Balancing the deployment of discretionary cash - Houston Takeaways

　　With oil holding near $50/bbl currently, and FY16 budgets set at $40-$45/bblfor many in the E&P space, for the first time in 24 months, companies areconfronted with the question of how to deploy discretionary cash flow. We metwith a number of producers and investors in Texas last week, and whileoutlooks vary, key common themes included: CFO is likely to be the limitingfactor into 2017, expect some balance between debt paydown and capitalacceleration, and desire to focus on returns over growth (easier said thandone). Company specific takeaways within.

　　Cash usage: Rig ramps, debt paydown, and avoiding the chase for growth

　　For the first time since 2014, E&Ps have a different type of decision to make:how to deploy “excess” cash flow. We estimate that at $50/bbl, our large-capcoverage will generate ~$11 Bn of excess cash flow over the next two years,relative to 2016 capital spend levels, increasing to ~$24 Bn at $60/bbl crude.

　　While the rise in oil price, and the subsequent increase in rig count, has led tosignificant investor focus on the drivers and potential of accelerating activitylevels, many of the companies across our coverage are likely to have a muchmore balanced (and slightly cautious) view towards capital deployment, asthey balance two immediate concerns: significant financial leverage anddeclining production. Debt remains a lingering concern, as we estimate that at$50/bbl flat, Net Debt/Cap for large-cap E&Ps at YE18 will still average 39%,falling to 34% at $60/bbl (3.3x and 2.0x Net Debt/EBITDA, respectively), whileproduction will decline by 6.5% across the group on average in 2016. Based oncompany conversations, we expect sufficient increase in capex to stem currentvolume declines, balanced by some effort to reduce absolute debt levels(although for those looking for an increase in cash return/dividends, I wouldn’thold my breath for now). Longer-term, managements acknowledge thechallenge of avoiding a return to the capital inefficient, “growth chasing”behavior of the last cycle, with a greater focus on sustainable, returns-drivenvalue creation.

　　Diversification still alive and well

　　Although the US onshore has taken the pole position across the space, NBL,MUR and APA were all quick to remind that quality conventional and/or longcycleopportunities remain very returns-competitive and that cost deflation andcapital efficiency of this part of the portfolio (Israel, US GoM, North Sea, etc) islikely greater than the market appreciates.

　　Valuation and Risk

　　Although we see the risk of increasing crude volatility in the near-term (supplydisruptions, Fed hikes, etc.), we remain constructive on crude price andcontinue to prefer PXD, DVN, COP and MRO amongst large-cap E&Ps.

　　Companies in our integrated/large-cap space are valued on either on aEV/DACF multiple (CVX, XOM, COP, and OXY) or on a blended NAV, EV/DACFmultiple methodology. NAVs assume $70/bbl, $65/bbl, and $3.75/mcf forBrent, WTI and Henry Hub pricing respectively. Primary downside risks includea decline in global oil demand and a decrease in the underlying commodity.

　　Upside risks include increased demand and increased operator efficiency.