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Investors Brace for Energy Q4 Earnings: What to Expect?

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Kinder Morgan (KMI - Free Report) kicks off the Oils-Energy earnings season with its fourth-quarter results on Jan 19. Schlumberger (SLB - Free Report) will report later in the week.

While the returns improved over the past few quarters on gradually tightening fundamentals, the October-December period should further reinforce the sector’s stability. The fourth quarter saw oil and gas prices revisiting their multi-year highs following the vaccine progress and the ongoing macroeconomic recovery.

Over the next month or so, as we make our way through the earnings deluge, here are some important things to look for:

Revenue & Earnings Comparison Relative to Q4 ’20

According to the U.S. Energy Information Administration, in October, November and December of 2020, the average monthly WTI crude price was $39.40, $40.94 and $47.02 per barrel, respectively. In 2021, average prices were $81.48 in October, $79.15 in November and $71.71 in December, i.e., much stronger year over year.

The news is also bullish on the natural gas front. In Q4 of 2020, U.S. Henry Hub average natural gas prices were $2.39 per MMBtu in October and rose to $2.61 in November before edging down to $2.59 in December. Coming to 2021, the fuel traded at $5.51, $5.05 and $3.76 per MMBtu in October, November and December, respectively. In other words, natural gas traded noticeably higher in all three months.

The significant year-over-year improvement in commodity prices paints a rosy picture for the Q4 earnings season. Per the latest Earnings Trends, Energy is on track for positive earnings compared to losses a year earlier. Per our expectations, the sector is likely to have trended back to profitability from fourth-quarter 2020 loss on 58.1% higher revenues.

How Will the Sub Industries Perform?

From upstream (exploration and production) to midstream (pipelines) to downstream (refining and distribution), let’s see how the different subsets of energy might have performed in the December quarter.

While the price boost will buoy the results of E&P companies for obvious reasons, refiners’ numbers are likely to benefit from favorable crude differentials, healthy margins for diesel, lower renewable fuel costs and robust volumes. There is also a marked improvement in fuel demand on the back of rebounding road and airline travel.

Meanwhile, though the E&P capital discipline continued throughout 2021, oilfield service firms like Schlumberger — that make it possible for upstream players to drill for oil and gas — are likely to have gained from an increase in onshore drilling and completion spending during the fourth quarter. The rebound in domestic production has led to an improvement in service fundamentals, leading to higher prices for SLB and its peers.

With rig count recovering considerably and costs being slashed, Schlumberger expects the to-be-reported numbers to grow across all divisions. In particular, things are looking good in the international markets where SLB sees a ‘sustained multipronged growth cycle’ on the back of a highly conducive environment.

Finally, the pipeline companies are expected to have capitalized on stabilized production and rebounding energy demand, riding on an increasingly vaccinated economy. In other words, the macro environment for energy infrastructure providers remained favorable during the fourth quarter, with earnings improvement expected versus last year.

What’s the Outlook for Dividends/Distributions?

As oil has come back strongly, the sector components have reacted very positively to this robust investment landscape.

Cash from operations is on a sustainable path as revenues improve and the companies slash capital expenditures from the pre-pandemic levels amid sharply higher commodity prices. To put it simply, the environment of strong oil prices has helped the energy operators to generate significant “excess cash,” which they intend to use to boost investor returns.

For energy investors, the recent dividend hike by Marathon Oil (MRO - Free Report) , among others, represents a tangible proof point of continued positive changes for the space in recent quarters. In October, MRO got approval from the board of directors to increase the quarterly payout by 20%.

The decision by Marathon management is seen as the path to return a higher percentage of cash flow to investors. While MRO’s dividend increase is one of the choices to ride the commodity price boon, Murphy USA (MUSA - Free Report) delighted investors with stock buyback news.

Last month, Zacks Rank #1 (Strong Buy) MUSA announced its board’s approval for a new share repurchase authorization of up to $1 billion. The scheme will commence once Murphy USA’s existing $500-million mandate expires.

You can see the complete list of today’s Zacks #1 Rank stocks here.

It should come as no surprise if more energy companies decide to follow Murphy USA and allocate the increasing cash pile in the fourth quarter to pacify the long-suffering shareholders.

The major midstream players like Kinder Morgan — being largely insulated to fluctuations in commodity prices — managed to maintain their distribution levels through the crisis-stricken 2020. With a far stronger midstream payout scenario now based on their relatively steady coverage and surging oil/gas realizations, cash flow visibility is even greater for the fourth quarter.

A case in point is KMI’s 3% year-over-year dividend increase for the third quarter (to $1.08 annualized) and the subsequent guidance that projects annual dividend next year at $1.11 per share.

Shale Producers in the Spotlight

Most indicators show that energy is in the midst of a long-term upcycle. Taking investors on a roller coaster ride, crude has made a rebound for ages — from the depths of minus $38 a barrel in April 2020 to reclaim a seven-year high above $85 in October. With this firmed-up price, shale operators could surprise on the upside.

As the output from the unconventional plays looks set for an uptick, all eyes will be on the companies working in the Permian Basin — America’s hottest and lowest-cost shale region, and by far the primary driver of crude production in the United States. The improvement in oil prices has prompted these firms to shore up drilling activity, leading to improved cash flows and increased chances of an earnings beat.

Keep an Eye on Positive Financial Guidance

Since the coronavirus-induced depths of 2020, the sector has staged a stunning recovery on rebalancing supply/demand fundamentals. We expect the positive momentum to have been carried into the fourth quarter based on the improving outlook for the global economy and oil demand.  

The quarterly announcements will also present an opportunity for the companies to highlight their plans of using the substantial free cash flows — whether to strengthen the balance sheets or pay cash back to shareholders. With the most encouraging macro backdrop in months and optimism around the demand picture, investors will be looking ahead to company-level improvements in the outlook.

An effective way to gauge a firm’s strength and resilience is to look out for improved guidance. Of particular interest will be the cost-reduction initiatives, updates on free cash flow, and upward revision in estimated production.