Talk about natural gas oversupply may not be the big story when the domestic exploration and production (E&P) sector unveils quarterly earnings reports over the next few weeks. Instead, conversations may center around the impact lower crude oil prices had on the third quarter, and how they may impact drilling plans into 2015, energy analysts said this week.
If West Texas Intermediate (WTI) crude oil were to remain around $80.00/bbl or below, it won't be a pretty sight for the U.S. rig count, or for the oilfield services (OFS) sector, said Wunderlich Securities Inc.'s Jason Wangler.
"What a long strange trip (down) it has been," wrote Wangler of earnings/capital expenditure (capex) plans by OFS and E&Ps. "After being the darling of the investing world during the first half of 2014 and seeing strong returns, the energy complex has had the wheels fall off due to oil price declines that caused concerns about the activity levels in the U.S. going forward.
"While these concerns have not hurt the real-time activity levels for the onshore OFS names, as the E&Ps have continued to execute their 2014 capex programs funded by healthier oil prices and open debt/equity markets, the timing of this uncertainty clouds the 2015 activity levels for the E&Ps and by proxy raises concern on the OFS activity levels (if not brings fear into play given the active building cycle that recently kicked off)...
"We think the 3Q2014 figures will be strong but sadly overlooked as a clearer picture of 2015 remains the focus for investors."
The biggest focus in the upcoming conference calls likely will be 2015 activity, "and the concerns of a re-emergence of oversupply, given the recent uptick in new equipment orders/delivery," he said, evidenced in recent strong quarterly reports by Halliburton Co., Schlumberger Ltd. and Baker Hughes Inc. (see Shale Daily, Oct. 20; Oct. 17; Oct. 16).
"The solid 3Q2014 results we expect for companies will be a nice feather in their caps, but the real question will be how the pricing and utilization environment looks both currently and heading into 2015. With natural gas remaining depressed and oil coming in dramatically of late, we think there is ample risk of slowdowns in the space but feel the high-spec equipment and best-in-class basins will remain active even at current levels."
The Morningstar Equity Research team led by energy director Jason Stevens said in a note on Wednesday there had been an overreaction in the market to sinking oil prices, and "quality" producers were trading at meaningful discounts to fair value estimates. Morningstar covers 18 onshore E&Ps from super independents that include Anadarko Petroleum Corp. and Apache Corp.
"To be certain, we have seen a remarkable shift in U.S. markets, as unconventional production technology has resulted in significant efficiency and production gains," said Stevens. "The result is U.S. tight oil shifted down the supply cost stack, while simultaneously increasing its share of world production. So effectively, some of today's pricing tumult is the result of this shift along the supply curve and the displacement of higher-cost barrels.
"If anything, then, this tight oil shift should insulate U.S. E&Ps from oil price concerns. No longer are U.S. E&Ps the marginal producer. In fact, our analysis suggests that the average break-even for our E&P coverage is $70/bbl, well below our $90/bbl marginal cost and below today's $80/bbl WTI oil price."
According to Morningstar's analysis, most of its coverage could continue drilling unchanged under a $75.00/bbl price scenario over a few years, but more leveraged names "would likely be required to scale back activity to preserve their balance sheets."
BMO Capital Markets analysts aren't expecting a "catalyst-rich" quarter for E&Ps. The earnings numbers should be off from the second quarter because West Texas Intermediate (WTI) prices are off 6% and Henry Hub gas is down 14% from 2Q2014.
"We expect close attention to any updates to 2015 hedging programs this quarter in light of the sharp drop in forward prices," said the BMO team. "This quarter is typically a busy hedging quarter for producers, and investors will be interested in dividend coverage and support for capital programs."
Topeka Capital Markets' Gabriele Sorbara, who covers a range of U.S. onshore operators, is expecting "disappointing" results for the quarter on a variety of factors: lower prices, wider differentials, operational delays, pad development adjustments, weather issues, etc.
"That said, at current valuations, our universe screens very attractively at our long-term WTI crude oil price of $90/bbl," Sorbara wrote. He'll be watching for 2015 spending/activity levels to be "in focus" with the oil price selloff.
