Introduction
Even before the Russia-Ukraine war spiked prices, the oil and gas industry’s fortunes changed drastically. Demand picked up after the Covid-19 outbreak and revealed a supply shortage after years of little investment.
Since their shares don’t appear to have priced triple-digit oil prices, investors can now grab a very high ten percent or higher yield with little risk of losing money should the bullish outlook for oil prices turn sour. Pioneer Natural Resources Company (NYSE:PXD) is currently sending a tidal wave of cash to the pockets of its shareholders, which is very desirable right now.
Background
In contrast to previous oil and gas booms, most businesses are cautious of fast-rising production. They would instead concentrate on repaying their shareholders. This resulted in a wave of updated shareholder return policies implemented in 2021 and 2022, some of which substantially favor dividends while others heavily favor share buybacks. Although each investor is free to have their preferences, I still believe that dividends are better than share buybacks in this case because of their flexible dividend policy, as shown in the graph below.
As seen from slide five of their investor presentation from June 2022, they want to repay 75% of their free cash flow in dividends as Western Texas Intermediate oil prices rise. This demonstrates their intention to supplement shareholder returns with modest share buybacks supported by the remaining free cash flow. In some circumstances, returning the vast majority of free cash flow would make the company more susceptible to a downturn, but this is not the case because of its solid financial position.
According to their Q1 2022 10-Q, their net debt as of the end of the first quarter of 2022 was $3.305 billion, which, even when compared to their $2.083 billion operating cash flow during 2020 during the downturn, would only result in a low net debt-to-operating cash flow of 1.59, according to their 2021 10-K. In other words, even with significantly worse financial performance, their leverage would still be minimal, allowing them to comfortably distribute as much free cash flow to their shareholders as they desire.
If oil prices remain high, the benefits are clear; Western Texas Intermediate’s pricing of $100 per barrel would provide yearly dividends of $27 per share, which, when applied to their current share price of $209.80, would see a very high yield of close to 13%. The world has had trouble meeting demand due to the lack of investment in oil and gas production over the past half-decade. In theory, this should provide substantial support even in the face of recession fears. However, despite these economic risks, the International Energy Agency has warned that there will still be more market tightness in the future.
Risk management is always crucial. Thus, this research considers what can happen if this bullish oil price outlook fails, despite the fact that this bullish oil price view should allow investors to secure a double-digit dividend return in the short run.
Valuations using Discounted Cash Flows
Oil and gas businesses can draw a variety of investors; some are more likely to draw speculative traders, whereas in this case, given their strong emphasis on dividends, they are more likely to draw income investors. As a result, their intrinsic value can be evaluated using discounted cash flow valuations, which replace their free cash flow with dividend payments. This indicates that their intrinsic value highly depends on the potential future income they can generate for their shareholders. If interested, more information on the inputs used for these values can be obtained in the following pertinent section.
Although there are multiple approaches to valuation, management happily made the decision very simple by outlining their projected dividends at a range of average Western Texas Intermediate oil prices, from $60 per barrel to $140 per barrel. These, in my opinion, are appropriate to serve as the foundation for the bearish through to the bullish scenarios, which, as shown in the previously included graph, have dividends of $17 per share to $35 per share at the lower and upper limits, respectively, and the other three steps lying in between the two.
Despite the recent expansion the oil and gas industry experienced when demand recovered following the Covid-19 outbreak, it is still true that over the long term, they will see a drop as the globe switches to clean energy. Although it’s unclear whether small oil and gas firms like Pioneer Natural Resources will eventually follow suit and find themselves a new position in the world, supermajor oil and gas companies like BP (BP) are already investing in these new places.
It was anticipated that in each scenario, their payouts would remain unchanged going forward before terminating after 30 years to account for this long-term uncertainty and give a margin of safety. This effectively assumes their overall dividend payments at the company level decrease slightly each year due to their concomitant share buybacks, resulting in a progressive winding down over the decades.
Reviewing these results reveals a highly intriguing fact: their current share price of $209.80 falls between the intrinsic values for the $60 per barrel and $80 per barrel scenarios. This means that their shares appear to be valued at only about $70 per barrel of oil, even though prices have spent most of 2022 around $100 per barrel. Their intrinsic value of $175 is only 16% less than their present share price, even in the gloomy $60 per barrel scenario, showing minimal downside risk over the medium to long term.
Although there is a chance that oil prices will one day fall even further, given how difficult it is to get supplies, this shouldn’t happen for a long time. Conversely, there should be times when oil prices are comparably high. It’s crucial to keep in mind that these scenarios are averages, given how unpredictable oil prices are month to month.
This is a good combination of results since investors may take advantage of a very high double-digit yield with little danger to the downside if the favorable oil price expectation fails to materialize. This does not imply that if oil and gas prices fell immediately, which is always a danger given the inherent volatility in markets, their share price would not change.
Furthermore, this indicates that investors should continue to do well over the medium to long term because the fundamental value of their dividends in this scenario is still close to their present share price. Readers can compare their opinions with these appraisals as we present a variety of outcomes.
Conclusion
When chasing yield, it’s still crucial to avoid being misled by the headline yield on the ticker quote page since this can frequently hide medium- to long-term fundamental problems or, on the other hand, result in investors suffering significant losses if the market reverses. Fortunately, their stock price appears to be a scenario in which Western Texas Intermediate oil prices only average about $70 per barrel.
As a result, even if the positive perspective is unsuccessful, investors only face a small amount of downside risk over the medium to long term. This allows them to take advantage of a very high yield of 10% or more right away and still get a good night’s sleep, so I think a buy rating is fair.
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