- A number of market narratives continue to depress valuations of the US oil and gas sector.
- There appears to be a disconnect where US shale industry is either viewed as too efficient or productivity and economics of the industry is about to implode.
- The more concerned the market becomes about the penetration of Electric Vehicles and a potential peak in global oil demand, the more likely a severe supply deficit will develop.
In this article, we will take a closer look at the United States (U.S.) Exploration and Production (E&P) sector (NYSEARCA:NYSEARCA:XOP), and in particular address some of the narratives or perhaps “myths” that continue to depress valuations in the sector or at least with respect to the smaller or mid-tier producers. This article follows on from two prior articles, the first focusing on U.S. oil production trends, and the second taking a broader global perspective on the outlook for oil prices over the next few years.
In our view, there are three key narratives or “myths” that continue to depress investor sentiment with respect to the US energy sector:
Myth 1 - U.S. oil production can still increase substantially from current levels, even with oil prices below $60
We already addressed this narrative in our first article where we showed that most, if not all of the incremental oil production in the U.S. will come from the Permian basin and most of that will be light oil or condensate (API of 45 or higher). In our second article, we also briefly discussed the latest Annual Energy Outlook (AEO) publication from the Energy Information Administration (EIA), where the EIA itself expects US oil production to top out at around 12mn bpd by 2020-21, based on a reference price scenario that assumes benchmark crude oil prices to eventually return to the $80-$90 per barrel price level by 2020-22.
In summary, there appears to be a bemusing disconnect in the minds of most investors or market participants with respect to the sector. On the one hand, shale economics is perceived as so attractive that U.S. production will grow sufficiently, not only to absorb the growth in global oil demand over the next few years but also to exceed this same demand growth and lead to a renewed crash in oil prices below $40 per barrel.
On the other hand, at a micro level (that feeds into the depressed valuations in the sector), there is a constant lingering doubt about the ability of the shale industry in the U.S. to continue growing production without moving into less productive acreage or rising operating costs. From a rational perspective, both narratives cannot be true at the same time.
Yes, there are considerable differences in the economics between shale basins and within these same basins. However, if you are going to assume that a handful of E&P companies with the best acreage will single-handedly drive overall U.S. oil production sufficiently high enough in order to lead to a renewed collapse in global oil prices, while the rest of the sector experiences flat production at prices between $50 to $60, then the former “best of breed” E&P companies should trade at a significant premium, which is currently not the case.
Myth 2 – The penetration of Electric Vehicles (EV) and autonomous driving technology will shortly begin to erode demand for oil, such that a peak in global oil demand will materialise within the next few years
We are not going to spend much time pushing back on this narrative or at least the optimistic prognostications for the growth in the electric vehicle (EV) market. Yes, the market will grow but a cursory analysis provides clear and compelling evidence that we are still many years away from reaching a significant inflexion point where the uptake in EVs will start to have a material impact on global oil demand.
Even some of the more optimistic forecasts still suggest that a peak in global oil demand will not occur before 2025, which suggests that global oil consumption will still grow by several million barrels per day (bpd) before peaking, and importantly, far outstripping the potential supply growth in the U.S.
As the graphic below compiled by S&P Global and Platts show, even if EVs start to become cost competitive with traditional internal combustion-driven vehicles this year or next year, their penetration rate globally would probably only amount to 2% by 2030. This is hardly the type of scenario that would lead to a meaningful shift forward in the projected timing of a peak in global oil demand. Rather, our view is that continued advancements in fuel efficiency and slowing population growth (or ageing populations) will be the decisive factors that determine when a peak in global oil demand occurs.
Source: S&P Global and Platts
In fact, what this narrative has achieved is to depress valuations and possibly longer-dated crude prices (three to five years out), and in turn, this same narrative helps to depress capital investment in the sector. As such, the ‘belief’ that a peak in global oil demand is at hand will ironically lead to a severe supply deficit at some point, possibly between 2020 and 2022 when US oil production tops out. This could lead to renewed spike in global oil prices above $100 per barrel.
However, what will be interesting to observe at that juncture is whether the industry responds and ramps up capital investment if executives at most major oil companies continue to fear an imminent peak in global oil demand. The irony of the situation is that the looming threat of a peak in oil demand may actually lead to another spike in global oil prices that could inadvertently be sustained for a number of years, perhaps until such time as the much anticipated peak in global oil demand actually arrives.
If this scenario does materialise, can one guess which companies will be best placed to exploit such a development? Yes, US shale companies where the lead time on production is relatively short-cycle, between 3 and 9 months. In fact, in most cases, 50% of a shale-well’s exploitable reserve is extracted within the first three years of its life. If we have a sustained backwardation where longer-dated (three years out or longer) prices continue to trade at a substantial discount to near-term prices, US shale companies will be in the unique position enabling them to hedge out a large portion of their production at much higher prices than longer-term future prices.
Their Free Cash Flow (FCF) generation profile will improve markedly and will very likely lead to an increase in mergers and acquisitions (M&A) as executives at the larger integrated oil companies scramble for the last remaining packets of competitive acreage. In fact, if this thesis proves correct, many if not most oil executives sitting on large cash piles or possessing a lightly geared balance sheet, will probably end up kicking themselves for not taking advantage of the depressed valuations in some of the mid-tier E&P companies that prevailed during 2016 and 2017.
Furthermore, we would also point out that in the event that a peak in global oil demand does materialise sooner than expected, OPEC and in particular, the Arabian Gulf States would probably (or least initially) continue to cut production in order to support the market. Given that these countries generally require an oil price of around $60 per barrel to support their fiscal commitments, it will be preferable to forgo some production but maintain prices at higher levels for as long as possible. For instance, Saudi Arabia would make far more money exporting 6mn bpd at $70 as opposed to exporting 7mn bpd at $40. So from a game theory perspective, this appears like the most rational policy choice for OPEC and even some other major producers such as Russia.
