The oil market in 2019 started year around $60/bbl WTI and looks set to end it around the same level, but the year has been far from uneventful. The SPDR S&P Oil & Gas Exploration & Production ETF $ (XOP) has been killed in 2019, down 25% in a year when the S&P 500 is up 25% -- severe underperformance. Only the last few weeks has seen a bounce of 15%, but is this set to continue?
The oil market has been hurt by increasing supply from U.S. shale, despite Iranian and Venezuelan oil sanctions and prices propped up higher with the OPEC+ alliance helping to keep 1.5 million barrels per day (mbpd) out of the market for most of the year. The EIA estimates that U.S. oil will grow by 900,000 bpd in 2020, but is that estimate too optimistic? According to CEOs of shale companies on Q3 2019 conference calls, they feel this number might be closer to 400,000-700,000 bpd.
One problem with these agencies forecasting future oil/gas balances is that they assume the historic rate of improvement will continue going forward. U.S. shale saw a massive increase over the past three years, defying most commentators as it took U.S. oil production from around 8 million bpd to around 13 million bpd over the past five years.
If demand is set to increase by around 1 million bpd, this can all be met by U.S. shale growth, assuming past rates of growth. If that were to be the case, the call on OPEC around 29.6 mbpd next year is at risk of being lower. But there are signs that shale may slow or even reverse in 2020. Given the overspend over the past few years and constant negative free cash flow, capital markets are now closed to most small to medium sized producers; they are struggling to raise money to drill. Rystad Energy calculates that shale investments declined 6% this year to $129 billion and predicts that it may fall another 11% in 2020. After years of under-delivering, U.S. shale producers are now pressured by shareholders to focus on costs and capital discipline.
According to an IHS Markit report, base decline rates of more than 150,000 producing wells in the Permian rose from 34% in 2018 to 40% this year, a contraction of around 1.5 million bpd equivalent. Base decline is the rate at which oil and gas producers need to add to new wells just to stay at their existing current production rates. These declines are set to be even more acute in the coming years and companies do not have the cash to keep producing.
Historically, Permian conventional wells have shown an annual decline of 13%. The drop in active drilling rigs, as seen by the Baker Hughes rig count, has fallen for seven straight weeks to around 663. One can argue that unless more investment takes place, Permian production has reached some sort of ceiling. Today it is about 4.5 million bpd out of the 12.8 million bpd U.S. oil production; it is a significant part of the U.S. shale growth story.
During 2018 and the first half of 2019, shale operators in the Permian, particularly those in the Delaware basin, experienced pricing differentials of $6-$8 a barrel versus WTI because of a lack of take-away capacity. Starting in H2 2019 going into 2020, extra pipeline capacity is coming online in the region of 1.5-2 mbpd. Permian pricing is expected to improve going into 2020 and related shale companies can expect significant improvements in pricing in 2020, even with flat WTI prices. This equates to a meaningful liquidity boost in 2020 and it will be reflected in year 2020 budgets when announced.
Assuming oil prices of $55/bbl WTI, and U.S. Nat gas prices of $2.5/mcf, the key is to identify companies that are growing production by around 10%+ CAGR with solid cash flow and capital discipline, trading on very cheap multiples from 5x-6x EV/EBITDA 2020. Those names are the likes of Diamondback $ (FANG) , Concho Resources $ (CXO) , and Continental Resources $ (CLR) , Pioneer Natural Resources $ (PXD) , to name a few.
Concho Resources has about 10% production growth at $55 WTI oil, and generates free cash flow of about $500 million. It is about 63% liquids, and a 2020 EV/EBITDA of about 5.8x with a share buyback of $1.5 billion around 10% of capital, which is supportive to the share price. Diamondback is a pure-play Permian operator that produced 280,000 bpd oil in Q2 2019 around 149% year over year. It has forecasted 2020 production growth to average 10%-15% and it pays a dividend with WTI at $45/bbl oil. In 2019, the company's oil price will average about $5.5/bbl below WTI, but due to the company's equity ownership in new pipeline capacity, it is expected to realize 100% WTI going forward, boosting its profitability per BOE with a free cash flow of $1.5 billion in 2020.
The energy sector has been a source of shorts for years now, with investors chasing the likes of growth-oriented sectors like technology. Many have tried to claim the prize to time the switch out of growth into value, that is a much larger secular call and better left for the bigger Macro players for now. But there is a case to be made where oil prices can squeeze into year-end going into Q1 2020, that can provide a floor for some of these oversold oil equities, ranging from Majors to E&P's and oil services.
E&P have the best leverage to the oil price, more than majors that take a crane to move the stock price more than 5% given how diversified they are. Hence it makes sense to focus on a basket of pure play E&Ps, as mentioned above, to get the best exposure with the best financial metrics as the oil market tightens in the near term. Refiners come back from maintenance going into winter heating demand season, and demand is set to pick up seasonally as well. It's a good thing the U.S./China Phase 1 trade deal has been agreed for now, regardless of how fake the deal is, removing one overhang for this sector. In addition, central banks so scared to see deflation are now stimulating at a rate unparalled in even 2008.
Be careful what you wish for, as commodities might just get the boost they have been waiting for and central bankers their much desired "inflation" Christmas wish.
