Visitor Post courtesy of blissful Sentieo shopper and power skilled Philip Dunham. Initially posted here on February 9.
2016 was a risky year for oil and fuel. WTI traded to lows within the mid $20s, then rebounded to finish the 12 months round $54. The street to recovery for the power industry in 2017 will be characterized as cautiously optimistic as WTI prices have stabilized over the previous couple of weeks and energy companies have started to slowly hire and ramp activity.
There were a lot of themes that emerged as the yr progressed including:
Rebounding rig counts and the return of service value inflation
The Dallas Fed and Permian-focused E&Ps expressing considerations over rich Permian Basin acreage valuations
Another year of low oil prices and OPEC production cuts
The RINsanity of ethanol mixing and a possible border adjustment tax
Natural gasoline coming out from the shadow of oil with demand catching up to produce
We are going to overview the themes of 2016 and those themes going ahead into 2017.
Oil Field Service Value Inflation
After the rig rely recovery of 2016 and stabilization of oil prices, it is evident that the North American land market has clearly turned the corner. For the oilfield services sector, 2015-2016 was dominated by cost deflation as drillers dramatically lowered exercise. Essentially the most resilient E&Ps that have been ready to maintain some level of drilling exercise have been in a position to push OFS providers for prices reductions to deliver down their financial breakevens.
Now that North American onshore has turned the corner and activity is rising, we want to monitor for service value inflation, either from supplies like proppant or labor. With a relatively tight labor market and unemployment rate of 4.70%, other industries like construction are competing for the same labor pool. The next couple quarters should start to reveal whether or not value inflation is beginning to chew and what kind of pricing energy OFS companies have in early levels of the upswing.
With Sentieo’s Doc Search you may set up key phrase searches to watch this. A seek for “cost inflation OR worth enhance” filtered by sector and only transcripts has started to return situations of those key phrases on Q4 earnings calls:
As the upcycle begins, growth in E&P investments shall be led by the North America land operators who appear to remain unconstrained by years of destructive free cash flow, as exterior funding seems more readily out there and the pursuit of shorter-term fairness value takes precedence over full-cycle return. E&P spending surveys at the moment indicate that 2017 North America E&P investments will increase by around 30% led by the Permian Basin, which ought to lead to both greater exercise and a protracted-overdue recovery in service industry pricing.
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There’s been a variety of change in North America over the previous couple of months. Dave shared with you ways we used our market share technique to regain profitability. The subsequent step in boosting profitability is rising prices, so let me begin by speaking about where we see pricing. Wild rumors are circulating within the trade about huge worth will increase. That is just not a universal truth. Given our position in North America, nobody is aware of extra about pricing than we do and right here is what I do know.
First, I like talking about value will increase greater than decreases. It’s a pleasant change. Second, the service value restoration is starting from an extremely low base; in many circumstances, beneath variable money cost. Third, the extent of pricing that satisfies a specific service company is determined by where they’re on the profitability continuum. And at last, although the business is beginning at completely different profitability ranges, every firm will have to march again up the same path to profitability.
In the course of the downturn, our business went by a steep regression in profitability as pricing and exercise declined. The business moved from positive operating margins to unfavourable operating margins, then to destructive EBITDA and in the end wound up struggling to cover variable cash prices. It was a fast and hard highway that triggered a dramatic shift within the landscape of the service trade and wiped out a significant quantity of shareholder fairness.
The pricing brawl continues as the trade recovers and equipment availability tightens. Pricing on the margin is in the end set by whoever is happy with the lowest returns. It’s important to know that our competitors’ motivation for margin returns is essentially constructed round the place their pricing is anchored immediately. For example, if they’re at unfavorable variable costs, then they try to get to a negative EBITDA. If they’re at negative EBITDA, then they are attempting to get to destructive margin and so on.
