Permian independent E&Ps: separating the wheat from the chaff
In a prior article I examined the financial performance of a group of independents that are pure Permian players. I concluded that the full-cycle returns of the companies, as measured by net income per barrel oil equivalent (BOE), illustrated the vulnerability of all of the group to oil prices less than $50/bo WTI. I proposed that the winners needed to be good at a number of things starting with accessing the best acreage at reasonable prices, through capital efficiency, operating efficiency and low corporate overburden costs. I suggested that economies of scale accessed through mergers and acquisitions might prove the difference for some companies, and that the skills of manufacturing excellence (e.g. lean, 6 sigma) could be critical to making the Permian truly a game changer.
In this follow up I have extended the analysis to include independent E&Ps that are involved in the Permian, but also are also drilling in other resource plays and often still involved in more conventional oil and gas, both in the US and internationally. The picture of overall vulnerability is emphasized with a building perspective that the “real” full-cycle breakeven is in the $50 to $60/bo range, further underlying the point made by many that breakeven costs that only allow for forward capital only are misleading.
There are a couple of pleasant surprises though. A handful of companies stand out as the top performers, and of that list of 6, four are Permian-only players. Even more surprising to me is of those four there is a range of production scales, perhaps suggesting that economies of scale aren’t needed for the very best, particularly if they have been first movers in buying leases.
Average Net income per barrel for 26 independent E&P companies that have Permian production are part of their portfolio compared to average WTI oil price for the same period. Note how profit margins have remain below $10/BOE even with rising price in 2017 and the first three quarter of 2018. (Source: image Capriole, data from SEC filings).
The first exhibit above illustrates the average performance through net income per BOE for the 26 companies reviewed. The margins over 2017 and 2018 have not been great, even with higher oil prices. As discussed in the previous articles past investments in access and drilling capex show through in DD&A, and net income is further reduced by operating costs, issues with marketing, and in some cases higher than expected corporate overhead. The recent drop in price - by about $18 from 3Q to 4Q is expected to drive most companies into the red in terms of real earnings. Some will continue to put a brave face on their performance by talking about EBIDTAX, or growing revenues, or great breakevens going forward, but these factors do not disguise overall business performance. I expect that only a few companies will post a profit for 4Q, revealing that a full-cycle breakeven is somewhere in the $50-$60/bo range. Several of the companies are already quite highly geared with debt/equity rations greater than 0.5, and a few have eye-watering debt burdens of more than 1 on that ratio. I expect further casualties if the price does not rebound in 1Q 2019.
Left hand chart plots average net income per BOE, 1Q to 3Q 2018 consolidated, for each of 26 companies with Permian and other production against production growth 1Q to 3Q. The size of the bubble is scaled to 3Q production for the company (not only Permian). Right hand chart takes the best profit margin performers in the left hand chart and plots the same net income per BOE but against Debt/Equity Ratio. The size of the bubble is the firm’s P/E ratio. Source: graphics by Capriole, data from company filings and Yahoo Finance.
The next exhibit drills down into the performance of individuals companies. The first point to reiterate is how little profit margin all these companies have been delivering in the first three quarters of 2018 and how that is very vulnerable to the price drop in 4Q. The second point that has been raised by a number of people in the last year is to point to the group of companies who are growing production, but not any profit in the process. It’s difficult to be deterministic about the motivations of these companies, but possibilities include drilling to secure leases with Pugh clauses, trying to impress people with growth, and keeping their Debt/EBIDTAX ratio below whatever covenant level they’ve agreed with their lenders. In any case, the flush of light oil to the market seems to be over-running the OPEX production cuts, and oil prices remains in the $40s.
There are a number of observations that came as some surprise to me. Firstly, of the top six companies in the analysis, firms that are both growing production and delivering the best profit margins, four are Permian-only players. I’d expected some of the bigger firms, with multiple shale businesses, to show off their prowess, skill and learning. Only EOG meets that calling, and their reputation as one of the best developers of oil and gas in the US remains intact. It’s difficult to tell how much the performance of the four Permian-only operators is aided by them being first movers and hence the cheapest access to the best spots in the basin; certainly several have been in the Permian basin for a long time. Also, to be fair, the investor presentations of the four firms carry a strong tone of “efficiency”, “manufacturing”, and so on. So these companies do appear to acknowledging and seeking to address the margin challenge.
The second surprise (at least to me) was how little profit has been made all round in 2018 despite the highest oil price in several years. This inspired me to start looking at the largest oil companies in the US and I will report more completely on “big oil” in due course, but what about Hess Corporation, a company I’ve admired for application of Lean etc in the Bakken - that firm produced 817 thousand BOE around the world in the first three quarters of 2018, and returned a net loss per BOE of 18 cents per BOE! As I reflect on that, I recall my early days in BP, a quarter of a century ago now, when planning price was $16/bo and a price in the $30s was happy days. I have to conclude that the overall cost of supply of oil, at least to producers outside of OPEC, is inexorably marching upwards. It’s taking more energy (= cost) to find, appraise and develop the next barrel, whether you’re fracking wells in west Texas, or floating in 10,000 feet of water in the Gulf of Mexico.
My analysis suggests that no-one is walking in the tall grass in the oil business, perhaps save mineral/land owners, and underscores the previous point that new technologies, processes and culture/behaviors are required to make a decent return on all this oil, and make it a mainstay of America’s energy plan.
I have no stock positions in any of the companies mentioned in this article, except for BP. I do have my eye on the top performers I have identified in the analysis, but I am nervous of the current market conditions and may wait until 4Q and annual results are posted and embedded in company valuations before acting. The reader should also be wary of these risks.