US E&P Independents: transformation required to meet the energy transition challenge
Back in January I blogged about the general lack of profitability of an analyzed group of US Exploration & Production (E&P) Independents during 2018. I found that despite elevated oil prices compared to the crash of 2015-16 only a few companies appeared capable of making a profit at oil prices (WTI) less than $55/bo. I argued, not for the first time, for more attention to be paid to processes, systems and culture to deliver transformed operational performance coupled with a more disciplined to capital deployment. Around about the same time many of the companies covered did indeed start projecting themselves as “free cash flow” focused with a capital discipline.
The 2Q results for the publicly listed companies are out, and I’ve noticed more than a few analysts and pundits commenting on the greater number of firms posting a better profit (as well as free cash flow). Yet the market has reacted with a decided “meh”!
I decided to take a look at this sector again, to examine causes for this negative or neutral reaction, to place it in the overall context of the energy transition, and test for any investing opportunities. I’ve included 35 independents in the analysis this time; I am still excluding the super-majors as quite a different sector. I’ve also looked at long term debt that the companies involved, because that may explain, at least in part, some of the concerns about the sector.
Figure 1. Profitability versus Leverage. The proxy for profitability is to subtract each companies net income per boe from the average oil price of 2Q 2019. The proxy for leverage is to divide the each company’s long term debt by balance sheet value of assets.
The first observation to confirm is that a larger number of companies are making money (= profit, net income) a oil prices that are not too different from the latter part of 2018, an average for the quarter of $58/bo. In my past analysis of the first three quarters of 2018, only 5 of the 31 firms analyzed had inferred breakevens (as per figure 1) of $55/bo or less. in 2Q 2019 the group has expanded to 20. However, it is interesting to note that less than half of the cumulative net production, totaling over 1 billion boe, is produced by the more profitable companies (figure 2) and the 7 most profitable companies only produce 5% of the total production in the quarter. This underscores the profitability of the sectors a whole is still very concerning and hence its ability to sustain let alone grow production at prices around $55/boe is highly speculative.
Figure 2: Profitability versus Share of Total Net Production.
I reaffirm my prior opinion that at a minimum there is still more to do to improve profitability of this production, with an every increase focus on operational excellence to enhance production at lower cost and disciplined deployment of new capital into the business. I still bear a deep concern that for some assets and their ownership there is just no redemption, and only very much higher oil prices will make the associated production and businesses profitable. That sort of price regime does not seem to be around the corner.
With respect to debt, there certainly is a mountain of it! The surveyed group has $128 billion between them, although the debt/assets ratio is reasonably healthy and not disparate from typically accepted levels of 0.4 to 0.6 and about half the group are below 0.3 which is best practice from a pure risk perspective (figure 1). I conclude that concerns about the ability to deleverage really come back to levels of financial performance.
Now let’s dig a little deeper into share price performance and market sentiment. To that I’ve looked at the stock price performance of the 35 companies over the last 2 years.
Figure 3: Stock price performance of the 35 companies in my analysis.
The first point is the oldest one for the oil & gas industry. Stock price performance tends to reflect confidence in oil price. So there are socks like EOG that more or less parallel oil price. But the performance of the vast majority of the 35 firms have performed much more poorly than the future oil price which is overall down 9% on two years ago. Why’s that? I offer four areas to consider.
Performance of shale assets
If the oil price crash didn’t demonstrate to enthralled investors that shale plays don’t work at sub-$50 prices, then the price fluctuations in 2018, particularly in the 4th quarter, had many more investors “wake up and smell the coffee”. Prices have been stuck in the $50s since then. In one of those “gradually then suddenly” moments, I believe the market has caught on to the basic problem that shale is hard to produce profitably at lower prices, and the majority of such assets need prices greater than $60/bo to produce decent returns. The problem is exaggerated if the company has paid through the nose for the leases, increasing debt and DD&A. Hence if one is not very bullish long term on oil, then these assets and businesses are not generating a competitive return on capital, nor offering the credible promise of same. The “jam tomorrow” story has grown old. There remain a handful of top performers, several of which have beaten both oil price and the S&P500 index. But they have the best assets (at the best price, hence lower debt, lower DD&A) and have the best investing and operational practices to deliver value.
