Q1 energy earnings review – what did we learn?

Petroleum, petrodollar and crude oil concept : Pump jack and a black barrel on US USD dollar notes, depicts the money received or earned from sales after investment in the development of oil industry.

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Ahead of Q1 results, investors focused on several key issues across the various energy sub-sectors. US E&P investors were focused on cost and activity guidance in the face of supply chain challenges and political pressure. Refining and integrated investors focused on demand outlook and strategy pivots following Russia’s invasion of Ukraine. Meanwhile, coal investor wanted to see companies capitalizing on improved seaborne markets, and a favorable contracting environment. In Canada, oil investors largely focused on the allocation of abundant cash flows.

From a macro perspective, weather, supply chain challenges and operational headwinds led to falling Q2 production guides. Most oil strategists are forecasting accelerating growth in 2022. Conoco (COP), Shell (SHEL), BP (BP), Chevron (CVX), Pioneer (PXD), Diamondback (FANG), Coterra (CTRA), SM (SM), and the Hess (HES) onshore business all guided Q2 production below Q1 levels. The updates came after the DOE flagged a ~450bkd reduction in US production from November through February.

Meanwhile, refiners and integrateds universally pointed to rising demand for oil products. When questioned about price-induced demand destruction, Shell’s (SHEL) CEO said, “we’re not seeing it. As a matter of fact, if you just look at the performance including in this year, we see continued increase in product demand around the world.. we definitely do not see a reduction in demand.” Valero’s (VLO) Gorder said, “We expect product demand to remain healthy with light products demand near pre-pandemic levels and the pent-up desire to travel and take vacations should drive incremental demand for transportation fuels as we head into the summer.”

Coal investors saw mixed results. As Alliance (ARLP) and Arch (ARCH) discussed improved contracting terms and robust cash flow from export volumes, Peabody (BTU) addressed several operational and financial missteps during the quarter. In aggregate, sustained high prices should benefit the entire sector, and Q2 should show improvement over Q1; though operational performance clearly drove dispersion throughout the earnings season.

In Canada, record free cash flow was largely promised to shareholders. Cenovus (CVE) puts a firm shareholder return framework in place, and Suncor (SU) promised more buybacks. Both would like to see debt balances fall further before directing incremental free cash flow to shareholders. Imperial (IMO) actually announced a tender for shares, an aggressive tactic applied when management wants to repurchase a lot of shares very quickly.

From a valuation perspective, with very few exceptions, energy names generated 4-8% of their market caps in free cash flow during Q1. With an improved Q2 macro environment, those 15-30% annualized free cash flow yields are likely to improve sequentially.

Arch (ARCH) made a compelling case for higher multiples in the coal sector, though the arguments hold across most energy sub-sectors. Interestingly, Morgan Stanley’s energy strategist wrote Wednesday, “the trade-off between energy security and energy transition is changing. Noticeably, this is putting the energy sector in a new light.” To pile on, BlackRock (BLK) wrote Wednesday, “Having supported 47% of environmental and social shareholder proposals in 2021, BIS notes that many of the climate-related shareholder proposals coming to a vote in 2022 are more prescriptive or constraining on companies and may not promote long-term shareholder value.” Given compelling valuations and a more balanced approach to ESG from the broader investment community, Q1 results may be enough to attract new money to the sector.

Caveats abound, as the energy sector (XLE) has rallied ~50% year-to-date and outperformed the broader market (SPY) by even more. Peace in Ukraine could reverse recent moves to cut off the world’s largest energy producer from global markets. A recession could change the demand backdrop, and quickly lead to falling prices. However, focusing exclusively on what investors learned from Q1 results — 1) demand is rising 2) supply is missing strategist expectations 3) cash flow valuations are compelling 4) capital allocation promises remain steadfast 5) generalist and ESG-focused investors appear more willing than ever to pour capital into the space.

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