With Low Oil Prices, Will Your Favorite Shale Company Prosper Or Flounder?

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Includes: APA, APC, CDEV, CLR, COP, CPE, CXO, DVN, EOG, FANG, JAG, MRO, OAS, PE, PXD, SM, WLL, XEC
by: Atticvs Research
Summary

Lower oil prices are here to stay.

OPEC+ cut-backs provide temporary support, they are not a game-changer.

Low cost, efficient E&P operators will succeed, high cost will struggle.

Not all shale companies are low cost. Do you know whether, on a fully loaded basis, your favorite shale player is low cost or high cost?

Use the market pull-back as an opportunity to invest in the best.

Introduction

A common refrain this past couple of years was that WTI would trade predominately in a $60 to $80 range.

During 2018, US E&P companies increased output by 2 million barrels a day with WTI averaging $65 a barrel for the year. Of this, 1 million came from the Permian basin where, net of Cushing differentials, they received average pricing of $58 a barrel.

Cushing differentials will evaporate in 2019, thereby significantly boosting net prices for Permian operators. If these companies grew production in 2018 with net pricing of $58 a barrel then, in 2019, this opens the door to another Permian oil tsunami.

Elsewhere, there is a growing threat of a recession in the USA and/or a global slowdown. This has potential to wreak havoc with oil prices.

Already there are enough headwinds to ditch the idea of WTI trading in a $60-$80 band. A more realistic trading range is $50 to $60.

Even at $50-$60, there are some excellent and efficient shale companies that will continue to prosper. Alas, there are also inefficient players that struggle at this level.

The key ingredient to be a successful company in the $50-$60 zone is that it must be a low-cost / high-profit operator.

Below, using data from Qtr 3 2018 SEC filings, I identify the fully loaded costs for a list of 18 E&P players and highlight their true profitability per Boe. I also take a preliminary look at their profit potential per Boe in 2019 with oil at $55 per barrel, right in the middle of the $50-$60 band.

During the recent market pull-back, oil stock prices have been hammered, notwithstanding early 2019 rebound efforts. Investors can seize the available opportunity by acquiring shares in companies at the top of the quality spectrum. Remember, opportunities in low quality companies happen all the time, they are value traps. But opportunities in the best quality companies seldom come along.

WTI old price range $60-$80, NEW $50-$60

The oil business has a long established tradition of lurching from boom to bust and back again. Higher oil prices invariably usher in excess production, followed by tough cutbacks and, soon after, we’re off to the races again.

An oft heard theme this past 2-3 years was that WTI would trade predominately in a $60 to $80 range. Below $60, it was thought shale companies would not be profitable and would then cut production thus bringing oil prices back into the $60-$80 band. And above $80 large profits would presage an oil flood.

Today, the problem for oil optimists is that, as soon as the oil price creeps into the $60s, virtually all shale producers, including the duds, are profitable. When that occurs, the inevitable consequence is that oil output expands.

Evidence 2018 when WTI averaged $65 a barrel for the year, US E&P companies, demonstrating continuing improvements in drilling and extraction processes, blew apart this pricing assumption by increasing output by 2 million barrels a day.

Of the 2 million increase, 1 million came from the Permian basin.

In 2019, with additional take-away capacity coming online, Cushing differentials will all but disappear. Already in early 2019, way ahead of expectations, differentials have closed markedly and in the past week alone have almost completely disappeared. This is a very significant development. Refer CME.

The implication here is that, if Permian companies receive similar net pricing in 2019 to that of 2018, they alone could grow production by over 1 million barrels per day.

Net of differentials, average pricing in 2018 was $58 a barrel for Permian companies. In theory for 2019, with differentials close to zero, WTI pricing of more than mid $50s opens the door to another new oil flood.

The EIA, in its Short Term Energy Outlook of January 15, 2019, forecast increased US oil production in 2019 of just 1.1 million barrel per day. Of this, they estimate that the Permian basin will add only 0.6 million Bpd before accelerating output again into 2020. This seems a touch light given the eradication of Cushing differentials. Also, keep in mind, US shale has already established a reputation for beating expectations and few will really be surprised if they rise to the occasion again in 2019 especially if WTI nudges towards $60.

There are other major factors that will influence US oil production growth in 2019.

In particular, there is growing threat of a recession in the USA and/or a global slowdown. Recessions and global slowdowns tend to have a brutal effect on the oil business because of oil’s supply/demand in-elasticity. Economic expansions don’t last forever, a recession will hit, it’s only a question of timing. Davos interviewees say the smart money is on 2020 with warnings surely becoming more pronounced as 2019 evolves.

