2021 Top Operators Report: Rocked by volatility, investors want to see stable returns on their capital

Editor’s note: Last year, when assembling the 2020 Top Operators Report, the COVID-19 pandemic had shuttered the global economy. Oil demand had been reduced by over 20 million bbls/d and prices were at lows not seen in decades.

The mood of the Canadian industry was grim. After five years of being rocked by wild price volatility the pandemic hit like a knockout punch.

The 2021 Top Operators Report looks back at how Canada’s oil and gas leaders pivoted to meet the challenges of 2020, and how they are positioning their organizations for future success.

Once again, we have tapped into the experience of professional services firm KPMG in Canada to provide insight into what strategies operators could pursue to thrive in the current environment.

The report also features a broad swath of the insights and opinions from industry leaders gleaned from Daily Oil Bulletin coverage, along with commentary from data providers Evaluate Energy and CanOils.

Download the report here.

The days of investors rewarding oil and gas operators solely for growing production and reserves are long gone, said Grant Brown, managing director and partner, KPMG Corporate Finance Inc.

While there is optimism in markets at current commodity prices, Brown said investors are still reeling from the volatility of the last few years and there is limited appetite to take on risk. Conservatism is the prevailing mindset, with the focus on debt retirement and then capital stabilization of the growth program.

“There is a more muted view on growth,” he explained. “Investors have shifted from growth metrics to return metrics, and that’s not going away.”

This sense of financial conservatism is evident in corporate guidance in the first half of 2021, said Bemal Mehta, managing director, Energy Intelligence for geoLOGIC systems ltd. and JWN Energy. While capital expenditures are up compared to 2020, they are not returning to pre-COVID levels this year.

“There was a 30 per cent decline in capital expenditures in 2020 due to the impacts of COVID-19. In 2021, as prices have recovered, many companies are putting some of their cash flow to work to stabilize their production. Our numbers based on corporate guidance tell us capital spending should increase around 20 per cent from last year’s lows.”

The industry lost a lot of financial ground in 2020. Industry-wide, free cash flow (operating cash flow minus capital expenditures) declined from almost $20 billion in 2019 to a little over $300 million in 2020, with the majority of operators reporting negative numbers. Dividends were cut or eliminated, and share buybacks dropped from almost $6 billion in 2019 to $1.2 billion in 2020 as cash flows collapsed. With higher commodity prices and muted growth spending, free cash flow is climbing through the first half of 2021, said Mehta.

Vermilion Energy Inc. president Curtis Hicks said any free cash flow generated in 2021 will go to debt repayment. At US$60 WTI, Vermilion would generate around $650-$700 million in operating cash flow in 2021 from its Canadian and international operations, Hicks told the Scotiabank-Canadian Association of Petroleum Producers (CAPP) Energy Symposium. The company expects capital expenditures of $300 million for the year with all remaining cash flow going to debt repayment.

“We have to focus on profitability,” said Hicks. “That will put us in a position when our balance sheet is taken care of to return capital to shareholders and grow from there.”

Historically, the company targeted 25-30 per cent of its free cash flow for dividends. Dividends crept up to around half of free cash flow before being suspended in 2020. Hicks said the company expects to return around five to 10 per cent of free cash back to shareholders after it fixes its balance sheet.

“As we have more available cash flow, we will consider whether we have a flexible dividend or buybacks,” he added.

KPMG’s Brown said flexible or variable dividends make sense for many companies looking to manage through increasingly volatile price cycles.

“A variable dividend policy allows the company to give more during up-cycles and less down-cycle. A fixed dividend policy is designed to grow in dollar value over time. This reliability may be good for the shareholder in principle, but it’s not capital efficient throughout the cycle and unlikely to optimize shareholder returns,” he said.

Parex Resources Inc. finds itself in the enviable position of having zero debt. New president and chief executive officer Imad Mohsen said at US$60 WTI the Colombian oil producer would generate around $500 million in free cash flow. Around $200 million of that would go to share buybacks, with the remainder going to accelerate projects to drive production growth.

Mohsen said Parex currently prefers using share buybacks to increase shareholder returns as it provides the company with financial flexibility. But longer term he would like to see the company provide a mix of shareholder returns through growth, buybacks and potentially dividends. To get there the company will first have to prove the potential of its growth projects.

“When we have visibility on cash flow, then we can give dividends,” he said.

Share buybacks have their place as a tool to efficiently return capital to investors, he added.

“They can be a useful lever to return excess cash and may be the best use of capital at times when companies have free cash and their share price is depressed. It may be a circumspect use of capital if the company is under-valued by the market.”

Whitecap Resources Inc. prefers a balanced approach to returning capital to shareholders, said president and chief executive officer Grant Fagerheim.

At US$60 WTI, Fagerheim said the company would generate around $860 million in free cash flow, with around $500 million going to capital expenditures, $110 million returned to shareholders through dividends and $200 million used to pay down debt. The remainder would go to carbon capture and hydrogen R&D work.

Fagerheim said in 2013 Whitecap developed a strategy to be a growth/dividend-oriented company. The company has built itself on low decline assets with low maintenance costs to achieve that strategy.

“Buybacks are another tool but they are secondary to balance sheet management and dividends,” he said, adding that the company is targeting returning no more than 20 per cent of cash flow as dividends to maintain flexibility in the face of volatile commodity prices.

Download the report here.

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