Raymond James 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 as independent E&Ps move closer to a ''manufacturing'' style model. 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 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 We then demonstrate why this model is now outdated and how the new paradigm of living within cash flow makes a lot more sense in today's environment.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. We found that the trade-off for quickly de-risking the asset base and driving rapid growth was the need to greatly outspend cash flow. This trade-off made a lot sense back when operators had faith that stable commodity prices would support future growth and validate the near-term outspend. In an unstable price environment, which is much more indicative of recent years, this approach leads to severe disruptions as operators are unable to reduce drilling activity quickly enough to respond to price shocks and must access the capital markets at very inopportune moments. In our view, this dynamic shifts the balance back in favor of a disciplined capital approach that not only improves line of sight into future cash flow generation and returns, but is also supported by an NAV based valuation as well.

This is a summary of a much more detailed commentary. Please contact your financial advisor for the full report.

There is no assurance any of the trends mentioned will continue in the future. Past performance is not indicative of future results. Investing involves risk and investors may incur a profit or a loss. Specific sector investing can be subject to different and greater risks than more diversified investments. Investing in commodities is generally considered speculative because of the significant potential for investment loss. Commodities are volatile investments and should only form a small part of a diversified portfolio. Markets for commodities are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

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