Exxon Mobil's (XOM) recent radical shift in its US onshore drilling focus away from natural gas and towards oil and liquids may have consequences beyond the anticipated decline in the company's natural gas production volumes. Exxon may come out of the current US natural gas down cycle with a reduced footprint in the natural gas shales. Exxon made substantial acreage additions in some of its core shale gas plays shortly before the natural gas prices declined deep into the sub-economic territory. Like many of its peers, Exxon is now facing a wave of lease expirations, most notably in the Marcellus and the Fayetteville. With its dry gas drilling effort cut to the absolute minimum, Exxon may not be able to retain by production all of the acreage it initially intended to hold. The strong shift in its operating priorities, even at the cost of losing some of its valuable gas acreage, may indicate Exxon's negative outlook on the US natural gas fundamentals both in the short and the long term.
In my earlier note ("Exxon Mobil's U.S. Natural Gas Production To Decline Following Curtailed Drilling"), I highlighted the dramatic reduction in Exxon's dry gas-directed rig count. The company's total North American onshore rig count has declined by 30% from the end of 2011, from approximately 70 rigs to 51 rigs currently. Importantly, I estimate that since the end of last year Exxon has eliminated or re-directed towards liquids as many as 35 rigs previously focused on dry gas. Exxon may have less than 10 rigs drilling for dry gas at the moment. A 35-rig drilling program operated for one year can retain by production as many as 300,000 net acres in a typical shale play, in my estimate. That is the incremental dry gas acreage that Exxon may not be able to hold if it maintains its drilling program unchanged for the next three quarters. Should the low natural gas prices persist throughout 2013, acreage attrition in Exxon's portfolio may be even more severe.
The areas where Exxon's lease expiration challenges are particularly acute are the Marcellus and the Fayetteville. In the Marcellus, Exxon has approximately 660,000 net acres under lease. Last summer, Exxon substantially expanded its acreage in the play by acquiring two privately held Pennsylvania operators, Phillips Resources and TWP, for $1.7 billion. The acquisitions added 317,000 net acres to Exxon's existing Marcellus position which stood at 390,000 acres at the end of 2010. To date, Exxon's Marcellus drilling program has been somewhat slow relative to other operators such as Range Resources (RRC) and Chesapeake Energy (CHK) who also have very large leaseholds in the play. It is hard to imagine that Exxon would be able to retain all of its vast leasehold with only four rigs it is currently running in the Marcellus area. The acreage retention challenges are further exacerbated by the infrastructure limitations, particularly for wet gas.
Exxon paid a relatively low price in the Phillips/TWP transaction (estimated at around $4,000-$4,500 per acre). This may indicate that not all of the acquired acreage was located in the most productive sections of the play. However, even the Tier II parts of the Marcellus look increasingly attractive. Operators have reported continuous improvements in their well performance driven by better completions and well design, and the processing and transportation solutions have progressed much faster than anyone would dare to forecast just two years ago. The play also has a promising multi-stack potential that the industry is starting to pay greater attention to.
In the Fayetteville, Exxon's acreage situation is similar. A year and a half ago, in December 2010, Exxon acquired 150,000 acres from Petrohawk, increasing its total leasehold position to almost 600,000 net acres. Exxon paid $575 million for the acreage and the 299 Bcf of proved reserves, and $75 million for the midstream assets. Given that the leasing activity in the Fayetteville peaked about five years ago, lease expirations are likely to accelerate during the second half of this year and into 2013.
Unless Exxon has been able to extend its lease deadlines through option exercises or "top leasing," it may see its acreage position in these two strategic dry gas plays shrink noticeably.
Potential loss of acreage to lease expirations would be a relatively minor damage for Exxon given the company's overall size and extensive opportunity set in North America. However, it may reflect several strategic trends that are worth mentioning.
- Exxon may not see much upside in dry gas not only in the immediate term, but also in a much longer perspective. Exxon's recent decision to pursue a major LNG export project may reflect the expectation that the low price environment for North American natural gas will be sustained for a very long time ("Exxon Mobil Throws Its Weight Behind U.S. LNG Exports").
- Exxon appears to be struggling to generate its target rate of return in its US onshore operations (hence the 30% overall drilling activity reduction). Except for the Bakken and the Barnett where the company holds strong positions within most productive core areas, Exxon does not seem to have enough large-scale "sweet spot" opportunities that would be truly compelling from the return perspective in today's price environment.
- Exxon is continuing to play catch up to the independents - this time around, the company is struggling to capture core positions in the oil and liquids plays. Exxon has largely missed on the Eagle Ford and several other highly successful horizontal oil concepts. And in its existing core areas in the Bakken and the Permian, Exxon's drilling has not been particularly aggressive (current gross production from the Bakken is only 30,000 Boe/d, not a big number for the size of the opportunity Exxon has). During the past twelve months Exxon has been working hard on rebalancing its North American onshore portfolio that had been strongly biased towards natural gas. The company has been particularly active pursuing leases in the liquids-rich Woodford Ardmore play where it now has over 300,000 net acres and in the Utica where its leasehold stood at 87,000 net acres at the end of the first quarter. In combination with its other oil and liquids positions which include the Bakken (400,000 net acres), the Permian (400,000 net acres), the Eagle Ford (90,000 net acres), and the Cardium (235,000 net acres), Exxon seems to have finally accumulated a reasonable liquids opportunity set that may compensate for the opportunities lost in dry gas.
Ultimately, the re-allocation of resources to the higher-return oil and liquids opportunities appears to be the universally endorsed strategy. Exxon deserves credit for its rate of return discipline which should pay off in the long run.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.