This coming economic slowdown is widely discussed in the media and its pending arrival is known within the oil industry. Going into a recession – and bearing in mind the harsh experiences that visited shale companies during the 2015 oil price crash - US shale companies are unlikely to stretch spending and knowingly weaken their balance sheets. Accordingly, we can expect shale companies to trim capex plans in 2019.

Because of a potentially darkening outlook, the high yield debt market is already reacting negatively. Pricing for E&P debt is now about 5%-6% over US Treasuries, that being 8%-9% for 10-year debt. That is pricey, prohibitively so for some companies. Ongoing high debt yields will help keep shale CEO’s away from their capex check books. The Financial Times, in an article dated January 23, 2019, discussed the capital raising difficulties arising within the oil sector.

The odds of US shale increasing production again in 2019 at 2018 levels are low. This, together with the OPEC+ cuts, should provide reasonable support for oil prices.

Within the oil industry, Harold Hamm, Chairman of Continental Resources (NYSE: CLR), claims that “Producers have become more disciplined in their approach to capex” and, consequently, shale output growth in 2019 could decline by 50%. In other words, 2019 growth could be as low as 1 million barrels.

Daniel Yergin, Vice Chairman of IHS and a widely respected luminary, in an interview on January 23, 2019 predicted that US production will increase by 1.5 million barrels per day in 2019.

Bloomberg, in an article dated January 24, 2019, discussed the evolving 2019 supply/demand balance. Their summary is insightful;

“…this year’s curbs (by OPEC+ and non-OPEC) should see consumption and production broadly aligned in the first half of 2019. The biggest uncertainty is about how much supply non-OPEC producers will add.”

US production growth in 2019 could conceivably be as high as 2 million barrels, or as low as 1 million barrels. Ultimately, Yergin’s 1.5 Mbpd figure may be the best bet. I suspect that we will see healthy discipline in the first half of 2019 leading to firmer oil pricing. In turn, this will induce production growth which triggers softer oil prices later in 2019. It’s a familiar pattern, we know how the story ends.

Major banks have lowered their pricing expectations for 2019. On January 6, 2019, Goldman Sachs cut its 2019 WTI price forecast to $55.50. Similarly, Société Générale revised their forecast down to $57.25. Ref Bloomberg January 7, 2019.

Bottom line: It’s time to ditch the idea of WTI trading in a $60-$80 band. Instead, we should be looking at $50 to $60, which is fully consistent with the Goldman Sachs and Société Générale forecasts.

Impact on US shale

For the US shale industry, a lowering of the WTI price band to $50-$60 has profound repercussions.

In this lower price environment, inefficient and higher cost operators will fail whilst low-cost, highly profitable producers – and there are some excellent operators - will flourish.

For investors to make money, or at least to limit losses, it is imperative to fully understand which companies are efficient operations and which are not.

Are all shale companies low cost?

Every investor has viewed company presentations where the operator describes itself as a low cost producer, boasts of having endless years of drilling inventory, has a strong balance sheet, and has IRRs that reached to the stars. Invariably data in presentations is incomplete and sometimes little more than aspirations.

To get a proper understanding of a company’s cost base an investor must work through the company’s quarterly and annual SEC filings.

Using data from SEC filings for Q3 2018, below is a list of 18 E&P operators, predominately shale players, where the “Costs per Boe” are highlighted, together with “Realized Price per Boe”. The difference between the two being “Profit per Boe”.

Focus on “Cost per Boe”, or “Profit per Boe”?

The term “low-cost operator” is somewhat of a misnomer. An entity that mostly produces Nat Gas will have a low cost per Boe. However, the revenue per Boe of Nat Gas is also invariably low and the overall business picture will usually be one of anemic profits. A more sensible measure for an E&P company is “Profit per Boe”.

Calculating “Profit per Boe”

Here are brief explanations of the approach used in compiling the list:

  • Sales include Oil, Nat Gas and NGLs. The Realized Price per Boe is a composite of the price realized for each component using actual product weightings.
  • All commodity hedging gains/losses have been excluded. Hedging is a temporary fix, it smooths out the bumps, but it does not fix underlying weakness in a business model.
  • All costs are included in Cost per Boe; Selling, General, Admin., Financing, etc.
  • Also included in Cost per Boe is the impact of non-controlling interests and preference dividends. The purpose is to to enable the reader to assess costs and profitability from the point of view of common shareholders.
  • Only true one-time items such as ‘gains/losses on sale of business’ are excluded.

What we end up with is a hedge-free view of fully-loaded Cost per Boe and Profit per Boe applicable to common shareholders.