I can tell you, regardless of what you hear in the market, it’s clearly a bridge too far to skip from unfavourable variable cash to constructive operating margin in one step. So the trade pricing regression I mentioned earlier must turn out to be a pricing development. This means that for now, Halliburton must compete with firms that are satisfied with lower ranges of quick-time period profitability, but we do not believe their pricing is sustainable. You can’t have destructive margins forever. Within the meantime, Halliburton will proceed to take care of our give attention to execution and repair quality as we defend our position with out sacrificing value. I imagine that superior service quality is a prerequisite to having a significant pricing discussion and our dedication to service quality helped create the profitable outcomes for the quarter.
However, as we also stated previously, the North American shale segment remains a wildcard in all of this. Since particulars of OPEC’s plans surfaced, rig counts have increased by 33% within the United States with over 170 rigs added and a corresponding increase in US shale manufacturing already underway.
Second, we said that commodity prices needed to stabilize for confidence in the customer community to improve and investment to accelerate. We continue to believe that North American operators need sustained prices within the mid to excessive $50 vary for this to happen. The North American shale operators’ ability to quickly increase manufacturing has resulted in commodity price recovery being shallower than expected and bringing uncertainty to the sustainability of these recent value increases.
Third, we mentioned that activity needed to increase meaningfully earlier than entry service capacity might be absorbed and pricing recovery might take place. We’re seeing the first indicators of this in choose product strains in just a few of the North American basins, however I still believe there stays a fair amount of capability that have to be absorbed earlier than service pricing will grow to be extra tightly correlated with larger commodity prices and increased exercise. With this backdrop it is clear the market has taken a optimistic turn and we now have all the elements in play for recovery.
Marc Bianchi, Cowen and Company – Analyst 
Okay. What sort of cost inflation gadgets are you watching? Where do you assume we’ll see price increase first? Any comment on how much those might improve, or have elevated?
Andy Hendricks, Patterson-UTI Vitality, Inc. – President & CEO 
You know, it may be the traditional cost inflation. The primary one and possibly the most difficult for the whole business, not simply us, goes to be around labor. In drilling, as an illustration, we saved the wages at the drilling rigs the identical for the position. In strain pumping we have minimize back on overtime. We’ve cut back on per diem. It is simply been a extra challenged business atmosphere.
And so there goes to be some inflation in labor in stress pumping. I think all people goes to have it, not simply us. It should be more challenging to recruit.
I believe a lot of people don’t realize for those who go to Midland, Texas right this moment, regardless that we have been on this downturn for two years, the unemployment rate in Midland, Texas is still lower than the national average. Many of the people that work in the oilfields in West Texas typically rotate in from other cities round Texas or other cities across the US. And in the event that they’ve been gone for six or nine months, they’re starting to get absorbed into their native workforce and should or is probably not so interested to come back to work in an oilfield.
As HAL’s Jeff Miller mentioned, service corporations like speaking about value will increase. Unsurprisingly, E&Ps do not. Both sides always generally tend to talk their ebook, with service providers emphasizing value will increase and E&Ps downplaying them, so it’s price monitoring the same or comparable search however filtered for E&P sector.
Whereas it is probably going that a tight labor market will result in some wage inflation, this needs to be taken in context of the doubtless trajectory of rig depend and drilling exercise. Effectivity beneficial properties like pad drilling imply that a lot fewer rigs (and therefore labor) are wanted to drill the same quantity of wells than just a few years ago. Therefore, even if oil prices had been to increase enough to warrant substantial increases in activity within the Bakken and different relatively increased cost basins, rig count shouldn’t be going to return to 2014 ranges of round 1500 US oil directed rigs. For instance, this remark from Vicki Hollub, CEO of Occidental $OXY on their Q2 2016 earnings call:
We’ve the capacity to increase considerably. We might be extra limited by our disciplined strategy, but we definitely have saved the potential within our organization. We’ve got the flexibility to put the infrastructure within the Permian, so we’ve got, I’d say, vital capability.
At one time we had been working over 25 rigs and we might, if costs have been in the vary that will warrant that, we may get back to that. However bearing in mind now that again after we had been operating 25 rigs, we were not as environment friendly as we are in the present day. We are considerably improved with our efficiencies so we might get truly the same amount of productiveness with half the number of rigs that we have been at, at that time.
