E&P: Will Production Resilience Continue in 2016?

E&P Companies Did More With Less In 2015

The year-long depression in oil and natural gas prices helped spur continued innovation in the energy space in 2015. E&P companies drove down well costs and operational expenses to deliver wells that remained economic, with far lower pricing, than imagined possible heading into last year. Industrywide, horizontal well costs declined by as much as 35 percent by late 2015 (vs. mid-2014) while lease operating costs were down more than 10 percent for many U.S. E&P operators.

Much of the well cost savings stemmed from lower rates from the service providers, which slashed fees to help maintain market share and keep crews working. However, drilling efficiency improvements were also a meaningful component of the reductions, and these savings will likely stick even in the event that service companies take pricing back up in the future. General and administrative (G&A) costs also fell more than 10 percent for most companies during the year as operators searched for ways to streamline organizations.

Well productivity climbed in several of the most closely watched basins including the Anadarko, Permian and Williston. For instance, NFX was able to improve its average horizontal well 30-day initial production (IP) rates in the STACK play (in the Anadarko Basin) by more than 40 percent to 930boe/d for its 2015 wells online by October, compared to its 2014 STACK well performance. E&P operators reported similar productivity increases industrywide throughout last year. Significant gains were made by using enhanced completions, improved lateral placement and some high-grading of drilling locations.

In the end, the compounding effect of less expensive wells being drilled faster and then producing significantly more than originally forecasted resulted in stubbornly resilient production throughout the year, even as commodity pricing remained challenged. In fact, seven Permian & Anadarko Basin-focused producers, which benefitted significantly from multi-STACK targets and increased well productivity, scored among the top ten stock performers in 2015 in our coverage group representing 56 companies.

Our two key takeaways from 2015: 1) The well productivity gains and cost cuts that kept activity and production levels elevated last year represented most of the low hanging fruit. Similarly sized improvements in 2016 should not be expected. 2) In the current commodity price environment, the status of a company’s balance sheet has supplanted production growth and now rivals even asset quality as one of the most important considerations behind investment decisions. Case in point: the bottom 10 companies in our coverage list based on 2015 stock performance have an average estimated 2016 net debt/EBITDA of about 8.0x. On the other hand, the top 10 performers in 2015 have an average estimated net debt/EBITDA of about 1.7x in 2016.

Why 2016 Will Be Different

Looking ahead, 2016 could be a critical turning point for the E&P sector, as production is finally likely to begin to decline in the second half of the year. We expect combined 2015 production for the group to be up seven percent vs. 2014 after year-end ‘15 numbers roll in over the next couple of months. In 2016, we are currently modeling full-year production totals to be flat vs. 2015. However, we expect year-end ’16 exit rates to show a decline vs. the 2015 exit.

There are a number of reasons why the production response lags the price declines that first appeared toward the end of 2014. First, the substantial hedges that were in place last year allowed operators to continue drilling on the hope that prices would recover before hedges ran out. That clearly has not happened and with hedges covering less production at lower prices in 2016 drilling activity will slow. For perspective, companies under coverage averaged roughly 50 percent of oil and 42 percent of gas production hedged in 2015. In 2016, we model average hedge positions for companies under coverage of 32 percent for oil and 27 percent for gas production.

Next, while some of the best acreage is economic at even today’s prices, operators will be reluctant to outspend cash flows to drill up the best inventory for hurdle rate returns.

Finally, beginning with third quarter 2015 reporting, many E&Ps began to set the expectation that CAPEX spending will closely mirror cash flows next year. We suspect that theme to continue as budgets are formalized in the coming months. For perspective, the average CAPEX budget for our coverage universe last year was 190 percent of cash flows. Based on initial company commentary, we model 2016 CAPEX budgets to average just 112 percent of cash flows for the year and expect that number to further decline. For our group that represents a 25 percent capital spending reduction (from $75B to $55B) year over year.

The production response from U.S. E&Ps is taking some time but it is inevitable. Last year’s innovations, hedge protection and drilled but uncompleted well inventories have postponed the slowdown, but massive drops in investment coupled with natural well declines will likely begin to catch up by the back half of this year.

Aside from potential macro events like slower growth in China or geo-political tensions in the Middle East, we view onshore U.S. production declines as the most significant signal for the onset of improving oil and gas prices. However, the precise timing of that decline is difficult to peg. Therefore, we favor companies with balance sheets that can withstand a challenging 2016 and have the liquidity to stave off any significant production declines of their own through 2017. If 2015 was the year of “stubbornly resilient production,” 2016 may need to be the year for “stubbornly resilient balance sheets.”

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