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Energy Stocks

The Long View: Economics Favor Stacked Energy Plays

By Elliott H. Gue, on Nov. 20, 2017

The ability of shale oil and gas producers to adjust to price signals relatively quickly should enable the US to take market share by responding to growing global demand for petroleum products and offsetting output declines related to aging fields and industry underinvestment. This opportunity should become most compelling toward the end of the decade when the effects of this lack of capital spending will kick in.

In addition to the short-cycle nature and predictability of US shale plays (bad wells aside, dry holes don’t happen), the industry continues to refine its drilling and completion techniques and processes to drive break-even costs lower and unlock additional resources.

In this intensely competitive environment, shale basins within the US onshore market will also jockey for market share, with the lowest-cost areas offering the best potential for volumetric growth.

Although all the major shale plays feature their sweet spots and marginal acreage, much of the asset acquisitions and drilling activity during the recent up-cycle have centered on the Permian Basin and central Oklahoma’s emerging STACK play—and for good reason.

The reservoir rocks in both areas include exposure to multiple oil-bearing formations, enabling producers to extract hydrocarbons from the same infrastructure—potentially a major source of cost savings and a huge competitive advantage.

For example, during Occidental Petroleum Corp’s (NYSE: OXY) first-quarter earnings call, the president of domestic oil and gas asserted that the company would realize a more than $10 per barrel reduction in its break-even costs on wells targeting secondary benches at its Greater Sand Dunes play in New Mexico.

At the Energy Information Administration’s annual energy conference, Scott Sheffield, CEO of Pioneer Natural Resources (NYSE: PXD), asserted that break-even costs in the Delaware Basin could be as low as $25 per barrel.

These opportunities help to explain the frenzy for exploration and production companies to add exposure to the Delaware Basin, an area where blocky acreage packages conducive to drilling longer laterals were easier to come by than in the Midland Basin.

In our view, EOG Resources’ (NYSE: EOG) $2.5 billion acquisition of Yates Petroleum in fall 2016 stands out on the list of deals involving assets in the Delaware Basin. An early entrant to many of the leading shale plays, EOG Resources boasts some of the lowest-cost core acreage in the Bakken Shale and Eagle Ford Shale; the company’s big splash in the Delaware Basin says a lot about the quality of the resource base and the opportunity set.

This urgency also extended to the midstream segment, where Plains All-American Pipeline LP (NYSE: PAA) and NuStar Energy LP (NYSE: NS) earlier this year purchased expensive gathering systems in the Permian Basin.

Given the equity issued to fund these transactions and the elevated yields at which these stocks traded, these deals won’t alleviate the risk to either master limited partnership’s (MLP) distribution or the challenges posed by impending debt maturities. These desperate moves underscore the potential for the Delaware and Midland Basins to take market share in an environment where oil prices remain lower for longer.

The elevated multiples associated with these transactions in part reflect the quality of the counterparties and expectations for output growth.

Meanwhile, appraisal and delineation activity continues apace in the Delaware Basin, with operators focusing on determining ideal spacing and development plans to maximize returns and recovery rates from the multiple hydrocarbon-bearing formations in the area—a process that remains in the relatively early innings.

The potential for oil and gas producers to realize additional cost efficiencies through pad drilling and large-scale developments targeting multiple formations suggests that the STACK and Permian Basin will take market share in an environment where oil prices remain lower for longer.

During their second-quarter earnings calls, Concho Resources and Energen Corp’s (NYSE: EGN) management teams highlighted the improved performance that comes from completing wells simultaneously in multizone patterns instead of sinking standalone wells and returning to drill and complete offset wells. Tim Leach, CEO of Concho Resources, made the case for a future in which project sizes of $100 million to $200 million become routine.

Dream Buys

Within the upstream space, we continue to focus on names with low costs, solid balance sheets, high-quality acreage in the STACK and Permian Basin, and the flexibility to monetize noncore assets or retain cash flow through captive midstream MLPs.

Although our outlook for oil prices and the US energy patch favors an overweight position in core midstream holdings, nimble investors can generate alpha in upstream names by buying when oil prices retreat to the low end of their range and taking some profits off the table when they recover. Timing and stock selection—easier said than done with shorter cycle times—will be critical to producing differentiated returns. Adhering to our Dream Prices can help in this regard.

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