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We’re on the Verge of a Reset of Expectations in the Oil Sector
The effect of lower prices on activity
The most probable scenario in my book is that lower prices bring about a sharp curtailment of drilling and a moderate reduction in completion activity in shale. Most of the shale drillers have a strong inventory of drilling locations where capex is funded with WTI at $40. But that’s a rainy day…or “rainy year” scenario, and doesn't mean the CEO's of these companies won’t pull back funds if the current weakness is sustained. In my view, if there’s any significant time in the $60's for WTI, capex budgets are going to start being trimmed. Sub-sixty, they will be slashed.
Investors who have gotten used to hefty dividends and massive debt and share count reductions over the past couple of years will demand it. The old saying the "Cure for low prices, is Low prices," is still true.
I discussed some of the challenges facing the U.S. shale industry in an OilPrice article at mid-year. Thus far improvements in technology and efficiency have kept this from occurring, but investors should regard this roll-over as being delayed rather than cancelled. Industry sources tell me that we are just about in balance with legacy shale declines, drilling just enough to move production higher incrementally higher. We've seen that over the past few months, with only the Permian and the Bakken adding net barrels incrementally.
For example, charts show a net addition in the Permian of 760K BOEPD in 2023. That’s good, right? Deeper inspection shows that much of this occurred in the first quarter of the year when the rig count was 20% higher than today. Since July the count has been a 100 rigs below that figure, and since August it’s averaged around 150 below the 779 with which we started the year. To tie a bow on this notion we can cite the Permian increase for December, 2023 at a measly 5K BOPD. This gives me confidence in my sources.
Thank heavens for the past couple of years though. Balance sheets are repaired, debt maturity ladders are benevolent, and companies have cash on the books, mostly. More importantly they have reconfigured themselves to survive in a sub-$60's oil price scenario. They will survive to see another day should that occur.
The first place capex will be cut is in drilling. Earlier this year some folks were forecasting a ~50 rig pickup in 2024 to somewhere in the 680 range. I think that's off the table over the short haul, that we could be headed for a sub-600 rig count scenario. That will also have an impact on the frackers, but not as extreme, at least in the near term as there are DUCs to bring on. That won't have the runway it did in 2020/22, as the DUC count is still way down, the industry only added for a few months, before returning to withdrawals. From late 2020 to mid-2022 the DUC count fell from the mid-8,000's to the mid-4,000's-pretty much where it stands as of now.
DUCs are not likely to be the complete panacea they were in 2021-2. Remember we are starting at half the DUC inventory of 2021. There is also a DUC "quality" issue with which to contend. The DUCs of today are probably not as prolific as the one's Turned In-Line-TIL'd in 21-22. I have had conversations with production engineers that were fairly disparaging toward the remaining DUC inventory. We may see!
Your takeaway
I noted above that I felt drilling would take the major hit as operators struggled to maintain output and cash flow in a sub-$60.00 oil price. Consistent with that belief I think the big land drillers, Helmerich & Payne, (NYSE:HP), and Patterson UTI, (NYSE: PTEN) could see the weakness they experienced in Q-4, 2023, continue into Q-1, 2024. The shares of both of these companies have declined by about 30% over this period, and as I said may be subject to further weakness, somewhat dependent on oil prices as we have discussed. My buy targets for PTEN and HP are sub-$10 and sub-$30 respectively.
So I am cautious on the drillers presently, where am I looking for short-term growth? One place is with the U.S. land frac’ers, with Liberty Energy, (NYSE:LBRT) being a top pick at current levels. Liberty is a segment leader and innovator with about a 20% market share according to industry sources.
Liberty is crushing it with industry-leading Return on Capital Employed, of 44% as reported in their Q-3, 2023 filing. Other earning metrics are discussed in the slide below. One key statistic is the rise in their EBITDA over time as they have integrated into being a multi-service company.
The company has a number of potential catalysts heading into 2024. One in particular that I will highlight is Liberty has just inaugurated a new segment that I think has the potential to drive revenues and margins higher in the New Year.
I am referring to Liberty Power Innovations here. This is just an idea whose time has come. With the focus on emissions related to frac'ing, having mobile delivery of CNG-compressed natural gas, to the rig site to run the pumps, is a stellar idea and one that should pay dividends in the near future. A point worth making is that they are shifting from a refined product that has been transported a number of times by the time it reaches the rig, to a locally produced material that requires relatively little treatment before being compressed. There is efficiency in this alone.
Consider that a single frac fleet can consume 6-7 million gallons of diesel annually, and you begin to have an idea of the amount of liquid fuel that could be displaced by CNG. The linked article notes that 1 MCF of gas replaces about 8 gallons of diesel, a tremendous direct savings with the gas selling for $2.5 MCF and diesel for $5.00 a gallon. It's early days and I can't put a revenue or EBITDA on this business. That said, it's a natural development given the macro emissions reduction picture, and in my way of thinking comes with a moat. I don't think this is readily replicable by other frackers. Chris Wright, CEO comments on the course he sees for LPI:
“First to power our frac fleets. But it's also of course going to supply other people's rigs, other operations in the field. There are other oilfield applications for that. And ultimately as you look ahead, what is Liberty generating expertise in. We're generating expertise, and having the highest thermal efficiency on wheels, mobile power generation there is. And we're generating expertise in how to move natural gas, how to remotely or on-site process natural gas to deliver natural gas, wherever it's needed and however it's needed.”
With the margins that Liberty delivers combined with innovations they are rolling out, and a market biased toward their service segment, I feel the shares of the company are significantly undervalued at current levels.
Liberty is currently trading at an EV/EBITDA multiple of 2.5X on a Q-3 run rate basis. Analysts rate the company as Overweight with price targets ranging from $20-27.00 per share. The company has a history of beating analyst targets over the past year, and only seasonal weakness might keep this from happening for Q-4. EPS forecasts are for $0.60 per share in Q-4, rising to $0.71 in Q-1, 2024. They easily beat estimates in Q-4, 2022, and Q-1, 2023 so a trend is established. If Liberty manages to beat in Q-4 then I think the company’s multiple should rise. A 3X would easily deliver the lower range of the price targets, and a 3.5X would put them in sight of the upper range.
None of these estimates take into account any revenue or margin growth that the company has consistently exhibited over the past several years. With that in mind, I have Liberty as a top pick. I think investors with a modest risk tolerance should carefully consider if the company meets their objectives.
By David Messler for Oilprice.com
