Freedom

By Tim Mullaney

When Devon Energy announced fourth-quarter earnings on Feb. 15, the world looked like its newly comfortable, fiscally conservative oyster.

After losing nearly 90% of its value from 2014 through October 2020, the Oklahoma City-based oil and gas producer was the top-performing 2021 stock in the Standard & Poor’s 500, thanks to a concerted strategy of throttling back on exploration, squeezing costs and taking less risk. It turned a 2020 loss of $2.5 billion into a $2.8 billion profit for 2021, raising its dividend 45% and plowing nearly $600 million into stock buybacks after spending just $38 million the year before, with promises of more cash to rain on once-beleaguered shareholders soon.

“Devon generat[ed] the highest level of cash flow in our prestigious 50-year history,” CEO Rick Muncrief crowed on a conference call. “We delivered exactly what our shareholder-friendly business model was designed for, and that is to lead the industry in cash returns.” 

Nine days later, Russia invaded Ukraine.

Now Devon and other producers face demands that the U.S. and Europe cut Russia off from world energy markets – not easy, since Russia’s 10 million barrels a day make it the world’s No. 3 producer of oil, and its natural gas supplies much of Western Europe’s heat and electricity. Even though a new Quinnipiac poll says 71% of Americans favor expanding sanctions on Russia to include its oil and gas industry, U.S. oil isn’t dying to pick up the slack – including Devon. 

There’s little wonder why oil isn’t eager to ride to Ukraine’s rescue: The exploration industry as a whole had nearly $20 billion in negative free cash flow as recently as 2015, losing $78 billion between 2005 and 2017 as hydraulic fracking took over the industry and drove crude prices lower amid oversupplied markets and overextended drillers. Free cash flow is a financial measure that accounts for the amount oil companies invest in new wells, which is deducted from accounting profits over the expected life of the wells.

Big Oil’s rebound and reluctance to drill

Devon’s turnaround was one of the more dramatic. In 2021, it reinvested only 32% of its operating cash flow in new wells, retired $1.2 billion in debt, raised its dividend, and bought back nearly $600 million of its stock just in the fourth quarter. This year, it planned for more of the same: Another $1 billion in debt reduction and $1.6 billion in stock buybacks,  a company worth $32 billion before war broke out, with only a third of cash flow being reinvested in more drilling.

The next day, Goldman Sachs analyst Neil Mehta’s bullish report on Devon didn’t mention Ukraine. No analyst had asked about it on Devon’s conference call to discuss quarterly results.

But as they said in The Godfather, just when Big Oil thought it was out, people want to pull it back in. And Devon CEO Rick Muncrief, for one, isn’t rushing to produce more, at least not without more explicit instructions from the White House.

“When you start thinking about investment decisions, upping capital budgets, trying to grow more, you really have to think about inflationary pressures and also think it will be about a year when you start to really see that production come in,” Muncrief told CNBC’s Jim Cramer last week. “So most publicly traded companies such as ourselves will be very thoughtful, very cautious about this. We’ve some head fakes, we understand the concerns about commodity prices right now, but we need to be somewhat patient and disciplined and stay focused.”

Days before that, though, he told Bloomberg that he was “mystified” that President Biden has not reached out to discuss raising oil production, as that might allow energy companies to make the case to shareholders more easily.

On Wednesday, in a speech to oil and gas executives at CERAWeek by S&P Global, the energy industry’s main annual conference, Secretary of Energy Jennifer Granholm called on the industry to produce more.

“We are on a war footing,” Granholm said. “We are in an emergency, and we have to responsibly increase short-term supply where we can right now to stabilize the market and minimize harm to American families,” she said, though she also indicated that further releases from the Strategic Petroleum Reserve are not off the table.

“I hope your investors are saying these words to you as well: In this moment of crisis, we need more supply… right now, we need oil and gas production to rise to meet current demand,” Granholm added.

On Wednesday afternoon, a Devon spokeswoman said nothing had changed in its position since the comments Muncrief provided to Cramer, but she stressed that the situation is fluid.

Replacing Russia’s 10 million barrels

Replacing the 10 million barrels a day of crude oil that Russia produces, according to the International Energy Agency, would take both time and money. President Biden’s announcement Monday that the U.S. would ban Russian imports was the easy part: The U.S. imported only 90,000-100,000 barrels a day from Russia, according to recent data, a tiny fraction of the 18 million barrels a day Americans consume. Replacing the four million Russian barrels that go to Europe daily – as well as Europe-bound natural gas – is much harder.

The industry quietly hopes to stay on the sidelines, as politicians like Senator Elizabeth Warren rage, and even as crude reaches $125 a barrel on world markets, analysts say. And investors plan to hold their feet to the fire, according to Rob Thummel, portfolio manager at Tortoise Capital, a heavy investor in energy stocks. The new financial arrangements in the oil industry suit Wall Street after it lost money on energy for years, with the S&P 500 Energy Index, dropping 75% from 2014 to early 2020, he said.

