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What E&Ps Can Learn From Big Tobacco

Here's a playbook for exploration and production companies to restore investor confidence.

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Given the vaporization of tens, if not hundreds, of billions in investor capital over the last decade, it’s understandable that U.S. exploration and production companies are shunned by investors.

Investors think greenhouse gas emissions are a key concern for U.S. E&P companies. Sustainalytics has highlighted carbon emissions as a key factor underpinning its Severe ratings for most of our E&P coverage. In response, U.S. E&Ps have reduced the carbon emissions they can control and focused on flaring efficiency. But they must do more to align with the World Bank’s initiative of zero flaring by 2030.

Another significant issue for U.S. E&Ps is the wide range of outcomes for oil demand and supply over the next few decades, particularly if we begin to see more of a global response to emissions concerns. As a result, E&P management teams cannot just think about more healthy near-term demand trends as justifying the need for additional oil supply. Further, U.S. E&Ps have to deal with demand destruction from electric vehicles, as we forecast that EVs and hybrids will account for 40% of new-vehicle sales in the United States by 2030.

U.S. E&Ps need a better playbook to address investor concerns. We think this is critical if the industry wants to reverse the long trend of poor stock price performance. Our action plan focuses on four key elements of value creation for the U.S. E&Ps:

  • Realign management’s short- and long-term compensation to focus on returns on invested capital, not production.
  • Shift the industry’s policy stance to argue for legislation on carbon taxes and greenhouse gas. We anticipate a valuation uplift of as much as 60% with reduced uncertainty around carbon legislation.
  • U.S. E&Ps should aim to spend no more than 75% of operating cash flow and keep leverage under control at 1-2 times EBITDA, reducing their exposure to the industry’s cyclicality.
  • U.S. E&Ps should commit to returning 75%-100% of their enterprise value in a decade, which would greatly reduce long-term investor uncertainty regarding well and acreage economics.

Big Tobacco offers a good model for the U.S. E&P industry for several reasons. First, in the U.S., smoking has been in decline on a per capita basis since the 1960s. Second, the industry battled in courts and Congress over the societal and medical costs of smoking for decades. Third, before the master settlement agreement in the late 1990s, the U.S. tobacco industry faced stiff competition from rogue manufacturers that entered the market with discount pricing. Fourth, Sustainalytics gives Big Tobacco a Medium ESG Risk Rating, much better than our typical U.S. E&P ESG Risk Rating of Severe, suggesting potential for improvement. We see parallels with the U.S. oil industry, given the expected decline in oil demand, the ongoing congressional and court battles over the costs of climate change, and the lack of industry discipline, compounded by constant pressure from new entrants.

The MSA in the 1990s ultimately made the tobacco industry stronger. It raised the barriers to entry, offered a predictable cost per pack, forced out weaker competitors, and prevented new discount competitors from entering the market. With this and congressional action that deregulated the tobacco leaf market and forced pricing for a key supply component downward, the remaining industry players, namely Altria and Reynolds, enjoyed years of pricing power. We don’t think U.S. E&Ps can duplicate this improved level of pricing power, but there’s plenty to be done to improve their fortunes.

Key Lessons From One Industry to Another
We think there are several key takeaways for U.S. E&P investors to consider from Big Tobacco, which has dealt with a similar decline in product demand that oil is eventually expected to experience and yearslong battles over industry legislation.

  • Legislation and settlements, while expensive, can raise the barriers to entry for the industry by increasing regulatory barriers but also forcing out industry participants, allowing the remaining companies to boost profits. This could also eliminate a major unknown for investors by quantifying a key risk--carbon legislation--thereby reducing uncertainty about profits and improving access to capital.
  • The advantage of scale in E&P could unleash a wave of further consolidation, unlocking similar benefits to what Big Tobacco enjoyed in the 2000s. This would eliminate less disciplined capital allocators and allow U.S. companies to better exploit economies of scale, lending support to our narrow moat ratings for the few E&Ps that have them (including Pioneer Natural Resources (PXD), EOG Resources (EOG), and Cabot Oil & Gas (COG)).

We think these similarities create an opportunity for E&P companies to follow the success of Big Tobacco. Our proposal is more nuanced than the strategy that environmental, social, and governance activists are pressuring the U.S. E&P industry and institutional asset managers who own energy to follow, which is simply reducing hydrocarbon production and greenhouse gas emissions. ESG activists like 350.org have launched campaigns to encourage institutional asset managers as well as public entities like pension funds and university funds to divest all equities with fossil fuel exposure.

What Parts of the Tobacco Model Should U.S. E&Ps Avoid?
Big Tobacco has found avenues that have been profitable, such as international expansion (mainly China), and tobacco alternatives that have not, such as Juul. But for U.S. E&Ps, the prospects for international success are highly uncertain, as the U.S. is unique from the perspective of geology, regulation, ease of access to capital, and ability to source high-quality drilling equipment and crews. Relatively few E&Ps have a long record of overseas success, and there is little need to pursue overseas investment given the quality drilling opportunities available for many U.S. E&Ps domestically. Hess (HES) stands out as an exception after its enormous exploration success in Guyana, and Apache (APA) may be able to replicate that success in Suriname. But in general, we think shale frackers should stick to what they are good at, and that means focusing on domestic resources.