Preliminary view of 2019

As well as listing the actual data for Q3 2018, I’ve included preliminary estimates for 2019. Three core assumptions were used:

  1. WTI pricing to be $55 a barrel and Nat Gas $3.00 per Mcf.
  2. Permian oil differentials to improve to $3 a barrel. From Q3 2018, when diffs averaged $12-$14, this represents a very significant improvement of about $10 a barrel.
  3. Costs per Boe to remain unchanged. There are too many company-specific variables to do otherwise at this time.

In reality all companies will push to lower their costs in 2019, and seek to migrate drilling activities towards premium acreage. All operators should register some success, the good and the bad. However, for inefficient players, this is a daunting task. The best companies have top acreage, a strong balance sheet and, above all, a skilled management group who are shareholder focused. The weakest may fail on several counts.

At the simplest level, weak operators will incur losses in a low oil price environment.

The real test is seeing who can make profits and grow production - all within operating cash flow?

The list, in alphabetic order:

E&P Operators

Profitability per Boe

Actual - Q3 2018

Estimates 2019

Realized

Realized

Cost

Price

Profit/(Loss)

Price

Profit/(Loss)

Company

per Boe

per Boe

per Boe

per Boe

per Boe

Anadarko (APC)

$43.09

$50.78

$7.69

$42.85

$(0.24)

Apache (APA)

$37.00

$44.93

$7.93

$39.05

$2.05

Callon (CPE)

$27.90

$50.19

$22.29

$44.04

$16.14

Centennial (CDEV)

$30.23

$40.58

$10.35

$38.61

$8.38

Cimarex (XEC)

$17.00

$28.98

$11.98

$26.51

$9.51

Concho (CXO)

$31.90

$45.23

$13.33

$39.89

$7.99

Conoco (COP)

$31.90

$54.09

$22.19

$44.11

$12.21

Continental (CLR)

$31.70

$44.81

$13.11

$36.85

$5.15

Devon (DVN)

$25.00

$33.50

$8.50

$30.45

$5.45

Diamondback (FANG)

$25.23

$46.59

$21.36

$43.23

$18.00

EOG (EOG)

$29.15

$48.20

$19.05

$39.05

$9.90

Jagged Peak (JAG)

$29.79

$46.64

$16.85

$43.84

$14.05

Marathon (MRO)

$34.30

$41.56

$7.26

$34.92

$0.62

Oasis (OAS)

$48.75

$57.61

$8.86

$47.22

$(1.53)

Parsley (PE)

$32.67

$47.59

$14.92

$40.68

$8.01

Pioneer (PXD)

$28.22

$44.64

$16.42

$41.05

$12.83

SM (SM)

$35.67

$38.20

$2.53

$35.44

$(0.23)

Whiting (WLL)

$36.20

$48.02

$11.82

$39.08

$2.88

Source; Author, using 10Q reports of September 30, 2018 for each company.

Observations

The three most profitable per Boe companies in Q3 2018 were Callon Petroleum (NYSE: CPE), Diamondback Energy (Nasdaq: FANG) and ConocoPhillips (NYSE: COP). All made profits per Boe of over $20. Honorable mention goes to EOG Resources (NYSE: EOG) which came in at $19.05.

For 2019, the top three performers are Diamondback, Callon and Jagged Peak (NYSE: JAG). ConocoPhillips drops down a notch because it has negligible Permian production (about 3% of the total) and will not benefit materially from more favorable Permian-Cushing pricing. Pioneer (PXD), as a well-managed pure-play Permian company, should also perform relatively strongly in 2019 as a result of its efficient operations and improving differentials.

Diamondback Energy is frequently described as one of the lowest cost operators. The evidence confirms this to be true - it is a low-cost shareholder-focused company. In 2019, Diamondback is forecast to be the most profitable operator and the balance sheet is set to remain strong with Debt/Ebitda of less than 2.0. The company has already issued 2019 guidance; production growth of 28%, payment of a dividend and all within cash-flow with WTI at $50 per Bbl. During the next few weeks, various E&P companies will issue their 2019 guidance. The challenge is to match the yardstick laid down by Diamondback: Solid growth @ $50 oil, dividend, all within cash flow.

