Investing in the Oil and Gas E&P Industry

Exploration and production, or E&P, companies occupy an important position at the beginning of the oil and gas supply chain.

Before you’re able to heat your home or fill your tank, an E&P must find a reservoir of hydrocarbons to develop. They find those reservoirs with labor and equipment leased from oilfield services companies, including rigs and rig operators. Then they develop those hydrocarbons into natural gas and crude oil before engaging a midstream company to distribute it through their pipeline network. The revenue generated by an E&P depends on the quality of the crude oil they develop and the location of the buyer. The farther the oil must travel to market, the more expensive it is.

The E&P industry is extremely fragmented because its product is fungible and a global commodity.

The largest producers tend to be national oil companies backed by governments. Competition is intense, which leads to strict regulation under the watchful eye of the Organization of the Petroleum Exporting Countries, or OPEC, which attempts to exert a level of control over the market and oil prices.

The Equity Research Team at Morningstar published a robust report in February 2024 entitled Industry Landscape: Oil and Gas Exploration and Production that details everything from the development of hydrocarbons to the investor outlook of E&P stocks.

Download the full report here.

The following content and charts are derived from ideas and commentary originally published in the report.

Cost advantage is key for commodity producers, but in short, it’s pretty tough to achieve in the long term. Nearly 70% of Morningstar’s E&P coverage has a no-moat rating. In fact, Morningstar doesn’t even assign wide moat ratings in the E&P space—the uncertainty of oil pricing is simply too high. But low-cost producers can earn narrow moats, and 32% of the companies covered in the latest report have. Maintaining production costs well below the long-run industry marginal cost is the only real way to generate excess returns on invested capital.

The E&P industry was once known for poor discipline and reckless spending. Capital allocation was often abysmal in the early days of the shale revolution. Extravagant, debt-fueled investment was the norm before oil prices crashed in 2015, and the “growth at any cost” mindset persisted for several years after that. Distributable cash flows were stuck in negative territory until the second half of the 2010s.

Management teams eventually learned their lesson. After the 2015 downturn, upstream firms focused on aggressive cost-cutting, with impressive results. This initially made them victims of their own success—by dramatically reducing the marginal cost of oil supply, they also eliminated the need for higher oil prices. Nevertheless, the industry kept exceeding expectations with efficiency gains and new technology, compressing costs further. By 2019, many firms were finally on the cusp of durable free cash generation, and a handful were already delivering it.

However, this swing to profitability was pushed back by the onset of the COVID-19 pandemic in 2020. The fading of the pandemic spurred extremely favorable conditions for E&Ps. Morningstar believes the upside is cyclical, not structural, and relaxing commodity prices will also erode cash flows. But because industry cost discipline has carried over from leaner times, we expect operating cash flows to level off near where they were during the 2010-14 boom. Only this time around, these leaner, more efficient companies will be reinvesting just a portion, leaving at least 30%-40% of operating cash available for distribution to shareholders.

Flush with cash, E&P management teams have started distributing a substantial portion of their inflows to shareholders. This broadens the sector’s appeal for income-oriented investors and underscores the firms’ newfound commitment to capital discipline.

Some firms have set up variable dividends designed to return a percentage of free cash directly, resulting in higher payouts during upcycles and vice versa. Others let management teams choose how and when to distribute surplus cash. The rest prioritize buybacks, which makes sense if the stock trades below intrinsic value. However, management teams often have rose-tinted views about their own stocks, and firms typically have more cash available for buybacks during upcycles, when stock prices are highest.

Morningstar recommends caution when using short-term yields to draw valuation conclusions when oil and gas prices are far from midcycle levels. We’ve seen management teams compare distributable cash yields with broader indexes to argue shares are undervalued. That’s a bit misleading, since top-of-cycle yields won’t last forever.

In 2023, distributable cash flow yields in our E&P sector coverage are about 36%. But projected distributable cash flows in 2026 are consistent with an average yield of just 19%. That’s still significant and underscores the sector’s strong potential for durable shareholder distributions, which is why we think it should be on income investors’ radars.

Morningstar Sustainalytics assigns an ESG Risk Rating of Severe to 30% of our oil and gas E&P coverage, and the remaining 70% has a risk rating of High. There are no E&P companies in our coverage rated Medium or lower. This emphasizes the increased risk for this industry compared with the distribution of ratings across all sectors (Sustainalytics assigns ESG Risk Ratings of Low or Medium to 81% of all companies). The ESG issues most driving this increased risk are greenhouse gas emissions (both from extraction operations and downstream consumption) and other emissions and waste (primarily oil spills).

Firms can clean up their operations in the field by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to limit the release of CO2 into the atmosphere during extraction. However, scope 3 (downstream) emissions are beyond producers' control, even though these account for the vast majority of total emissions.

Spills are mainly a threat for the few E&Ps with significant offshore operations. Another devastating accident like the 2010 Macondo disaster is unlikely, but the liability could be significant if the operator is at fault. In contrast, onshore firms are vulnerable to spills at or around the wellsite. These tend to be frequent, but relatively minor. Costly legal challenges are unlikely for this kind of event, and we see little chance of significant value destruction. Nor would E&Ps be on the hook for adverse events during long-haul transit onshore, like the Kalamazoo River (Michigan) spill in 2010, as this activity is typically outsourced to midstream firms.

Morningstar projects oil demand will peak around 2030 and the subsequent decline will be mild. Electric vehicle adoption will accelerate quickly for private and commercial uses, but the vehicle stock will shift more slowly because internal combustion engines have long lives. For aviation, shipping, and petrochemicals, the substitutes are far from ideal, even with generous allowances for technological improvements. This does not necessarily signal climate disaster, though; emissions will decline faster as the share of noncombustible uses rises.

Natural gas is more climate-friendly than coal and a better complement for renewables in power generation. Consumption is increasing rapidly in Europe and Asia, spurring a surge in U.S. exports. This benefits U.S. producers to an extent, but infrastructure constraints cap the potential for growth. Despite rising energy costs, many politicians are reluctant to compromise their climate credentials by supporting pipeline or export terminal approvals.

Read the full report, Industry Landscape: Oil and Gas Exploration and Production, for more commentary.

Some other notable sections of the report include:

• Industry Basics: From Underground Reservoirs to Refineries and Power Stations
• OPEC: The Global Cartel That Influences Oil Prices
• Crude Oil Outlook: We Expect Uncertainty With Demand Peaking in the Medium Term
• Natural Gas Outlook: Global LNG Demand Is Boosting Demand for U.S. Gas
• E&Ps Look to Reduce Emission Intensities Over the Upcoming Decade

Download the report now.

Curious how the Equity Research team at Morningstar does their research and analysis? All of the data presented in this report was generated using Morningstar Sustainalytics, a provider of ESG research, ratings, and data across a full spectrum of asset classes and investment types, and Morningstar Direct, a comprehensive platform that helps asset and wealth managers build their assets and manage their portfolios.