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Oil Investment Opportunity - Shale Baby, Shale!

|Includes: Callon Petroleum Co. (CPE), NBL, PE, PXD, XOM

This is a follow-up to"Oil Investment Opportunity - Introduction"

  • The Saudi Aramco IPO is likely to occur in 2018 or early 2019.
  • Investor optimism towards oil is assured at that time.
  • Ahead of that event, investors can make big profit via shale.
  • For best gains, seek aggressive long-term growth stocks.

The Saudi Aramco IPO must take place against a background of an improving oil market and reasonable investor optimism with oil prices that are not so high as to induce fears of another bust and not so low so as to keep investors away.

In 2014, the market viewed Canadian oil sands, US shale and ultra deep water exploration as expensive sources of oil and they were destined to fail under OPEC's move to maintain market share by pumping freely and drowning high cost producers in cheap oil. Fast forward to 2017. An impressive combination of lower costs, efficient pad drilling, high grading acreage, and much improved well design and fraccing methodologies has enabled shale to win induction to the low cost hall of fame. Consequently, shale is now being welcomed as an accepted part of the global oil solution. Refer Daniel Yergin interview of January 18, 2017.

Comments from the EIA on January 31, 2017 express similar views: Major U.S. tight oil-producing states expected to drive production gains through 2018.

The 2016 OPEC Production Cut Deal bridges the oil market between a weak winter 2016 period and a noticeably healthier 2017 market. Over subsequent years, with a dearth of conventional oil discoveries and budgets for conventional oil exploration curtailed, and with demand continuing to grow, the scene is set for oil prices to move a touch higher.

There is even emerging talk that the ongoing cuts to exploration budgets might lead to a supply crunch, possibly as soon as 2020.

Regardless, with demand currently increasing at over 1 million b/day annually and conventional supplies requiring years to be brought on line, the door is open for fast-moving low-cost producers to increase production. Enter US shale.

It is already widely understood that the Permian Basin of West Texas and into New Mexico is the shale play of choice. This Reuters article dated 1 February, 2017, outlines some of its main advantages. Note comments such as;

"the Permian reflects the simple math of profitability and a complex set of geographic advantages and technological advances that make it cheaper to drill here than in other major U.S. oil regions."

Oil was discovered in the Permian Basin in 1920 and to date it has produced almost 30 billion barrels of oil and 75 trillion cubic feet of gas. It contains multiple strata of oil bearing rock, the number of which and thickness thereof varies across the basin but many operators have oil bearing targets that are over 3,000 feet thick and occasionally over 4,000 feet thick. This compares to a few hundred feet of oil bearing strata in Eagle Ford and less in the Bakken. In many instances the Permian oil bearing zones may be more than 10 times, or 20-30 times in some cases, the thickness of other comparable formations in the US. Put another way, a company that owns 100,000 acres of Permian acreage can be equivalent to a company owning something like 500,000 to 1,000,000 acres in most other shale plays, except that the Permian acreage would normally be more profitable.

More maps and info here from Shaleexperts.com

As you can see from the foregoing map, the main sub-basins of the Permian are the Midland Basin to the east, the Delaware Basin to the west and the Central Platform in the middle.

According to the United States Geological Survey (USGS), the largest single formation on its own in just the Midland basin, the Wolfcamp, is estimated to contain 20 billion barrels of technically recoverable oil and 16 trillion cubic feet of gas. Even larger figures have been bandied about. In 2014, Pioneer Resources (NYSE: PXD), stated in a presentation (see above exhibit) that the main oil bearing formations in the Midland Basin - again excluding the Delaware Basin and the Central Platform - held 75 billion barrels of recoverable oil equivalent. Add in the Delaware Basin and you get what? Who knows, just enormous numbers. For sure, the recoverable numbers will be lower when one addresses the question of what is economically viable at $50 WTI as opposed to what is technically recoverable. Regardless, the Permian Basin is a potentially giant hydrocarbon resource on a world scale. Given its enormity and favourable economics, little wonder it has recently featured in so many M&A deals.

A picture tells a thousand words and, whilst $50-$55 oil is good for most US shale companies, this picture underscores the stunning advantage that operators focused on the Permian have over others; 4x growth at $50 oil versus 20% growth at $55 oil. No contest.

There are three other important points that need be made about the Permian:

1. As conventional drilling has existed in the Permian for decades, infrastructure, take-away capacity, support services and expertise is either in place or readily available. Similarly, there is invaluable seismic data spanning many decades.

2. From an exploitation point of view the shale party has been relatively recent in arriving at the Permian basin, particularly in the western part, the Delaware Basin. This suggests that, compared to other more developed shale plays, there may be more upside improvements in the performance of Permian wells as the process of improving the knowledge base and 'cracking the code' continues.

3.Western Texas is sparsely populated. Hence, draconian regulatory and environment issues stemming from proximity to urban settlements, or associated legal activity, are all less likely to occur. This is an important consideration over the longer-term as Government administrations modulate from one pole to another.

