The ability of shale oil and gas producers to adjust to price signals relatively quickly should enable the US to take market share by responding to growing global demand for petroleum products and offsetting output declines related to aging fields and industry underinvestment.
In addition to the short-cycle nature and predictability of US shale plays (bad wells aside, dry holes don’t happen), the industry continues to refine its drilling and completion techniques and processes to drive break-even costs lower and unlock additional resources.
Every earnings season, companies in the oil-field services industry highlight emerging technologies that can help upstream operators to improve their well productivity, boost operational efficiency and reduce per-barrel production costs.
For example, Paal Kibsgaard highlighted Schlumberger’s (NYSE: SLB) recently introduced AxeBlade drill-bit, which increased the penetration rate on Matador Resources’ (NYSE: MTDR) horizontal wells in the Permian Basin by 35 percent.
The company also spotlighted its PowerDrive Orbit rotary steerable system, which sold out for the third consecutive quarter and helped Parsley Energy (NYSE: PE) to reduce its average drilling time in the Midland and Delaware Basins by 17 percent and its cost per lateral foot by about 30 percent.
Baker Hughes (NYSE: BHI) likewise touted the growing popularity of its AutoTrak rotary steerable franchise, which accounts for about 80 percent of the company’s drilling margins and significantly reduces the time needed to sink longer horizontal wells that target the formation’s most productive horizons.
Halliburton’s management team set aside time on its first-quarter earnings call to focus on the company’s efforts to improve efficiency and reduce costs by leveraging big data, machine learning and other digital technologies to automate drilling and completion processes—topics that came up repeatedly at the DUG Permian Basin Conference we attended in early April.
On Core Laboratories’ (NYSE: CLB) first-quarter earnings call, management highlighted several trends that will shape oil and gas development in coming years.
In addition to well-established trends toward longer laterals, increased proppant loads and tighter spacing between fracturing stages, management highlighted growing interest in Core Laboratories’ pioneering effort to develop techniques to enhance oil recovery from mature shale wells. The company reports that cycling miscible gases through the play can boost recovery rates from 9 percent of oil reserves to between 13 and 15 percent—a breakthrough that can increase an upstream operator’s return on investment significantly.
Instead of regarding these innovations as company-specific upside drivers, we prefer to view these advances as another sign that upstream operators will squeeze additional efficiencies out of US shale plays, lowering break-even costs and boosting productivity.
Moreover, these technological advances and operators’ improving understanding of shale geology enables the industry to unlock additional resources that can compete for capital.
Consider the revivification of the Haynesville Shale via the application of longer laterals and enhanced completion techniques or Parsley Energy’s impressive well results in the Wolfcamp C, an oil-bearing horizon that many operators had given up on after discouraging early results.
Apache Corp (NYSE: APA) also made big headlines with its discovery of the Alpine High play, which the company billed as a massive oil discovery. Thus far, the roughly 40 wells that Apache has sunk in this region have produced primarily natural gas and natural gas liquids (NGL), though the company plans to target some shallower horizons that could be prospective for crude oil.
And earlier this year, we heard rumors that the Wyoming’s oil-rich Powder River Basin had emerged as a hot property among private-equity outfits seeking to acquire, develop and flip undervalued acreage. Rig counts and well permitting in the Powder River Basin have ticked up considerably during the up-cycle, and economics continue to improve.
Chesapeake Energy Corp (NYSE: CHK) has hyped its 307,000 acres in the region as the primary driver behind its push to grow its oil output and has announced some impressive well results with oil cuts above 75 percent. EOG Resources (NYSE: EOG) and Devon Energy Corp (NYSE: DVN) also remain active in the play and hold sizable acreage positions, though both companies remain focused on developing their marquee assets in Permian Basin and other established plays.
Bottom Line: The short-cycle nature of shale plays, coupled with improving efficiency and productivity that continue to unlock more resources, should enable the US to continue to take market share in an environment where oil prices remain lower for longer. We’ve already seen this phenomenon in the current up-cycle.
Recent developments in the petrochemical market support this view. This year has brought a second wave of potential petrochemical projects that will source their feedstock from prolific shale plays—implying some confidence among operators in Europe and the Middle East that US output will continue to grow and that NGL prices will remain attractive over the long haul.
A joint venture between Exxon Mobil Corp (NYSE: XOM) and Saudi Basic Industries Corp, for example, continues to explore the feasibility of siting a world-scale ethane cracker on the Texas Gulf Coast, while Dow Chemical (NYSE: DOW) plans to expand its Freeport ethylene plant’s capacity by 500,000 metric tons by 2020.
Total (Paris: FP, NYSE: TOT) also has a joint venture with Borealis and Nova Chemical—companies in which Abu Dhabi’s IPIC sovereign wealth fund owns at least a majority interest—to build an ethane cracker in Port Arthur, Texas.
