Shale Oil Stocks - Time To Reassess

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 |  Includes: BCEI, CLR, EOG, KOG
by: Atticvs Research

Summary

Most shale oil stocks are already fully-valued.

Drilling inventory of shale oil companies isn't great on closer examination.

A growing confluence of important negatives lies ahead.

How Many Years Drilling Inventory, Did You Say?

One of the most central questions asked of any shale driller is how many drilling locations remain. The answer is critical in determining how many years of dependable growth lie ahead, how much money needs to be set aside for acquiring additional acreage, whether a dilutive share offering is likely, and so on. Companies with multiple years of drilling inventory can have sky-high stock valuations, whilst those with limited inventory have low stock valuations.

We have all pored through company presentations and investors' conference calls with a beady eye searching out valuable information about drilling locations. The situation is complicated by drillers adopting differing standards. Cautious drillers only include locations in their overall drilling inventory that management is confident will achieve high rates of return. At the other extreme, some companies use potential drilling location numbers that include all possible downspacing (drilling more wells in a given acreage) and even include possible wells that would be barely economic and lead to a significant downgrading of the company's overall profitability.

Overall, there has been great progress on downspacing and well design these past three years, and shareholders have benefited hugely. Given that not all companies advance with the same efficiency, it is understandable that drilling inventory numbers differ significantly from operator to operator. Still, considering the improvements achieved along the way, long may this situation continue.

However, the signs are clear that the best days are over for downspacing, although some further advances will obviously come. A telling factor is that occasional reports are appearing where communication between wells is causing EURs (Estimated Ultimate Recovery for a well) to be lowered. In early April 2014, Deutsche Bank OAS)+to+Hold/9336201.html?si_client=intbro" rel="nofollow">downgraded Oasis Petroleum (OAS) citing:

a decline in capital efficiency and inventory shift to lower quality Three Forks drilling with reduced EURs... and Oasis is not alone in seeing lower EURs in the Williston as drilling shifts towards more Three Forks inventory...

With this in mind, investors should not fall into the trap of assuming that the downspacing wagon will merrily roll on. Instead, they must examine each driller's shale plays in order to arrive at educated calculations as to what the driller's inventory is really likely to be in periods ahead.

This note will attempt to assess how many years of drilling inventory selected companies have. In so doing, I assume in all cases that, due to the naturally steep production decline curve, and in order to maintain solid growth, small and mid-cap shale companies will drill 20% more wells from one year to the next once they pass their initial high-growth phase. As a reference point, this is the same approximate growth rate that Continental Resources (NYSE:CLR) adopted for its 2014 capex budget with wells drilled going from 329 in 2013 to 400 in 2014.

The significance of a 20% annual drilling increase is twofold. First, shale drillers are growth companies and are valued as such. Therefore, in order to support high equity valuations, they need to be able to maintain good growth going forward. Second, it is well-understood that drillers with multiple years of drilling inventory command significantly higher equity valuations than companies with limited inventory. Drillers, presumably in an effort to support their stock valuations, normally present their drilling inventory in terms of "years inventory at a recent drilling rate." If these companies were to incorporate an annual 20% uplift to their drilling assumptions - which is much more realistic than using a flat recent drilling number - the resulting "years drilling inventory" would be much smaller. In some cases, the more correct years drilling inventory number would cause investor concerns about limited drilling visibility with a negative overhang putting pressure on the stock price.

Kodiak Oil & Gas (NYSE:KOG)

On April 14, 2014 Richard Zeits, a respected energy industry consultant and investment analyst, published an excellent report on Kodiak detailing the results of an in-depth examination of Kodiak's acreage and potential drilling inventory. This report is a must-read for investors wishing to better understand the differences between what a company calls its potential drilling inventory and what the underlying truth may be. The thrust of the report showed that, even using more cautious and realistic drilling inventory than that used by the company, Kodiak's stock still holds potential upside for investors. But the subtext about drilling inventory is what I found to be most revealing. After concluding his examination and eliminating potential wells deemed uneconomic, Zeits estimates that Kodiak has about 650 valuable potential drilling locations. This is half the 1,300 estimate used by Kodiak.