“The sector went through the last decade growing production like crazy, and energy was the worst performing set of stocks in the S&P 500,” said Thummel. “So people questioned the business model. It sparked a shift to a ‘prove-it’ model. The investor wants cash flow, wants to see debt paid, see a dividend and stock buybacks.’” 

If U.S. oil is largely hamstrung financially, where would the oil likely come from to fill the gaps in the 95 million barrel per day world oil market resulting from lost Russian production or sanctions?

Analysts at Goldman Sachs argue that expanded U.S. production would be no more than the fourth biggest source of new barrels to meet a cutoff of Russia.

The first place replacement barrels would come from is OPEC, the Organization of Petroleum Exporting Countries, which works with Russia but has not formally admitted it as a member. Goldman says the core OPEC nations of Saudi Arabia, the United Arab Emirates and Kuwait could add 2.1 million million barrels per day of production within “a few months.” 

Prospects for that are hampered, however, by reports that leaders of Saudi Arabia and the UAE have recently declined to accept phone calls from President Biden, while talking to Putin.

“While such an outcome becomes increasingly likely the more Russia is excluded from the global economy, driving core-OPEC, Iran and the West closer together to increase supply, it would nonetheless likely take weeks to reach and a month for supply to start increasing,” analysts led by Damien Courvallin and Jeffrey Currie wrote. 

On Wednesday, crude oil shed 12% as there were signs of more willingness from OPEC nations including the UAE to increase supply.

The next two sources would be pariah nations, Iran and Venezuela, that get a pass for past transgressions against the U.S. and the West because their oil is needed now, Goldman’s analysts wrote on March 7.  

The U.S. has been trying since Biden took office to get Iran back into compliance with its 2015 nuclear disarmament deal so sanctions imposed by the Trump administration in 2019 can be lifted. Venezuela was sanctioned by former Presidents Donald Trump and Barack Obama over suppression of protests, cooperating with terror groups fighting to overturn Colombia’s government, alleged drug smuggling and other transgressions.

But Goldman is cautious about the potential for more production from those two nations. It believes Venezuela would only be able to add about 500,000 barrels per day if sanctions were lifted, and that production in Iran wouldn’t rebound until at least summer, not reaching 1 million barrels a day until the fall. 

Inflation is an issue for oil companies, too

That leaves the U.S., where oil production fell by more than 3 million barrels a day between 2019 and early 2021, according to government data, and have bounced about halfway back. The reason for the drop was the sharp pullback in drilling activity by Devon and others: The number of oil rigs working dropped to 250 in mid-2020 from 1,077 in late 2018, according to industry data compiled by Baker Hughes.

The logistical hurdles to boosting production quickly are severe, said Matt Portillo, research director at Tudor, Pickering and Holt, a boutique energy bank. These include labor shortages that would be hard to fix, as workers laid off during production cuts have found other jobs. And supply chain challenges, which affect everything from steel tubing to the specialized sand used in hydraulic fracking. ConocoPhillips CEO Ryan Lance said in a CNBC interview that oil production’s supply chain is seeing double-digit inflation for key inputs like sand.

“We’re in a really dire situation,” said Vicki Hollub, CEO of Oxy, on Tuesday at CERAWeek by S&P Global. “We’ve never faced a scenario where we need to grow production, when actually supply chains not only in our industry but every industry in the world [are] being impacted by the pandemic. … Now, with supply chain challenges, it makes any kind of attempt to grow now — and at a rapid pace — very, very difficult,” she said.

This is on top of the fact that Hollub says investors view capital discipline as “essentially no growth.”

Portillo thinks U.S. shale production will rise by about 650,000 barrels per day this year, with most of the gains coming from smaller producers whose shares are not publicly traded and can afford to ignore investor pressure. Integrated oil companies like Exxon Mobil have announced small production hikes, but the midsized exploration companies that account for most drilling are trying hard to resist, he said. 

“In 2022, there’s little chance you’ll see a difference in capital commitments, Portillo said. “And there are physical constraints that limit expansion in the short term.”

There’s not much the Biden administration can do to speed new production, said Peter McNally, vice president and global energy sector lead at Third Bridge. Options like expanding drilling leases on federal lands, as some politicians have urged, wouldn’t deliver new barrels fast enough because of the time needed to build wells and prepare to drill – a point echoed by Pioneer Natural Resources CEO Scott Sheffield, who said on CNBC that nearly all U.S. oil comes from privately owned land anyway. 

“That won’t help in the next 12 months,” McNally said. “That’s more like three years.”

That means the outlook is for little relief for consumers at U.S. gas pumps, who have seen average prices jump 50 cents to $4.10 per gallon of regular fuel in the last week, according to the U.S. Department of Energy.

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And at the top of the list of causes is an industry, and investor base, not convinced that even today’s prices will last long enough to generate a durable, reliable return on investors’ money.

“We have a contract with our shareholders to pay back 80% of our free cash flow back to the investors,” Sheffield said. “So we have to get shareholder support.”