Penn West Petroleum's Rally Will Strengthen

| About: Penn West (PWE)

Summary

PWE has shot up impressively in the past couple of months on the back of a rally in oil prices, which is not surprising considering its cost-reduction moves.

PWE has managed to reduce operating costs in an impressive manner by increasing its investments in key production areas such as Cardium where the cost profile is low.

PWE is increasing its capital outlay from $90 million this year to $150 million next year to enhance output from core areas at an annual rate of 10% a year.

This strategy will enable PWE to benefit from an increase in oil prices, which should get better due to higher demand and lower global supply.

As the oil pricing environment has improved, Penn West Petroleum (NYSE:PWE) shares have recorded massive gains on the market, rising close to 50% since the beginning of August. In my opinion, the rise in Penn West Petroleum shares will continue going forward as the company's focus on lowering its costs during a tight pricing environment will enable it to enhance margins in a stronger pricing scenario. Let's see why.

Penn West's margins will improve due to better pricing

Penn West Petroleum has remained focused on reducing its cost base in order to mitigate a weak oil pricing environment. In fact, a look at Penn West's year-over-year cost comparisons will clearly shows us that the company has made great progress as far as reducing costs are concerned. For instance, in the last reported quarter, Penn West had managed to reduce its operating costs by 30% to $12.70/barrel, which is lower than its forecast of $13.50-$14.50 for the entire year.

Considering that Penn West's core production assets carry a lower cost band of $10-$12 per barrel, it won't be surprising if the company is able to further reduce costs as it enhances production from these areas. In fact, Penn West is currently getting over 40% of its production from its core assets that include Alberta, Cardium, and Peace River. Now, in order to increase its output from these regions, Penn West has decided that it will increase its capital spending at its core assets.

For instance, back in August, Penn West had announced that it will increase its 2016 capital budget by 80%, or $40 million. The majority of this increase in the capital budget will be allocated to Cardium at 61%, with the rest going to Alberta. Given that its Cardium assets can generate oil at a price of just $10/barrel, Penn West Petroleum is making the right move by focusing more in this area.

What's more, the company intends to ramp up its total capital outlay from $90 million this year to $150 million next year as it will be increasing its output from the core areas at an annual rate of 10% a year going forward. Hence, Penn West's strategy of hiking production from low-cost areas will be beneficial for the company going forward in light of an improving oil price environment.

Better oil pricing will be beneficial for Penn West

As Penn West reduces its cost base further going forward, the company will be able to enhance its netbacks on each barrel of oil equivalent. For instance, last quarter, the company's netback on each barrel had increased by 6% from last year due to its cost reductions. Now, as the oil pricing environment gets better, Penn West should see further improvement in its netback profile.

In my opinion, investors can expect more upside in oil pricing. I'm saying this because the recent rally in oil prices might just be the beginning as more production cuts could be on the way given recent developments in the OPEC, while the strength in oil demand will keep inventories low and prices high.

In fact, as a result of production cuts by producers, the demand for oil has superseded supply by 500,000 barrels per day this year. In my opinion, this trend of higher demand and lower supply is set to continue going forward. This is because demand for crude oil will increase 1.4 million bpd in 2017 after a rise of 1.5 million bpd this year.

Concurrently, crude oil supply will continue to falter in light of the recent steps undertaken by the likes of OPEC, which has decided to reduce its output to the tune of 1%-2%. Along with reduced output from the U.S., where production is expected to go down from 9.4 million barrels per day last year to 8.8 million barrels per day this year, the overall supply of oil will remain under control.

On the other hand, even Chinese and Russian oil production is also expected to take a hit going forward, dropping 190,000 bpd and 220,000 bpd, respectively. As a result of these supply declines across key producers and strong oil demand, there will be continued inventory correction in the industry and this will lead to better pricing.

Conclusion

Thus, considering the points discussed above, it is likely that Penn West Petroleum will be able to sustain its recent rally going forward as the company has been focused on lowering costs and enhancing production from its core areas. So, according to me, investors should remain invested in Penn West Petroleum shares as the stock should be able to sustain its rally in the future.

Disclosure: I/we 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.