For investors, a key to unlocking excellent stock gains is to focus on E&P companies who are concentrating their activities in the Permian and who have already targeted aggressive oil production growth. Remember, Permian companies don't need higher oil prices to achieve strong growth, they're doing it now with $50 oil.

Stock prices run hard in the early part of an up-cycle. Today the market is skittish but in the next 2 years the oil supply overhang will disappear, oil prices will improve and confidence will return. The Saudi-Aramco IPO is a major catalyst - the IPO won't occur without the market being confident and I would use that event as a potential date for cashing out some gains.

The Saudi Aramco IPO is set to occur in 2018 or early 2019.

For shale producers that show continued aggressive growth into 2019 this will already begin to support company valuations and stock prices in 2018.

The market is a forward pricing mechanism.

The great majority of potential stock price gains expected between now and the IPO will likely be realized over the next ~12 months as investros focus ahead.

Working out detailed valuations with respect to earnings and EBITDA going out 2-3 years into the future, at a time when many well design and performance improvements are happening and when prices are changing, is a tough ask, or impossible, and results in spurious accuracy. At such junctures an investor would be better advised to take comfort in a Warren Buffet style back-of-envelope calculation that will result in a valuation that is ball-park correct. Get the big picture correct and don't sweat the small stuff.

M&A Activity

Here's a look at some shale M&A activity from December 2016 to February 2017:

  • December 2016; Callon Petroleum (NYSE: CPE) paid $615 million to buy 16,500 acres in the Delaware Basin including 2,000 Boe/day production, 71% oil. Refer Richard Zeits article where he calculates the value as ~$40,000 per undeveloped acre.
  • January 2017; Noble Energy (NYSE: NBL) paid $3.2 billion to buy 71,000 acres in the Delaware Basin including 10,000 Boe/day production and mid stream assets. Refer Richard Zeits article, he estimates the value per undeveloped acre at $35,000 to $40,000.
  • January 2017; Exxon Mobil (NYSE: XOM) paid $6 billion for 250,000 acres mostly in the Delaware Basin including 18,000 boe/day production, 70% liquids and also mid stream assets. Refer Richard Zeits article, he estimates the net price per undeveloped acres is $23,000 to $25,000. He does point out, however, that the best, most oily and most sought after parts of the Delaware lie further south and hence they enjoy a justified price differential.
  • February 2017; Parsley Energy (NYSE: PE) is paying ~$2.8 billion to acquire 71,000 acres in the Midland Basin including 3,600 Boe/day production. The estimated cost per undeveloped net acre is about $38,000.

During 'normal' times, shale oil companies typically sell for $50,000 or even $60,000 per flowing barrel of oil production plus a certain valuation for undeveloped acreage depending on a multitude of factors such as quality and depth of oil bearing rock, estimated locations, EURs, oil cut, non-oil production and so on.

Value per flowing barrel

The above M&A transactions incorporate a value of about $30,000 to $35,000 per flowing barrel. This is understandable given that we are in a low price oil environment. However, as confidence improves, valuations per flowing barrel should move back towards $50,000. When looking forward to 2018 and 2019, I use $50,000 per flowing barrel figure.

Value per undeveloped acre

Based on recent transactions, when valuing Permian undeveloped acreage, I use $40,000 at the top range, $25,000 for less oily acreage and $30,000 for in-between land.

So, the back-of-envelope valuation methodology is: Make an estimate of 2019 production, give it a $50k/bbl price tag, add it to the land valuation = Total 2019 EV. Work back to share cap and equivalent share price, and compare to today's share price. Tweak workings according to special circumstances.

Caveat: As can be readily gauged from the map shown above the acreage of particular E&P companies can vary greatly in value depending on which oil bearing formations lies beneath. Similarly, the Gas/Oil ratio (GOR) varies and formations are not located at uniform depths across the basin. These features, allied to companies having acreage that is Core, or Tier 1 etc makes it difficult to do a neat comparison from one company to the next. Accordingly, please treat the comparisons done with great care and I would stress the importance of investors doing their own in-depth due diligence.

These are big picture calculations with no frills. Conveniently overlooked is the fact that significant increases in production in the next 2-3 years will be driven by increased drilling which means that the amount of "undeveloped" acreage will diminish. As a counter balance I omit any valuation for proved reserves or infrastructure and mid-stream assets.

For the most part growth is assumed to be within cash flow, or at least will be after the first year or so. In this way the EV calculations going forward do not require to be adjusted for growth in borrowings.

I intend to follow up this article with articles highlighting specific examples of Permian shale stocks where I see potential for outsized gains over the next year or two.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation but rather a description of how the author takes a long-term view of industries and companies and the data presented is illustrative by nature. As such the views and data is subject to change. The author strongly urges that potential investors undertake comprehensive research on their own. Any liability that may arise from use of this material is explicitly disclaimed.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VARIOUS OIL COMPANIES over the next 72 hours.