During 2014, Kodiak plans to drill 100 net wells. At this rate, the company has only 6.5 years inventory using Zeits' 650 number.

In this exercise, I will take a slightly modified view. Assuming that, with further improvements in well technology, Kodiak's entire estimated well count of 1,300 is reasonably economic, albeit not as profitable as their best wells, and assuming that Kodiak reverts to drilling 20% more wells year after year, then this 1,300 well count translates to 7 years drilling inventory. This still brings us back to the same embedded conclusion as Zeits - that Kodiak will soon need to find more drilling locations one way or another. Most probably, this means that Kodiak will have to acquire additional acreage and, given that time will soon start to become more critical, I suspect the company will do it soon. Furthermore, I'd say that Kodiak's moves to keep the 2014 capex budget flat or below 2013 levels is an effort to improve its balance sheet specifically aimed at facilitating acreage acquisition work during 2014.

Bonanza Creek (NYSE:BCEI)

Bonanza's main asset is 35,500 acres in the Wattenberg. There are a number of prospective zones; Niobrara A, B, C and Codell and possible others in the future, including Carlile, Greenhorn and J Sand. The A, B and C zones are prospective across the entire 35,000 acres, and Codell is prospective over about half of BCEI's land. Carlile sits under Codell.

Bonanza produces mostly from the B zone, followed by C, with a small amount from Codell. The B and C zones are now successfully downspaced to 40-acres, which translates to remaining drilling locations of 707 gross (495 net) in B and 888 gross (614 net) in C. Bonanza estimates it has 101 gross (75 net) locations in Codell. All told, this, together with proved locations of 145 gross (130 net), amounts to total drilling inventory of 1,841 gross (1,314 net) locations.

In 2014, further downspace testing and probing of the eastern extremities of Codell will occur, and Bonanza will do some initial testing in Niobrara A. Given that Codell thins out towards the east side of the play (down to just ~2 feet) where Bonanza is looking to extend its economic reach, and that the A zone isn't generally viewed as a very attractive pay zone in its own right, the upside to Bonanza's drilling inventory may be limited to "a few hundred more wells" for the time being - say about 300. This would amount to a revised total number of drilling locations of about 2,150 gross or 1,525 net. And even with this 2,150/1,525 gross/net number, it may be that some of the additions may have EURs and IRRs that aren't as good as Bonanza's current inventory count.

Bonanza has other assets, such as Cotton Valley and Brown Dense in the Mid-Continent and North Park in the Niobrara basin. The related drilling is vertical, the asset bases are of a smaller scale than Bonanza's flagship Wattenberg land and, because this exercise is specifically looking at drilling inventory, these ancillary plays are not considered material, and hence are excluded.

During 2014, Bonanza plans to drill 140 gross Niobrara wells. At the 2014 drill rate, Bonanza has potentially 15 years drilling inventory. However, assuming Bonanza has a growth rate of 20% in future years, its 2,150/1,525 gross/net wells would be completely drilled in 7.5 years.

Bonanza is an imitator and, with innovative immediate neighbors like Noble Energy (NBL), that strategy should continue to bring success, even though Bonanza wouldn't be expected to achieve Noble's absolute level of performance. In particular, investors can expect to see Bonanza achieve good efficiency gains via longer laterals. However, since current drilling visibility is limited to about 7.5 years, it would be wise for Bonanza to acquire additional acreage so that this task doesn't soon become more compulsory and start to act as an overhang to the stock price. It would also be extremely helpful for investors if the company could retain its core executive team, as recent senior management losses hurt the stock.

