As the Dinosaurs Retire, the U.S. Energy Industry Is Evolving
Can you imagine JR Ewing sitting on a mat saying “Namaste”?
Most people would not associate oil executives or the energy industry with yoga. But at Hart Energy’s DUG Permian Basin conference last week, yoga sessions were offered on the agenda for the first time. Attendees got to practice their downward dog pose before learning about the latest drilling practices.
“We’ve got a bunch of old dinosaurs that are retiring,” Matthew Hembree told Bloomberg. The owner of several mineral and land companies then added, “I think our industry is evolving.”
Mr. Hembree is right—energy is evolving. And nowhere is that more apparent than in the Permian Basin.
America’s evolution into a major oil exporter
According to a report by the International Energy Agency (IEA), the U.S. is poised to overtake Russia in oil exports by 2024, and be nearly on par with Saudi Arabia. It’s a mind-boggling development. In less than a decade, growth in U.S. shale has catapulted the U.S. to the center of the global energy stage.
“These are times of extraordinary change for the oil industry,” says Fatih Birol, Executive Director of the IEA. “Everywhere we look, new actors are emerging, and certainties of past years are fading."
The IEA forecast projects the U.S. to account for about 70% of the total increase in global capacity by 2024. Other countries joining the U.S. in adding supply growth include Brazil, Iraq, Norway, UAE and Guyana. Meanwhile, Iran and Venezuela are expected to lose share.
At the epicenter of the shale boom lies the Permian Basin. Oil production in the region stretching from West Texas to Southeast New Mexico is expected to top 4 million barrels per day this month. That represents roughly one-third of total U.S. output. Much of the new supply is sourced via fracking—a technology that uses high-pressure liquids to crack rock formations deep in the earth.
According to Shale Magazine, several traits make the Permian uniquely attractive.
1. Huge territory. The Permian is so big that many folks in the industry call it “Saudi Texas.”
2. Stacked shale formations. Most major shale regions, such as the Eagle Ford and Bakken, consist of single oil and gas bearing formations. In the Permian, multiple formations are stacked on top of each other, which creates excellent cost efficiency since multiple formations can be accessed in a single wellbore. For example, a Permian well can be profitable with WTI crude at $35. Breakeven is closer to $50 in the Eagle Ford or Bakken regions.
3. Favorable politics. Most of the acreage resides in the “Lonestar State.” Texas regulators appreciate the oil and gas industry and maintain some of the most accommodative policies in the world.
One challenge the Permian faces is bottlenecks. There aren’t enough pipelines to transport all the crude from the fields to refineries and export terminals. Analysts expect new infrastructure to start alleviating that problem by the end of 2019.
In the meantime, big oil companies underexposed to the region are not hesitating to invest. Chevron recently announced a $33 billion bid to buy Anadarko Petroleum, which controls Permian drilling rights across an area twice the size of Los Angeles. The acquisition would help Chevron meet its goal to more than double production in the Permian to 900,000 barrels a day.
Exxon Mobil also plans to boost its Permian output by 80% over the next five years. Management likes the region’s risk/reward setup, estimating that returns on investment could still average 10 percent even if crude futures fell to $35 a barrel. Currently, WTI trades at $65 a barrel.
Oil’s 40% rally this year and rising M&A interest in the Permian may foreshadow a consolidation wave. At last week’s 13D Monitor Conference, hedge fund manager Keith Meister called Diamondback Energy, Concho Resources, and Pioneer Natural Resources “must own” takeover targets—saying he would be “shocked” if these were still independent companies in a few years.
Better capital discipline points to better shareholder returns
Over the last ten years, the energy sector has been a dismal relative performer. Poor investment standards by the companies are largely to blame. Many players spent at a feverish pace to expand shale operations. U.S. oil and gas production subsequently exploded. However, balance sheets became stretched as projects failed to deliver adequate returns.
Investors are more the wiser. Different metrics are now being used to evaluate U.S. exploration and production firms. Per Bloomberg:
In a recent report, analysts at Tudor, Pickering, Holt & Co., a boutique energy bank, noted investors were switching up the metrics they use to track E&P performance. Previously, the favored ones were enterprise value-to-EBITDA and net asset value, or NAV, essentially a modified discounted cash flow figure. These days, according to TPH, investors are more interested in price/earnings multiples, free cash flow and return on capital employed. The shift from NAV towards earnings or cash-based metrics, in particular, suggests a shift from a startup-like phase — grabbing land and burning cash — to a (hopefully) more mature, self-funding model.
Certain energy CEOs seem to get it.
For instance, Chevron is now generating positive free cash flow. Chairman and CEO, Michael Wirth, recently told CNBC, “It’s a good time to be Chevron. Our portfolio is stronger than it’s ever been, and you don’t have to look any further than the Permian to see that. We’re delivering strong production with low risk and disciplined spending, which leaves plenty of money to be returned to shareholders.”
In the firm’s recent Investor Day presentation, Chevron highlighted that 70% of 2019 capex is expected to deliver positive cash flow within 2 years.
Emphasis on capital discipline is a change in focus compared to a few years ago. From 2013 - 2016, many energy firms relied on friendly capital markets to fund shaky budgets. Operating cash flow was insufficient to cover dividends, stock buybacks, and capital expenditures.
A lot of firms, including Chevron, had to rely on debt. As shown in the graph below, cash flow dynamics began to improve in 2017.
Yet investor skepticism persists. Consensus is underweight energy and valuation for the sector resides near a multi-decade low. The 2016 energy debacle clearly left a lot of investors bruised and battered.
Earlier this month, analysts at JPMorgan argued that energy offers one of the best sector risk-reward setups in the market. I tend to agree. After being virtually naked the sector since 2014, I began upgrading my exposure toward the end of last year and am now modestly overweight.
Even though energy has outperformed year-to-date, the pace of gains pales in comparison to oil’s ascent. According to JPMorgan, this disparity puts the price-to-oil ratio for the exploration and production index at a record low. In other words, E&P stocks are cheaper today—relative to the underlying commodity—then during the 1990s, financial crisis, and 2016’s energy bear market.
The investing scavenger hunt is all about trying to find improving fundamentals not already discounted. Keeping that thought in mind, investors ought to give U.S. energy stocks another look.
Disclosure: I own shares of Pioneer Natural Resources and Chevron.