From Reuters
Seven years ago, Diamondback Energy Inc went public with a modest parcel of drillable land in the Permian Basin of West Texas.
Like dozens of other Permian startups, the firm then pursued a classic wildcatter’s strategy – borrowing to buy up acreage, acquire competitors and quickly boost output in the booming shale field. Today, Diamondback (FANG.O) is the 7th largest producer in the top U.S. oil region, according to researcher Wood Mackenzie.
But Diamondback differs from most of its peers in a crucial way – it’s poised to make more cash than it spends. The firm promised to reward investors by buying back up to $2 billion in shares and delivering $750 million in free cash flow next year if U.S. oil prices remain at about $55 per barrel. It started paying shareholders a dividend last year and raised it by 50% this spring.
“That’s a big pivot for our industry, living within cash flow and not being part of that ‘drill, baby, drill’ crowd,” Diamondback Chief Executive Travis Stice said in an interview.
Only a handful of independent shale firms collect more than they spend. Total overspending by a group of 29 such firms totaled $6.69 billion in 2018, according to Morningstar data provided to Reuters by the Sightline Institute and the Institute for Energy Economics and Financial Analysis. Diamondback was among the outspenders, but Morningstar projects it will produce free cash flow this year.
The stark challenges facing the companies that pioneered the Permian signals a seismic shift in the shale economy – driven by investor demands for returns and a flood of investment from major oil firms including Chevron (CVX.N), Exxon Mobil (XOM.N), BP (BP.L) and Royal Dutch Shell (RDSa.L), with their boundless budgets and integrated operations stretching from the oilfield to the service station.
To survive and thrive, independent shale drillers must continue expanding production while slashing costs, returning profits to shareholders, and expanding into new operations such as pipelines to achieve efficiencies, according to interviews with a dozen shale executives and financiers.
Not all will make it. Six North American exploration and production firms have filed for bankruptcy this year and others are on the brink, according law firm Haynes and Boone LLP. Smaller producers on average plan to spend 20% less this year than last, with some slashing budgets as much as 60%, according to researcher Drillinginfo.
The industry’s new focus on cash flow requires scrutinizing every cost down to “pennies,” Stice told Reuters, and shifting into what shale firms increasingly call a “manufacturing” strategy for drilling.
That means placing multiple wells on one patch of gravel and fracking them one after the next, then connecting them to a pre-built processing systems that link to pipelines.
A Diamondback rig that Stice can see just behind his backyard will stay in that location for six months, moving 30 feet at a time to drill eight wells in four oil layers stacked on top of each other like a pile of books. With horizontal drilling technology, the rig targets oil from a few miles away, beneath a Midland, Texas, shopping mall.
“It used to be we’d do one well, and it took 60 truck loads to move a rig,” Stice said.
Now it takes four to eight hours to start on the next well.
“The guy that wins the game in manufacturing is the guy that can manufacture at the lowest cost,” Stice said.
Cash is king
Shale firms used to lure investors with bold talk of newfound oil reserves under the ground. Now they talk about how cheaply they can get it out – emphasizing the flow of cash over the flow of crude.
Exploration firms for decades saw their stock prices surge on new discoveries. Investors assumed oil was scarce and prices would rise. But the West Texas shale boom has upended that mindset with a flood of output that has made the United States the world’s top oil producer, overwhelmed domestic refiners, sent exports soaring – and kept a tight lid on prices.
Today’s shale investors want quick profits and have little use for statistics on reserves or soaring production.
Two years ago, Permian bellwether Pioneer Natural Resources said it would target 1 million barrels of daily production by 2026. This year, Pioneer CEO Scott Sheffield told analysts that goal was “no longer a focus.”
Investors had warned the company that they would dump its stock if it “added any rigs at all this year,” Sheffield said in the first-quarter call with analysts. In May, the shale company disclosed it had laid off a quarter of its staff to save $100 million and “remain competitive.”
Smaller, private-equity backed firms have traditionally assembled acreage, proved the reserves and sold out fairly quickly to a bigger firm. That strategy needs a “complete rethink,” said Todd Dittmann, a managing director at investment firm Angelo Gordon.
Energy investors, he said, are now more interested in firms that prove themselves capable of the operational “blocking and tackling” needed to profitably grow production.
Small Permian producer Elevation Resources LLC would like to sell out to the bigger firms working neighboring properties – Occidental, Diamondback and Exxon – but so far has no takers. So CEO Steven Pruett has gone ahead with a $200 million investment to build out his operations for the long term, aiming to reward investors with regular distributions rather than a lump sum payment from a sale.
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Chasing higher prices
Stice and other shale executives are moving away from selling their production at the wellhead, taking stakes in pipelines that allow them to mimic the majors by selling at export hubs along the U.S. Gulf Coast, where prices can be several dollars higher per barrel.
Diamondback bought a 10 percent stake in two crude pipelines that will start operating this year. The investment secures transportation to the export market and gives it a cut of the profits as other firms pay to move oil along the route.
Occidental Petroleum Corp (OXY.N) – one of the top Permian producers, which recently bested Chevron with a $38 billion bid for Anadarko Petroleum (APC.N) – has emerged as one of the top three U.S. exporters of U.S. crude oil.
Pioneer Natural Resources moves about 200,000 barrels per day of crude to the Gulf Coast, with 80 percent of it loaded onto ships for transport to Europe and Asia, and is looking to sign long-term deals directly with foreign buyers. Selling oil at higher international prices has earned the firm an additional $600 million over the last five quarters.
Peter Hays, a Houston lawyer who represents Permian producers, said the focus on cost-cutting and accessing higher-priced oil markets has his clients revamping their processing and pipeline contracts. They are adding provisions to limit costs and add flexibility to move products by whichever pipeline route fetches the highest price, he said.
“A decade ago, the average gas-gathering and processing agreement was 20 pages,” he said. “Now, they are 80 to 100 pages.”
