“After the near-death experience in 2015 to 2020, the Permian producers focused on financial discipline, focusing on return on capital on projects and company-wide, and other financial metrics, versus just production growth and, most importantly, including these financial metrics for executive compensation.”—Michael Underhill, Capital Innovations

ConocoPhillips, which pumped an average of 634,000 bbl/d of crude oil in the Permian during the second quarter, expected a 7% to 8% inflationary impact on the company for 2022, said Bill Bullock, executive vice president, and CFO, during the second-quarter earnings call.

“Like everyone else, with our higher activity levels in the Permian, that’s where we’re experiencing the most inflation, what we’re watching, and we’re continuing to keep an eye on that,” Bullock said.

Get the Weekly Newsletter Thousands of Mineral Rights Owners and Investors Rely On.

Midland, Texas, in the heart of the Permian Basin, is experiencing some of the roughest impacts from inflation in the country, according to a Moody’s Analytics report in May. The area is remote, so most goods must be transported there over long distances, which drives up prices in any economic climate. The city also suffered more than most from the COVID-19 pandemic, when the collapse in demand for oil forced a drastic reduction in its workforce. Filling positions in the oilfields as the industry booms means paying high wages to induce workers to return.

Concern about inflation in the Permian was echoed by Robert L. Peterson, senior vice president and CFO of Occidental Petroleum, during his company’s earnings call. Oxy will shift $200 million to its Permian operations in 2023 to account for the inflationary impact in the region.

In mid-September, Credit Suisse increased its price forecasts for Brent and WTI, citing inflation in the upstream supply chain and underinvestment in the sector. A mid-September research report noted that between 2015 and 2021, the oil and gas project CAPEX declined by more than 25%. The impact will be elevated crude prices and a curtailing of significant projects coming online.

Financial discipline

So, why would an investor favor an E&P (shares up 25% as a group for the first half of the year) over the broader S&P 500 (down 20%) or Apple Inc. (down 25%) or Amazon Inc. (down 38%) or Tesla Inc. (down 44%)?

It wasn’t the realization that fossil fuels were not, in fact, on the verge of irrelevance, nor was it the soaring revenue that accompanied skyrocketing commodity prices. Neither of these factors is particularly novel and they failed to spur investor stampedes in the past. The difference is the industry’s pivot from growth to free cash flow generation.

“After the near-death experience in 2015 to 2020, the Permian producers focused on financial discipline, focusing on return on capital on projects and company-wide, and other financial metrics, versus just production growth and, most importantly, including these financial metrics for executive compensation,” Underhill said. “They took operating costs out, lowered their breakeven oil/natural gas prices, reduced financial leverage (Oxy), increased free cash flow, and returned excess cash to shareholders via share repurchase and dividends.”

Vicki Hollub, president and CEO of Oxy, acknowledged the changed priorities when she discussed the primary reallocation of cash flow to shareholders instead of debt reduction. The company expects to repurchase $3 billion of stock by the end of the year, Hollub said during the company’s earnings call. The plan for 2023 is to return capital to shareholders through a common dividend. The plan relies on a $40/bbl price of WTI.

“Given our focus on returning capital to shareholders, it is possible that we may reach a point next year where we’ve returned over $4 per share to common shareholders over a trailing 12-month period,” she said.

Time to buy back

Nothing illustrates the transformation better than the reaction to this year’s massive revenue expansion. Companies resisted the impulse to “drill, baby, drill” in favor of “distribute, baby, distribute.” Not as catchy, perhaps, but from the perspective of investors, a strategic improvement.

“The companies have continued to maintain financial discipline through the upturn in oil prices, which has reassured investors that they will not make the same mistake as before by escalating capital spending too fast,” Underhill said. “This is a big difference versus previous cycles and investors have rewarded this strategy by oil producers with higher stock valuations, which has reinforced these disciplined strategies.”

Devon president and CEO Rick Muncrief was not shy about pointing this out during the company’s earnings call: “The first call on our free cash flow is the funding of our fixed plus variable dividend.”

Devon expects to pay out about $5 per share, an 8% yield, this year, which ranks it No. 5 on the U.S. News list, the highest-yielding stocks in the U.S. market. No. 1 on that list: Pioneer Natural Resources Co., the Permian-producing powerhouse with a yield of 10%, or $8.57 per share.

“I’ve always said we would aggressively repurchase shares when the market presented opportunities,” Scott Sheffield, Pioneer’s CEO, said on his earnings call.

The company generated $2.7 billion in free cash flow in the second quarter and increased its base dividend by 40%. The increase, its third in four quarters, means that Pioneer’s base dividend nearly doubled in the 12 months ending with the second quarter.

Even the mighty Permian Basin can endure headwinds, and Underhill’s list includes: lower demand from a potential recession, a stronger U.S. dollar, lockdowns in China, ever-present geopolitical volatility, and the release of crude oil from the Strategic Petroleum Reserve, which he expects to end shortly before the midterm elections in November. However, Underhill expects these to be under control by the end of the first-quarter of 2023. As long as E&Ps stay on track, they can expect to be rewarded.

“We expect the producers to continue the focus on financial discipline until they get the tacit approval from investors to increase capital spending given the higher oil/natural gas prices,” he said. “We expect the producers to be measured in providing both shareholder-friendly actions such as dividend hikes and share repurchase, special dividends combined with disciplined growth in capital spending.”