Diversification away from oil could be a costly temptation. For tobacco, investments in alternatives like Juul have proved disastrous, as Altria (MO) has written off over $8 billion on its Juul investment. While the Juul investment has not been successful, heated tobacco products have proved more successful in Japan, where they make up about 20% of the market. Similarly, Equinor (EQNR), Shell (RDS.A), and Total (TOT), three of the more aggressive European companies with renewable investments, all have stock prices that are below where they were five years ago. We would expect no better from U.S. independents: The main source of their competitive advantage (if any) is low-cost crude-oil resources associated with their acreage leasehold. This group would have no edge over competitors in any other arena.

Given the substantial decline in renewable costs, the future does look better, but E&Ps should still be cautious. Returns for Shell and Total are around 6% on their power investments currently, and the companies expect to be able to boost those returns to double digits only with the help of their integrated model, a benefit that U.S. E&Ps do not have.

Big Tobacco Has Advantage of Low Capital Intensity
A large part of the reason Big Tobacco has been able to return so much cash to shareholders is the lower capital intensity of its business. Generating a dollar of income requires only a fraction of the capital investments of U.S. E&Ps, which have substantial up-front commitments to make in terms of drilling and completing a well before they can earn a dollar of income. In fact, looking at our 2020-24 forecasts for each group, E&P capex intensity looks closer to the tobacco industry’s returns on invested capital, when we’d be hoping for something closer to the reverse. This also reflects the wide-moat nature of the tobacco industry and the largely no-moat U.S. E&P industry.

While we do not think the U.S. E&P industry can close the gap, given the differences in business models, we do think this points to the need for capital discipline and a realistic view that not all U.S. acreage is economic to produce. We’ve long had a healthy skepticism of the adjusted and expected returns that U.S. E&Ps highlight for investors. Using a more consistent and full-cost accounting would help here. While this shift toward investing less capital and only in very profitable wells would create more volatility in cash flows and production levels, to some extent, this can be hedged, as many E&Ps already do. In other cases, selling off unprofitable assets to players better positioned to generate lower costs and higher returns may make sense, while retaining mineral rights to earn royalties off future production. If U.S. E&Ps free themselves of the need to increase production year in and year out, we believe they can be far more creative about allocating capital and improve returns while lowering capital intensity. The end result should be an improved ability to return capital to shareholders, similar to Big Tobacco.

Energy Is a Tougher Target for Activist Pressure
We do not expect ESG activist campaigns around divesting energy equity holdings from investors’ portfolios or pressuring capital markets to limit access to debt to be very successful in terms of affecting company valuations. Ansar, Caldecott, and Tilbury have reviewed numerous divestment campaigns, including tobacco, and concluded that the impacts are immaterial. We estimate that about $230 billion in assets under management can be divested from public pension funds and university funds, and using Morningstar Direct data, about $60 billion from public mutual funds that have intentionally reduced their energy exposure to zero. We don’t see this as a material driver for E&P valuations, primarily because if the stocks trade at a discount to intrinsic value, investors should ultimately return the stocks toward their fair value over time.

ESG activists have also campaigned for banks and the debt markets to not fund oil and gas projects. With an extremely deep U.S. market for debt financing, where private equity will step in if there is a perceived lack of financial capital, we don’t see this as a material issue compared with companies based in emerging markets that may not have access to U.S. capital markets. Prior divestment campaigns focused on coal, which has a global market capitalization of under $50 billion. In contrast, the global oil and gas industry has a market cap well over $1 trillion if we include Saudi Aramco (U.S. sector market cap is around $700 billion) and has ample competition.

How Much Could Our Action Plan Boost Valuations?
Big Tobacco industry valuations bottomed in 2003 after a collapse in cigarette average selling prices as a result of the master settlement agreement and competition from rogue manufacturers, but shareholders have enjoyed an outstanding decade-plus of returns since then. In fact, valuation multiples for Big Tobacco stocks increased by about 60% on average. E&Ps could enjoy a substantial uplift as well if they can reduce investor uncertainty to a similar extent that Big Tobacco did by following our action plan (although the comparison is not perfect: The capital intensity of oil and gas operations is much higher than what Big Tobacco has contended with).

We think the MSA for Big Tobacco marked a turning point for the industry in terms of capital allocation and investor perception. It raised the barriers to entry by enacting substantial taxes and requiring larger economies of scale to enter the business, which forced out weaker industry players and allowed the stronger manufacturers to consolidate the industry, gaining pricing power.

Likewise, by supporting carbon tax legislation, we think U.S. E&Ps could enjoy a halo effect by taking action to address the social cost of their business, while demonstrating to the market that such action would add less than $5/barrel to the cost of supply. Taxing all players would also raise the barrier to entry, forcing weaker companies out of the market and triggering a wave of consolidation that would parallel what Big Tobacco did in the enormously successful period we are highlighting. A more consolidated U.S. oil industry could better negotiate international contracts and pricing, putting it on a firmer footing to handle industry cyclicality, especially given the uncertainty of OPEC+ moves in the future.

Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.