Note from Morgan Stanley

[dan_s]

Devin McDermott – Morgan Stanley
January 25, 2022

E&Ps continue to offer strong FCF (18% yield in '22), discounted valuations (2x historical discount to S&P), & leverage to higher oil. We remain constructive & would be a buyer of further weakness, but rising inflation skews us tactically toward larger producers with scale heading into 4Q results.

Solidifying a new value proposition.

2021 marked the start of a new era for US E&Ps, one defined by pervasive capital discipline and an emphasis on growing shareholder returns instead of production. Along with 4Q earnings updates, we expect the introduction of full-year 2022 guidance will reaffirm this regime change for investors, a key step in re-rating still discounted valuations. That said, rising inflationary pressure presents stock specific risks heading into earnings season.

For the industry overall, rising costs and the need to stabilize declining well inventories means spending will need to move higher in 2022 despite limited production growth. As a result, capital efficiency will generally degrade after several years of gains. This backdrop should create a divergent outlook across the sector - one that favors larger diversified producers with scale over smaller peers.

Despite higher costs, FCF is set to increase further. We forecast median y/y capex increase of ~12% across our E&P coverage. Importantly, FCF yields are still positioned to rise from ~11% in 2021 to ~18% in 2022 ($80 WTI). This FCF growth is tied to the combination of higher commodity prices, low reinvestment rates (~37% of CFO, down from 41% in '21 and well below the 2016-19 "normal" of 125%), and the roll-off of below market hedges.

Within our Integrated Energy coverage, FCF yields are around 12% for the US Majors and 15% for Canadian producers.

Positioning into earnings. While strong FCF, discounted valuations, and a constructive oil price outlook continue to support our Attractive sector view, the prospect of rising costs alongside 2022 guidance updates biases us toward more defensive positioning heading into 4Q earnings. Specifically, we prefer exposure to producers with scale (COP, EOG, CVE, OXY & XOM) and are tactically more cautious on CPE, MUR, CLR, CTRA and RRC. E&Ps:

Our median 4Q capex estimates for oil-weighted E&Ps are 1% above consensus, oil production 1% below, and CFPS (cash flow per share) estimates are 4% below. For 2022 guidance, we are generally in-line on production but see modest upside to capex versus consensus expectations. AR, CLR, CPE, & MUR stand out as the biggest capex outliers.
Conversely, EOG still expects flat-to-down well costs in 2022 while select companies should benefit from M&A driven synergies (COP, EQT, FANG).

Separately, we expect cash returns to remain a key driver of relative performance, but expect fewer new frameworks to be announced in 4Q than 3Q. That said, we do expect a formal cash return framework from AR and another special dividend from EOG (MSe ~$1B).

In addition, we expect OXY to achieve its mid-$20B net debt target in 1Q22 — a key prerequisite to reinstating a more meaningful dividend or other cash returns to shareholders.

Majors: For CVX, we forecast a modest beat on cash flow and capex versus consensus in 4Q. We expect management to retain prior 2022 cash capex guidance of $11.7 B (MS & cons: $11.7 B) and look for updates on Tengiz/TCO and recent Gorgon outages. We currently assume buybacks toward the midpoint of the $3-5 B range in 2022, rising to $5 B in 2023. While XOM has already released earnings drivers for 4Q, we do expect the company to tighten its $20-25 B spending range (MSe $22 B).

[dan_s]

More from Morgan Stanley

Resetting our price deck. With this note, we update our commodity price
assumptions in 2022/23to reflect the strip as of 1/7.
> Our WTI price assumption rises from $70/$63to $76/$69 in 2022/23,
> Henry Hub moves from $4.21/$3.38 to $3.84/$3.43,and
> Mont Belvieu NGLs increase from $34/$28 to $35/$29.
Our long-term (2024+) assumptions of $67.50/bbl WTI and $3.25/mmbtu Henry Hub
remain unchanged.

Positioning beyond the quarter. Our key E&P stock picks remain FANG & OVV
(peer-leadingFCF with strong cash returns), OXY (attractive rate of change +
differentiated ESG strategy),and COP (more defensive "quality on sale"). Within
the Majors, we retain our preference for XOM, where we see more upside to
consensus earnings, over CVX. In Canada, SU remains our top pick.