I know I am beginning to sound like a broken record, but I firmly believe there is more upside in the energy sector than downside from here. The past year has been rough across the space — except for the refiners, which continue to outperform — but there is just no way I can foresee that sub-$50/bbl oil can last long.

I don’t expect a sprint back to $100/bbl for oil, but rather a move back up in the $60/bbl range within the next year. If I believed oil was headed back to triple digits soon, we would recommend fracking sand providers and highly leveraged, smaller oil producers. Those would likely double in value if oil made a significant move higher. But we feel caution is still in order.  

Many companies are claiming that they can profit with oil at $50 or $60 a barrel. Certainly some can. After all, it wasn’t all that long ago that $40/bbl was a normal price for oil. But some companies that are over-leveraged and have significant production in fringe shale regions will not be profitable at $60 oil. How can we distinguish the haves from the have nots?

A good place to start is by looking at the evolving free cash flow (FCF) position of the oil and gas producers. FCF is an important, but often misunderstood metric. FCF is essentially the amount of cash generated by a company that is available for reinvestment or distribution to shareholders. Oil and gas companies that are headed toward profitability in this low commodity price environment should see their FCF position increasing.

There are several similar ways to calculate FCF, but one common way begins with a company’s net income, adds back depreciation and amortization (because those relate to historical expenditures), and then subtracts changes in working capital and capital expenditures:

FCF = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure

Of significance for oil and gas companies is the subtraction of capital expenditures from income. The reason oil and gas companies have had negative FCF in recent years is that they were investing heavily when oil prices were high.

Imagine you are running a business, and making very hefty margins on the products you are selling. You would likely want to plow your profits back into the business to grow your volume as long as those margins are strong. But this may very well put your business in a negative FCF position.

This isn’t necessarily a bad thing. As long as margins are good, you can grow your business rapidly. But what happens when margins fall? It depends. If you grew by highly leveraging your business — in other words not only did you plow earnings back into the business but you borrowed lots of money to grow it even faster — then you could be in trouble. If, on the other hand you don’t have a lot of debt to service and are able to slash your capital spending, you may be able to generate profits even though margins have collapsed. Further, you may be in a position to buy out some of those rivals that were too leveraged.

With oil prices now low, companies are slashing capital expenditures, and so we should see their FCF positions improving. To be clear, almost all oil and gas companies are still in a negative FCF mode, but many made major moves toward positive territory in the past quarter. Those companies are the focus of today’s analysis.

To identify companies that are most likely to be able to profit despite low oil (and gas) prices, I used our proprietary stock screener to figure out which oil and gas companies made a substantial improvement in their FCF based on the most recent quarter’s earnings.

FCF can be levered or unlevered. Levered FCF considers the debt and interest repayments a company must make, and given the nature of leverage in the oil and gas industry, it is the FCF calculation that I prefer.

In conducting this analysis, I looked at the FCF for the trailing 12-month period (TTM), averaged that per quarter, and then compared that to the most recent quarter’s results. I then looked at the companies making the biggest improvements relative to the TTM period. The FCF calculation was extracted from the S&P Capital IQ database. For this screen I limited this to companies with:

• An enterprise value (EV) above $300 million
• Positive EBITDA for the most recent quarter
• An EV/standardized measure (SM) ratio of less than 2.0
• Net Debt/EBITDA below 2.5.

Applying those criteria cut the initial list of 122 exploration and production companies down to 21. I then sorted those survivors into those that are predominantly oil producers (which I defined as those with oil reserves greater than natural gas reserves) and those that are predominantly natural gas producers.