Negative reaction to consolidation and other performance improving measures
Several industry pundits have been pointing out for some time that mergers of companies is one method to drive cost out of the operation and provide opportunities to improve performance with better quality through choice. For this to work, the deal has to have no premium, the purchase has to be for cash (stock deals only dilute investors’ equity) and new controlling management team has to have the ability to make good on consolidation opportunities. There are sadly several examples of acquisitions which didn’t have some or all of these attributes and hence bombed in the market. One example is Occidental’s acquisition of Anadarko which has now led to an activist fight by Carl Icahn. Another is Callon buying Carrizo, with their stock dropping like a rock because of perceived over-pricing of the deal and the dilution caused by the stock offer. Ironically Callon are one of the top 5 serial performers in my profitability analysis. Other measures to improve financial performance, such as reducing rig count to high-grade the capital efficiency of the new wells drilled, has of course the side-effect of reduced production growth or even decline which is a resource company’s only real way of delivering company growth.
Longer term risks to asset value
While in a large way this risk is associated with a longer term bearish outlook on oil price, it can also be associated with perceived reduction in reserves value as a result of new regulations or loss of market due to new technologies. Investor analysts value companies through NPV estimates from future cash flows associated with proven reserves “on the books” of the company. Hence if the analyst believes in a higher probability of a general lower price than today, the company’s valuation suffers. This risk is exaggerated if the today’s production already requires a higher than current price to be profitable. Similarly, if there are perceived risks to production from changes in regulation (e.g. tougher constraints on emissions or flaring), then booked value will get discounted.
ESG risks, especially those associated with climate change
The largest super-major oil and gas companies, particularly in Europe, are now responding to greater demands from institutional investors, employees and other stakeholders to respond to the risks of climate change and to engage in the energy transition. Shell, Total, BP and Equinor have been accelerating investments in renewables, new lower carbon technologies, and projects, for example Carbon Capture and Sequestration (CCS) associated with maintaining in hydrocarbon production, but in a a net zero manner. Such Environmental, Social and Governance (ESG) risks are currently less apparent in the United States, except in “green” states like California and New Mexico. The US Independents sector examined here is responding in an interesting and diverse way. At one end of the spectrum in the industry there are vocal climate change deniers who see no problem with the industry continuing as it is today. The current White House administration appears to be sided with this thought group, but the adminstration’s efforts to roll back certain environmental measures such as those associated with methane emissions control and reduction have met with a very diverse reaction from the industry. This diversity of reaction is reflected in the environmental and sustainability stances of companies in my analyzed group. I hope to do a more comprehensive review of this topic in the future but here are some preliminary observations.
At one end of the spectrum are companies that are silent or at best muted on climate change risks. This includes several of the smaller companies in the top quartile of 2Q net income per barrel performance. Continental Resources (CLR) and Parsley (PE) stand out as being bigger companies that are currently unresponsive to climate change risks.
At the other end of the spectrum is Occidental which is the only company in my analyzed group that is a member of the Oil and Gas Climate Change Initiative (OGCCI). Oxy’s leadership in this space extends through GHG emission reductions, to an investment fund, Oxy Low Carbon Ventures, focused on technologies to enable the net lower carbon production and use of hydrocarbons.
In the middle of the spectrum are two groups, both acknowledging the climate change risks associated with GHG emissions. The first group, for example WPX Energy (WPX) and Callon (CPE) are demonstrating laudable progress in emissions reduction and are transparent on emissions performance.
The other middle group are more progressive than the first. Not only are they transparent on efforts to measure and reduce emissions, they have conducted assessments of the risks associated with climate change that could affect the financial performance of their business. For example, both Diamondback (FANG) and CononoPhillips (COP) have used the EIA’s energy demand scenarios, which factor in different outlooks on policy change on emissions, to test their portfolios and businesses against financial impact.
So the first pass review suggests that the US E&P Independents are becoming far more mindful of ESG risks than perhaps I at least would have anticipated. It’s an axiom of mine that good management of risk creates opportunity and it comes as little surprise to me that the higher performing and larger shale companies like Diamondback and ConocoPhillips have plans in place to deal with climate change-related risks.
Figure 4. Diamondback explanation for sources and uses of cash in different oil price scenarios (Source: Diamondback Investor Presentation).
What does the foregoing mean for the US shale oil industry as represented by this group of 35? Is there a new dawn, or is it sunset? To answer that question I first look at the best of the crop. In a past blog I held up EOG as a role model for how to run a shale business by including their cash flow model with respect to uses of cash, capex versus return to shareholders are different oil price ranges. In Figure 4, I’ve reproduced Diamondback’s version of the same model. I regard Diamondback as one of the best shale cos, having relentlessly improved their cost structure and capital efficiency, successfully absorbed Energen into their portfolio, and now confidently depicting a “pruned growth” agenda in which they can survive at lower prices, marginally grow at mid range prices and return a lot of extra cash at high prices. Diamondback prove to me that (good) shale assets can be made to work and if I am more bullish than $55/bo in the long run, and they are attending to ESG risks, then they are a good company to own. Another possible proof of the shale pudding is the presence of ExxonMobil (as XTO) in the Permian - while it is more difficult to discern their specific Permian performance, they have been a profitable, decent yield stock for years and I wouldn’t expect them to be in something that doesn’t positively influence their business.3
Figure 5. Oil and Gas Price forecasts for various scenarios to 2050 in the EIA’s 2019 Annual Energy Outlook. Note that oil price is Brent, not WTI, which runs at a $6-$10 lower differential to Brent.
