The challenge facing US shale companies as oil prices recover: Produce more crude or more cash?
As oil prices recover from the lows of 2014, US shale producers face a choice: continue to invest in record production or start returning cash to investors who helped them weather the downturn.
It used to be that investors rewarded US upstream operators that could quickly grow production. More crude output growth per quarter separated oil patch E&P champions from the rest of the pack. That paradigm came under pressure starting in 2014, when prices plunged and common wisdom said producers would curb output and ride out the storm.
But nimble US shale companies surprised everyone, finding ways to slash costs, drill more efficient wells, and pour cash back into drilling and production.
Onshore producers have added nearly 4 million b/d of production since 2011. Their innovations pushed US production over the 10 million b/d mark in November for the first time since 1970—earlier that the US Energy Information Administration had expected.
And even as their wells turned out higher outputs, their profits went back into drilling and production growth. Overall, they were not generating free cash flow for shareholders, who in recent months have sent a strong message to oil executives that they want to see more of it.
Free cash flow is cash a company generates after expenses required to maintain or expand an asset base. During much of 2015-2016, company executives talked about getting to “cash flow neutral” — a state where cash generated matched expenses. Now, the goal is to turn out excess cash and use it for purposes besides production growth.
While oil companies want to keep investors happy, they are still talking about production growth — or at least they were during the third quarter, Trisha Curtis, co-founder of energy analytics and advisory firm PetroNerds, said.
“From banks and the investor community, it sounds like the pressure has been more intense between the third quarter and what we’ll see in fourth-quarter calls,” Curtis said. “I still don’t think that means producers will forego production volumes [since] most talked about increasing output” in 2018.
FREE CASH FLOW MORE LIKELY IN 2018
Most companies will likely not be free cash flow positive until at least mid-2018, she said, citing recent oil company commentary.
Some companies may not reach that status until even later.
“Second-half 2017 saw plenty of disclosure from producers suggesting the status quo was no longer acceptable and that a more measured and value-conscious approach to corporate strategies is warranted,” Evercore ISI analyst Stephen Richardson said in a recent investor note.
Producers in their upcoming quarterly calls on 2018 outlook “should provide some tangible evidence of restraint,” Richardson said. “Capital budgets based on oil prices below the forward curve is a good place to start.”
Oil companies appear to have gotten the message. The challenge lies in resisting the temptation of going off the rails on production growth even as tempting WTI prices beckon them to spend more and enjoy the advantage of long-awaited current oil price levels.
Mizuho analyst Tim Rezvan expects upstream company rhetoric around shareholder returns will lead to at least some increased focus on return on capital employed from here on. But “the higher oil prices go, the harder it will be to ignore the incentive to grow production,” he said in a recent investor note.
COMPANY STRATEGIES VARY
Mark Papa, the highly respected CEO of recent start-up Centennial Resource Development and former long-time EOG Resources CEO has a contrarian view. He said during his company’s Q3 call that dwindling Tier 1 acreage meant that big plays like the Bakken Shale in North Dakota and Montana and the Eagle Ford Shale in South Texas are no longer the growth engines they once were.
The plays ramped up relatively quickly several years ago when they were new to horizontal drilling. For example, oil production from the Eagle Ford Shale, which is currently 1.34 million b/d, had averaged 1.72 million b/d in March 2015, up from 178,000 b/d in March 2011. And in the Williston Basin, where the bulk of production is from the Bakken, oil output hit 1.28 million b/d in mid-2015, up from 232,000 b/d in mid-2008. Oil production there is currently 1.2 million b/d. Output figures are supplied by S&P Global Platts Analytics.
As a result, “the resulting production growth that you are going to see from current levels in those assets, I predict, is going to be disappointingly low,” Papa said.
Permian Basin presence appears to make a difference in how companies see growth potential, since the prolific West Texas/Southeast New Mexico Basin with its multiple stacked plays still appears to be in its early stages, with some zones still largely untapped.
The Permian is the most active US producing basin with well over 400 drilling rigs running, according to Baker Hughes.
For example, three prominent public oil companies — Marathon Oil, Oasis Petroleum and Halcon Resources — debuted in the basin last year. Marathon rounded out its suite of three other large oil plays in the Bakken, Eagle Ford and Oklahoma into a quartet, while Oasis wanted more upside to offset its aging Bakken production. Halcon, also a Bakken player, needed to change its direction.
“Having Permian in your name is like having blockchain in your name,” Ben Tsocanos, a director for S&P Global Ratings, said. “It’s worth 20% [premium to a company’s stock price] to just have that asset in your portfolio.”
THE PERMIAN TEMPTATION
But as new Permian entrants, the companies naturally want to build up the asset.
Take Oasis, for example. The company’s nearly $1 billion entry into the Permian took Wall Street by surprise when it was announced in early December 2017.
Founded in 2007, Oasis early on focused its attention in the Bakken. Owing to that play’s remoteness and relative high transport costs, Oasis took a beating in the downturn.
For company CEO Tommy Nusz, the Delaware Basin in the Permian is the company’s new growth region.
The company expects to grow production 15% in 2018 while generating positive free cash flow in its upstream business.
“We’ve got an opportunity [in the Permian] … to really be resilient to low oil prices,” Nusz said during a call on its Permian entry.
Hedges can help cash generation by locking in prices and providing assured revenue levels. But companies that eagerly hedged as oil prices moved in late 2017 above the $50/b level where they were largely stuck for the last few years, failed to capture the upside as oil pushed through $60/b this year.
Curtis pointed out that every company’s set of assets is different and each asset is at a different development stage. Consequently, it is difficult to judge when a company will get to free cash flow.
“What matters are that companies are doing what they say they’ll do,” she said. “You may see the ones that can’t do it, may get swallowed up.”