EOG Resources (NYSE:EOG)

Formed out of Enron (EOG stands for Enron Oil and Gas), EOG is as efficient and publicity-cautious as Enron was dubious and brash. One of EOG's greatest achievements was instituted during 2008 when CEO Mark Papa ordered his landmen to lock up 200,000 acres in Eagle Ford after his geologists identified the area as worthy of exploration for oil. With the industry at that time heavily focused on natural gas rather than oil, EOG quickly hit its 200,000 acre target at cheap lease rates. Word soon emerged that Petrohawk, run by Floyd Wilson - now CEO of Halcon (HK) - had encountered encouraging amounts of oil in an Eagle Ford exploratory well. Although EOG still hadn't drilled a single well, Papa decided, rather than risk ballooning lease rates, to quickly push on to 300,000 and 400,000 acres before doing any test wells. This was the making of EOG.

Today EOG has 632,000 acres in Eagle Ford, of which 564,000 is in the oil window. In the best parts, drilling is being done at 30 to 35 acre spacing and elsewhere at up to 50, 60 or 65 acre spacing. This averages out to 40 acre spacing. In the Eagle Ford, the company estimates it has a total well count of 7,200, of which 1,200 has already been drilled, with a remaining inventory of 6,000.

During the Q4 '13 conference call on Feb 28, 2014, it was put to EOG's management that some Eagle Ford operators are testing drill spacing down to almost 20-acres. EOG admitted that it too had tested to lower spacing but, considering the solid understanding of well communication that the tests provided them, it viewed that, on average, 40-acre is the optimal spacing towards obtaining the best overall NPVs for the company.

It is way too early to sound the downspacing death knell, particularly for EOG, a company that is constantly at the forefront of advances in shale drilling and typically gun shy about its most recent progress. Still, it's hard to see EOG dramatically improving the current 6,000 Eagle Ford drilling inventory number over the next year or so.

EOG also has acreage in the Bakken and in the Permian. At latest count, this had about 3,800 total drilling locations. This is clearly significant, although, even when combined, not on the same scale as the Eagle Ford.

In total, EOG has about 10,000 remaining drilling locations, and plans to drill net 665 wells in 2014. This works out at 15 years inventory at the current drill rate. Assuming EOG increases drilling by 15% per year (instead of the 20% growth rate for smaller companies), the 10,000 locations would equate to just over 8 years inventory. Realistically, EOG will increase the current 10,000 locations number, particularly in the multi-layered Permian basin, where EOG is at an earlier stage of its development life, although further substantial upside in Eagle Ford may be more difficult to register.

EOG's drilling inventory will increase for another important reason; EOG tends to be more cautious than many operators with regard to putting numbers into the public domain. Also, it is more demanding of itself with regard to performance. For example, during the Q4 2013 earnings conference call, the Chairman confirmed that the company is very focused and selective with regard to looking at oil plays, and it only adopts targets that can generate after-tax returns of more than 50% (spare a thought for all the lesser drillers that are happy with their 30%-50% IRR plays). As such, the EOG drilling inventory data in the public arena is not likely to contain much fluff. And, as more efficiency gains roll off the pad over the next couple of years, this would lead to current marginally poor wells graduating to the inventory class.

Assuming that EOG manages to increase total remaining drilling locations to, say, 15,000 and, taking account of EOG's need to drill something like 15% more wells year after year in order to drive growth, then EOG would have about 11 years drilling visibility.

At face value, EOG has a strong balance sheet, with $6 billion long-term debt comfortably outweighed by $15 billion shareholders funds. The company also has $5.5 billion of other long-term deferred liabilities, almost entirely tax, which may become payable at least in part in the event of a slowdown. There will be slowdowns at some point in the future, and the balance sheet will have to be managed with that in mind. Therefore, EOG isn't really in as strong a liquidity position when you look under the kimono because, with slowing downspacing progress and with diminishing drilling inventory visibility, EOG will have to acquire additional acreage within the next few years.