The Permian Basin:
2016 was the 12 months of the Permian. With stacked pay, existing infrastructure and other advantages, it has been a transparent low value, high return chief. The market finally came round to that view in 2016. I arrange a key phrase alert in 2015 and it actually lit up this previous yr as capital flowed into the basin because the market noticed a rise in oil flowing out regardless of low prices. This is in distinction to the Eagle Ford and Bakken the place production had started to decline.
A manufacturing table from the EIA:
Permian, Eagle Ford, Williston and DJ-Niobrara Rig Counts:
Permian deal activity from 2015 and 2016:
As of January 2017, there have been over 30 Midland and Delaware deals since 2015. Deal activity accelerated in 2016, in both Midland and Delaware with the value paid per acre roughly doubling. Already this year, Exxon acquired privately held assets for $6.6B and Noble purchased Clayton Williams for $3.2B. (Exxon and Noble Stoke Permian Passions)
Under is a valuation table with all E&Ps and IOCs which have talked about Permian acreage positions of their most current filings, with acreage holdings and cut up between Midland and Delaware sub-basins if disclosed.
Nonetheless, things could also be getting frothy. The Dallas Fed not too long ago printed its quarterly vitality survey of business participants. For Q4 2016, particular questions about Permian acreage prices had been added. Under are some excerpts:
Feedback expressing concern over acreage costs:
“The Permian transactions are approaching worth multiples related to a bubble or a Ponzi scheme. A number of non-public equity (PE)-backed patrons are simply buying and selling assets from one to the other—very much like transactions we witnessed within the early 0s actual estate bubble, the tech bubble of 8- 1 when venture capital companies co-invested with each other to drive up paper beneficial properties, and the oil transactions prior to 2014 when every PE fund, pension and endowment manager needed shale in their portfolios. /p>
Comments mixed on whether current acreage costs are overvalued:
“Stacked plays and improving expertise make the Permian Basin very prolific for the production of oil and gasoline, so relatively high acreage prices are justified. That mentioned, current acreage prices have reached an exuberant degree that leaves little protection towards prolonged durations of sub-$60 per barrel oil. Leasing Permian acreage at current acreage prices just isn’t one thing that we’d do. /p>
“With companies suggesting that as many as 64 wellbores are potential in a single part within the Delaware Basin, it’s not surprising that acreage prices have skyrocketed. In lots of cases, this is a multi-decade proposition. To counsel to investors that this is possible is probably acceptable however to counsel that it is achievable, is, not less than, suspicious. There shall be a day of reckoning in how high the acreage cost goes. If we stay in the $forty five-$fifty five vary, then many of those ‘prospects can be uneconomic. /p>
“No. I believe acreage prices are overvalued in sure areas based mostly on hypothesis on what oil prices could develop into and what production may be proved in the future from these areas. Some areas costs are justified primarily based on present data, however others are not. This isn’t atypical for oil and gasoline investing. /p>
Permian E&Ps have been noting comparable issues on calls
Parsley Vitality ($PE) is a pure play Permian E&P and was very energetic buying belongings in the basin the past 12 months or so, making five acquisitions since December of 2015, including a deal for Midland and Delaware property on January tenth of this year. Utilizing Doc Seek for “delaware acreage costs” returns Parsley CEO Bryan Sheffield’s comments from the corporate’s Q2 2016 earnings call in August of 2016:
John Freeman, Raymond James – Analyst 
And if I shift over it to Delaware, you realize, Bryan, you may have at all times been really candid on what you might be seeing in sort of the A&D area, and obviously when we look on the acreage costs. You picked up acreage from the Delaware within the spring after which as just lately as last year’s name you type of stated within the Delaware you had been seeing acreage prices like $10,000 to $5,000 acre, and clearly last month we’ve seen like a double. I’m just curious from your perspective what you assume drove such an enormous improve just rapidly? Is there something you can level to when it comes to confidence of additional zones, costs or anything like that?
