Wednesday, August 2, 2023

Update on the Shale Treadmill

Oil & gas producers have started reporting earnings, so we can give an update on the Shale Treadmill that we wrote about in May. You may recall that we have been looking at production growth versus capital expenditure growth. It is really important to keep track of the amount of capital expenditure that is required to keep production constant.

Devon Energy gives good disclosure of capital expenditures and production quantities for each basin where it is producing. (They even give the average horizontal well lateral length for each basin, the only producer we follow that discloses this.)

Their production (BOEs) was up only 7.5% year-over-year from Q2 2022 to Q2 2023, with oil up 7.7% over the same time period. However, their upstream capital expenditures were up 87%. Remember, we call it a "production shortfall" when the production growth is less than the capital expenditure growth. So, Devon's production shortfall metric for Q2 is about 80%, which is quite bad.

Their free cash flow was only $300 million in the second quarter. On their enterprise value of $40 billion, that's a FCF yield of three percent.

These shale companies are drilling so hard even with lower commodity prices and the deteriorating well performance. Devon's BOEs produced are about one-quarter natural gas, and they were selling gas for $1.27/Mcf in Q2. (They actually got a negative gas price in the Williston.)

The Devon shareholder list seems like mostly index funds. This thing is on autopilot just drilling wells even if they have to give away the output. Great for management and the royalty owners.

Occidental Petroleum reported oil production up 5% year-over-year from Q2 2022 to Q2 2023, but it was down 5% sequentially from Q1 2023 to Q2 2023. Their capital expenditures were up 69% year-over-year and up 13% sequentially from the prior quarter. Oxy's oil production in the Permian was up 14% year-over-year and down 1% sequentially, and their capital expenditures in the Permian were up 65% year-over-year and up 17% sequentially.

So there is a production shortfall, but not as bad as what we see at Devon. Something else we noticed is that in the Permian, OXY's ratio of oil to natural gas went from 1.81 to 1.94 year-over-year. Rising water cuts and rising natural gas cuts are warning signs of field depletion.

Oxy's free cash flow for the quarter was $1.1 billion, a 5.4% yield on their enterprise value.

Marathon Oil reported oil production up 2% sequentially from Q1 2023 to Q2 2023. (They had an acquisition that closed in Q4 2022 making the y/y comparison less meaningful.) Their capital expenditures were up 20% sequentially. Their free cash flow for the quarter was $440 million, an 8% yield on their enterprise value.

For the ten shale producers that we have looked at so far, free cash flow totaled $3.3 billion in the first quarter on $263 billion of combined enterprise value; a FCF yield of 4.5%. Three smaller producers had negative free cash flow: EQT, RRC, and AR. (Those three produce almost all natural gas.)

We can see that cash flow dried up for shale producers in the second quarter. The low cash flow and production shortfalls are probably caused by several factors:

  • deteriorating resource / basins - rising water cut and natural gas production
  • labor and material inflation - the PPI is down year over year but up 30% since before covid
  • deferred maintenance is a possible factor - this would imply that the production shortfalls would get better as the maintenance gets caught up

So far what we are seeing is confirming the idea of focusing on royalties and slow decline assets like Canadian oil sands and deepwater.

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