outstanding shares.

Investors reacted favorably to this move, and the price of Anadarko shares jumped by 8% the day the program was announced.

Share buybacks can have several possible implications for investors. Taking a positive view, it can imply that the company believes it is significantly undervalued, saying “we are cheaper than other options, and are therefore the best use of money.” If the market accepts this view, it can boost a company’s share price significantly. In addition, buybacks provide a method for returning capital to investors in a tax-efficient way, as a special dividend is taxed and therefore less investor-friendly.

However, a share buyback can have negative implications as well. A buyback program can imply “we have nothing better to do with our money than buy our own shares.” For example, Anadarko could drill hundreds of unconventional wells using $2.5 billion. Choosing not to drill wells can imply the company lacks confidence in its own assets or in the global supply/demand outlook.

High debt levels drag down share valuations

A second option for companies is to pay down their debt. While useful for funding drilling and development programs, high debt loads weigh on a company. In general, higher debt levels lead to lower valuations in the market, and as illustrated by the number of bankruptcies in 2015 and 2016, can threaten a company’s fiscal survival in low commodities price cycles.

For a company with a sizeable debt load, the best thing to do with capital may be to pay down part of this debt and reduce its leverage. Highly levered companies may see a significant increase in valuation when debt is reduced, thereby providing value to shareholders. However, if a company already has low debt loads, paying down debt may not provide much benefit to investors.

Drilling wells may not be the cheapest way to acquire reserves

The third option for companies is perhaps the most obvious one—invest in a drilling program.

Oil and gas companies are continually pressured to grow reserves and production, and the drilling program is a proven method for converting resource potential into booked reserves. But drilling a full slate of oil or gas wells is an expensive endeavor, particularly in the unconventional plays, such as an extensive shale drilling and completion programs.

This does not always provide the best return for shareholders, as sometimes a company’s share price implies a lower price for reserves than its historical F&D cost defines the level at which it can acquire them. In this case, buying back shares may be the cheapest way to “transfer dollar value to reserves.”

This was the case for Anadarko, as the company’s enterprise value-to-reserves before the deal was announced was $21.90 per BOE. APC’s one-year finding and development costs are $22.56 per BOE. This implies that, on a value per reserve basis, the company’s shares are less expensive than its current activities for acquiring reserves. Therefore, a share buyback was, in this case, a better use for capital.

EnerCom’s analysis of 56 cash-heavy oil and gas companies came back with the average best use of cash: drill baby drill

EnerCom Analytics examined the financial situation of 56 major oil and gas companies to determine the best use of cash for each.

• Based on current valuations, debt levels and F&D costs, 30 companies should invest in their drilling program.
• Eighteen companies analyzed have debt levels that weigh on the company’s valuation, meaning paying down debt may be ideal.
• Eight companies have low debt levels and low valuations, indicating a share buyback may be the best use of excess capital.

This month’s EnerCom Industry Data & Trends Report examines 56 companies’ dispensing of cash options. Subscriber-members of Oil & Gas 360® will have full access to the 56-company data and analysis as soon as it is released this week. To gain full access, subscribe here.

A sample of the data appears below, comparing three companies’s individual situations.