We have said it again and again: In order for this domestic glut and oil price disaster to end, oil production needs to be rolled up, either through a disciplined strategy of deferred well completion or through outright bankruptcy and dispersal of assets.
We've also repeatedly noted how surprisingly slow this process has been, barely chipping at our output of 9.3 million barrels a day since the beginning of "much lower than breakeven" prices more than a year ago. My take has always been that continued uneconomic drilling and production was a product of Wall Street bias. Energy companies need to be constantly increasing production to earn the support of analysts and shareholders and keep their bond ratings strong.
But the Wall Street Journal correctly pointed out one more reason production has been particularly slow to roll off: CEOs have their bonuses directly connected to increasing production targets.
Of course the most interesting part of the WSJ piece, and the one that informs our investments, is the percentage of bonuses that is weighted into production and reserve targets. Not surprisingly, only 8% of EOG Resources (EOG) CEO William Thomas's bonus is connected to those numbers. That is another reason why EOG has been able to delay far more quality drilling of prime acreage than just about every other company in U.S. shale oil and continues to be one of my top long-term picks.
Of those on the other side of the spectrum, Chesapeake Energy (CHK) CEO Doug Lawler earned a $2.7 million bonus in 2014, half of which was related to uneconomic production increases. Harold Hamm, CEO of Continental Resources (CLR) earns fully 75% of his bonus based upon production. Chesapeake and Continental have been two of the worst-performing energy independents in a sector of horribly performing stocks.
But we have been encouraged by Continental slashing capital expenditures by more than 60% and dropping its production target for 2016 by 10%. Indeed, these moves, once thought to be a death knell for independent oil and gas exploration and production companies (E&Ps), were met with a rally in CLR shares. Indeed, we were encouraged enough to even add a small position in the company to our portfolio.
There is clearly a changing world in energy, where the old rules -- production increases and higher reserve targets -- begin to go unrewarded and return on capital starts to mean more. As that mindset continues to move through the industry, we are likely to see more positive declines in production and a faster clearing of this glut in energy -- and perhaps the end of this uneconomic and destructive collapse in energy prices.
Note No. 1: The rapid rise of oil prices into the high $30s strikes me as almost entirely about OPEC/Russian jawboning on impossible-to-implement production freezes combined with a massive short-covering rally we have been expecting since the first of the year. We removed one-half of our midterm long plays last week and my recommendation now is to get out of the rest. Oil does not need to retest lows again to resume weighing on energy shares, and the upside from here is limited by real fundamentals. For now, only long-term oil investments remain.
Note No. 2: This Thursday, I will do a "rapid roundup" of energy names for my column. I'll give you my take on any specific energy companies you choose; whether E&P, services, pipeline, refining. Email me here: Dan.firstname.lastname@example.org