Now that we are over half way through earnings season for companies here in the U.S., there is an interesting trend developing amongst the hard hit energy companies. That trend is not so much in earnings figures, which are obviously abysmal on a year to year basis, but on costs. Some cost-cutting in the industry, and particularly amongst E&P companies, was inevitable and probably essential. What is interesting though is that in many cases cost-cutting has been achieved without cutting production. In fact is some cases, such as Concho Resources (CXO), production is growing at an amazing rate, even as overall costs decline.
When CXO reported on Wednesday, nobody expected a stellar story of profit with oil being around 60 percent below where it was at this time last year, but the adjusted earnings still came in positive and beat expectations. EPS of $0.38 compared to a consensus estimate of $0.28 was obviously welcome news, but that was overshadowed by the bigger picture. Operating costs per Barrel of Oil Equivalent (BoE) fell for the fifth consecutive quarter, and were down to $13.99 from $17.81 a year ago.
Figure 1: Source: Company Presentation
What is really impressive is that it comes alongside a 37 percent year on year increase in production, so it wasn’t achieved by simply closing the more expensive facilities. I guess we shouldn’t be shocked that many of these shale oil companies have fat to trim away as they have existed for a few years in an environment where increases in production were only outpaced by increases in the realized price of oil and, to a lesser extent, natural gas. In a cash rich environment such as that, waste is almost inevitable and can be readily targeted by management when things get tough.
I am using CXO as an example here, but cost reduction alongside continued expansion has been the story from other firms also. For investors, there are mixed implications of that pattern dependent upon timing, and for a stock like CXO flexibility will be the key.
Wednesday’s results from Concho have caused the stock to pop somewhat and I would have no problem with following that momentum and looking for a short term move back up to the high $120s, maybe even $130, but at some point the good news in these earnings will cause a problem.
The initial drop in oil prices was, at least in large part, about oversupply. It would normally be assumed that such a situation would correct itself, as unprofitable wells are closed and expansion plans put on hold in reaction to low prices. That is how supply & demand 101 works. That there seems to be enough fat to trim from many of these upstart fracking companies to reduce costs while continuing to expand, however, indicates that this may not be the case here. A fact which will certainly not be lost on OPEC countries who assumed that maintaining production would force closures, and who are well used to playing an extremely long game. The eventual production cuts from Saudi Arabia and other OPEC countries that many expected are looking less likely now as the response of the U.S. firms becomes clear.
In the medium term then, this pattern of cost-cutting by means other than shrinkage will have a negative effect on the price of oil. That may not push prices significantly lower depending on demand levels, but it certainly indicates a much slower recovery than many analysts are currently factoring in.
Go out even further, however, and this trend cannot be anything but good for the long term prospects of the younger U.S. companies. They will be leaner, meaner operations going forward and those with the balance sheet to survive a second downturn in prices or at least a slow, steady recovery will be better for it in the long run. I would include Concho in that category. One of the other things to come out of the earnings report was that they expect to be cash flow positive in H2 2015. Recent experience should ensure that at least a portion of that cash will be hoarded or used to pay down debt, allowing for long term viability.
The strategy here then, is fairly obvious: buying a stock like CXO now makes sense but, as the year progresses, watch OPEC and other production figures closely. If significant increases in supply persist then take a quick profit and look for a return to a price around $90. At that point shares can be accumulated for the long term at a nice average.
Of course a strategy such as this is dependent upon not just one, but three moves in the market, so has multiple chances to be derailed. If you do buy now with a sensible stop loss, however, your risk is limited and if the first part of the trade works out you will be playing with house money.
Whether you choose to play it this way, just play the short term move, or just buy and hold for the long term, one thing is clear: the ability of the larger fracking firms in the U.S. to cut costs without a big negative effect on production is pretty impressive and the long term profitability of the industry that some doubted now looks a lot more likely.