Bryan Sheffield, Parsley Energy Inc – CEO [forty nine]
I am still little bit in shock what I’ve seen in the past couple months. I imply we just paid final April got here out and you take a look at April, we paid round $9,000 an acre, and I do know a few of these sellers, current transaction sellers, paid about equivalent, about six months in the past, or nine months in the past, if look on the [Ogder Stevens on his bond], and [as analysis] you know the way much — you possibly can kind of put together what the transaction is after which six months later.
So it is truly superb. We’ve gone from $9,000 acre print to a $25,000 acre print and now a $35,000 acre print. I think we’re on the planet of $20,000 to $25,000 within the Delaware. I really think that’s the truth. Anything north of $30,000, I feel that is form of — we will not get to it on a map in the return on acquisitions.
Taking a look at Parsley’s January acquisition, if we take the Delaware portion of the deal, which is $205 million for five,300 internet acres, back out 1,a hundred flowing Boe/d at $forty,000/Boe/d, price per acre is roughly at the $30,000/acre ceiling Sheffield mentioned again in August.
Parsley isn’t the only one noting high acreage values.
Anadarko ($APC) Q3 2016 earnings name in November:
Arun Jayaram, JPMorgan – Analyst 
Good morning. Al, I wanted to start out just a little bit within the Delaware. We noticed a reasonably punchy analysis for the Silver Hill asset bundle in Loving and Winkler with the transaction, I feel, fetching greater than $forty,000 per acre.
I was wondering first if you might remind us of your acreage place in Loving, and if you would talk about your broader delineation efforts past the Wolfcamp A as a result of clearly the industry is fairly excited in regards to the stacked pay potential in the Delaware.
Al Walker, Anadarko Petroleum Company – Chairman, President and CEO 
Well Arun, thanks. I might have Darrell help me somewhat bit with a number of the questions you ask. However let me simply say, as we checked out Silver Hill — and clearly you recognize the geography fairly properly, you know they’re quite right next door to us when it comes to how their acreage is very shut — as I’ve checked out how these acreage values have more and more gone to locations I’d never have imagined — I imply, we are paying — or seeing individuals, reasonably, pay price per acre in the present day that exceeded acreage values when oil was over 100. And so consequently I believe we have a little little bit of pause around simply the valuations and the way certain of those have escalated in places.
EOG’s ($EOG) EVP, Exploration and Production speaking at UBS Houston Energy occasion in September of 2016:
Unidentified Participant 
Loads of time for questions. Maybe I’ll begin with a quick one (inaudible). You’ve seen so many transactions in the Permian within the last several months. And seemingly, every single one is finished at 25,000 per acre or more. And then, the Yates deal, if you make some adjustments, it is pretty clear that you got the Delaware at less than 10,000 per acre. Could you simply give us some background about how that transaction is put together and assist us perceive how the worth may be so enticing?
David W. Trice, EOG Assets, Inc. – EVP, Exploration and Manufacturing 
Yes. I feel, actually, this was a private deal. It was a negotiated deal. The Yates household have been — they had been very eager on doing a corporate deal and doing a stock deal. And so they actually wanted EOG inventory. And so actually, what this transaction represents is — I imply, it actually is a merger within the sense that Yates family’s been in business for a very very long time. And they’re taking a look at a longer time horizon. And so they’re wanting to completely maximize the worth of their acreage. They usually felt that EOG was the easiest to do this.
And the rationale why we haven’t historically been an acquirer is because usually these transactions are very low price of return. However that is just a type of conditions where the 2 parties had been aligned. Yates family was — in addition to being lengthy-time period gamers, they’re very concerned about their legacy, and so they need to be partnered with a great company. So it all got here together, and we were capable of have type of a win-win state of affairs there.
However I agree that the transactions that are happening within the basin — I mean, they’re very high-priced. I definitely wouldn’t expect EOG to do any of these sort of offers. Because we don’t actually really feel like if you’re paying $30,000 or more an acre, it is going to be very, very arduous to get an excellent all-in charge of return on that.