The survivability of some companies at sub-$50 prices (WTI) and the potential for better shareholder returns above $60 begs the eternal question, what is oil price going to do? In Figure 5 I’ve pasted in the scenario charts for oil and gas pricing from the EIA 2019 Energy Outlook. Note that their range is appropriately big from a low case - suck in the $40s, to a high case, growing to over $200/bo! Their reference case still shows a growing price. If this is to be believed, then stock like EOG and Diamondback are reasonable bets and shale assets of a similar quality to the ones in portfolios of the successful companies have a future in providing oil and gas to the American economy. But for the sector to thrive there needs to be an overall transformation of the industry. Not enough of the sector sufficiently profitable and resilient to price volatility. The industry does its reputation no good by being reluctant to engage in the energy transition discussion and only blots its copy book further with wasteful and environment unsound practices like excessive flaring. C-suite managers benefitting from reward schemes that don’t align to financial performance only smack of cronyism and worse. In the final section of this blog I propose a few recommendations that spring to my mind, recognizing that there a whole lot more things to do.
No more “Chapter 22s”!
The first set of recommendations are for investors, backers, board and shareholder activists.
Don’t let your dogs be your pets. If your management team has failed in running your business, then let them go, no second chance. Get a team on board that can do the job or sell the assets to a company with a good track record.
Let the current price regime sort out the wheat from the chaff. Make sure that the assets actually have the quality and potential to sustain at sub-$50 and deliver value at anything above.
Don’t throw good money after bad. If the assets aren’t up to it, write them down.
If you don’t have the wherewithal to judge competency of a management team and the quality of the assets then get somebody in who can.
Lean into defect and risk management
For management teams who retain privilege of running a business.
Spend more time addressing the defects and risks in your business. Adopt Lean and other operational excellence principles to ensure that every dollar spent returns value and every inefficiency and waste is rooted out and eliminated.
Push down accountability to the front line, but give them authority to act to improve the business within your guidance and boundaries. Test to ensure your organization is capable for this purpose.
Make every capital deployment decision robust to low oil prices - that’s some distant below $55 - and ensure that the revenue and depreciation impacts are credible. Are there opportunities to enhance current production at lower capital outlays?
Ensure mindfulness of risks that could impact your business, including ESG risks. Ensure that the high risks have real plans to mitigate them. Acknowledge the energy transition and place your strategy and business model within it.
Take pride in your company’s role in the American energy transition.
Look after the resource and the environment
Lastly, I dare to suggest some changes to the way the industry is regulated.
Stop the excessive flaring. If an operator isn’t ready to sell or re-inject the associated gas, don’t allow them to drill.
Leaking methane into the atmosphere isn’t good for anyone. Require greater transparency on emissions tracking and mitigation. Roll back the roll backs.
Look at the structure of leases and other contracts for problems that force operators into wasteful activities, such as Pugh clauses and spacing rules.
Put constraints on the ability of executives that have a history of bankruptcy to form and/or manage new companies.
Finally, revisit the lifting of US crude oil export ban.
Figure 6. EIA’s view of petroleum and other liquids production and consumption in the US.
To conclude this blog let me ask this question: does the American energy transition need a healthy US E&P Independents sector producing oil from American fields? I believe the pragmatic answer is yes. The forecasts from the EIA depicted in Figure 6 suggest to me, very approximately, that the US could meet its own petroleum liquids needs through domestic production. That would be hugely important for energy security, allowing the US to wean itself off of oil imports. Ironically, decarbonizing sectors such as transportation, which accounts for 70% of petroleum consumption, offers the dual benefits of closing the shortfall of US production to consumption and reducing emissions. To play its role the US oil industry needs to be transformed in to a lean, continuously improving margin-focused business, actively engaged in reducing its own carbon footprint, and confident of its role in the American energy transition.
The reader is reminded of the risks involved in investing in the stock market and particularly the oil & gas sector with the sustained volatility in that market. Of the companies mentioned by name in this article I am currently long on BP, Shell, Diamondback and Callon.