Energy - Q4 2022 Earnings Season

Oil prices have been in a drawdown since they peaked at $123.70 per barrel in March of last year (with an echo peak in June in the $120 per barrel range). As energy investors, we have been fighting two headwinds:

• The Federal Reserve has been shrinking its balance sheet (tightening) since last April. From a peak of $8.96 trillion, it has declined 6%. We have seen since 2008 that the Fed's attempts to shrink its balance sheet (i.e. "taper") are bearish for risk assets. They have also been short lived, and associated with rebounds that are much larger than the amount of reduction, which is why the balance sheet has grown over time and is an order of magnitude larger than it was twenty years ago.
• Releases of oil from the Strategic Petroleum Reserve have averaged about 600,000 barrels per day over the past year. The liquidation of crude oil inventories is unprecedented and will necessarily eventually end.
  

It will be interesting to see what happens when all of the world's economies are fully reopened, there are no more liquidations of SPR or commercial inventory, and the Federal Reserve (together with other central banks) resumes printing instead of tightening. 

Our view is that eventually all three of those factors will be acting as tailwinds and not headwinds, and that when they are it will be bullish for oil. We just do not know when those stars will all align. (Fed Funds futures currently predict that rates are most likely peak this June, although possibly as late as December. If the SPR were to continue selling at a rate of 600k bbl/d, it would be completely exhausted in under two years.)

Since we do not know when an oil bull market will resume, and we also do not know what price oil will sell for over the long term, it is instructive to see what our energy companies are earning now, at recent commodity prices and refining margins. Fourth quarter results can give us a good look at this, and earnings results are out for Suncor, Cenovus, and Marathon. (We are still waiting for Canadian Natural Resources, which does not report results until March.)

Suncor's market capitalization is $45 billion (at a $34 share price) and the enterprise value is $55 billion. They reported earnings [pdf] for the fourth quarter of $2 billion, which means that shares are trading for under six times net (annualized) earnings. Their adjusted funds from operations for the quarter were $3.1 billion, which gives an annualized (Q4) AFFO/EV yield of 23%. 

Suncor claims to have 7 billion barrels of proved and probable reserves, which is an enterprise value of less than $8 per barrel. The PV-10 of their proved and probable reserves was $50 billion at the end of 2021, which was calculated based on the $66.56 average WTI price that year. Keep in mind in addition to the value of the upstream reserves (which are worth almost the entire enterprise value at a lower oil price than today), Suncor also has its refining and marketing operations, which earned $4.2 billion in 2022.

The shareholder returns are also very impressive. Suncor spent $3.7 billion on capital expenditures last year, versus $2.7 billion on debt repayment, $3.8 billion on share repurchases, and $1.9 billion on dividends. The combined amount spend on debt, buybacks, and dividends was $8.4 billion, which is 19% of the current market capitalization. (The shares repurchased during 2022 were equal to 8% of the beginning of year share count.) Suncor said that they expect to increase their share buyback allocation to 75% of "excess funds," meaning whatever is left over after capex of $4 billion and a dividend of $2 billion ($1.53 per share; a 4.5% yield, by the end of the first quarter of 2023. (The other 25% would continue to be spent on debt reduction, until a target of a $6.7 billion "debt floor" is reached.

Cenovus's market capitalization is $36 billion (at an $18.50 share price) and the enterprise value is $39 billion. They reported earnings [pdf] for the fourth quarter of $580 million and $4.8 billion for the full year, which means that shares are trading for 7.5x last year's earnings. Their adjusted funds flow for the fourth quarter was $1.7 billion, which gives an annualized (Q4) AFFO/EV yield of 17%. Cenovus had some issues with third-party pipeline outages during the quarter that impacted their downstream (refining) operations.

According to the company: "at the end of 2022, Cenovus total proved reserves were relatively unchanged at approximately 6.1 billion BOE, while total proved plus probable reserves increased 7% to approximately 8.9 billion BOE." That makes for an enterprise value per barrel of 2P reserves of under $5 per BOE.

Last year's capital allocation and shareholder returns were impressive. They spent $2.7 billion on capital expenditures for the whole year. Meanwhile, they reduced their net debt to $3.2 billion, which was a decline of $4 billion year over year and $740 million from the prior quarter. They spent $667 million on dividends and $1.9 billion on share repurchases (which was enough to buy back 6% of the beginning of year share count). The combined amount spend on debt, buybacks, and dividends was $5.6 billion, which is 16% of the current market capitalization. They think that by the fourth quarter, net debt should be below the "floor" of $3 billion, at which point they would target "100% shareholder returns" using excess free funds flow.

Marathon Oil Corporation's current market capitalization (at a $26.75 share price) is $17 billion and their enterprise value is $20 billion. They reported earnings for the fourth quarter of $525 billion, which means that shares are trading for 8 times annualized earnings. Free cash flow was $763 million for the quarter which is an annualized (Q4) FCF/EV yield of 15%.

They delivered total shareholder returns of $3.0 billion, representing a distribution yield of 17% on the current market capitalization, including $338 million during the fourth quarter. Most of this was done via share repurchases (totaling $2.8 billion), which resulted in a 15% reduction in outstanding shares. They generated approximately $4 billion of free cash flow for the year and the $3 billion which was returned is 75%; higher than Suncor or Cenovus. The 2023 capital budget and guidance is for $2 billion of capex and $2.6 billion of adjusted FCF, assuming $80 oil and $3 natural gas.

It is interesting to compare the results that these three companies had with a competitor, Devon Energy, which also reported earnings this week. Their capital expenditures were up 80% (Q4 2022 versus Q4 2021) but their production was only up 4%. 

It is good to see a shale producer and competitor exhibiting deteriorating economics. This is why we are interested in royalties and resources with front-loaded costs and long reserve life.

Devon has a market capitalization of $42 billion and an enterprise value of $47 billion. Free cash flow for the fourth quarter was $1.1 billion which was the same as the year prior. It is also interesting that Devon's FCF/EV yield (annualized) is only 9%. It goes to show that other investors do not realize how superior royalty investments and long reserve life investments with front-loaded costs will be in an inflationary environment.