It’s been a long dry spell in the Permian. Shale drilling and completions activity has collapsed to levels not seen since before 2000 (as far back as records are kept). That was the year shale activity first began to pick up from essentially nil and hit all-time peaks in 2008. With occasional ebbs and flows, it had gradually drifted down to the start of the current calamity, where active rigs stood at a somewhat healthy 805 rigs turning to the right.
Fracking has also taken a commensurate dive over the last eight months, defying the conventional wisdom that as prices began to improve, activity would increase. It hasn’t happened in either case. Why?
Driven by low prices not seen much in modern history, formerly high-flying shale drillers like Chesapeake Energy have gone bankrupt. The service providers who do the actual work like Halliburton, (NYSE:HAL), Schlumberger, (NYSE:SLB) have written off tens of billions worth of fracking-related equipment, closed facilities and laid off thousands of workers.
Much of the expansion from 2016 onward was fueled by growth at any cost mindset in the drillers, and aided by bankers willing to accept ever-increasing estimates for the value of reserves. In 2018 much of that laissez-faire mentality in the boardrooms of the drillers and in the vaults of the bankers came to an abrupt halt as profits and cash flow were demanded. That was the moment shale activity began to falter numerically, while at the same time, a miracle was taking place. Production grew from advances in technology and a deeper understanding of key reservoirs to record levels.
Peaking at nearly 13 mm BOE in March of this year, a failure of OPEC+ nations to agree on production cuts that same month, led oil to begin a precipitous decline in price.
A decline that was soon matched in production as drillers laid down rigs, and then in April took the unprecedented step of actually shutting-in wells with the single-minded goal of forcing prices higher. With a little help from the OPEC+, which after realizing the enormity of their mistake in March, also voluntarily shut-in wells with the same goal in mind, prices responded.
But drilling and completion activity hasn’t rebounded, and it’s not going to do so. At least in the most likely pricing scenario being forecast, where WTI stays in the mid-$40’s to a high of around $50. It should be noted that there are alternate scenarios out there. I covered one in an OilPrice article last week, where I laid out a case for WTI rising to over $100/bbl by early next year.
One thing that will limit the rebound, is the capacity simply is not there from a service and supply standpoint. Halliburton CEO, Jeff Miller commented on the prospects for a recovery in activity in their recent quarterly investor conference call-
‘We do not anticipate large technology recapitalization programs similar to the build-out of our leading Q10 pumps and the iCruise drilling systems. And finally, the North American business now has structurally lower capital requirements. It is a mature market, and frac job intensity is plateauing. The Halliburton I have just described to you is charting a fundamentally different course.
The growth in digital technologies, the position of strength in the international markets, the sharper approach to North America and a lower capex profile, all of that comes from the hard work that we’ve been doing over the last few years. We are not waiting for an upcycle to drive significant free cash flow and returns for our shareholders. We believe that the strategic actions we are taking today will further boost our earnings power and free cash flow generation ability as we power into and win the eventual recovery.”
Miller is telling us that the oilfield of the future will be a smaller, less capital intensive place than in times past.
Further, there is a lack of will in many of the key shale drillers, who are determined to repair their balance sheets, and reward long-suffering shareholders with dividends. Going forward many are basing their economics on $35 oil, or less.
In this article we will take a look at the second half plans for a couple of the largest shale drillers and how this will impact the level of shale production over the next half year.
The look-ahead for the Permian
Occidental Petroleum, (NYSE:OXY) is the largest producer in the Permian, with daily production of nearly half a million barrels. Its ill-fated acquisition last year of Anadarko, a deal whose timing could simply not have been worse, has led this oil-giant to the brink of bankruptcy. In its quarterly call this month where they took a $6.6 bn asset write-down, management outlined a vision for its future in the Permian that is vastly different from the one they promised investors when the Anadarko deal was struck. OXY shares have lost 65% of their value in 2020, primarily due to the debt, ~$38 bn they took on when Anadarko was acquired.
Vicki Hollub, OXY’s CEO commented in the call-
“We do not intend to grow production until we have significantly reduced debt and we view the long-term price of WTI to be sustainable at higher levels than where the current curve indicates. In any eventual growth scenario, we expect that annual production growth will be less than the 5% per year that we had previously stated.”
Instead OXY will merely look to sustain the decline of its shale portfolio to less than 25% YoY. For reference in early 2019 Anadarko was running 12 rigs in the Permian, and the old OXY was running 10. For the rest of 2020 they will have one-net rig, and allow daily production to decline to 1.3 mm BOEPD for the whole company, and to ~435K BOEPD for Permian Resources, their primary shale drilling sub-entity.
You will note in the slide above that capex for growth will not come until debt has been substantially reduced, and shareholder dividends have been restored.
On the plus side OXY has received an analyst upgrade based on valuation from JP Morgan’s Phil Gresh. He commented in a review of OXY-
“Given the magnitude of underperformance, the de-risking of the maturity wall and the recent stability in the oil price. Significant oil price torque in either direction remains the key to the stock’s performance.”
In summary, the future is uncertain for OXY. In order for them to survive two things must happen. Oil prices must rise, and they must push back debt maturities that are insurmountable with projected cash flow. They seem to be having success in both cases with oil prices rising, and have recently rescheduled near term debt maturities.
Now let’s look at another Permian focused driller, Parsley Energy, (NYSE:PE).
Through a combination of capital restraint and cost-cutting this Permian player has sought to secure its survival. It notably shut-in production early to prod other shale drillers to do the same. As previously noted this gambit has been successful in large measure, and recently the company restored the shut-in barrels.
After a complete drilling shut down in the second quarter, Ryan Dalton, Parsley Energy’s CFO commented about activity through the rest of the year-
“We plan to run a maximum of 11 rigs and 3 to 4 frac spreads, through the balance of the year. As implied by our tightened budget range, our quarterly capex spending will step down from second-quarter levels in the back half of the year. “
In the second half of 2020, Parsley will look to maintain, and not grow production while increasing capital efficiency through technological improvement. Parsley is also generating significant free cash flow (FCF), at WTI prices above $35/bbl. The estimate for FCF in 2020 is ~$350 MM. On a Price to Cash Flow (P/CF) basis, PE is undervalued with a multiple of 13.5. That compares favorably with OXY’s P/CF of 15.6. PE has also recently raised their dividend where OXY has slashed theirs to $0.01 for the current quarter.
As I discussed in my prior article on the direction oil prices might take the expectation is that they will continue their upward trajectory. This is based on an emerging gap between daily production and increasing demand. I did some arithmetic on this calculation in the linked article. Readers should have a look if they are interested in the numbers.
For the rest of this year the expectation is from a lack of new drilling and completion activity, production from U.S. shale will continue to decline. Many more shale drillers have outlooks similar to the companies covered in this article.
My year-end exit forecast for U.S. shale is ~5 mm BOEPD.
Note-For those who are interested in testing the waters with an investment in OXY or PE, should look carefully before they take the plunge as there are inherent risks in both. That said, valuations are attractive for both companies at the present time, and the stock prices for both should continue to rise with oil during the coming months.