"With the fast and furious sell off in WTI oil prices, we expect early discussions around 2015 drilling plans/budgets. We continue to believe $85-95/bbl WTI crude oil remains a healthy level for the supply/demand balance longer-term. At these levels we expect E&P capex budgets to be up 5%-plus; however, with prices in the low-$80s/bbl and the continued macro uncertainty, we believe budgets will be more flattish, if not down, until there is further visibility around a stabilization or improvement in crude oil prices."
It could be a bumpy ride into 2015 if WTI prices were to remain steady in the $80s, according to Tudor, Pickering, Holt & Co. (TPH). The analysts held a conference call on Monday to discuss the price of oil and its potential impact on U.S. onshore drilling if crude were to remain around $80 or below.
"Most of the basins are still in the money at $80.00, but some are barely in the money," said TPH Managing Director Dave Pursell. "What happens is that balance sheet leverage starts to increase fairly materially at $80 crude over any length of time..."
Below $80.00/bbl oil prices, the leverage on the balance sheet is high enough that some producers "will begin to lay rigs down," Pursell said. "And it's no surprise...that the large caps will have more ability to sustain lower oil oil prices, but the smaller caps will be a bit more sensitive to leverage..." In any case, "our view is below $80 is not sustainable for any period of time."
In that $80.00 and below scenario, TPH identified the most vulnerable plays as the:
- Tuscaloosa Marine Shale
- Permian Basin vertical tier 2 (Cleveland, Tonkawa, Marmaton)
- Mississippian Lime
- Eagle Ford Shale oil tier 3; and
- Bakken Shale oil tier 3
"We estimate that 140-160 horizontal and 30 vertical rigs are running in these plays and thus are more at risk in a 470-80 oil price environment."
When OPEC, the Organization of the Petroleum Exporting Countries, announces that it will cut back output, the news has an immediate impact on the markets. When North American operators lay down rigs, it may take weeks before the production decline has any effect.
"The challenge in the U.S. is that it takes time for rigs to get laid down, to see the ultimate decline in production," said Pursell. "The longer it is with less activity, the bigger the impact...The challenge for that is, the longer the prices stay lower and the lower the rig count goes, the harder it is to turn production back on," to move the rigs back into a field and ramped up.
"As we get a demand response, the United States won't be resupplying the market, and it will put all of the pressure on OPEC to restore production and then some...We think there is limited excess capacity inside OPEC..."
Lower oil prices will hurt E&P revenues "immediately, with most of the drop falling straight to the bottom line because of their high operating leverage," according to Moody's Investors Service. If lower prices persist, drilling and oilfield services companies would be pressured as E&P companies reduce capital spending and their demand for services.
However, despite growing oil supplies, particularly in the United States, longer-term pricing should remain above $80.00/bbl, given growth in global demand, said Moody's Managing Director Steve Wood. But prices could dip into the $70s over the next few months, he warned.
"It's hardly shocking that oil prices have weakened in the face of growing supply. But last week's sharp drop has been surprising and can be attributed to expectations of weaker demand growth in China and Europe at the same time that Saudi Arabia has threatened to defend market share rather than acting as OPEC's -- and the world's -- swing producer." The other significant factor weighing on prices is the strengthening U.S. dollar. Because oil is denominated in dollars, a stronger dollar leads to lower oil prices.
The International Energy Agency (IEA) earlier this month said even if crude oil prices were to drop below $80, U.S. unconventional oil would remain profitable (see Shale Daily, Oct. 15).
Sanford C. Bernstein & Co.'s Bob Brackett disagrees. In a note Monday, Brackett estimated that up to one-third of all U.S. shale oil output would not be economic at that price. "We disagree with other estimates, including those cited by the IEA, which suggest the vast majority of shale oil production is robust at such prices. Our expectation is that oil price will revert back to a level where a much smaller portion of production is uneconomic." Like TPH, Brackett thinks oil prices are near the bottom.
If there is a slowdown in U.S. oil production, it would domino into reducing domestic gas output but not by much, according to Pursell.
"Any reduction in associated gas and any balance sheet issues also impact natural gas production," he said. "It may help on the margin, but we look at the amount of gas production coming in '15...We maintain our longer term bearish view on gas because supply is so robust."