On a final note, we would also like to point to another apparent disconnect in the market with respect to the US E&P sector and specifically those companies that also produce natural gas or have both large oil and natural gas reserves. There is little doubt that a substantial and rapid penetration of EVs in the US would ensure continued demand growth for electricity and hence demand for natural gas as a cleaner burning fuel compared to coal. Natural gas is also more economical or competitive when compared to the large upfront capital costs required for nuclear power.
There is an evolving narrative that renewable energy capacity from sources such as wind and solar is going to grow so rapidly that it will more than offset incremental demand growth for electricity, and more than that, end up absorbing a significant amount of capacity from coal and nuclear.
Something that market participants forget is that without efficient, economical and large-scale storage solutions, renewable energy cannot serve as baseload power. In fact, studies from some countries (such as Germany) have shown that the intermittent nature of wind and solar can lead to large fluctuations in supply, which can in an extreme scenario even destabilise the entire grid.
As such, the growth in renewable capacity will have to coincide with the further growth in natural gas generation capacity as gas-fired power plants, apart from having shorter construction lead times, can also be quickly switched on or off, helping to even out and stabilise grid supply as increasing amounts of overall power generation come from renewable but intermittent sources such as solar and wind. In summary, if you are bullish on the prospect for EV adoption and penetration, you should also be bullish or positive on the outlook for natural gas consumption.
Indeed, the chart below from the EIA’s 2018 AEO forecasts continued growth in natural gas production and consumption relative to coal and other fossil fuels (forecast specifically pertains to the U.S.). Shrewd energy executives, even in a future where global oil demand peaks sooner rather than later, should be taking advantage of the current depressed valuations for quality, large natural gas reserves.
In fact, building a portfolio of quality oil acreage that could exploit any potential temporary supply deficit and sustained multi-year backwardation in oil prices, coupled with natural gas assets that will ultimately be underpinned by increasing demand for electricity from EVs, will surely be seen as a wise strategy at some point in the next few years.
Source: EIA’s 2018 AEO
Myth 3 – The “business model” of shale E&P companies is fundamentally flawed, in that the large decline rates for shale wells require continuous capital investment, which prevents them from generating Free Cash Flows (FCF).
The first years of the shale boom were indeed characterised by a type of “ wild west” fervour as companies scrambled for acreage and following that, further development expenses in order for them to hold onto their leases over the long term. Many companies also needed to invest substantial amounts in gathering, processing and transportation infrastructure (so-called “ midstream” infrastructure).
This type of thing is not unusual and is often the case when a vast new resource is discovered. One only needs to read and familiarise themselves with the history of the discovery of diamonds in Kimberly, South Africa, as well as later on gold on the Witwatersrand, also in South Africa.
However, what history also shows is that eventually the smaller operators either go bankrupt or end up being absorbed by the larger and better funded operators. Eventually as the initial development capital investment has been made, the companies’ end up becoming far more profitable or cash flow generative as capital investment falls to “sustaining” or steady-state levels. In the extreme case of the diamond producing Kimberlite pipes discovered in South Africa, they ended up being consolidated into a single monopoly company (De Beers)!
Such an extreme scenario will obviously not play out in the US shale industry, but there is little doubt that shareholders (if they can induce management) would benefit from continued consolidation of various companies and some of the cost synergies that would materialise. Furthermore, once a company has built up a large acreage position that is already “held by production,” it can develop and extract the resource in a more measured fashion consistent with achieving positive free cash flow.
Most market participants, at least in our view, fail to distinguish between sustaining capital investment and development capital investment. The perception is that shale companies cannot generate free cash flows, when in fact even some mid-tier companies operating in less attractive basins (such as the Bakken) are becoming extremely cash generative at oil prices of around $50. We will provide but one example, Whiting Petroleum (NYSE:WLL).
In its fourth quarter 2017 results (please refer to the table below), WLL generated USD 307mn in EBITDA while reducing its capital investment to USD 171mn, very close to what we would consider a sustaining or “steady-state” level. In fact, in its guidance for 2018, WLL said it expected capital investment to amount to $750mn ($188mn per quarter), while still anticipating further production growth of 10% by the end of 2018.
Source: Raymond James Research, Company Reports
Returning to the results table presented above, we can see that WLL essentially generated $86mn ($344mn annualised) of Free Cash Flow in Q4 2017 at realised prices of $51 for crude oil and $1.87 per Mcf for natural gas. In fact, according to research from Raymond James, the company’s free cash flow yield at current strip pricing could rise to 20% by 2025. We would hardly describe an oil company with the ability to generate double-digit free cash flow yields at $50 oil prices as having a “failed” or “flawed” business model.
To be sure, there are many smaller listed or privately-owned operators that own poorer quality acreage and/or retain a relatively small reserve base. These operators currently still contribute a meaningful proportion of overall shale production and in many cases are even increasing their output. However, the sustainability of their contribution, especially where operators are trying to maximize the number of well locations by narrowing the spacing between wells, should be questioned. But this dynamic should not be extrapolated to the entire industry or all shale operators in the US.
In fact, this dynamic only increases our conviction that US oil production will likely top out sooner rather than later, as these smaller operators eventually “hit a wall” where the productivity of their acreage declines or they are forced to move into less economical acreage as they deplete their “core” acreage. In our view, this only makes those companies with very large reserves, predominately in “core” areas, even more valuable.
This article was written by
Analyst’s 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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