We believe oil prices are likely to move quickly to higher base prices of $55 and $60 if the indications from Q3 reporting are indeed pointing to less than expected production growth from the Permian. In Chevron’s Q3 last week, it highlighted that, with their low or zero royalties, their Permian pads have >30% full cycle IRRs and payout in 28 months. No one seemed to pay attention to 28-month payout and it wasn’t raised in this week’s Permian Q3 conference calls. The emerging narrative is “value over volume”, which looks like clear signaling for lower Permian production growth. There is a more disciplined capex spending narrative, but the reality is that this discipline is to a great part forced on them by the huge drop in equity issues for US E&P in 2017 vs 2016. Apart from a big rush of equity causing a problem, the reason why we believe oil is going to move more quickly to base prices of $55 and $60 is in great part linked to lower than expected Permian growth, whether it be viewed from the narrative of the new-found discipline or the reality that the payout period of the wells is probably more like 2 years and not 1 year.
Oil prices can move quickly into Phase 2 and 3 if US shale growth isn’t as strong as expected We look at oil in 3 Phases and that the key factor to move prices into Phase 2 and Phase 3 is how quickly markets buy into US shale not growing as fast as most expect. Based on the Q3 disclosure so far, we expect to see analysts lower their growth expectations for the Permian. Phase 1 is where oil is now, stabilized at $50 or above driven by OPEC cuts extensions expected to happen and that will lead to the oil oversupply being gone in H2/18. There is still the fear that oil could drop back in the $40’s, driven partly by the fear that US shale drilling and completions of DUCs (drilled uncompleted wells) will accelerate with oil solidly over $50 leading to US oil production ramping up quickly. And the $40’s weren’t that long ago. Phase 2 is the view that oil is >$55 looking to $60 in a matter of months not years and with little risk of dropping back into the $40s. Based on the Q3 reporting comments on the Permian to date, we expect this could happen soon as markets digest Q3 earnings and outlooks, despite oil oversupply correction slowing down with the normal seasonally lower oil demand every winter. Permian players may not be guiding, but are certainly inferring more modest production growth in 2018. Phase 3 is the view for >$60 oil with, importantly, an expectation of longevity to this view. We believe this happens as markets realize peak oil demand and EVs are not going to crater oil demand soon, and that even when peak oil demand is reached, the world has to add 3 to 4 mmb/d every year to replace declines and that the marginal supply cost to add 3 to 4 mmb/d every year for the next decade and longer is nowhere near the forward strips of less than $52 from 2019 thru 2025.
WTI Forward Strips Thru 2025
Source: Bloomberg
Chevron’s Q3 did the unusual – it provided payout for its Permian pads and its 28 months. Chevron held its Q3 call last week and it did something unusual – it provided payout on their Permian well pads. As a general rule, the US producers do not provide the same level of well economics as the Cdn E&P group, in particular for the payout period of wells. We believe payout is particularly important in periods where there is less equity and debt capital availability. The longer the payout period, the greater the need for external capital to fund growth. On its Q3 call, mgmt. said “Our realizations are advantaged by our legacy royalty position and add to strong returns. As you can see by the chart on the right, the typical profile of cumulative cash flow from production allows capital to be recovered very quickly. We expect the average time from initial investment to payback to be about 28 months, and cumulative cash flow over the life of the pad to be nearly two times the capital cost. This is very good use of your money.” Chevron highlights its economics have an advantage because of its low or no royalties. In its Permian Fact Sheet [LINK] Chevron notes it has been in the Permian since 1925 and “About 85% of the acreage has low or no royalty fees. This is a significant differentiator in terms of the value of our production. This advantage is even more compelling in the current price environment.” Below is the Permian pad economics slide from the Chevron Q3 call slide deck.
Chevron Permian Pad Economics – Q3/17 Results Presentation
Source: Chevron
If Chevron’s payouts are indicative of the industry, its will be that much tougher most competitors who have 20% or more royalties. We were surprised that analysts didn’t raise Chevron’s 28 month payout as a question in this week’s Permian Q3 conference calls. In the Q2 calls, analysts asked all companies about Gas Oil Ratios for their Permian wells after the Pioneer call that surprised analysts with higher GORs. Chevron’s 28 month payout for its Permian pads would be much longer if it had a more typical 20% or higher royalty, we would think at 4 to 6 months longer. Unfortunately, we have not seen any other Permian producers provide payout periods for their Permian type curves and most don’t even provide IRRs. However, these other producers will need to have wells that significantly better to make up for normal royalties and to get payouts down below two years. Even still, a payout of just under two years is not a self funding strong growth program. If Chevron’s Permian payouts are indicative of industry Permian payouts, there will have to be a return of big equity injections in excess of cash flow to deliver any strong growth.
The emerging “value over volume” narrative also suggests lower Perrman growth. One of the common Permian themes emerging in Q3 reporting is the theme of “value over volume” in the Permian and the US shale in total. It seemed that producers were keen to emphasize their discipline in spending and focus on value and returns. We believe the emergence of this “value over volume” theme is also pointing to lower production growth going forward. The Permian players and the big service companies are telling investors that production growth is not the priority. Apache said “For most of the last three years, the E&P industry has been engaged in excess spending to drive short term oil growth. Today, we are seeing a return to the fundamentals of capital discipline and focus on long term returns. We welcome this change and believe it is very constructive for the long term health of our industry.” Devon Energy said “finish my remarks with a few preliminary thoughts on our outlook for 2018. First and foremost, our capital program in the upcoming year is being designed to optimize returns, not production growth.” Schlumberger said “E&P companies have added significant CapEx over the past year, the production growth is so far falling short of expectations, driven by supply chain inflation, operational inefficiencies and the need to step out from the Tier 1 acreage. This has led to a moderating investment appetite, where the previous pursuit of production growth is now being balanced out with an equal focus on generated solid financial returns and operating within cash flow. This moderation can be seen in the flattening trend of the U.S. land rig count during the third quarter and it is also reflected in our customers’ 2018 activity outlook.” In its Oct 18 investor day, Encana said “The market dynamic is shifting from value and production growth and acreage quantity to placing more emphasis on value creation to execution.”
The “value over volume” choice is also being forced by less equity availability in 2017. We expect this narrative of “value over volume” to continue through the rest of Q3 reporting. No question the producers appear to be taking a more disciplined approach to capital spending. However, the reality is that part of this discipline is being forced on the producers (not the supermajors like Chevron) by the big drop in equity issues for US E&Ps in 2017 vs 2016. The below graph is the US E&P equity issues to Oct 31, 2017.
US E&P Equity Issues To Oct 31, 2017
Source: Bloomberg, Stream Asset Financial
We see a quicker move to $60 if Chevron’s Permian pad economics are indicative for industry. Oil seems to have found a base above $50 with view that OPEC will extend cuts thru 2018 and this will eliminate the oil oversupply sometime in H2/18. This makes the rate of US shale growth as the major wildcard. We believe oil prices are likely to move quicker to bases of $55 and $60 if markets believe Permian oil growth will be lower than expected. We believe the indications from Q3 reporting so far is indeed pointing to less than expected production growth from the Permian. Apart from a big rush of equity causing a problem, the reason why we believe oil is going to move more quickly to bases of $55 and $60 is in great part linked to lower than expected Permian growth, whether it be viewed from the narrative of the new found discipline or the reality that the payout period of the wells is probably more like >2 years and not 1 year.