As each day passes since we have been able to access shale oil here in the U.S., investors are becoming more and more discerning about which companies will make the transition from fast-paced start-up to long-term success. Finding oil doesn't seem to be the problem for anyone, but growing a business without mortgaging the entire business with debt is. According to a recent article in Bloomberg, more than a dozen companies invested in the shale revolution are spending 10% of total sales in debt payments. Not everyone wants to park their investment dollars in debt-safe companies like big oil, because frankly, those companies haven't been great investments either. Instead, let's take a look at two key things investors should watch for in domestic producers, and why you should take a deeper look at EOG Resources (NYSE:EOG) and Devon Energy (NYSE:DVN) for your portfolio,
Cash is becoming king
One of the biggest issues with companies in the U.S. energy space today is that many are still reliant on issuing new debt in order to cover their ambitious capital expenditure programs. If we were only a year or two into the shale boom, it could be forgiven, but now we're at the point where many companies have had capital expenditure programs outpacing their operational cash flow for quite some time.
For example, Continental Resources' (NYSE:CLR) capital expenditures have outpaced its operational cash flow since 2007, and over that time period, the company has seen its EBITDA to interest expense ratio sink from 32.4 times all the way to 11.5 times. This doesn't leave the company a lot of wiggle room in the event of lower oil prices or operational setbacks. The reason I'm highlighting Continental, here, is that it's actually one of the companies in better financial shape than many other oil and gas players today. With an interest expense of 6.4% of total revenue, it's only slightly above the industry average of 4.1% based on a survey of 61 exploration and production companies by Bloomberg.
Doing your homework
Investors in the exploration and production space need to start incorporating the rising tide of debt into their investment thesis, because it is starting to take a bigger and bigger chunk of earnings. So, here are two critical questions worth asking when it comes to looking at exploration and production companies.
1. Is the cash flow gap closing?
It's no secret that the high decline rates from shale wells mean capital expenditures will remain high to either grow or maintain production, but it doesn't mean companies need to consistently cover payments with debt. Ideally, we would like to see cash cover capital expenditures with some left over, but for many, it's still acceptable to be spending more than what they make, provided the difference is getting smaller. This table shows Continental, EOG, and Devon's operational cash flows as a percentage of capital expenditures over the past three years.
|Operational Cash Flow (as % of capital expenditures)|
Based on this chart, it looks as though EOG is in very good financial shape going forward. With operational cash outpacing capital expenduirures, it might even start to pay down debt, or give back more cash to shareholders. Devon has been in the middle of a turnaround to become a more diversified energy company, but its current capital budget for the year should put it operational cash flow positive by the end of the year.
2. Is covering Interest expenses becoming a smaller or larger problem?
Another way to measure the health of these companies is to see how well they are covering their interest expenses on their debts. After all, most of these companies will be able to secure debt at different rates than others. A decent metric to look at in this situation is EBITDA to interest expense, also known as the interest coverage ratio, and how it has changed over time. Obviously a company needs to have that number be greater than 1 in order to meet its obligations, but that's just barely squeaking by as a company. So, not only only do we want to see this number considerably greater than 1, but it should also be growing over time.
|EBITDA to Interest Expense|
What a Fool believes
In the early stages of the oil and gas boom, it was a piece of cake to find a company that would make a decent return over a couple of years. Surging production led to fantastic revenue growth that brought lots of promise, and in turn, surging share prices. As the shale boom starts to mature, though, we need to be more selective about the companies we choose to invest in, and the financials of a company are going to start playing a much more important role. The two metrics here are a good start for investors making their first foray into the oil and gas space, and they should help you in making better decisions about your investments. Also, these metrics go to show that both EOG and Devon are ready for this new phase of energy growth, and investors would be wise to take a deeper look at both stocks.