Second-quarter earnings are in for nearly all of the publicly traded exploration and production companies operating in the U.S. Oil and natural gas prices were substantially higher during Q2, so we should see that reflected in the quarterly results. Today, I thought it would be a good idea to evaluate the producers based on free cash flow (FCF).

To review, FCF measures cash generated by a company in excess of its spending, including capital expenditures. It is generally calculated from net income, adding back depreciation and amortization (because those non-cash costs relate to historical expenditures), adjusting for impairments to oil and gas properties (those non-cash impairments are applied against net income but not cash flow) and then subtracting interest paid, changes in working capital and capex.

I screened for recent FCF using the proprietary stock screen I developed for The Energy Strategist. This screening tool is Excel-based, and extracts data from the subscription-only S&P Global Market Intelligence database. I developed it specifically for energy companies, compiling metrics that you won’t see in other screens. For example if you want to know how production costs stack up between producers, or how capital spending has evolved in response to changing oil and gas prices, I can quickly sort through hundreds of publicly traded companies to retrieve that information.

Among the 83 U.S.- and Canadian-based publicly traded companies classified as “Oil and Gas Exploration and Production,” the average FCF deficit in Q2 was $5 million. However, this was on average $88 million better than the FCF deficit for Q1, and there was great variation among producers. Here are the 10 producers that improved FCF the most during the quarter, ranked by the absolute amount of sequential improvement:

• EV – Enterprise value in billions of U.S. dollars, as of Aug. 11
• EBITDA – Earnings before interest, tax, depreciation and amortization, in billions for the trailing 12 months (TTM)
• FCF – Levered free cash flow, in billions
• FQ – Fiscal quarter
• FCF IMP – Improvement in FCF between Q1 and Q2 2016
• Debt – Net debt at the end of the most recent fiscal quarter
• YTD Ret – Total shareholder return, including dividends, thus far in 2016   

This group made major strides on the free cash flow front, with 3 of the 10 increasing FCF by more than a billion dollars from Q1. Each of these companies had positive EBITDA for the quarter, and all but Chesapeake Energy (NYSE: CHK) reported positive FCF for Q2. Several of these companies have seen year-to-date shareholder returns reflective of their improving cash flow, although ConocoPhillips (NYSE: COP), EP Energy (NYSE: EPE) and Whiting Petroleum (NYSE: WLL) are still in negative territory YTD.

Debt levels for this group remain elevated, with only Apache (NYSE: APA) and EOG Resources (NYSE: EOG) below 3 times EBITDA. Those most heavily in debt, like Chesapeake, pose tremendous downside risks, especially if oil and gas prices are softer in Q3 and Q4.

Among the companies with the largest quarter-over-quarter decline in FCF, Devon Energy (NYSE: DVN) stands out:

Looking at the cash flow over the past year, Devon’s quarter appears to be a one-off. There are significant changes in capital spending, cash acquisitions and in debt levels from the previous quarter that explain the decline. Because FCF is affected by capital spending we always have to factor that in before jumping to a conclusion solely on the basis of lower quarterly FCF. (This is the primary reason I include the trailing 12 months in the chart; to place the most recent quarter in a broader context.)   

Ironically, the stocks of the FCF laggards have on average slightly outperformed those of the companies showing the biggest improvement. However, the 10 laggards also have three double-digit losers YTD, vs. one on the previous table.  

You may have noticed that most of the companies on the list have rather large enterprise values, and therefore it would make sense that they could see a large swing in FCF from quarter to quarter. This is in fact true. The improvement in FCF for WPX Energy (NYSE: WPX), for instance, was equal to 30% of its current EV. ConocoPhillips, on the other hand, only improved FCF by 1.8% of its current EV.

However, most companies with the biggest improvement in FCF relative to their size trade at under $5 a share, have high debt levels and disappointing YTD shareholder returns. For example, Stone Energy (NYSE: SGY) had the 6th-largest relative improvement in FCF of all the oil and gas producers, but its share price is down 76% YTD. The primary culprit is high indebtedness. While Debt/EBITDA is “only” at 6, SGY has a market capitalization of $57 million and debt of $1.4 billion. Just a reminder that there can be a lot hidden deeper in the details.

But there was one other interesting subset that I noticed on the relative FCF outperformer  list, and that is companies that have more cash on hand than debt, like Gran Tierra Energy (NYSE: GTE) and Earthstone Energy (NYSE: ESTE). Gran Tierra may be worth a deeper dive, but it is a company with a market value below $1 billion and a share price below $5 that operates outside the U.S.

When I scan the rest of the list I see that all companies in this category (more cash on hand than debt) are either trusts or obscure stocks that used to trade on the AMEX. Thus, while it is a potentially fruitful exercise to look for companies with more cash on hand than debt, in this case it doesn’t really turn up any hidden nuggets.   

Conclusions

FCF among the oil and gas producers continues to improve, with several companies reporting improvement of over $1 billion from the previous quarter. It is always important to keep in mind that FCF is affected by many factors, in particular capital spending. A company that is investing heavily in the future may see deterioration in FCF with the anticipation of a future payoff. Likewise, a company may see a dramatic improvement in FCF if it stops spending capital from one quarter to another.

But over time, we like to see that FCF is positive and increasing. That has indeed been the case with many of the major oil and gas producers, but some are racing against the clock with excessive debt levels. Apache and EOG Resources continue to look like the healthiest businesses in the group, while Chesapeake remains at risk of bankruptcy even as it attempts to shore up its balance sheet.   

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