Callon Petroleum is an under-the-radar Permian pure-play. It spent 2018 migrating from single well to multi-well pads, with plans to continue the evolution in 2019. Management have a commendable focus on shareholder returns. More cost savings are anticipated in 2019, especially via water management and in-basin sand sourcing. Being a pure-play Permian company with a high liquids cut, Callon will get full benefit of the disappearing Cushing differentials. As of Q3 2018, whilst registering year on year production growth of 55%, Callon’s capex was not covered by operating cash flow. Pro-forma Debt/Ebitda at September 30, 2018 was 2.0 and, in an era of low oil prices, it is important that excess capital spending over operating cash flow doesn’t continue unchecked. Hence, one of the most important points to watch out for in their 2019 guidance is the question of whether or not they reach operating cash flow neutrality.

For some years now, ConocoPhillips has proven itself to be a well-managed company with excellent focus towards shareholders. In December 2018, the company guided for 2019 that, with WTI at $50, they can grow production by 5% whilst keeping capex flat and also paying a dividend, all within cash flow. This is particularly admirable given that ConoccoPhillips has negligible Permian oil production and won’t benefit from improving differentials. Much may depend on Nat Gas pricing. In Q3, 2018, 36% of total production was Nat Gas which was sold at $5.81 Mcf, way above a normal $3 Mcf benchmark. I cannot state categorically that they will maintain this premium pricing going forward but, to give the benefit of doubt, I assume they will continue to do so and I’ve penciled-in $5.00 per Mcf. In 2018, they also beat oil pricing benchmarks via their Alaska/UK/Brent and international sales. Again, I assume this trend will continue. That said, because of a lack of Permian basin production, ConocoPhilips’s oil business is exposed to lower oil prices in future. On a Profit per Boe basis, the company, though of course still good, will be less profitable unless more operational improvements are made.

Jagged Peak, because of its high oil/liquids mix, total 89%, and being a pure-play Permian company, should benefit substantially in 2019 from improving Midland/Cushing differentials. This is essentially why its Profit per Boe in 2019 remains strong. Jagged Peak is a well-managed company. Production growth in 2018 is tracking above 90% versus 2017. And the balance sheet is robust with Debt/Ebitda of just 1.0. The Profit per Boe numbers may be slightly flattering because, with growth at >90%, and latest generation wells having a lower cost per Boe than earlier generations, this feeds through to generate overall lower cost per Boe numbers. Still, low costs are low costs and Jagged Peak is and should continue to turn in low costs per Boe. Inevitably, because of the >90% growth rate, Jagged Peak is not operating within cash flow. Presumably 2019 will see a significant production growth slowdown. Still, I believe the company is unlikely to achieve cash flow neutrality in 2019 but, with Debt/Ebitda of 1.0, it does have some time on its side. Instead, shareholders would like to learn from management’s 2019 guidance announcement, that cash flow neutrality is in sight within a relatively short time frame.

The companies at the bottom of the list are a concern. After all, if many of these companies earned modest Profits per Boe in Q3 2018 when WTI averaged $69.50 per barrel, it points to difficult times ahead when oil is $15 lower.

In 2019, almost all the less profitable companies have small or negligible Permian production. Hence, they get little or no benefit from improving differentials. Anadarko Petroleum (NYSE: APC) has 30% Permian production, Apache Corporation (NYSE: APA) 45%, Devon Energy (NYSE: DVN) 20%, EOG Resources <10%, Marathon Oil (NYSE: MRO) 5%, Oasis Petroleum (NYSE: OAS) 7%, and Whiting Petroleum (NYSE: WLL) 0%. SM Energy (NYSE: SM) has a large Eagle Ford Nat Gas legacy business and only 42% of sales are Permian oil. Excluded from Oasis numbers are the revenue and costs of its profitable mid-stream business, leaving what appears to be a high-cost core E&P business.

No doubt all the companies listed have some commodity hedges in place. However, with low oil prices here to stay, these commodity hedges can temporarily mask the truth if the underlying business is poor.

Investor Summary

This listing can be used as a starting point for identifying those companies with the best chance of success in this new low oil price era. Bear in mind that the cost per Boe data presented here is static, it is historic from Q3 2018. Similarly, the Oil, Nat Gas and NGLs sales mix also come from Q3 2018 and may change. And finally, commodity hedging gains/losses have been excluded to highlight the true underlying business.

The 2019 yardstick has already been set by Diamondback; production growth of 28%, payment of a dividend and, crucially, all within operating cashflow with WTI at $50 a barrel. As various operators announce their 2019 guidance over the coming weeks, it will be interesting to see how many can get close to Diamondback’s benchmark.

For the most part, I believe investors may expect management groups to incorporate into their 2019 guidance plans positive initiatives to help the businesses succeed going forward.

Abetted by the recent stock market pull-back, an attractive investment window has opened up.

Carpe diem.

Disclosure: I am/we are long CPE, FANG, CDEV. 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.