Oil and gas investors set for jump in returns as producers near debt targets

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If there’s one sector of the Canadian economy that seems distinctly buoyant amid the gloom of rising interest rates and a possible recession, it’s oil and gas. After 18 months of soaring revenues from high commodity prices, a significant portion of energy producers are on the path to meeting or surpassing debt reduction targets in the next year and a half.

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Analysts now predict shareholder returns could jump across the sector as companies that were previously preoccupied with debt repayment begin plowing more cash into dividends and share buybacks — all while sentiment across the Canadian economy deteriorates to levels not seen since the beginning of the pandemic.

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Oil and gas companies may be particularly well positioned to navigate the current inflationary environment, rising interest rates and a potential economic slowdown, according to a recent report by credit rating giant DBRS Morningstar.

“The primary reason is the fact that they’ve reduced leverage so much over the last two years, the balance sheets are looking better today than they did at any time over the last decade,” Ravikanth Rai, DBRS Morningstar vice president and analyst, said.

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Rai said the companies rated by his agency could generate meaningful cash surpluses even if U.S. West Texas Intermediate (WTI) oil prices were to fall to US$60 per barrel. WTI futures closed down above US$85 Tuesday. “I think the underlying story is the fact that they’ve improved their balance sheets so much they have given themselves a lot more cushion to operate through a cycle if they need to.”

Companies poised to hit their near-term net debt targets — assuming WTI crude prices around US$75 per barrel — include Whitecap Resources Inc. in the fourth quarter of this year, Baytex Energy Corp. in the second quarter of next year and Vermilion Energy Inc., Cenovus Energy Inc. and Suncor Energy Inc. in the third quarter of 2023. Imperial Oil Ltd. has already reached its debt target, according to a recent note from Scotiabank Global Equity Research.

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“We believe as companies continue to hit their interim and long-term debt targets, there will be another step change in shareholder returns,” the note said.

The sector’s newfound aversion to debt, even during the latest bull run in commodity prices, may be down to fresh memories of financial hardship in the last oil downturn during the pandemic. Oil and gas producers carrying significant debt when COVID hit and demand collapsed suffered as prices bottomed out in the spring of 2020. Some companies were forced by creditors to sell assets or hedge production in order to survive.

The companies that endured have emerged from the pandemic with stronger balance sheets and a disciplined approach to spending, said Birchcliff Energy Ltd. chief operating officer Chris Carlsen.

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“We have taken the approach, (starting) a couple of years ago that we wanted to get the debt to zero, essentially,” Carlsen said, noting the company is approaching its goal after having retired approximately $840 million in total debt and preferred shares since June 2020. Birchcliff elected to declare a special cash dividend of 20 cents per share at the end of October and is now on track to reach a cash surplus position at the end of Q1 2023.

Gone are the days when a rise in commodity prices could prompt producers to immediately deploy cash to drill more wells or build new energy projects.

“Today, the shareholders are wanting returns, not growth,” Carlen said.

“Now what you’re seeing is companies want to take the risk out of their business and get the company in a great spot and that’s what we’re trying to do, versus spending it all.”

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