(Bloomberg Opinion) -- Frackers are having their best week in a long time, courtesy of oil pushing back above $50 a barrel. One of them, QEP Resources Inc., got some more specific help in the form of a takeover offer from Elliott Management Corp. The nature of the bidder and the timing say a lot about where E&P stands at the start of 2019.
Elliott showed up at QEP almost a year ago. Soon after, the company pledged to become a pure-play operator in the Permian shale basin and went on to announce a string of disposals and the exit of chairman and CEO Charles Stanley, who had led QEP since 2010. However, while news of Elliott’s stake caused the predictable reaction in QEP’s stock, it eventually gave way under the pressure of falling oil prices and uncertainty about whether its biggest disposal, in the Williston basin, would actually complete.
Elliott’s strategy looks two-pronged. The most straightforward element is a bet on QEP’s valuation. While exploration and production stocks haven’t kept pace with oil’s recovery over the past two years or so overall, QEP has really slumped (which is presumably why Elliott showed up in the first place).
Prior to Monday’s announcement, QEP was trading at about 5 times forward Ebitda, whereas the pure-play Permian operator it aspires to be would likely trade above 6 times at least. Rystad Energy, a consultancy, estimates that QEP’s current portfolio, assuming no efficiency gains, is worth about $4 billion, assuming a long-term oil price of $50 a barrel. At $60, that rises to $5.8 billion. Elliott’s offer values QEP at just over $4.5 billion.
The other prong is flushing out another bidder. Elliott’s offer — priced at where the stock was trading just seven weeks before — isn’t an agreed one and was lobbed in roughly a week before new CEO Timothy Cutt was due to formally take the reins. In its letter to the board, Elliott urges QEP to open a data room for the core Permian assets and hire advisers to “oversee the process with us and potentially others.” Altogether, it is less a nudge and more of a shove in the direction of putting the entire company up for sale.
The market appears to see it similarly: QEP closed a penny above Elliott’s offer on Tuesday and now trades slightly below it at around $8.50. What happens from here will provide clues for the broader E&P scene this year.
That’s partly because QEP has been a microcosm of what ails its peers. Look back at that chart of the sector versus the oil price. While E&P stocks never fully bought into the oil rally, they sure took the year-end slide to heart. And that makes sense because the lesson of the past decade is that while E&P stocks ought to include an option on oil prices, the risks and rewards are asymmetric. When oil prices rise, spending ( including C-suite compensation) rises to take advantage, leaving no free cash flow to reward shareholders. When oil falls, balance-sheet leverage and risk premiums rise, trashing stocks. In short: Heads I win, tails you lose.
Between 2010 and 2017, QEP generated just over $8 billion of cash from operations, according to data compiled by Bloomberg. Net disposals topped that up to $12.4 billion. Over the same period, capital expenditure and acquisitions of new properties came to $14.3 billion. This wasn’t just a function of the post-2014 crash: The two totals were running virtually neck and neck at the end of that year, at almost $10 billion. Even as production increased by almost 40 percent — and, within that, output of higher-value oil jumped almost sevenfold — operating cash flow per barrel of oil equivalent slipped from $26 in 2010 to about $11 in 2017. More importantly, while cash flow per barrel was 1.7 times finding and development costs in 2010, it fell below 1 times in 2015 and stayed there.(1) In short, QEP generated positive free cash flow in just one out of those eight years.(3)
As with many of QEP’s peers, part of the problem can be traced back to incentives. Before changes were made following a “shareholder outreach program” in late 2016, a large part of management’s compensation was encouraged growth as opposed to returns. In the 2016 proxy report, for example, more than half of the executives’ annual incentive payment was tied to raising production and reserves and pursuing new plays or acquisition targets.
Little wonder, therefore, that QEP has fared even worse in the public markets than most. Since its spin-off from Questar in 2010, the stock has generated a total return of negative 81 percent, according to Bloomberg calculations. Meanwhile, the SPDR S&P Oil & Gas Exploration & Production ETF lost you about 20 percent, and the S&P 500 returned a gain of 157 percent.
Many firms, QEP included, have changed their tune in the the past 12 to 18 months, emphasizing returns and payouts. But it is early days compared to the long period of value destruction that came before. Moreover, almost half the respondents to the Dallas Fed’s latest survey of oil bosses said they were prioritizing growth this year.
The resulting ennui on the part of public markets makes E&P companies a target-rich environment for activists and private equity. In theory, it should also make smaller companies such as QEP attractive takeover candidates for the larger producers that have begun consolidating the fractured, capital-hungry Permian shale basin. Elliott’s offer, both as potential transaction and tactical move, captures all of this.
(1) I use trailing three-year average finding and development costs to smooth out annual swings.
(2) The same holds true if you include acquisitions and disposals. QEP generated $3.3 billion of proceeds from net disposals in 2014, which pushed this adjusted-free cash flow figure into positive territory.
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Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
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