Excerpt from Latest Nuttall ArticleWe estimate the average Canadian energy stock currently trades at an estimated 2.7 times enterprise value to cash flow and a 25-per-cent free cash flow yield at US$100 WTI. How, with one simple act, can a board force a rerating in trading valuation back closer to historical levels of seven times or more? Maintain flat production, eliminate debt or at least get down to fortress-like strength, and then use every single dollar of free cash flow to buy back shares. The timeline to such a rerating is surprisingly short, given that the average Canadian energy company approaching debt-free status by the first quarter of next year will be able to buy back all its outstanding shares in just four years with free cash flow at US$100 WTI.
After all, what is the value of the very last share of a debt-free company that has billions of dollars of annual free cash flow and 15 years on average of stay-flat production? How can a share price not meaningfully rise, assuming flat oil prices, if 25 per cent of the outstanding shares are being cancelled each year via the use of significant issuer bids?
Looking forward to the next several years, should oil stay at current prices and the sector approaches debt-free status by early next year while having adequate drilling inventory so as to not have to use free cash flow for M&A, companies face a unique problem: unprecedented free cash flow with limited ways to spend it.
My advice to companies is this: If you no longer have any debt to pay off, if you have adequate inventory depth and don’t have to buy more land, and given that depressed valuations cannot justify production growth, there is only one thing left to do with the free cash flow … give it all back to shareholders.
It is, therefore, not unfathomable that the energy sector could soon pay the equivalent of a 25-per-cent dividend yield if oil stays at US$100 WTI, and therein lies the power. Will stocks trade at an implied 25-per-cent dividend yield if investors view the dividend as sustainable? I would suggest not.
A rerating to a 10-per-cent yield, which (given debt-free status and 15 years of identifiable free cash flow) seems like a reasonable valuation level, would mean a 150-per-cent rally in energy stocks from current levels. Still think you’re late to the oil party?
Eric Nuttall is a partner and senior portfolio manager with Ninepoint Partners LP.