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E&P Manufacturing Methods Forecast to Dominate Headlines in 2014

Sustained natural gas and liquids output again may dog commodity prices in 2014, but analysts are keen to see how U.S. exploration and production (E&P) companies hone their operations into manufacturing marvels.

E&Ps, now preparing to unveil 4Q2013 and full-year results, will show impacts from the end-of-year winter storms, particularly operators in the Permian Basin and Midcontinent, following well freeze-offs. Apache Corp. last week and Pioneer Natural Resources Co. have became the latest of several big Permian names to acknowledge that the quarterly numbers won't be as strong as it had planned.

Most analysts will be watching the weather impacts, but they also will be looking for guidance on what E&Ps are planning in 2014, as they sell off fringe assets and concentrate on organic growth.

Wells Fargo Securities analysts David Tameron and Gordon Douthat believe the transition from exploration to manufacturing "will dominate the headlines" this year. As they put it, it will be less E (exploration) and more P (production).

"In our view there are three focal points to this story: optimal field development; efficiency gains from drilling and completion operations; and the possibility for the E&P group to narrow the persistent multiple gap to other sectors, such as industrials." The next phase in the U.S. energy revolution "can best be characterized as hydrocarbon manufacturing.

"While the transition to this phase began in 2013, it's still very early and relative to other 'manufacturing' industries, from a straight manufacturing perspective we think the E&P industry has the potential for massive gains."

The technological breakthroughs in horizontal/fracturing led to a land grab that resulted in many E&Ps with lots of land and not enough money to develop it (see, for example, Chesapeake Energy Corp.).

Today, E&Ps better understand the nuances of the onshore performers, allowing them to trim up the portfolios and ready for hydrocarbon manufacturing. Net asset values (NAV) dominated the investor mindset last year and should continue to drive share performance, but the focus going forward likely will shift from downspacing to maximizing leases on a field-scale level, said Tameron and Douthat.

"As an example, 24-hour rates used to be a key metric for new wells, arguably due to pressure from the Street and investors. They remain an important factor admittedly, but they have lost some of their luster as industry focus shifts toward 30 day/60 day/120 day rates" over mind-boggling initial production (IP) data.

While NAVs will continue to drive the share price, are one factor, and estimated ultimate recoveries (EUR) are touted, net present value (NPV), which takes longer to determine, has the lasting impact.

"It's not about maximizing IPs, location counts, or EURs necessarily -- it's about maximizing NPVs," said the Wells Fargo analysts. "Quite frankly, it is exciting and impressive to watch this part of the story unfold in our view."

This year likely will be a "tough commodity price year for E&Ps, but opportunities are there "for well-managed, high volume growth E&P companies," said Raymond James & Associate Inc.'s J. Marshall Adkins.

"First of all, we believe natural gas prices still look healthy relative to the past five years," he said. "Second, a key tenet of both companies and investors is improving capital efficiency."

Efficient pad drilling and downspacing success should continue to mute well costs per unit of production, while better-than-ever technology and tried-and-true experience advance initial production rates and output growth. New technologies hold particular appeal for operators already holding leases held by production, and those working the "most economic" areas, like the Permian Basin, and Eagle Ford and Bakken shales.

The bottom line is performance, underground and above ground. Perhaps the "most critical indicator" of an E&P's prospects in 2013 was financial discipline. The same holds true in 2014. Operators that keep spending within cash flows, actively hedge and sell assets that don't fit in the portfolio "will be the best positioned to endure weak commodity prices," Adkins said.

Irene Haas, who covers North American E&Ps for Wunderlich Securities, noted that natural gas prices firmed at the end of 2013, but "Appalachian production continues to cast a long shadow" and that will continue through the year.

"Currently, we have a 2014 natural gas price forecast of $3.70/MMBtu, and we are in the process of reviewing our outlook with a positive bias. However, we are not looking for average pricing north of $4.50/MMBtu in 2014, as more monster wells are being completed in the Marcellus and the Utica."

Some investors worry that U.S. oil supplies will balloon as gas supplies have, but Haas said those concerns are "somewhat overblown from the supply side since we continue to import 7-10 million b/d of oil," she said. Transportation difficulties also are a problem in some areas like the Williston Basin, and basis is widening for crude in the Niobrara formation. The demand side, though, indicates some stabilization and growth as the U.S. economy recovers.

"All of these points cause us to believe the overall market for E&Ps looks strong in 2014," Haas said. "While basin-specific issues and differentials could crop up, and our capacity to process light sweet in the Gulf Coast area is tightening, we believe that 2014 should be another positive year operationally and financially for the segment."

Analysts at Tudor, Pickering, Holt & Co. Inc. (TPH) said the U.S. energy sector will be a wildcard, as it usually is.

"This is the least bold prediction we could possibly make," said analysts. The United States "is always a wildcard coming into the year given the large number of E&P operators and the effectively spot nature of so much of the business." Strong land rig contracting and a bullish early look for capital expenditures from public independents, however, underlie a "bullish sentiment" overall.

Not getting enough discussion is whether the private E&Ps will increase their spending on par with the public operators, which TPH analysts doubt. If that doesn't happen, spending growth may be closer to 5% than 10%, analysts said.

The domestic oil growth "has played catch up to the known vast natural gas opportunity," TPH analysts said. But plenty still has to happen for those new resources to be exploited: natural gas demand, liquefied natural gas exports, fixing the light oil oversupply through exports, refining capital spending, etc. Those events, they said, won't happen this year.

Could onshore oil growth diminish deepwater expansions in the Gulf of Mexico this year? While some investment bankers and government agencies are forecasting shale oil will threaten the offshore, Douglas-Westwood's Steven Kopits doesn't think so based on the evidence.

"We have contended that the world is short of oil, and this shortage, rather than changes in habits or demographics, is driving decreasing oil consumption in the advanced countries. If the oil supply increases, then any overhang will be quickly absorbed. And that’s what the record shows..."

There may be soft patches in the year ahead for oil, "but expect any excess supply to rapidly find a home, with prices returning to recent levels in a few months. Shales are no threat to deepwater."

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