Want US Energy Independence from shale oil, and cheap gas at the pump? Don't rely on US Oil & Gas Independents.
I have been extending my 2018 financial analysis of US oil independents with significant shale from my start on the Permian Basin, into the Eagle Ford. I hope to blog on the Eagle Ford in a future blog, but right now I want to report on a finding that I found very interesting and indeed a little alarming.
I’ve now looked at the 1Q to 3Q 2018 quarterly filings of 31 companies with shale in their asset portfolio, and of those only 18 (58%) reported a profit (net income) in the three quarters with the average WTI oil price of $63/bo, and only 7 (22%) better than $10/BOE net income. As I reported in the prior blog, there are a number of factors that are commonly at work, starting with lower realizations per BOE when the gas mix is higher. Nevertheless, with 4Q prices significant lower at $55/bo, I am expecting results for that quarter to be even more disappointing.
While the math is a bit agricultural I know, I have equilibrated the average oil price in the three quarters examined with the average net income per BOE to estimate a fully levelized profit breakeven for the company. This is plotted against 4Q production, 1Q-3Q production growth, and Price/Earnings (P/E) ratio in the charts below.
Charts illustrating the profit/loss per BOE produced performance of 31 US independent oil and gas companies with significant shale production in their portfolio. The “breakeven” oil price axis in all three charts equilibrates average net income per BOE performance in 1Q to 3Q 2018 of each of the companies with the average WTI oil price of the period to estimate a price at which the companies would have been expected to make a profit. The top left hand chart plots this “breakeven” price against production rate in 3Q 2018, illustrating a handful of higher performers, who can make a profit at $60, but most are unprofitable below $55 (as at the moment). The top right hand chart plots the “breakeven” against production growth report in 2018, with the size of the bubble recording 3Q production volumes. The bottom chart plots “breakeven” against P/E ratio. (Source: Graphics are Capriole Energy, data from SEC filings, Morgan Stanley and Yahoo Finance).
The first conclusion I draw is that without either a substantial increase in price and/or performance improvements, a large majority of these companies analyzed are incapable of delivering profitable growth. For most oil price needs to be markedly better than $60/bo, for many better than $70/bo, and for some better than $80/bo to even keep them afloat!
In spite of that, Price/Earnings ratios for the most part predict healthy earnings growth, which I take to mean that the analysts for big investors are assuming both margin improvement and production growth. For sure the presentations of the companies involved are well endowed with points of production and capital cost efficiencies, together with projections of increasing margin and revenue, supported by 100s of well locations in their piece of the resource play pie. I haven’t done so, but I imagine it a reasonably easy task to put together a discounted cash flow to predict a value for the company, but the essential underlying assumption is that more wells are drilled, produce more, for less dollars invested. One problem with this is that when oil fields are drilled up, the next incremental barrel typically becomes more expensive, even with efficiencies and new technology, until eventually it doesn’t work at any price. A related issue for these companies is that their past performance just a few years ago, when oil prices were unusually high, above $100/bo, wasn’t good either. So when the price dropped in 2015 many operators in shale had no resilience and either struggled to stay afloat, or sunk into bankruptcy. Some have emerged from bankruptcy to be given another go; others managed to stay in the game with reorganization of their debt burden.
From EOG’s 3Q earnings presentation - not much free cash flow at $50/bo, but plenty “jam” at higher prices.
These points are well illustrated in a recent investor presentation by EOG Resources. I’ve respected EOG since in I led BP’s Mid-Continent, Gulf Coast and Permian businesses in the early 2000s and watched EOG make a tidy profit out of horizontal gas drilling in tight sandstones and carbonates. They are also the best performing larger company in my analysis so far - with an average $13.14/BOE net income in the first three quarters of 2018 coupled with a 16% growth of production, although to be fair to ConocoPhillips, they are a close second. That performance is mimicked in the chart above which shows a good amount of free cash flow at $60/bo and above (the average price for WTI in 1Q-3Q was $63/bo). I reiterate this is one of the best companies in terms of 2018 profit performance and growth. Another chart from the presentation posted below reveals further illustrates just how capital inefficient the first boom of shale oil drilling was in 2008-2014. EOG now point to the strategy of premium locations (sweetest spots of the remaining resource) coupled with improving capital and operating cost efficiencies, all to push the return on capital employed (ROCE) back to 10%! Look how they were doing in the early 2000s (although natural gas was highly priced at that time), returning well above 15% ROCE. But much more interesting is the plummeting of ROCE in the first shale boom, 2008 to 2014, which I interpret as very inefficient capital deployment into access and early shale drilling that created the shale phenomenon. A return to low teens ROCE in 2013-14 was only achieved at the highest prices in decades.
I am not saying that shale cannot return some profit to investors - the very best companies who do all the important things well, will lead the sector. However, I suggest that the majority who lack the foundation of profitable financial performance today, will struggle to deliver their “jam tomorrow” projections. I still believe that new processes, organization models and cultures will allow some of the better placed companies to perform, but without dramatic change, I think more companies will become unstuck. Early signals of failure will be reflected in shrinking of stock price as analysts see the cracks in the performance and forecast, and hence delisting from the exchange, as Sanchez Energy, EP Energy and Yuma Energy have been recently warned.
Somewhat ironically, the (at least short-term) savior of these strugglers could be OPEC and particularly Saudi Arabia, who are believed to want an oil price closer to $80/bo (Brent, ~$70/bo WTI) to drive the economy of their country, and are prepared to make further cuts in their production. For that to work, it will require the shale producers to realistically equilibrate their capital investment with oil price, although it appears that is proving difficult for some, who appear to be continuing to drill at low prices in the last 3 months, for other reasons such as securing leases with Pugh clauses, or trying to keep their EBIDTAX/Debt covenants below the trigger points set by lenders. If it does work, gasoline prices will be headed towards $3/gallon.
All of this underscores the need for a balanced, multi-sourced energy plan for the US and the world. All the eggs in the basket of shale oil is not a plan. For the modest investor interested in oil and gas, there are only a few sound bets for growth in my view, and I think one needs to be overall bullish on oil to want to invest in this sector.
The reader is reminded of the risks involved in investing in the stock market and particularly the oil & gas sector with the volatility in that market. Of the companies mentioned by name in this article I currently have stock only in EOG Resources.