Whereas others are less concerned.
Scott Sheffield, Pioneer Natural Resources ($PXD) CEO, speaking at Barclays CEO Energy and Power convention in September of 2016:
Additionally we got lot of questions yesterday about acreage values. Acreage values have moved as much as the identical price, or greater than they were in 2013 and 2014. I think it shows most corporations that aren’t in the Permian or have to move with the Permian. Most of the Midland Basin has already been bought up. The very best price paid within the Midland Basin just lately was [$fifty eight,000] per acre. Persons are usually paying [$forty,000 to $45,000] per acre. After which within the Delaware, it’s as much as [$37,000] per acre. And so, issues are being bid up, just because there’s a scarcity of stock. People know that the Permian may be very oily they usually need to be there long term, especially if you happen to believe within the strip pricing over the subsequent several years. We do say that there’s room to make money, however once you pay these costs, as a result of we use a PV-10. When you take a 1 million BOE equal well and run it out, it is price someplace between $80,000 and $a hundred,000 per acre. So that is why individuals are still paying as much as $60,000 per acre. There is still room to make cash should you believe in the present strip value.
So, is the Permian overvalued? Searching transcripts confirms what the Dallas Fed discovered of their survey. Many Permian centered E&Ps with an extended track record in the basin suppose valuations are at minimum on the rich side. Others seem to be extra complacent, however they seem to be within the minority.
One other significant occasion in 2016 was the landmark OPEC decision to cut production by 1.16MM barrels per day.
Saudi Arabia, Iraq, Kuwait will shoulder 966k barrels per day of the overall. Non-OPEC countries agreed to chop by 562k barrels per day, with Russia cutting 300k of that whole and other non-OPEC producers like Mexico and different smaller producing international locations via natural declines.
The rationale OPEC changed technique from its prior technique of maintaining market share is for a handful of causes.
- US Decrease 48 production has fallen from a peak of 9 million barrels per day to a trough of eight million barrels per day in mid-October and has since rebounded to 8,250 barrels per day based mostly on EIA four-week common of L48 production. OPEC’s market share strategy succeeded in that it pressured producers to scale again drilling, particularly extremely levered producers (a few of which have filed for bankruptcy), while others are impaired because of excessive debt burden and lack of entry to capital markets.
- OPEC country fiscal conditions are deteriorating resulting from falling oil revenue. OPEC successfully acknowledged that they have to reside with low-price shale producers within the Permian and different basins that were in a position to benefit from cost deflation that lowered break-evens. At the identical time, they acknowledged that they too, have been feeling the pain of low prices. Especially international locations like Venezuela. As far as market influence, the introduced cut should serve to set a floor. However, returning production from the Permian as well because the lingering risk of dishonest on manufacturing quotas serves as another issue serving to keep a ceiling on costs, thereby discouraging the over-levered high-yield debt-fueled exuberance of US E&Ps that characterized the shale growth main up to 2014-2015. Whereas it’s unlikely the deal will fall apart, compliance will have to be monitored. Examining the news flow reveals this headline about document exports from Iraq which sent oil decrease and this headline about Saudi Arabia reducing exports to some prospects.
One potential wildcard is the Trump and GOP border adjustment tax. See Why OPEC should fear the Trump administration and Trump Tax a Wild Card for Oil for more details. Another potential wildcard is a border wall tax on Mexico- Border Wall Tax on Mexican Crude Oil Would Cost U.S. Drivers.
If both is handed, which appears unlikely at this point because of WTO Rules, it’s very troublesome to gauge impression with any affordable certainty. The only certainty will be extreme volatility within the short term. Goldman Sachs estimated that a border adjustment tax influence may very well be a move in WTI of $thirteen/bbl immediately and a resulting move by means of to gasoline enhance of $0.30/gallon. Absent a wild card just like the border adjustment tax being handed or political volatility, fiscal stimulus, and so forth. it’s reasonable to assume oil costs will stay vary bound in the mid-excessive $50s to high $40s. That stated, political risk to markets going forward is far larger than on November 8th.
