- More energy companies are focusing on profitability and generating free cash flow for share buybacks and dividend payouts.
- The maturation of shale drilling and pressure from Wall Street are 2 reasons why exploration & production (E&P) energy companies are becoming more disciplined stewards of their businesses.
- E&Ps remain attractive given their higher free cash flow, with many undervalued.
A growing number of energy companies are becoming more disciplined stewards of their businesses, reducing capital spending, and lowering expenses. They're more focused on profitability, with many generating positive free cash flow (FCF). And they're using that cash in shareholder-friendly endeavors, such as buying back their own stock and increasing their dividend payouts.
For the first time in a decade, several oil & gas E&P companies have a better FCF yield than the largest industry bellwether stocks in the sector. There are 2 major reasons. First, the shale technological drilling revolution, which made the US arguably the most productive supplier of crude oil and natural gas across the globe, has reached a new phase in its development. Signs indicate that the race to drill for the sake of simply boosting (commodity) production—without regard for profitability—has peaked. In recent years, many E&P companies have focused on increasing volumes (production) without creating value in the form of return on capital employed and other profitability metrics. This has kept commodity prices low, and at levels that have threatened corporate profitability.
Second, energy stocks have been out of favor for the five-year period ending October 31, 2019. Energy has been the worst-performing of the 11 sectors in the S&P 500 during that time, with an annualized return of -4.95%, and the only sector with a negative return. Meanwhile, the S&P 500 index is up 10.78% per year over the same period. As a result, more energy companies have shifted attention from production to profitability and shareholder-friendly efforts, even amid historically low crude oil prices.
Many energy producers have been increasing their FCF, despite significantly lower crude oil prices. Since 2015, the number of E&P companies with expected FCF yields above 5% (using consensus estimates) has been rising as oil prices have roughly dropped in half.
Recently, the market has tended to reward the stocks of companies generating FCF and returning capital to shareholders, and many remain incredibly cheap. We have focused on companies with these characteristics relative to the MSCI US IMI Energy 25/50 Index. Dividend increases indicate that management teams believe FCF is improving and sustainable. Share repurchases indicate that management teams think share prices are attractively valued.
Next steps to consider
Research the Fidelity® Select Energy Portfolio (FSENX).
Get the details on the lineup of mutual funds.
Go back to the full 2020 sector outlook.