Whiting's 2017 Guidance Is A Bet On Higher Oil Prices

| About: Whiting Petroleum (WLL)

Summary

Whiting's 2017 guidance increases production by 23% from Q4 2016.

Increased production motivated in part by delivery commitments and coincides with higher oil prices.

Ramp in production coupled with higher oil prices will dramatically increase cash flow by 2018.

"I skate to where the puck is going to be, not where it has been." - Wayne Gretzky

This quote sums up Whiting's (NYSE:WLL) Q4 earnings release and 2017 guidance in a nutshell. By the market's reaction, it seems a bit surprised by the $1.06B in capex commitment for 2017, which per our calculations represents an outspend of $400M from our projected cash flow of $650M. Why would a company that spent the past year aggressively and painfully deleveraging increase its debt load again? Why re-lever? We think there are two reasons driving this decision. First and foremost is that you'd have to believe that higher oil prices are coming and you plan to be proactive instead of reactive.

Exit 2016 Production

Average 2017 Production

Exit 2017 Production

Production Increase/(Decrease)

118,890 boe/d

123,000 - 126,000 boe/d

140,000 boe/d

23%

Here Whiting is planning to increase production 23% by Q4 2017. Is this a calculated bet? Certainly, because spending today what you don't have in anticipation of a better tomorrow is a probabilistic bet, but perhaps one that's tilted in our favor.

We've always said an investment in Whiting is a bet on oil. So long as the company executes well, then it could enjoy the ramp-up when oil prices turn, which we've long-held that they eventually will.

Outspend (Wants and Needs)

Let's put Whiting's outspend in perspective. While the current oil strip for 2017 is hovering around the $53.50/barrel range, we believe oil prices are headed higher by year-end. Accordingly, the outspend will be less than the $400M.

If production averages 125K boe/d (close to the midpoint of its guidance for 123K to 126K boe/d), Whiting is projected to produce 45M boe for the year, 30M of which is oil (assuming a 70% oil component). Approximately half of oil production is hedged, which means the remaining 15M barrels of oil is subject to spot rates. If oil prices continue to climb from today's $53.50/barrel (NYSE:WTI) to $60/barrel, the incremental $7/barrel can offset $105M of outspend ($7 * 15M barrels). Thus, total outspend is only approximately $300M. Not exactly onerous given where debt levels and cash flows will be for 2017.

On the conference call Whiting also hinted at entering joint ventures for the Niobrara, which could further increase production/cash flows. We've never been large fans of these "asset sales" because let's be honest, when you add a partner you're really giving up something, but perhaps it's a more conservative way to ramp production in a low price environment and maybe even a necessity (see below).

Delivery Commitments

It's also important to understand why Whiting is dedicating most of this outspend (i.e., $420M of capex) to the Redtail region. Recall that Whiting has delivery commitments in Redtail 1 and Redtail 2 in Weld County. For the next three years, these are the following volume commitments (per the 2015 Form 10K):

Current Redtail Production (Q4 2016)

9,210 (boe/d)

Period

Redtail 1 (NYSE:BBL)

Redtail 2

Total

Bbl/d

Jan - Dec 2017

12,325,000

7,300,000

19,645,000

53,822

Jan - Dec 2018

14,150,000

7,300,000

21,470,000

58,822

Jan - Dec 2019

15,975,000

7,300,000

23,295,000

63,822

Penalty per Undelivered Barrel

$4.75/barrel

$4.00/barrel

Failing to deliver the requisite minimum volumes means Whiting pays a penalty of $4.75/barrel for Redtail 1 and $4.00/barrel for Redtail 2. If Whiting had simply maintained Redtail production at Q4 2016 levels (i.e., 9,210 boe/d, or 6,445 bo/d (assuming a 70% oil weighting)), then the penalties for undelivered oil would have exceeded $77M, $86M and $95M for 2017, 2018 and 2019, respectively. So if faced with a $77M penalty in 2017 (if Whiting only maintained production), why not spend $300M to grow production in anticipation of higher oil prices. This was a rational decision because the net outspend was really the difference between the increased capex and penalty (i.e., in essence grow production for $223M). (Note we're assuming that the increase in capex spend will result in production that satisfies most of the volume commitments. We have an open query into this with investor relations. If not, perhaps any shortfall could be covered by a JV investment that increases production. TBD)

Timing

The timing of the outspend will also be heavily weighted toward the back-half of 2017 when oil prices should trend higher. Take a look at the scheduled cadence for drilling wells:

Wells to be Drilled (2017) (Gross)

1st Half

2nd Half

Total

70 Wells

163 Wells

233 Wells

At an average price of $5M a well, most of Whiting's outspend will thus occur in the latter half of 2017. With two-thirds of the wells to be drilled and/or completed later, the strain on cash flows should be muted for the next two quarters. The upward ramp will further allow oil prices to continue recovering, benefiting the unhedged barrels.

While we believe that Whiting's rationale for outspending cash flow was heavily influenced by its delivery commitments in Colorado, this decision was not made in isolation. In the end we believe Whiting's increased production coincides with rising oil prices, which establishes a higher base for increasing production again in 2018.

Crux of the Question

Let's assume Whiting's right. If they produce 140K boe/d in Q4 2017 and then hold that production flat for 2018, Whiting will produce close to 50M boe for 2018, or 35M barrels of oil (again using a 70% oil component). We project the company could generate $1.2B to $1.3B in cash flow at $65 oil (using the same 2017 cost projections). Assuming also the same multiple, this translates to a +$25/stock. Note that we're already two months into 2017, and as we head quickly towards the latter half of the year, 2018 earnings could become the primary determinant for driving Whiting's stock higher.

So where do you think oil prices will be in 2018? Whiting's actions today are telling you that they believe it will be significantly higher. Even if the production increase is partially motivated by commitment penalties, it's still deliberately choosing to spend more. Why outspend if you believe oil prices will continue to stagnate or fall? No rational actor would. Thus, we believe investors' myopic focus on this year's capex/cashflow is misplaced. This isn't a 2017 story, this is a late-2017/2018 story.

When/if oil prices head higher, the operating leverage will increase quickly, and we believe this is why Whiting is ramping so aggressively. This is a company willing to take the bet that higher oil prices will be coming soon. The question investors need to answer is, are you willing to skate with them? We think you should . . . because Great Ones skate to where the puck is going.

As always, we welcome your comments. If you would like to read more of our articles, please be sure to hit the "Follow" button above.

Relevance: USO, BNO, CR, CRAK, DBO, DDG, DIG, DNO, DRIP, DTO, DUG, DWTI, ERX, ERY, FENY, FIF, FXN, GUSH, IEO, IEZ, IYE, NANR, NDP, OIH, PXE, PXJ, RYE, SOP, UOP, UWTI, VDE, XES, XLE, XOP

Disclosure: I am/we are long WLL.

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.

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Tagged: , Oil & Gas Drilling & Exploration, Earnings
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