Switzerland-based petrochemical outfit INEOS last week announced plans to build a world-scale propane dehydrogenation unit, likely in Antwerp, that will have a nameplate capacity of 750,000 metric tons and will run propane imported from the US. The company also aims to expand its ethylene production facilities in Grangemouth, Scotland, and Rafnes, Norway—both of which source their ethane feedstock from US exports.
The announcement of these projects came on the heels of a May 2017 press release highlighting INEOS’ plans to build a massive butane storage facility in Antwerp that will supply its petrochemical operations in Koln, Germany, with inexpensive feedstock imported from the US.
Despite US shale plays’ long-term promise, investors must remember that oil prices (and the capital markets) will impose a speed limit on this process, resulting in shorter cycles than in the past.
During first-quarter earnings season, many US exploration and production companies indicated that they would stick to their drilling, completion and capital spending plans—often weighted toward the back half of the year—if oil prices ranged between $45 and $55 per barrel. Some management teams indicated that they would moderate these development plans if oil prices tumbled below this level.
In this intensely competitive environment, shale basins within the US onshore market will also jockey for market share, with the lowest-cost areas offering the best potential for volumetric growth.
Although all the major shale plays feature their sweet spots and marginal acreage, much of the asset acquisitions and drilling activity during the recent up-cycle have centered on the Permian Basin and central Oklahoma’s emerging STACK play.
The reservoir rocks in both areas include exposure to multiple oil-bearing formations, enabling producers to extract hydrocarbons from the same infrastructure—potentially a major source of cost savings and a huge competitive advantage.
For example, during Occidental Petroleum Corp’s (NYSE: OXY) first-quarter earnings call, the company’s president of domestic oil and gas asserted that the company would realize a more than $10 per barrel reduction in its break-even costs on wells targeting secondary benches at its Greater Sand Dunes play in New Mexico.
At the Energy Information Administration’s annual energy conference, Scott Sheffield, CEO of Pioneer Natural Resources (NYSE: PXD), asserted that break-even costs in the Delaware Basin could be as low as $25 per barrel.
These opportunities help to explain the frenzy for exploration and production companies to add exposure to the Delaware Basin, an area where blocky acreage packages conducive to drilling longer laterals are easier to come by than in the Midland Basin.
In our view, EOG Resources’ (NYSE: EOG) $2.5 billion acquisition of Yates Petroleum in fall 2016 stands out on the list of deals involving assets in the Delaware Basin. An early entrant to many of the leading shale plays, EOG Resources boasts some of the lowest-cost core acreage in the Bakken Shale and Eagle Ford Shale; the company’s big splash in the Delaware Basin says a lot about the quality of the resource base and the opportunity set.
This urgency also extended to the midstream segment, where Plains All-American Pipeline LP (NYSE: PAA) and NuStar Energy LP (NYSE: NS) earlier this year purchased expensive gathering systems in the Permian Basin.
Given the equity issued to fund these transactions and the elevated yields at which these stocks traded, these deals won’t alleviate the near-term risk to either master limited partnership’s (MLP) distribution or the challenges posed by impending debt maturities. These desperate moves underscore the potential for the Delaware and Midland Basins to take market share in an environment where oil prices remain lower for longer.
The elevated multiples associated with these transactions in part reflect the quality of the counterparties and expectations for output growth.
Concho Resources (NYSE: CXO) is the anchor shipper on the Alpha Connector system that Plains All-American Pipeline paid $1.2 billion to purchase, while Parsley Energy is one of the main customers for NuStar Energy’s newly acquired Navigator system in the Midland Basin. In addition to the volumetric upside on the gathering systems themselves, this throughput should feed some of the MLPs’ other assets.
In this environment, we prefer midstream names that offer the best leverage to volumetric growth stories and have the balance sheet strength to pursue joint ventures with cash-strapped rivals.
Not only do these MLPs pay generous yields that can improve your total return during periods of volatility, but the most recent down-cycle also prompted many midstream operators to take the necessary steps to put themselves on a more sustainable path by cutting their distributions and paying down debt.
Investor sentiment toward MLPs remains weak, reflecting concerns about oil prices and the reputational damage inflicted when blue-chips like Energy Transfer Partners LP (NYSE: ETP), Kinder Morgan (NYSE: KMI), Plains All-American Pipeline LP (NYSE: PAA) and Williams Partners LP (NYSE: WPZ) slashed their payouts.
But MLPs’ recent underperformance, above-average yields, and leverage to US shale oil and gas producers taking market share make for a compelling risk-reward proposition for patient investors. These qualities make our favorite MLPs excellent buys during periods of volatility in the energy market.
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Elliott and Roger on May. 31, 2018
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