The U.S. Energy Industry has defied past norms where declines in drilling and completion activity would quickly result in lower production. Technology has turned that paradigm on its head in recent years. Extended reach laterals, optimizing well spacing, and increasing the Completion Intensity-frac stages per foot, upping sand and water concentrations per foot, have enabled this result. In the most recent Energy Information Agency-Drilling Productivity Report-DPR, the tally is in, once again we have a “bumper crop” in the U.S. oil patch.
One effect of this bounty has been to boost crude inventories as much as 35 mm barrels from seasonal lows, at a time when refineries are doing annual maintenance, and questions about U.S. and international economic growth are increasing. This has helped to put a drag on the pricing of the two key crude baskets, West Texas Intermediate-WTI, and Brent since November, of 2023, taking them down about $10 per barrel, respectively.
As you might expect, 2023 was a brutal year for the valuations of U.S. and Canadian upstream exploration and producing companies-E&P’s, with the stocks of many of 2022’s standout performers, dropping 20, 30, and even 40% from their highs. Lower prices for WTI, particularly in Q-4 of last year have caused analysts to lower EPS and cash flow projections for these companies. Investors who quickly became used to enhanced shareholder returns in the form of spectacular dividends and stock buybacks, have deserted E&P stocks in droves.
As an example, one former high-flyer, Devon Energy, (NYSE:DVN) is trading in the low $40’s, down from $75 in November of 2022, a nearly 47% decline, far out of proportion to the commodities that underpin its value. Of course, in that time, WTI and natural gas have fallen from the low $90s and nearly $8.00 to the low $70s and low $2s, respectively. Devon is still running a solid business and trades at a solid, but perhaps uninspiring free cash yield of ~9.0%. If you dig deeper, you will find their Return on Capital Employed-ROCE to be a very respectable ~24%. Right now, investors just don’t care about any of that and have focused only on the lower Q-4 EPS forecast of $1.40 per share, a decline of about 9% from Q-3’s EPS beat of $1.65. The stock has been pummeled ~18% in that time.
Drilling activity has been on the decline since the end of 2022, as companies have shifted capital allocations to maintaining production at current levels, paying down debt, and funneling cash to shareholders. Since peaking post-COVID at ~780 rigs in late 2022, by the middle of 2023, the U.S. rig count had declined to ~621, where it essentially remains today. Rigs drilling for gas have dropped at a proportionately higher rate than rigs targeting oil.
As previously noted, thus far, the decline in shale activity hasn’t adversely impacted production, but obviously, this can’t go on forever if output is to be maintained. A point Vicki Hollub, CEO of Occidental Petroleum, (NYSE:OXY) noted in recent sideline remarks at Davos this week. Hollub was quoted as saying, “In the near term, the markets are not balanced; supply, demand is not balanced,” adding that: "2025 and beyond is when the world is going to be short of oil".
The EIA graphic below puts Hollub’s comments into context. The data isn’t in for 2023 yet, but there is little doubt that when the EIA updates this graphic, proved reserves will take another year-over-year dip. With the declines in activity over the last couple of years, conceptually, this could be a big dip. One that could shock the market out of its current complacency regarding crude supplies.
Several years ago, I published an article on OilPrice suggesting that years of under-investment would lead to shortages in the future. If Hollub is correct, the future of tighter oil and gas supplies could be just around the corner.
It is clear that E&P operators are not generating sufficient returns at current prices to do much more than maintain flat capital programs, improve their balance sheets, and pacify shareholders with share count reductions and juicy dividends. What will it take to get them to begin reinvesting in their businesses, and perhaps flatten the curve?
For some high-level indications, we can turn to the Kansas City Fed. The Kansas City Fed’s 10th District, which covers the states of Colorado, Kansas, Nebraska, Oklahoma, and Wyoming; 43 counties in western Missouri; and 14 counties in northern New Mexico, conducts a quarterly survey of oil and gas operators.
In the survey, a group of oil and gas operators working in the district were queried on a couple of key points. The first question for oil and gas was, “What oil and natural gas prices were needed on average for drilling to be profitable across the fields in which they are active?” To run a profitable operation, the firms participating in the survey replied with a threshold price of $64 for WTI.
The next question in the survey asked, “What prices were needed for a substantial increase in drilling to occur across the fields in which they are active?” Here the respondents came back with $84, a price they didn’t expect until 2025-6.
Those drilling for gas told the survey that Henry Hub pricing of $3.12 was to make an acceptable return, and for a substantial increase in activity, a price of $4.04 was needed. Operators were a little more dour in their outlook seeking a price they didn’t really expect to occur in the next 5-years.
Oil and gas firms have adjusted their capital allocation plans to a maintenance mode for 2024, driven by prices that, in the case of oil, make them profitable, but not at the levels that justify increasing capex for E&P activities. In the case of gas, companies focusing on that commodity, are not getting returns that provide free cash and are reducing activity to minimize losses.
In order for an inflection point to occur that reignites capital allocation for new drilling, substantially better pricing is needed. As long as production from shale is increasing or nearing a balance point, the market will continue to discount WTI and Brent.
The good news for investors in E&P companies is there is some light at the end of this tunnel, and in a year or two hence, a price signal could be sent that tells the industry to begin expansion once again. When this occurs, revenues and cash flow will increase, sending share prices higher. Potentially much higher.
By David Messler for Oilprice.com
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