President Trump has made very clear that he just isn’t a fan of regulation, with particular ire directed at the EPA and the Renewable Fuel Customary (RFS). A detailed look at the RFS and problems with it are past the scope of this submit, however you possibly can read extra here. Trump advisor and refinery proprietor Carl Icahn has been very vocal as properly. Basically, the RFS requires that refiners blend a biofuel, both ethanol or biodiesel, into every gallon of gas produced and offered in the US (exports are exempt). Or, refiners should purchase a RIN instead. RINs are generated with every gallon of biofuel produced. These can then be offered to refiners that select to not mix biofuel. Costs might be risky (What brought about the run-up in ethanol RIN prices throughout early 2013?) which makes compliance for refiners without mixing functionality expensive as RIN prices rise. One in every of the issues with the RFS mandate is the “blend wall”: a sensible limit past which refiners say the quantity of ethanol in a gallon of gasoline will begin to damage engines. You’ll be able to learn more about the mix wall here. Using Doc Search with the query “RIN OR “mix wall”” and Plotter, we will see a transparent development of mentions in 2013 and 2016.
Given President Trump’s statements and GOP majority in both Home and Senate, it seems very probably that RFS can be at minimum modified to relieve the burden on refiners like Icahn’s $CVI. As I mentioned above, a potential wild card for oil and fuel (and any firm or trade that imports substantial amounts of goods) is the border adjustment tax. It was mentioned on Q4 2016 earnings calls of Exxon($XOM), Marathon($MPC) and Valero($VLO). However it’s not just oil refiners which are discussing the potential tax, GM, UPS, AT&T, Domino’s have all mentioned it so far this year. It is most likely a good suggestion to avoid wasting a border adjustment tax search on all public corporations to concentrate on potential winners and losers if the tax becomes legislation.
The oil glut of the previous few years has overshadowed the pure gasoline market. 2017 ought to bring it out from the shadows. In 2016, natural gasoline production is predicted to decline 1.Three Bcf/day to 77.5 Bcf/d from 2015 ranges (EIA STEO). It marks the first annual decline since 2005, which was the yr simply before the appearance of fracking kicked off the shale gasoline increase. Because natural gasoline can solely be transported by pipeline and it takes time to build power plants and incentivize industrial shoppers to construct natural gas-fed plants, demand is much less elastic than shale gasoline provide. This has led to a protracted glut that first emerged around 2009-2010. 2017 demand is anticipated to deliver the market more into balance as home demand is expected to increase, along with exports to Mexico growing and LNG exports ramping up as Cheniere brings its third and fourth liquefaction trains online. Whereas the demand outlook is bettering, we still want to observe a number of things:
- How quickly fuel producers improve rig depend in response to increased costs.
- The related gas coming out of the Permian.
- The rising SCOOP/STACK play in Oklahoma which produces oil and liquids-wealthy pure gasoline. It is value remembering how related gas from the Eagle Ford and other liquids-rich gas performs exacerbated the gas provide glut. How much of an affect it might have on gasoline supply is troublesome to say for certain at this level, but one thing to bear in mind.
With North American drilling exercise turning the corner and on the upswing, OPEC, and natural fuel supply/demand balance, 2017 actually won’t be boring for oil and gas.
Full disclosure: I, Philip Dunham, am the primary creator of this text, and it expresses my very own opinions. I’m not receiving compensation for it. I haven’t any enterprise relationship with any company whose inventory is mentioned in this article, beyond buying and selling small numbers of shares of Parsley Power, Inc. in the normal course of my trading actions. The knowledge and information presented in this article were obtained from firm documents and/or sources believed to be dependable, but haven’t been independently verified. Therefore, neither Sentieo nor I can guarantee their accuracy. Please do your personal research and get in touch with a certified investment advisor before making any investment decisions. Neither Sentieo nor I are liable for funding selections you make.
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