Major Implications Of Pioneer Natural Resources' Big Buyback Program

About: Pioneer Natural Resources Company (PXD)
by: Callum Turcan

What management may be signaling to the market after Pioneer Natural Resources Company announced a $2 billion buyback program.

This possibly marks a seminal moment in Pioneer's capital allocation strategy, as it spent less than $100 million repurchasing stock from 2015 to 2017.

Commentary on capex, drilling activity, production growth, and firm transportation agreements.

Pioneer Natural Resources Company (NYSE:PXD) is a giant in the Permian Basin with a large 750,000 gross (660,000 net) acre position in the play. Most, if not all, of that acreage is located within the Midland Basin in West Texas, which is a basin within the Permian. From 2016 to the third quarter of 2018, Pioneer Natural Resources Company has grown its net Permian output from 171,000 BOE/d to 288,000 BOE/d with no end in sight, unless management is subtlety signaling otherwise through the firm’s recent decision to step up its share buyback program. Let’s dig in.

Capex commentary

Management is focused on two things; the Permian Basin (Pioneer is in the process of divesting all of its other upstream holdings and is actively marketing its Eagle Ford position) and growth. Pioneer added two additional rigs to its Permian operations back in August, increasing its total rig count in the play to 22. With plans to add another two rigs to this unit in December, it appears Pioneer is undeterred by the recent downturn in oil prices. During a presentation to existing and prospective investors in November 2018, management noted that the firm was on-track to spend $3.4 billion on capital expenditures this year.

In order to sustain that level of drilling and the related completion activity (those wells need to be completed in order to start generating the cash flow Pioneer needs to cover its capex spend), Pioneer would need to increase its 2019 capex budget by a nice chunk over 2018 levels. However, that may be harder to accomplish than it has been in the past for a few reasons.

Cost reinflation is definitely at play in the offshore unconventional industry. This can be seen through Pioneer’s Q4 2018 guidance that calls for its DD&A per BOE expenses to climb upwards on a sequential basis. Pioneer’s Q3 2018 guidance called for its DD&A/BOE expenses to come in between $12.50 and $14.50, and in the end that figure came in at $14.25/BOE last quarter. Management is forecasting Pioneer’s DD&A/BOE expenses will climb up to $13-$15 in Q4 2018, and considering that metric came in at the high-end of the company’s forecast last quarter, it is reasonable to assume that will be the case this quarter.

Pioneer has a few tricks up its sleeve to keep well development costs contained, such as rig leasing arrangements based partially on WTI and relatively cheaper sources of sand for completion activities, but the general consensus is third-party and labor costs are on the rise in the shale patch.

While Pioneer did a great job keeping its operating costs contained, which protects its cash flow generation, the firm needs to be prepared that a combination of additional development activity and cost reinflation will require significantly greater cash outlays next year. True, the firm’s Permian output is roaring upwards and that will lend a helping hand, but there are hurdles on that front that need to be taken into account.

Firm transportation agreements fully utilized

During the third quarter of 2018, Pioneer produced 186,000 barrels of oil per day in the Permian. Pioneer’s marketing team secured firm transportation commitments for 165,000 bpd of takeaway capacity in Q3 2018, which increases to 185,000 bpd in November and up to 200,000 bpd by January 2019. These takeaway options allowed Pioneer to receive premium pricing (LLS/Brent-linked) for those barrels as the firm exported 130,000 bpd of its Permian output to foreign markets and the rest was sold to Gulf Coast refineries.

Any barrels not covered by firm transportation agreements were sold at Midland prices, which trades at a discount to WTI (sometimes a very steep one). As Pioneer’s firm transportation agreements ramp up, that provides the room the firm needs to grow. That being said, the company is likely to reach 200,000 bpd in net oil production out of the Permian by the first quarter of 2019. Once that level is reached, Pioneer must choose whether or not it wants to increase its Permian oil output knowing that those volumes will be sold at Midland prices in an environment where WTI is trading below $50/barrel (based on strip prices as of this writing) and the Midland-WTI differential is at $7-8/barrel. Additional firm transportation capacity would alleviate some of those concerns, but that depends on the timing of new pipeline developments.

With all of this in mind, note that on December 13, 2018, Pioneer Natural Resources announced a $2 billion share buyback program (equal to ~10% of its market cap as of this writing). This replaces the $100 million buyback program that was launched in February 2018 and could mark a seminal moment in Pioneer’s capital allocation strategy. From 2015 to 2017, Pioneer spent less than $100 million buying back stock and paid out a negligible dividend. Growth was priority number one.

Considering Pioneer has built up a sizable production base in the Permian and has secured firm transportation capacity for almost all of its oil production as things stand today, it is possible management wants to shift gears. That would entail stepping off of the gas pedal and slowing down development activities in the Permian, cutting its 2019 capex budget in the process.

To be fair, Pioneer’s debt load of $2.3 billion at the end of Q3 2018 is very manageable considering the firm’s $1.7 billion cash equivalent position (which is larger on a pro forma basis when taking expected divestment proceeds into account). With a current ratio of 1.2x at the end of Q3 2018 and additional asset sale proceeds on the way, that could justify share buybacks. That being said, it is very likely Pioneer would run a large cash flow outspend (capex > operating cash flow) next year based on strip prices and its growth ambitions (assuming capex is increased).

Final thoughts

Pioneer Natural Resources Company's hedging program is not very generous next year, leaving the firm at the mercy of volatile energy prices. Maybe management is signaling that Pioneer Natural Resources Company doesn’t want to grow beyond its firm transportation agreements, as those barrels would fetch very lackluster realizations. Instead, Pioneer Natural Resources Company wants to take advantage of the downturn by repurchasing its stock on the cheap. We'll see how this plays out. Thanks for reading.

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.