Operationally, EOG remains top-of-the-class bar none. However, from an investor's perspective, the stock is already fully-valued with a lot of good news already priced-in; the upside over the next few years is likely to be limited.

Continental Resources

Continental's founder Harold Hamm became one of the foremost trailblazers in the nascent shale energy world during the 1990s when he quietly and aggressively started acquiring cheap leases in the best parts of liquids-rich Williston Basin, often paying under $100 per acre. Like EOG's Papa, Hamm clearly understood the critical importance of having a huge inventory of economic wells that could be drilled for a great many years ahead. These smart early moves were the foundation of modern day Continental. Now, much later, Continental has 1.2 million acres in the Bakken as well as 400,000 acres in South Oklahoma Woodford Shale [SCOOP].

Recently, the company estimated it has 9,976 drilling locations using 320/160 acre Bakken/TF spacing or 19,353 locations using 160/80 acre BK/TF spacing. The related unbooked reserves were 4,600 MMBoe and 7,200 MMBoe and, at December 2013, Continental had proved reserves of 1,080 MMBoe, implying EURs of 566 MBoe and 430 MBoe for the remaining inventory. These EURs are lower than the EURs for Bakken and SCOOP indicated in Continental presentations. I can only presume the differences are largely due to the same phenomenon identified in Richard Zeits' report highlighted above i.e. that inventory numbers as presented often include wells that are only marginally economical. That said, Continental remains an excellent company operationally, and it is at the forefront of achieving efficiency gains in the Bakken. Therefore, when we have further information about Continental's current large-scale downspacing projects, we may soon learn that the company has, say, over 13,000 economically attractive drilling locations. That would equate to over 11 years drilling inventory assuming continued strong drilling growth at 20% per year.

Drilling Inventory Summary

During the past three years the downspacing gods have been generous beyond expectations. Additionally, due to improvement in drilling and completion techniques, well economics are substantially better today than they were 3 years ago - a remarkable achievement in the face of intense downspacing work. It has all been tremendous for shareholders; just look at the three year stock price performance of any decent shale oil company.

The companies just examined are a small sample from a large field. They are all well-managed companies with attractive acreage, more so than many shale players. Still, a common theme quickly emerges - that inventory numbers of high IRR drilling locations are not great, and a lot of drillers will have to substantially boost their acreage sooner rather than later if they are to continue growing at a reasonable clip.

The age of cheap shale acreage containing high IRR oil wells is all but over for now. Companies having to buy large tracts of oily shale acreage must now pay an expensive price for the privilege. Such purchases may be settled in cash or with equity but, in either event, the share price of the acquirer runs the risk of compression as the need to buy acreage becomes more pronounced.

Reassessing Shale Oil Stocks

Normally, questionable drilling inventory shouldn't cause undue worry for well-run drillers and, over the long-term, most shale oil stocks should continue to deliver solid returns. However, a growing confluence of negatives is upon us, and this turns the short-term risk-reward profile on its head. These are:

  • Markets are 20% overvalued versus long-term norms, and indices such as the S&P500 are within about 5% of the consensus 2014 year-end target of circa 2,000. At this altitude, bouts of vertigo are to be expected.
  • There has been much hope by mainstream economists that U.S. economic activity will noticeably pick up in 2014 following the inclement weather interruption at the start of the year. Such hope of economic revival is not new. It has been the repeated mantra by economists and the Federal Reserve since the end of the financial crisis. Overall economic trends these past few decades show an economy in maturing/declining phase - even with the help of exploding consumer credit. That the economy should now achieve escape velocity seems fanciful. Yes, a marginal pick-up in economic activity is currently underway via a post-harsh winter bounce, but then what? Back to anemic growth and lower profit estimates by reporting companies with an accompanying stock market re-adjustment? Refer to the accompanying chart courtesy of Doug Short and read the related report.

