If you like companies that return large amounts of capital to shareholders, you may well like Equinor ASA (NYSE:EQNR) quite a lot. But if you also like companies whose capital payouts are sustainable and/or likely to grow, it’s a much more challenging story as Equinor is likely to continue facing real pressure on pricing and production growth.
I do like Equinor, but it’s harder to argue that the shares are meaningfully undervalued right now, particularly given likely declines in payouts, potential weakness in natural gas prices, and ongoing challenges to maintain, let alone grow, oil and gas production. Of course, energy prices are notoriously difficult to predict and higher prices would certainly improve the outlook for cash flow and capital returns, I’d also note that Equinor is in a position to put capital towards M&A if management elects to go that route to shore up its long-term production outlook.
The Drivers Of The Q2 Beat Aren’t Likely Sustainable
Equinor did report better than expected results for the second quarter, but I don’t regard the drivers of the 7% operating income beat or 8% adjusted net income beat as sustainable, given that overlift (essentially the production of oil and gas above targeted levels) is unlikely to repeat and the other source of upside, the MMP (Marketing, Midstream & Processing) segment, is likewise pretty notoriously volatile.
Revenue rose 12% in the quarter, though, with revenue driven by a 3% growth in production (including a 7% growth in gas production that offset a 1% decline in oil/liquids production). Realized liquids prices were up 10%, while European gas realizations were down 13% and U.S. gas realizations were up 5% (with a nearly 6.5x difference between the two, reflecting the far higher price of gas in Europe).
Operating income declined 1% from the year-ago period, with the E&P Norway business up 2% (generating close to 82% of adjusted operating income), E&P International down almost 2%, and MMP down 22% (but better than expected). Cash flow from operations reversed a year-ago loss, but declined 67% sequentially and missed expectations by about 4%.
Gas Prices May Well Be Unsustainable
With close to 50% of production in natural gas and roughly a third of overall production tied to European spot gas prices, the direction of natural gas prices in Europe is a major consideration for Equinor’s outlook.
As management put it in the conference call, the market remains “fragile”, with industrial demand recovering in Europe, but also quite a bit of gas in storage and more LNG import/export capacity coming online over the next year or so.
Futures are currently showing a $12/mtbu price for December 2024, $12.47 for December 2025, and $10.95 for December 2026, all below the $13/mtbu upon which management has been basing its guidance. At the same time, the latest natural gas storage report for Europe suggests the highest level of inventory in five years at nearly 83% of capacity.
The longer-term outlook is challenging as well. Not only has Europe embraced imported LNG as an opportunity to offset its prior reliance on supplies from Russia, but it’s a relatively clean arbitrage opportunity for producers in lower-cost regions (though LNG production/export remains politically divisive in the U.S.). On top of that, there are active programs underway in Europe to move commercial and industrial consumers of natural gas away from that in favor of electrical systems. Though it’s true that increased electricity demand would lead to generation gaps that natural gas plants could fuel, that’s a longer-term driver at best.
Maintaining Production Is Getting Tougher
Equinor has always relied upon the Norwegian Continental Shelf for the bulk of its production and resources, and that isn’t likely to change in the foreseeable future, particularly as ventures like U.S. onshore shale production really did not go well for the company (while financially conservative, Equinor has long been willing to try its hand in operationally challenging areas).
The trouble, though, is that Equinor has to spend considerable sums just to maintain production there (around $6B/year) and among the European majors (including BP p.l.c. (BP), Eni S.p.A. (E), TotalEnergies SE (TTE), and Shell plc (SHEL), Equinor has the worst production growth outlook through 2030, with growth likely coming in below 1% a year (Total is at the top with around 4% expected growth).
As is the case with energy prices, predictions of energy production are notoriously difficult, but I don’t see a lot of growth coming from Norway, and Equinor is also facing more challenges in areas like Africa and Canada. New opportunities like the Canada Bay du Nord project can help offset this, and Equinor actually has been a leader among its peers in organic reserve replacement (as well as in organic finding and development costs at around $12/boe versus $18 for the group), but a reserve life of less than 8 years is definitely concerning.
The Outlook
I do believe that it’s more likely than not that realized gas prices will come in below management expectations, and I do think that will have a definite negative impact on cash flow and distributions. I’m only looking for annual free cash flows of around $6B to $7B over the next five years, less than half the level of 2023 and less than a quarter of 2022, and that is going to lead to lower dividend payouts, as I don’t see management sacrificing balance sheet liquidity and its financial conservatism to maintain an unsustainable level of payouts.
Obviously, a great many things could change that outlook. Global political or economic shocks could once again send natural gas prices substantially higher, and even a stronger-than-expected recovery in Europe’s economy could be helpful. It’s also possible that lower natural gas prices will be “self-correcting” in some respects as they may discourage future switchovers to more expensive electrical alternatives, thus maintaining a higher level of demand further down the line.
It’s also worth mentioning that Equinor has positive leverage on oil prices. Not only does Equinor produce a meaningful amount of oil, but the taxation of its oil production is more favorable, so “net net” there is an upside here if oil prices head higher.
On the production side, Equinor could find some major new discoveries (or additional resources in known fields) and/or could look to augment its reserves through selective M&A. It’s also at least possible that longer-term endeavors like clean hydrogen and renewable energy generation (solar and wind) could accelerate.
Even so, I’m assuming that Equinor is looking at a slow, but inexorable, long-term decline in both revenue and free cash flow generation from 2023. That’s still enough to support a fair value in the high-$20s, and Equinor likewise looks undervalued next to peers on metrics like EV/EBITDA, but I do think there is sentiment risk to likely further cuts in capital returns to shareholders.
The Bottom Line
I’ve owned a small position in Equinor largely as an imperfect hedge against higher energy and because I’ve liked how management has run the company for some time now. It’s not a core position to me, though, and as much as I may respect management, I believe the production growth and reserve outlook is a significant limiting factor for the company and stock.
I think the valuation is still good enough to merit a “hold”, and again there are potential drivers for a more bullish outcome, but Equinor is basically a leveraged bet on European natural gas prices that I’m not as excited about today as in times past.
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