The Fuse

Despite Strong First Quarter, Oil Industry Still Faces Investor Trepidation, Bottlenecks

by Nick Cunningham | April 03, 2018

The first three months of 2018 was the worst quarter for the share prices of energy companies in three years. Energy stocks in the S&P 500 declined by 6.6 percent in the first quarter, dragged down by the reemergence of oil price volatility in February.

Energy stocks have lost their luster among investors over the past year, even though oil prices have bounced back sharply.

But the poor showing was not new. Energy stocks have not seen a lot favor from investors over the past year, even though oil prices have bounced back sharply. Brent crude prices have rallied more than 40 percent since last June, while ExxonMobil, for instance, has seen its share price fall by 10 percent over the same timeframe. Nevertheless, companies will soon report first-quarter results, and the figures are expected to reveal further improvement in the oil and gas industry, which may finally lead to significant improvement in share prices.

Oil up, but not energy stocks

Brent prices are holding around $70 per barrel, but the share prices of energy companies have not significantly improved as investors are staying away energy stocks, a sign that oil and gas is no longer seen as favorable by Wall Street, even with oil prices up sharply from recent years.

However, the outlook for energy stocks could soon improve. As the Wall Street Journal noted, energy reported the strongest earnings growth out of any of the 11 major sectors held in the S&P 500 in the fourth quarter, and is expected to have continued to performed better in the first three months of this year. The energy sector is forecast to increase profits by 79 percent, the strongest growth out of any other sector in the S&P 500, according to the WSJ.

The energy sector is forecast to increase profits by 79 percent in the first quarter, the strongest growth out of any other sector in the S&P 500.

While the strong performance is arguably simply the result of the industry recovering some lost ground, oil companies have succeeded in lowering costs and finally generating profits. In fact, the shale industry is expected to become broadly cash flow positive in 2018, essentially for the first time since the drilling activity picked up early this decade.

The energy sector may also finally begin shaking off its poor image with Wall Street. In March, as the WSJ reported, the S&P 500 fell by 2.7 percent, but energy stocks were up 1.6 percent, a sign that the oil and gas industry is regaining momentum. “Those cash flow streams going out into the future are far more valuable, yet the stock prices haven’t kept in sync with that,” Michael Scanlon, a portfolio manager with Manulife Asset management, said in WSJ interview. “That’s an environment where oil can be held higher from here. Those stocks are very attractive.”

Lower breakevens increases profits

The improvement in the financial outlook is a sign that oil and gas companies are finally putting the difficulty of the oil market downturn behind them. Goldman Sachs recently laid out a case that argued that the period following a price slump has typically been a period of time when the oil majors post their strongest returns. Oil companies have succeeded in cutting costs and have not yet returned to the profligate spending that tends to occur during a boom phase.

Even offshore drilling is seeing a revival. Chevron, for example, says that it is working on offshore projects that are competitive with shale drilling. The oil major is aiming to develop new drilling projects while using older infrastructure in an effort to keep costs down. By tying back new wells to existing platforms, Chevron argues that it can substantially lower breakeven prices. “So new areas like Anchor, Waterloo, Tiger, Gibson, Whale, Ballymore, we’ve got a portfolio of new discoveries waiting for development as we continue to bring these costs down,” Jay Johnson, Chevron’s executive vice president for upstream, said at a New Orleans energy conference in March, according to Bloomberg. “There are a lot of questions whether deepwater can compete. But things are changing in deepwater quite dramatically.”

TransOcean’s chief executive confirmed Chevron’s positive outlook on deepwater, saying that a number of offshore projects in the Gulf of Mexico have breakeven prices in the low-$40s per barrel.

A large number of shale E&Ps are sitting on drilled but uncompleted wells (DUCs), and as they work through that backlog, they will be able to increase production at low costs.

Onshore shale, where most investment is focused, is also seeing improvements. The shale industry has lowered breakeven prices significantly in recent years, even if the efficiency gains are nearing their limit. Shale companies have two other factors working in their favor this year, according to Wood Mackenzie. First, oil prices are expected to rise by an average of about $10 per barrel (WTI) this year, compared to 2017, moving higher than the breakeven prices for most shale companies.

Second, a large number of shale E&Ps are sitting on drilled but uncompleted wells (DUCs), and as they work through that backlog, they will be able to increase production at low costs. “All the stars seem aligned for Tight Oil Inc. to generate positive cash flow in 2018, two years earlier than we predicted,” WoodMac said in a February 2018 report.

Obstacles remain

Still, there are some unanswered questions facing shale drillers this year that could undermine performance. A recent survey from the Federal Reserve Bank of Dallas showed evidence of rising costs, with inflation setting in for labor, equipment, rigs and completion services are strained because of the resurgence in drilling. Cost inflation has actually led to a higher breakeven price for much of the Permian at $52 per barrel, which is up $2 per barrel from a year ago.

The lack of pipeline capacity in West Texas could keep shale production forecasts from being realized.

Another question surrounds the lack of pipeline capacity in West Texas, which could keep shale production forecasts from being realized. Output from the Permian is growing so quickly that the region’s pipeline systems are starting to bump up against their limitations. The IEA says that only about 160,000 barrels per day (b/d) of available pipeline capacity was in the Permian as of December 2017, a relatively small buffer. “This small capacity cushion is likely to come under pressure this year, despite capacity expansions of the Midland to Sealy, BridgeTex and Permian Express 3 pipelines,” IEA analyst Olivier Lejeune wrote in a March 28 commentary. “Ultimately, Permian and Eagle Ford takeaway capacity is likely to become insufficient by mid-year, with a deficit possibly reaching as much as 290,000 b/d during the first half of 2019.”

If new pipeline capacity does not come online fast enough, steep discounts for Permian crude will emerge, or shale companies may have to slow production growth.

Meanwhile, the lack of pipeline capacity for all the associated natural gas coming out of Permian shale fields is also a problem. Bloomberg reports that Permian drillers are drowning in gas production, and natural gas prices in the Permian are the lowest in the country, even below gas from the Marcellus Shale. While drillers can flare some of that gas, regulations cap the amount that can be burned. Ultimately, the pipeline bottleneck for gas is forcing some shale companies to cut back on oil production.

Wall Street wants profits, not growth

There has been ongoing discussion in the press and among analysts about shareholders demanding cash flow, dividends and share buybacks, rather than production growth. The recent stock performance of a variety of shale companies indicates that Wall Street is indeed favoring companies that return cash to shareholders instead of using that money for new drilling. This trend is a departure from past years when companies with the most aggressive production forecasts were granted the strongest valuations.

Wall Street is indeed favoring companies that return cash to shareholders rather than using that money for new drilling.

This pressure could prompt the shale industry to manage growth and scale back production plans. Such an outcome would likely be fine with Wall Street—with the sector set to enjoy profits this year, there could finally be more cash flow. But as a result, the U.S. may come in at the lower end of expectations in production forecasts.

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