Click to enlarge

  • Last week, premium gasoline prices broke through the $4.00 ceiling. Each time this has occurred in recent years it has, without exception, transmuted into weaker consumer activity and contributed to an economic soft spot and significant stock market weakness. Is it different this time? Recall that a high gasoline price acts as a tax on consumers, and the mighty U.S. consumer is responsible for 70% of GDP. Refer to this telling chart from Doug Short.

Click to enlarge

  • When QE 1 and QE 2 programs ended, the market fell 13% and 17%. The taper process of 2014 is scheduled to end QE Infinity by the fall. Given the weight of history and the fact that markets are richly valued compared to where they were when QE1 and QE2 ended, it would be surprising if the markets didn't experience a sizable wobble in 2014 related to the QE exit.
  • Technically, the S&P500 didn't experience a drop to the 200-day moving average during 2013. According to reports, this was the first time in 15 years this has not happened. Betting that the markets will not experience a pullback to the 200-day moving average in 2014 on top of it not occurring in 2013 is mathematically a high risk bet.
  • "Sell in May and Go Away" has been shown by studies to be a definitive trend over about 100 years. It doesn't play out exactly every single year; it didn't work in 2013, for example, but over time, it holds true and playing the trend leads to significantly better investor performance. Read more here about the trend over history. With 2014 suitably laden with downside risk, with markets overvalued, with Fed taper about to end the QE Infinity program, the odds suggest that the Sell-in-May groupies will strike in 2014. One top-rated seasonal forecaster is Sy Harding. He runs a blog which you can follow for free.
  • Is the U.S. housing market about to experience a hiccup? Asset wealth is a strong underpin for the U.S. consumer who, in turn, drives 70% of economic growth. Refer to this report asking if the dead cat housing bounce is over. The signs don't look positive.
  • U.S. oil supplies should experience a production surge in Q2 and Q3 this year. Recall that during Q1, completion work on shale wells slows due to inclement weather, especially in the northern states, and the major seasonal production surge occurs after the weather improves. With U.S. shale output soon heading to 4 million barrels per day, this has propensity to cause WTI to soften and differentials for regional producers to widen. Shale oil producers may be victims of their own successes, and a price drop for WTI can be expected in the months ahead. Later in the year, this domestic production surge and falling WTI price should lead to a price decline at the pumps, which helps consumers - but first we need to see a nice WTI pullback.
  • With markets overvalued and with many investors aware of risks and volatility ahead during 2014, there is a possibility that the markets may viciously and suddenly turn south. We got an inkling of this in the first ten days of April when the market did just that. On that occasion, the down-thrust was averted by Q1 earnings season kicking in with good reports. As we come to the end of Q1 earnings season and, considering that it will be almost three months until companies once again report, one has to ask the question; what will pull us out of the next nosedive? It won't be the Fed; it cannot pull the taper until after the market corrects.
  • Most shale oil stocks are trading at or close to the analysts 12-month target price. EOG is at $99 against analysts target of $107, CLR is at $132 versus analysts target of $137, KOG is just under $13 compared to the target price of $15. Where's the attractive upside? It's not there anymore. There's not much toothpaste left in the tube, and you can only squeeze so much.
  • Geopolitics. As I conclude this note, it's Friday April 25 and, among other issues, the market is experiencing a pre-weekend bout of worry about Russia. I may be wrong, but I don't think Russia/Ukraine matter so much to global trade or to oil. However, the media may drone on about it and amplify the scare factor, and if only for that aspect, investors will need to keep an eye on it.

Summary and Actions

For all the above economic, seasonal, technical, valuation and Federal Reserve-related reasons, plus the fact that many shale oil companies will need to acquire more acreage, the risk-reward to me is clearly and strongly to the downside, and I have used recent market strength and high stock prices to exit all shale oil positions. I'm not calling the top of the market, and I wouldn't dare short shale oil stocks, because I believe in the bright long-term picture. I'm just happy to cash in my few chips into market strength with the plan to come back in at lower stock prices - probably this summer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.