More than 1 million barrels of new oil hits the market in 2020 whilst global oil demand growth stays weak.
Oil prices to remain in a lower for longer $55 WTI holding pattern.
Following the severe selloff in oil shares during 2019, do E&P companies finally offer investors good prospects with $55 oil?
Are there hidden gems that will make big gains for shareholders?
The oil industry is likely to continue to experience tough times in 2020 through a combination of excessive new oil supplies and weak demand growth.
The severe slide in E&P share prices during 2019 suggests that much of the bad news may be priced in. Already, there are some E&P stocks that offer investors attractive returns even in a low oil price environment. And, when the oil sector benefits from improved sentiment heading towards 2021, the best managed companies will perform strongly for investors.
In this article I aim to highlight the best investment opportunities in the shale space that the ever-irrational Mr Market has thrown up.
In 2020, almost 1 million barrels of new oil will hit the global market, coming from Guyana, Norway, Brazil and Canada. The US will also increase supply. Elsewhere, global oil demand growth is weakening and the Saudis are maneuvering for firmer oil prices.
This is a difficult backdrop for oil bulls, and with further oil surpluses on the cards for 2021, it is no wonder that US shale stocks have been hammered throughout 2019.
Production Growth Estimates
Year 2020 oil production growth estimates for the US are being reduced.
The EIA predicted in October 2019 that US oil output in 2020 would rise by 900,000 b/d.
This contrasts with cautionary words from company CEOs during Q3’2019 earnings conference calls. Scott Sheffield, CEO of Pioneer Natural Resources Inc, predicted that US oil output will grow by 700,000 b/day in 2020, adding, “I don’t think OPEC has to worry that much more about US shale growth long term”.
Globally, looking beyond 2020, we have open possibilities. One school of thought says there will be fewer new projects coming on line after 2020 and this will support firmer oil prices. On the other hand, Iran, which has just discovered another giant oilfield, will not always remain out in the cold and their return would see a further 1.5 million barrels hitting the market. Guyana and others also plan additional supplies.
The general outlook for 2021 and subsequent years is that oil prices will be healthier, mostly as a result of lack of capital expenditures by the super-majors on expensive mega projects. From an investment perspective, we should see a gradual improvement in sentiment towards the oil sector during 2020 in anticipation of moderately better times ahead.
Lower for Longer Continues
When all is said and done, the year 2020 does look difficult for producers and continued downward pressure on oil prices can be expected for much of the year.
In a February, 2019 Seeking Alpha article, I argued that $55 WTI was a fair price for oil, neither strong enough to encourage excessive production nor weak enough to curtail investment which would then presage an oil price surge. Essentially, we still remain in a lower for longer holding pattern of about $55 where only the best oil producers will flourish whilst operators with high cost bases will fall by the wayside.
With year-end 2019 approaching, and with oil stocks having been beaten up this year, it’s time to look at shale producers to see what their prospects are for 2020.
Who measures up and who falls short?
The following data table has been put together using an assumed WTI price of $55 per barrel. Nat gas is assumed at $2.50 per Mcf and NGLs at $15 per bbl. Production volumes and growth for 2020 are taken from each company’s Q3’19 earnings presentation and conference call and/or guidance. Financial data is compiled from SEC filings with one exception: Gains/losses on commodity hedges are removed so that one can more accurately assess the true profitability of the underlying business. One other important assumption is that Permian companies will generally benefit in 2020 via narrower pricing differentials vs. Cushing. This beneficial situation doesn’t apply so much to Pioneer, which has already avoided the Permian takeaway problem in 2019, nor to Continental, which isn’t a Permian player, nor to EOG, which has relatively little Permian exposure. Share price data, EPS estimates and market capitalization numbers are as of close of business Nov. 29, 2019.
Cimarex Energy (NYSE: XEC)
Cimarex is a well-run company and has a low valuation on many measures. For year-end 2020, its EV/EBITDA valuation of 4.35 and p/e ratio of 8.7 are both the lowest in this group.
However, the fact that it has an oil cut of only 33% makes it less appealing. Still, it is worth watching because about 85% of its $1.4 billion capex budget for 2020 is being targeted towards the Permian basin and this will improve the oil cut. It is one to watch, especially given the low valuations.
Concho Resources (NYSE: CXO)
Concho is comfortable in 2020 with oil at $55 WTI, growing production moderately but sustainably. At this oil pricing they should have growth of 10% and generate free cash flow of $500 million – right in line with this schematic from their Q3’19 earnings presentation release.
Concho has a liquids cut of 63%. However, whilst CXO is well run and is a low-cost operator with growth potential at WTI $55. Some investors are wary of two-stream reporting, particularly when NGL pricing is weak. Currently, NGLs are selling at only 25% of oil pricing.
Concho should end 2020 with an EV/EBITDA of 5.84, which is reasonably good value. The company has a $1.5 billion share buyback program, which represents 10% of the share capital, and this too will support the share price. Overall, attractive.
Continental Resources (NYSE: CLR)
Continental is primarily a Bakken operator with about one-third of production coming from the Anadarko basin in Oklahoma. As with others, Continental also reports production on a two-stream basis and has a total liquids cut of 58%. According to the following schematic, Continental can generate $500 million to $600 million free cash flow in 2019 with WTI at $55. For next year, I estimate a free cash flow figure of around $700 million, and this implies a growth rate of about 8%.
