I’ve been arguing recently–in posts on my paid JubakAM.com site like this one http://jubakam.com/2017/01/red-hot-permian-goes-to-white-hot-with-another-big-acquisition-and-freaks-out-global-oil-market/ and on this site with posts like “Permian power! Pioneer Natural crushes production guidance–that you need to own a piece of the Permian Basin in your portfolio.
I’ve spelled out the reasons in more detail in other posts (like those cited above) but let me throw a few reasons around here briefly. According to the U.S. Energy Information Administration (EIA), the Permian Basin has seen a 60% increase in oil output since 2007. It’s now the leading production basin in the United States, having passed the Gulf of Mexico, and currently accounts for about 25% of U.S. oil production. Its production of 2 million barrels a day makes it the second largest oil field in the world by production, second to Saudi Arabia’s Ghawar field, which produces 5 million barrels a day. Estimates put the Permian second to Ghawar in recoverable resources too. A leading Permian Basin producer Pioneer Natural Resources puts recoverable resources in the basin at 160 billion barrels of oil equivalent. (Ghawar holds an estimated 160 billion barrels.) Other estimates say recoverable reserves are more likely in the neighborhood of 20 billion barrel, which would still make the Permian one of the ten largest oil fields in the world.
But that’s only half the story. Thanks to improvements in the fracking technologies used to extract oil, natural gas, and natural gas liquids from the rock formations in the Permian, costs have been dropping like a stone down an abandoned well pipe. Pioneer, for example, reduced costs by 29% in 2016. That has made oil from some parts of the Permian exceedingly profitable even at today’s $50 to $55 a barrel oil prices. And since wells in the Permian are easy to shut down just short of completion and easy to put back into production after that shutdown, the Permian has become a big part of the story that has turned U.S. oil shale producers into the swing producers in the global market place.
Okay, that’s the big picture. But for investors there’s the “little” picture too. What do you buy so that you’ve got a piece–and the best piece no less–of the Permian in your portfolio?
You start, I think, with Pioneer Natural Resources (PXD). To me this producer is the standard for judging all other producers in the Permian. Let me remind you of some numbers from the company’s fourth quarter earnings report. For the full year production climbed 15% from 2015’s average level. Production costs per barrel fell 29% year over year. In the year Pioneer added 205 million barrels to proved reserves from discoveries, extensions, and revisions of previous estimates at a finding and development cost of $9.11 a barrel of oil equivalent. That amounted to reserve replacement of 232% of 2016 production. And the company projects that it will grow production to 1 million barrels a day by 2026. That would be four times 2016 production. The company will be able make the investments necessary to hit that goal from cash flow beginning in 2018. Numbers like this are why Permian has been a member of my long-term 50 Stocks portfolio since 2012.
For a long time, Pioneer Natural was my only Permian pick. With the painful volatility of the energy sector in the last few years fresh in my memory I’ve shied away from overweighing the sector in general and the geology in particular.
But I’ve changed my mind abut that because of the way that risk and reward have changed for oil. Right now the price of oil–and therefore the track of most oil stocks–depends on the ability of OPEC to live up to its agreement to cut production. If the cartel can carry through on its plans, it will reduce the global glut of oil and oil prices will stabilize around $60 to $65 a barrel, perhaps higher. That would obviously be good, very good, for just about all oil stocks. That’s the potential reward of investing in the sector now. If, on the other hand, OPEC members play their usual games of cheating on quotas, the organization will not eliminate the glut. Instead oil would initially rise in price just enough to encourage lower cost producers outside of OPEC, such as the lower cost U.S. oil shale producers, to ramp up production. And that would leave oil vulnerable to a drop below the current range and into the $40s. That would be bad for most oil stocks. That’s the risk. (This is the relatively near term view of oil and doesn’t take into account the challenge to the sector from what looks to be permanent reductions in demand as the global economy moves away from carbon fuels.)
