Houston Chronicle – Stephen Chazen believes Wall Street’s recent push for U.S. shale drillers to return cash to shareholders isn’t meant to turn oil companies into a retirement plan for investors. It’s really a move to fix a high-rolling industry that chased a lot of not-so-great investments in the nation’s energy revolution.
In a wide-ranging interview on Tuesday about his upcoming return to the U.S. oil patch at the head of a new public company, the former chief executive of Houston’s Occidental Petroleum Corp. said it doesn’t make much sense for investors to demand dividends and share repurchases from smaller oil companies that can’t compete on those grounds with far more stable rivals like Exxon Mobil – unless they’re really after something else.
“If you want dividends, you should buy Exxon stock,” Chazen said. “What they’re really saying is, ‘actually, we don’t trust you to hold the money because you’ll waste it, so we want it back.'”
Chazen, 71, spoke to the Houston Chronicle on Tuesday shortly after his publicly traded investment vehicle TPG Pace Energy Holdings Corp. announced the $2.7 billion purchase of 360,000 net acres in South Texas from Houston oil company EnerVest, an acquisition the executive plans to use as a launching pad for Magnolia Oil & Gas Corp., a new Houston-based oil producer that will trade on the New York Stock Exchange.
Chazen picked out EnerVest’s 14,000 net acres in the Eagle Ford Shale’s oil-rich Karnes County to be the heart of the new venture, and he sold investors a business plan that’s almost identical to his playbook at Occidental: keep spending relatively low, use little debt and focus on generating free cash flow, which is the money generated after companies make investments known as capital expenditures.
It’s a message that has picked up adherents on Wall Street, and one Chazen says is reverberating across the U.S. oil industry. Late last year, big institutional investors began telling U.S. oil executives they want companies to curb their enthusiasm for booming shale plays and focus on profits, marking a seismic shift in financiers’ priorities after years of pushing for surging crude production and the accumulation of vast chunks of onshore oil land.
The switch came as investors realized they weren’t getting much back for the billions of dollars they shoveled into shale drillers. Investors poured $150 billion in public equity and bond debt into U.S. oil companies, and private equity firms raised more than $200 billion for energy-focused funds over the past three years, according to IHS Markit.
The cash influx saved the oil industry from a much more brutal downturn than the one that sent 116 U.S. oil producers, including 60 in Texas, into bankruptcy proceedings. Because of those investments, the oil bust only claimed a handful of larger oil companies, and it didn’t lead to a wave of corporate consolidation, as analysts had predicted in the early days of the downturn. And without that money, the Energy Department almost certainly wouldn’t be talking about U.S. crude output climbing above 10 million barrels a day, Chazen said.
“It was certainly good for Houston,” he said. “But it wasn’t a particularly good investment. At the bottom, it might have been.”
For example, it wasn’t uncommon, Chazen said, for oil companies to spend $10 million drilling and pumping oil from a well and collect $11 million in total revenue over the life of that well. That translates into a 10 percent return over five years, or a mere 2 percent per year. There financial returns, he said, weren’t really there.
“And not only that, but (oil companies) took the money and paid it to (themselves) in G&A,” he said, referring to general and administrative costs. “There’s no cash being built up. Every year the guy comes out and he says we need more money.”
Wall Street has altered the U.S. oil industry’s destiny a few times in recent years. With the advent of major U.S. shale plays, investors wanted oil production growth. Later, they asked for better internal rates of return, which is controlled by how fast a company can make its money back. That prompted oil companies to pour more money into U.S. onshore fields, where they could start pumping oil much faster than in the deep-water Gulf of Mexico, where investments can take more than five years to pay off.
Investors’ call for shareholder returns came after the U.S. energy industry fell from 12 percent of the S&P 500 before the oil downturn to about 6 percent. Portfolio managers, Chazen said, now see energy as less important than, for example, the technology and financial sectors, which make up a larger share of the major stock index.
“What they really want is capital discipline,” he said. “The returns on invested capital were less than they think Google could make.”
Since 2015, oil companies have touted efficiency gains that have lowered the oil price at which drillers can break even in certain areas. But Chazen said the industry’s emphasis on “breaking even” misses the point. Investors, he said, aren’t interested in just getting their money back; they want to know at what price companies make a reasonable return. A few years ago, he said, that number was $75 a barrel. Now, with cost reductions and technological improvements, that level is around $65 a barrel, close to where prices hover today.
“You’re not going to get rich,” he said. “But you’ll make at least your cost of capital. So you’re close to that.”
One major problem U.S. shale drillers face is that, even as oil prices float near favorable levels, they’re producing too much natural gas, which fetches a far lower price tag than oil. When Chazen began looking at potential assets to acquire for Magnolia, natural gas was everywhere.
Magnolia’s Karnes County acreage, which the company will take ownership of in the second quarter after the EnerVest transaction closes, produces 75 percent oil, one big reason Chazen pursued the deal. It’s a relatively small area with a lot of concentrated oil, similar to older conventional fields that, unlike today’s shale plays, didn’t span hundreds of thousands of acres.
Drilling new wells in that region, he said, will generate free cash flow in five to six months. Compare that to some areas of the coveted Delaware Basin in West Texas, for example, where oil companies are producing a lot of natural gas, and many of the wells there start generating cash over two years. It’s a more capital intensive venture than drilling in areas with a higher oil cut.
“It’s not one of my goals in life to make Halliburton rich,” he said. “Ideally, you drill one well and drain the whole place.”