Oil and gas chief executives and chief financial officers are facing a pivotal moment: Wall Street is looking for not just healthy returns from the sector but also a clear and viable capital strategy that underpins expanding and durable enterprise value. Based on market multiples, it’s not seeing that. Instead, after years of disciplined cost cutting and project selection, the sector is still unable to command top-tier multiples. It’s time to rethink the capital playbook.
More than a decade ago, the United States became the fracking capital of the world. Back then, oil and gas companies rarely saw an exploration and production (E&P) project they didn’t want to green light. But it became increasingly apparent to Wall Street that these projects were not always producing adequate returns on their investments.
Investors shifted their view on the E&P sector from a growth investment to a value one and proceeded to punish E&P for the next 10 years — long after many oil and gas companies began achieving healthier internal rates of return and resisting the most unprofitable land-based E&P projects, particularly in the United States.
The problem: Investors failed to reward the sector for safer capital deployment — primarily because it was not always smarter capital deployment. Instead, companies often based investments on traditional metrics such as growth, net present value, or internal rates of return rather than enterprise value. They continued to support low-growth projects and highly volatile activities, especially legacy activities where managers felt more comfortable. They also failed to focus on delivering predictable returns to investors.
As a result, profit growth for the sector lagged the rise in its cost of capital, and capital became less accessible. Total shareholder returns and earnings multiples also sat considerably below the average for the overall market — with less than 25% of exploration and production companies outperforming the Standard & Poor’s 500 Index during the last three years.
For investors, the ways companies deploy capital reflect their long-term priorities and confidence in various segments of their business. Capital allocation shapes corporate outlooks for at least three to five years. Thus, misaligned capital — especially from an investor perspective — sends negative signals even if that deployment is more conservative.
To increase enterprise value, corporations must shift capital allocation toward businesses with stronger structural outlooks and more predictable results, even if these are not always the legacy segments they have come to rely on for growth. In this way, capital allocation can be used to reflect where a company is going as opposed to where it has been and become a lever top leadership can pull quickly and effectively to help boost enterprise value.
Evidence of the difference capital allocation strategies can make
Restructuring capital allocation provides an opportunity to unlock rapid, outsized growth in enterprise value — not by investing more, but by making enterprise value the common currency in every capital expenditure (CapEx) decision. That means redirecting capital toward opportunities and businesses the market values most. While most corporate leaders believe that they do this already, many operate under the mistaken idea that projects with high internal rates of return automatically translate into an increase in enterprise value. That is not the case.
For example, during the last three years, E&P-focused enterprises have seen a return on average capital employed as high as 22%. Yet the $150 billion in capital Invested during that same period has only yielded $30 billion in added enterprise value for the sector. The results are even worse for oilfield services and downstream, which ended up with negative enterprise value for the tens of billions in capital invested during the last three years.
Enterprise value only moves when capital allocation decisions credibly shift a company’s portfolio economics and change investor expectations. Corporate returns that sit below weighted average cost of capital (WACC) will not command higher multiples. For companies with many business units and geographies, a single WACC may not fully capture the hurdle rate necessary to move from a “no-go” to a “go” on projects because it doesn’t reflect all the risk and capital costs. Even exceeding the WACC doesn’t guarantee higher enterprise value if potential risk costs, as well as the return profile of the underlying business, is not fully incorporated.
We have seen misaligned risks and rewards play out at several companies. At one of the oil and gas companies that we evaluated, their standard company WACC only reflected the actual risk profile of 25% of their earnings. The lines of businesses generating the remaining earnings were much riskier than the standard WACC captured. Based on peers, these other lines of businesses deserved WACCs as much as two to four percentage points higher than the company’s overall WACC. This discrepancy falsely inflated returns on sizable chunks of the company’s business.
Why focusing on capital allocation and enterprise value matters now
With investors lowballing the sector’s value for almost a decade, rethinking capital allocation strategy is now more important than ever. Oil and gas — especially the oil and the E&P business units — is up against a litany of threats. First, US tariffs and threats of increases have thrown global commodity markets into disarray.
Oil faces challenging conditions, with prices per barrel dropping steadily since January and OPEC+ producers — the Organization for Petroleum Exporting Countries plus Russia, Mexico, and other large producers — increasing output recently, despite the additional pressure the move puts on prices. The potential for persistently low oil prices increases the urgency of having resilient returns through a thoughtful capital allocation process.
Faster capital cycles have also thrown the cost of misallocated capital into the spotlight with investors looking for portfolios and narratives that signal disciplined redeployment into high-margin, high-growth opportunities and away from legacy activities with low returns, missed expectations, and less than promising futures.
Despite higher cash flows, earnings multiples have contracted approximately 25% versus their early to mid-2010s levels, showing how much investors discount growth without returns. The conflicting signals of improved capital discipline with little to no reward show the urgency for energy companies to reformulate their strategy around using a capital allocation approach driven by enterprise value.
While it’s true that oil and gas company valuations are influenced by oil price expectations, investors are responding to missed expectations, not necessarily lower returns. Additionally, returns are only one piece of the puzzle. Multiples for downstream, oilfield services and equipment, and integrated oil operations remain subdued as well, due to a combination of controllable and uncontrollable factors such as capital intensity and the higher cost of capital charged oil and gas, high leverage ratios, and inconsistent capital performance.
Understanding the future for oil and gas companies
Spending less will not necessarily alter the composition of a company’s portfolio, which is ultimately what investors desire. Wall Street wants a reinvention of how oil and gas does business with significantly more money directed towards digitization and asset-light investment in the latest technologies like artificial intelligence. Hence, we have seen companies like Schlumberger and Baker Hughes rewarded by investors for their software solutions and equipment contributions to data centers.
While smaller, less complicated merger and acquisition activities still tend to excite the market for a fleeting period, investors are looking for a more fundamental rethinking that can be reflected through innovative capital allocation — resisting the more-is-more mentality that has dominated the industry. We recommend that our clients take a 10-20-40 approach, or the four R’s — 10% of capital investment gets reduced, 20% gets re-engineered and invested in new activities, 40% gets reallocated across various existing business units, and the remaining 30% is retained where it is currently invested.
Companies must first identify the areas of the business where capital investment generates the highest enterprise value. Once a company names its most promising value levers, the next key to success is getting senior executive buy-in. That usually requires tying executive compensation to capital allocation as it produces enterprise value.
Finally, the executive team must craft a clear and concise investor narrative for Wall Street that outlines where investors can expect to see CapEx directed. It must also explain the impact that has already been achieved and what they should look for in the midterm and long term. Too often companies believe that their actions speak for themselves. But maximizing enterprise value requires companies to not only change their capital allocation process to reflect their new goals but also communicate that plan to investors in a compelling way.
If oil and gas leaders want to be rewarded by the market, they must demonstrate their ability to act boldly, pivot to higher-value strategies, and communicate those moves. Now is the time to pull the capital allocation lever and make enterprise value a guiding metric — in every project, in every well, every quarter.