Except that this risk and reward scenario works out substantially differently for some producers in the Permian. If your costs are low and you can increase production rapidly, your earnings will skyrocket if OPEC keeps to its agreement and succeeds in pushing up oil prices. If your costs are low and you are able to relatively quickly expand or cut production, you won’t get hit too badly if OPEC doesn’t carry through on its deal. Obviously, a Permian producer would make more money at $60 a barrel than at $45, but at $45 some Permian players would still turn in solid earnings and would still be able to grow production. In essence the returns and risks for owning the right Permian producers aren’t symmetrical and they don’t follow the bell curve that I laid out in my recent post on that topic. A position in the Permian isn’t only likely to outperform that market if OPEC holds to its deal. It’s likely to outperform the energy sector if OPEC’s agreement falls apart.
That said, the question becomes “Is it better to put all your Permian money into Pioneer Natural Resources or would it be better to diversify a bit?” In general a reasonable amount of diversification is good–despite what I know now about Pioneer Natural Resources, the company could do something stupid or just wrong and lag its peers. Diversification would make especially strong sense, though, if I could find another Permian play that looks, in some ways at least, better than Pioneer.
Because after all Pioneer Natural Resources isn’t the perfect Permian stock–it’s merely a very good one. Because it is the best known Permian name, it attacks cash, which pushes it up in these days of the Permian boom. But that also makes the stock expensive in relation to its peers. Credit Suisse figures that Pioneer trades at something like a 47% premium to its peers on a price to enterprise value basis. And because it has attracted so much cash–as someone who bought back in 2012, I’m not complaining too much, of course–the stock now sports a market cap of $32.5 billion, which makes it too pricey for anything but the very largest acquirer. That means that while Pioneer is indeed the beneficiary of the increasing prices paid by Big Oil to build up positions in the Permian, the company isn’t likely to get the big one-time premium that an acquisition might bring to shareholders.
So I’ve scouted around for a second Permian Pick and I’ve found one. Today, February 10 I’m going to add shares of Diamondback Energy (FANG) to my Jubak Picks portfolio. The shares closed at $103.93 on February 9. I’m putting a target price of $130 on the shares.
First, of all, because you don’t want just a play on the Permian in general but on the most production parts of the Permian–the Wolfcamp and Spraberry regions–in particular. It really, really matters where you drill (and where you own leases to drill) in the Permian. Forbes contributor Art Berman put together a detailed study of production costs in the Wolfcamp and Spraberry back on June 19, 2016. Costs have come down considerably since then–remember that Pioneer, for example, reduced costs by 29% in 2016–but Berman’s figures still give a good sense of the differences among producers in the Permian Basin. For example, among the Top 5 producers in the Wolfcamp breakeven costs ranged from $110 per barrel for Devon Energy (DVN) to $45.28 for Anadarko (APC). In the Spraberry, Berman’s breakeven estimates ranged from $91.50 for Apache (APA) to $43.23 for Laredo Petroleum (LPI). At $5.24 Diamondback Energy’s break-even costs were a bit lower than the $52.20 a barrel for Pioneer back in early 2016. (Both companies are Top 5 producers in the Spraberry region of the Permian. Diamondback recently acquired 76,000 acres from Brigham Resources that expanded the company’s presence in the Wolfcamp region.)
Daimondback isn’t cheap but it is cheaper than Pioneer. The shares trade at roughly a 43% premium to the company’s peers instead of the 47% premium for Pioneer.
But that premium looks to be deserved. Diamondback is the only Permian producer that I’ve been able to find that shows higher projected production growth than Pioneer. Production is projected to grow by 27% in 2016, by 65% in 2017, and by 43% in 2018. The company is currently cash free flow negative when you include capital spending on new wells, but it looks like free cash flow will turn positive in 2018. That’s roughly the same schedule as at Pioneer.
And with a market cap of just $9.4 billion Diamondback is a big but much more manageable acquisition candidate for any member of Big Oil looking to expand in the Permian.