Being a non-Permian operator, Continental won’t benefit from improved Permian pricing in 2020. And, whilst Continental’s EV/EBITDA of 5.17 in 2020 is cheaper than that of its Permian peers, it becomes a touch less attractive as an investment over time due to the huge economy-of-scale advantages that will continue for the Permian operators. On the other hand Continental has a $1 billion share buyback program which will underpin the shares. Overall, CLR stock is reasonably good value.
Diamondback Energy (Nasdaq: FANG)
Among this group of shale operators, Diamondback is best positioned to grow production and free cash flows in a low oil price environment. It has already issued preliminary year 2020 guidance for production growth of 10%-15%, and it pays a dividend within cash flow with a $45 WTI oil price. Achieving 15% growth at $45 oil is impressive. Overall, FANG’s excellent metrics are unmatched in the shale patch.
With market-beating returns, investors might expect FANG shares to trade at a premium. However, Diamondback dropped the ball in Q3’19 when an offset driller spent two and a half months fracking a 24-well cube development immediately alongside one of Diamondback’s most prolific production spots. The shutdown led to a gross production loss for Q3 of 12,000 barrels per day. From everything said on the earnings conference call, which I recommend investors read, it is clear that this was a temporary interruption with no lasting damage to Diamondback’s production base – output from the interrupted wells has recovered 100%.
As always, investors are slow to forgive mishaps, regardless of where the fault may lie. Whilst Diamondback’s low stock price is clearly a buying opportunity, I suspect the market will like to see the company deliver strong results for Q4’2019 before restoring a premium rating to the shares.
The year 2020 is set to be a big year for Diamondback. In the current year, 2019, oil pricing will average about $5.50 below WTI. But in 2020, helped by Diamondback’s equity ownership in new takeaway capacity, the company expects to realize 100% of WTI. That’s a significant pricing boost. Refer to “Profitability per Boe” on the above table – FANG will earn $13.48 profit per Boe next year, considerably higher than the peer group.
Diamondback’s estimated year 2020 p/e ratio is 8.8, the lowest in the group except for Cimarex which has an estimated oil cut for 2020 of 33%. By contrast, FANG has a 66% oil cut, the highest in the group.
Diamondback shares have a lot of upside potential following the Q3 pullback. Analysts see the upside as best-in-class at 64% from the current $77.34 price. Diamondback also has a $2 billion share buyback scheme, this being 16% of issued share capital.
EOG Resources (NYSE: EOG)
In 2019, EOG, by shipping direct to the Gulf of Mexico (GOM), achieved pricing at a premium to WTI. With additional oil hitting the GOM in 2020 via new Permian takeaway, one wonders if this might slightly erode some of the GOM pricing premium. In any event, because EOG has a relatively small amount of Permian production, the company won’t benefit significantly from the Permian/GOM price lift that pure play Permian operators will get in 2020.
EOG is well positioned to grow production in 2020 by 15% based on $55 WTI. I estimate this will produce over $2 billion free cash flow assuming $6.3 billion capex.
Based on the current share price, EOG will end 2020 with an EV/EBITDA of 5.54. For a company that is excellently managed year in year out, this represents solid value.
Pioneer Natural Resources (NYSE: PXD)
Pioneer has an enormous Permian footprint, potentially owning rights to over 10 billion barrels of oil equivalent. Largely for this reason, the stock is seldom cheap and typically trades at a premium.
Pioneer has been a very well-managed company over the long term. It’s not the cheapest or most efficient operator but it is taking steps to reduce its cost base by eliminating a swathe of middle management. For the full year 2019, it will generate only about $4.27 profit per Boe. The cost-cutting measures should increase this profitability but, in terms of profitability per barrel in 2020, Pioneer is quite some distance behind EOG or FANG. Refer to the “Profitability per Barrel” metrics in the data table. On a positive note, the current weak Profitability per Boe numbers represent potential for improvement in the longer term.
On the oil-pricing front, Pioneer has been ahead of its peers in gaining exposure to GOM pricing. This has insulated Pioneer from the Permian takeaway capacity problems in 2019. By the same token, whilst most of its peers will get a substantial pricing boost in 2020 by shipping direct to the GOM via new pipelines, Pioneer will be largely unaffected by these improvements.
During the Q3’19 conference call, CEO Scott Sheffield confirmed that the company was looking at growth in the mid-teens with oil in the mid-$50s for 2020. Also confirmed was the company’s capex budget of $3.3 billion for 2020. I’ve used these same figures in the above tables.
Overall, whilst Pioneer has been a well-managed company, albeit with plenty scope to reduce costs, the stock isn’t particularly cheap. The current share price puts the EV/EBITDA valuation at almost 7 by year-end 2019. Allowing for 15% production growth in 2020, the EV/Ebitda then becomes 6.27 for year-end 2020. Not cheap.
Looking towards 2020, and following the oil sector selloff during 2019, most oil stocks represent reasonable value. All the companies listed in this exercise have genuine merit particularly as 2020 is seen as a transition year towards somewhat better times.
More aggressive investors who want to win the investment game will go with the lowest-cost, most profitable producer. Diamondback’s metrics of 15% production growth plus free cash flow with oil above WTI $45 are best in class. As a consequence of Diamondback missing Q3’19 expectations, the stock has become a top value play. Being able to buy the best company when its stock also represents top value is a rare treat.
Carpe Diem? Yes, but always within a balanced portfolio.
Disclosure: I am/we are long FANG. 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.