What Rising Interest Rates Could Mean for E&P FCF and Valuation
Mathematical Impact on FCF and Valuation Low
Sector Rotation and Funds Flow Drivers may be Positive Tailwinds
TD Investment Conclusion
Given the hawkish signalling from the U.S. Federal reserve last week and potential portfolio rebalancing geared towards a rising interest rate environment, in this note, we look at the potential implications of rising interest rates on the upstream oil and gas sector. In our view, the key takeaways include:
1) Rising Interest Rates have Negligible Impact on FCF: Given the massive industry debt reduction in 2021 and minimal balance-sheet leverage in 2022E, rising interest rates and the resulting increase in the cost of debt have a negligible effect on 2022E CF and FCF for virtually all producers. Specifically, for non-integrated producers, on average, a 1% increase in the cost of borrowing in 2022 would reduce 2022E FCF by only 0.7%.
2) Rising Interest Rates have Slightly Larger Potential Impact on Valuation:
Rising interest rates could negatively affect valuations of E&Ps. As the risk-free rate rises, investors may demand a higher return for assuming the risk associated with equities. This has implications for both NAV- and CF-based valuation methodologies.
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Impact on NAV: Using an NAV-based methodology, a 1% increase in the discount rate used for non-integrated E&Ps reduces our NAVs by an average of 6.2%.
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Impact on CF-based Valuation: Given the increasing importance of FCF and FCF-based valuation methodologies (i.e., FCF yield), we also calculated the implied valuation impact of a 1% increase in FCF yield (i.e., unchanged equity risk premium over a 1% increase in the risk-free rate). Based on this analysis, on average, the non-integrated producers could see 5.6% downside in market value should interest rates rise 1%.
Real-world Factors Likely Offset the Negative Pressures Stated Above: In isolation, rising interest rates are mechanically negative to our CF estimates and potential target prices: however, rising interest rates do not occur in a vacuum. We believe the following factors could more than offset the aforementioned impact of rising rates.
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Rising Rates Exist in an Improving Economic and Inflationary Environment: Rising interest rates are generally accompanied by an improving economy that could result in improving demand for oil and stronger commodity pricing.
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Sector Offers Deep Value on Key Valuation Methodologies: On average, our E&Ps are not currently reflecting full net asset value. Specifically, on average, the non-integrated producers are trading at a 42% discount to 2P NAV under a strip-pricing scenario. Energy producers are trading at deep value relative to other sectors at an average unlevered FCF yield of 17% (at current strip).
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Near-term FCF Being Returned to Shareholders: Furthermore, given shareholder return strategies, investors will likely directly participate in this FCF via cash returns and growing pro rata ownership (via buyback programs).