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Concho Taking Basis by the Horns in Permian Midstream Buildout

Permian Basin crude oil pricing increasingly is impacted as bottlenecks develop, but Concho Resources Inc. isn't waiting around for someone else to expand the midstream systems, CEO Tim Leach said on Thursday.

Speaking with analysts during a conference call to discuss second quarter results, Leach said Concho remains on track to accomplish its "two-by-three" growth plan in the Permian -- doubling production in three years.

To do that, however, it's going to take Concho's muscle in the West Texas-New Mexico land mass to increase pipeline and storage support, he told analysts.

Production in the second quarter averaged 108,000 boe/d, 6% higher than the year-ago period and at the high end of quarterly guidance.

"We still see annual production growth of 20-24% over '13 and expect third quarter volumes to average between 113,000 and 116,000 boe/d," said the CEO. The advantage of running one of the Permian Basin's "largest horizontal drilling machines" is translating into operational efficiencies and improved returns.

"We're now seeing greater capital productivity as we continue to enhance well design and stimulation techniques," which are driving growth in the Permian's Delaware and Midland subbasins.

To meet its production forecast to double output in three years, one key is a midstream joint venture (JV) with Frontier Midstream Solutions LLC to develop the Alpha Crude Connector (see Shale Daily, May 16). The 400-mile pipeline and various facilities include a 300,000 bbl storage system to be built in the northern Delaware Basin, where most of Concho's activity is today.

"By the end of '15, we expect this gathering system to connect to a majority of our tank batteries in the northern Delaware, as well as to other third-party shippers," said Leach. It would provide the operator with more marketing optionality and "get our crude off our trucks on the highway."

Not too long ago, the CEO said, Concho was focused only on building reserves.

"But the game changed in the U.S., and the Permian's no exception." He pointed to the more than 550 drilling rigs now operating across the Permian, nearly one-third of U.S. onshore rigs. Most of the drilling (60%) is horizontal, with producers now targeting up to eight different zones.

"All production in the Permian has doubled in seven years, following a four-year decline," said Leach. "As a result of this robust activity and growth, it's not uncommon for the Mid-Cush [Midland-to-Cushing] basis differential to be volatile, to fall in refinery outage or a curtailed pipeline. Mid-Cush for the month of August just settled above $10.00/bbl."

The Permian "clearly" is a "fragile market, but some expansions are expected to begin flowing soon and into the first half of 2015. The takeaway capacity of new and expanded pipes is "over 750,000 b/d," said Leach.

One expansion, BridgeTex Pipeline Co. LLC's proposed 300,000 b/d pipeline, "could provide a relief valve for the basin, but it is far from a cure-all for producers," said Wunderlich Securities Inc. analyst Irene Haas. BridgeTex partners launched an open season for the project in July (see Shale Daily, July 10). ACC would go through Lea and Eddy counties of New Mexico and Culberson, Loving, Reeves and Winkler counties of Texas. Using pipelines versus trucking is expected to reduce costs by $1.00-2.00/bbl.

"Like many other successful plays, we are seeing bottlenecks develop in the Permian," said Haas. "Basis differentials between the Permian and Cushing have widened as production takes off."

Concho hedges for the Mid-Cush differential with basis swaps, but "there is only so much hedges can do," Haas said. "Financial hedges do not solve the physical problem of spotty infrastructure and getting the oil out, especially in the northern Delaware basin," where the producer trucks all of its oil output.

Concho Executive Vice President Jack Harper said "the industry has been waiting on BridgeTex," which "should begin flowing here relatively quickly. We think though, until the additional projects come on in the first half of next year, that will be when we would start seeing some relief on that Mid-Cush differential over and above where you see in the futures market today. "

However, "the challenge to producers doesn't end there" on differentials, said Leach. "Refineries are running at record utilization rates and in some cases, are retrofitting to handle a wave of light sweet crude."

Implementing Concho's long-term midstream strategy has become a challenge in the complex environment. So it's using its Permian muscle to "secure physical transportation to the best markets and improve the prices we realize at the wellhead," said Leach.

The ACC "accomplishes both of our strategic midstream objectives and also provides significant value to our core upstream business in the northern Delaware Basin, where we currently rely on trucks to haul our crude oil to scattered delivery points," said Leach.

However, there are other types of bottlenecks in the Permian, said COO Joe Wright. Concho is facing delays to get sand used for hydraulic fracturing (fracking) as demand continues to rise. It's a big problem for operators in the Delaware, he said.

"There has been a lot of chatter around sand shortages," Wright told analysts. "It's really more of a transportation of sand, or distribution of sand” issue. Delays are seen for the next month at least, he added.

Since an equity offering in May, Concho has acquired an additional 13,000 net acres in the northern part of the Delaware, which complements its existing leasehold.

"We're increasing our acreage footprint and more importantly, we're adding more extended lateral opportunities across our acreage position," said Leach. "Year-to-date, we've agreed to acquire over 22,000 net acres, and we continued to look at opportunities that will fit well in our existing portfolio."

More than half of this year's spending is devoted to the Delaware subbasin, where Concho has drilled more than 300 horizontals since 2010. Today, it's about extending the laterals and increasing the number of fracks.

"Our average drilling days are going down, but at the same time, we're drilling longer laterals and completing wells with larger fracks," said the CEO. "As a result, the productivity of our wells is increasing. With all these improvements, we're still in optimization mode in the northern Delaware Basin, and we're working toward driving similar improvements across all of our core areas."

The most recent 31 wells in the Delaware recorded an average 30-day initial production rate of 931 boe/d, 81% weighted to crude oil -- both new records for Concho. The second quarter was the first in which Concho's average lateral extended beyond 5,000 feet, said Leach.

In the southern part of the Delaware, Concho is running six rigs and has added eight wells with average lateral lengths of 5,400 feet, more than 20% higher than in the first three months of this year. Most of the development is taking place in Concho's Big Chief prospect. The first three-well pad also is planned for the Wolfcamp Shale of the Delaware in the third quarter.

Mostly on derivatives losses not designed as hedges, Concho's net income in 2Q2014 fell to $11.8 million (11 cents/share) from $84.7 million (81 cents) in the year-ago quarter.

The latest results were impacted by one-time items that included a $164.7 million loss on derivatives, a $26.1 million loss in cash payments on commodity derivatives, $11.2 million of leasehold abandonments, a $4.3 million loss on extinguishing debt and a $9.6 million loss from asset sales. Excluding the one-time events, Concho earned $113.8 million ($1.04/share), versus $102.5 million (98 cents/share) in 2Q2013.

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