With that preamble, here are the companies that have made the most significant improvements in their FCF position, along with some other important financial metrics. First, the predominantly oil companies, in order of descending improvement in FCF:

• EV = Enterprise Value in billions as of August 10
• EBITDA = 2014 earnings in billions before interest, tax, depreciation and amortization
• Standard Measure = Present value of the future cash flows from proved reserves as of year-end 2014 in billions
• Res = Proved reserves in billion barrels of oil equivalents (BOE) at year-end 2014
• Debt = Net debt at the end of Q2
• FCF = Free Cash Flow in 2014 in millions
• TTM = Trailing 12 months  
• Imp. = FCF Q2 – FCF TTM /4 in millions
• Proj. Q3 = FCF in Q3 if same improvement in FCF made in Q3 in millions

The “Proj. Q3” column is simply a thought exercise to see which companies are on a trajectory that could turn them FCF-positive in the near future. I extrapolated the Q2 improvement in FCF against the past 12 months of FCF, and assumed the same improvement is made in Q3. Interestingly, of the 11 companies in this table, 5 would have positive FCF in Q3 if they can replicate Q2’s improvement in Q3.

Conservative Portfolio recommendation ConocoPhillips (NYSE: COP) showed the largest overall move toward positive FCF with an improvement of $753 million in Q2. This isn’t surprising for two reasons. One is that this isn’t COP’s first rodeo. Management has been through many of these business cycles, and knows how to adjust to them. Second, it is by far the biggest company on the list, so it isn’t surprising that it’s made a large move in the direction of FCF. This improvement was accomplished mostly through aggressive cuts in capital spending, but oil and gas production was higher as well in Q2.

Other companies, however, made larger relative improvements to their FCF. If we look at the quarterly improvement relative to the enterprise value of the company, Bonanza Creek Energy (NYSE: BCEI), Laredo Petroleum (NYSE: LPI), Energen (NYSE: EGN) and Sanchez Energy (NYSE: SN) all made more impressive moves toward positive FCF than did ConocoPhillips. However, all but Energen are more highly leveraged than COP.

The distinction I drew between oil and gas companies is admittedly somewhat arbitrary. Based on the predominance of gas in proved reserves, here’s my list of the most proactive “gas” companies:


I could have sorted my list based on the percentage of revenue obtained oil vs. natural gas. Had that been the case, only Memorial Resource Development (NASDAQ: MRD), WPX Energy (NYSE: WPX), Antero Resources  (NYSE: AR), and Southwestern Energy (NYSE: SWN) would have remained as gas companies. Even Chesapeake (NYSE: CHK) has obtained more revenue from oil than from natural gas for the past three years.

Of the gas producers, Southwestern Energy made the biggest move toward positive FCF in Q2 — a much larger move even than ConocoPhillips. In fact, the company was very nearly FCF positive for the quarter. SWN’s improvements were a result of higher natural gas volumes and reductions in capital expenditures.

Southwestern Energy had the second-highest improvement in its FCF position relative to its EV, but was beaten out there by the highly leveraged Stone Energy (NYSE: SGY). Also making relatively large improvements in their FCF position were Panhandle Oil and Gas, WPX Energy, and Memorial Resource Development.

Conclusions

While oil and gas companies have been overwhelmingly cash flow negative for the past year, there are encouraging signs that many are turning the corner. Of the 122 companies examined by the screen, 64 improved FCF relative to the past 12 months (but only 21 also met the screen’s other criteria.)

Again, I will provide the caveat that this sort of stock screen is merely a tool. It is used to generate ideas and to find companies that appear to be worth a deeper dive. I would never use a screen like this as the basis for making an investment. Many items that can impact FCF for a quarter may not be recurring. Some of these companies may backslide next quarter, and some of those whose cash flow position worsened this quarter may have done so as a result of non-recurring, extraordinary capital expenditures.    

But what this tool does do is give us an idea of which companies seem to be headed in the right direction in this low oil price environment. There are lots of familiar names on the list, but there are also some I don’t know much about. I don’t know much about Energen, Panhandle Oil and Gas, or Stone Energy — but I intend to look into them a bit deeper. Perhaps their appearance in this screen was a fluke. We will see over the next few quarters. Meanwhile, the companies in these tables bear closer scrutiny, which we will provide in the weeks ahead.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)