Last December I published an article on Oilprice discussing why I thought land drilling contractors would start to rally after the first of the year. It turned out I was a bit early in my thesis and both of the companies I highlighted in the article, Patterson-UTI Energy, (NYSE:PTEN), and Helmerich & Payne, (NYSE:HP) have both fallen about 60% from where I thought they were attractively priced. At this point, I will quote Dr. Niels Bohr who once famously said, “Predicting is very difficult, especially when it is about the future.” What happened? If you were one of the more than eighteen thousand folks who read that article, you deserve more than a juicy quote from a long-dead physicist. The underperformance in the OFS sector was primarily due to well-known external factors - fears about demand from Fed interest rate induced softening in the U.S. economy, a large inventory build-up from refinery turnarounds, and the interminable questions revolving around the resurgence of Chinese demand. The final straw for the drillers was the crushing decline of natural gas over the period. The market prices things forward generally and the smart money felt OFS companies would fall short of forecasts in Q-1, 2023, and deflated multiples for the entire sector.
The smart money turned out to be wrong, as reports from bell-weather OFS companies, Schlumberger, (NYSE:SLB), and Halliburton, (NYSE:HAL) turned in stellar quarters for Q-1, as did many 2nd tier OFS companies, and are guiding for a strong year. In this article, we will discuss why we believe the original thesis to still be valid, and why we feel it will begin to play out in 2023. But we do note, there is some bifurcation in the overall sector as we will discuss. While the top frackers may have a clear field to run, there is trouble ahead in the drilling category. At least for the short term, and we will provide commentary in that regard.
We will start by discussing why if America is to continue relying on oil and gas from shale wells for about half of its daily ~20 mm BOPD needs, the current rate of drilling must be sustained. If we need more, then the rate of drilling must increase. In order to maintain our current output, any pullback in drilling needs to be short-term, and that supports our original thesis that investors should take a hard look in the OFS category for entry points.
Why shale requires constant renewal and the core of our thesis for OFS in 2023
It needs to be said. shale rock has little or no horizontal connectivity between its pores. This is the result of the low-energy sedimentation environment under which shale reservoirs form. Homogenous accumulations of particles coated with gooey organics fall to the bottom of shallow lake beds and ocean bays, and are compressed over time into a tightly-bound lithic structure, often referred to as “unconventional.” The result is there are essentially no interconnected pores in the rock that allow for fluids to move horizontally toward the well bore at low-pressure drops. It’s why we must fracture the rock, perpendicular to its bedding planes to produce significant quantities of oil and gas.
By comparison, conventional sandstone reservoirs have well-developed pore structures that permit this interstitial flow. Sandstones are known for a more heterogeneous “Turbidite” higher energy method of sedimentation that is characterized often by wide particle size distribution (PSD) between the individual grains that make up the framework structure of the stone. This is particularly true with many deep water reservoirs where sediments accumulate after tumbling down an incline such as the Continental Shelf. This dissimilar grain structure creates the interconnected rock “pores,” or channels, that allow for horizontal flow capacity. This flow capacity results in low percentage declines YoY, which range from 6-10% typically, and justifies the long-cycle costs attendant with deep water exploration and production. Once a conventional well is brought on line, an operator can expect many years of production with only occasional interruptions for well repairs.
The math for shale is much harsher. Shale wells that have been stimulated have a high rate of Initial Production-IP, due to the huge increase in permeability (1000’s of times). Within a couple of months these wells generally start a sharp decline that ends with water coning and finally cutting off the flow of oil. Usually after 12 months on line, the flow has declined by 60%, and by 24 months it’s probably no longer economic to operate. At that point, it's time to call the cement truck then and apply some 16# Class H. In 2-3 years from being turned in-line (TIL’d) the well has run its race, and a new one must be drilled to replace it. Technology-well spacing, treatment concentration, etc., can flatten the curve a bit, and the initial quality of the rock-Tier I, II, III, and IV will also play a role in just how much oil is eventually recovered. But all shale wells share the short-cycle DNA that compels constant drilling to replace declines.
What this means is that every year we will lose an average of 40% of our legacy production. At current shale production of 9.4 mm BOPD that's a loss of 3.76 mm BOPY or 313K per month, which must be replaced with current drilling just to stay even. What does that mean for the number of wells that must be drilled?
We have had about 600 oil rigs turning to the right since the middle of last year. Since June, 22 we have gone from 8.7 mm to 9.4 mm BOPD in shale output, or about 700K BOPD of increase. That's less than 58K per month of new production, meaning that about 82% of the ~14K wells drilled in 2022 were to replace legacy production. It only gets worse from here.
Shale math is a harsh mistress and requires constant drilling and fracking to maintain output. The alternative is to fall behind. Quickly.
Visual references can be helpful here, so here is a graphic put together by Ted Cross, Director of Product Management at NoviLabs.
Bam! The point of this exercise was to highlight that OFS companies have a fertile market as long as America depends on shale production. Now that we have established that activity levels must be maintained to keep production up, who will be the beneficiaries of this spending?
Shale frackers are rocking and rolling
We discussed the two drillers-H&P and PTEN, thoroughly the last time around, so we will just touch on their financials for Q-1, 2023. If you are new to them, please give my previous article a read for details about them. Most of our time will be spent on two large fracking companies that together represent ~20% of the total U.S. market
The first is Halliburton, (NYSE:HAL). HAL is the largest U.S. fracker with Q-1 revenues for pressure pumping in the neighborhood of $1.4 bn for the quarter, according to an industry source. That puts them solidly ahead of #2, Liberty Energy, (NYSE:LBRT) at $1.262 bn for the quarter. Both companies saw sequential revenue and earnings growth, but the thing that really interests us is EBITDA margin growth shown on the slide below. What this tells you is that these companies are retaining pricing power independent of short-term moves by the oil price.
To point out the obvious, HAL is a much larger company with more diverse revenue sources, so comparisons might seem a bit of a reach. Let’s not be hasty though. One thing that these curves do suggest is fracking has become increasingly profitable over the last year, looking at the slope of the LBRT curve. In fact in LBRT, the fracking pure-play the slope steepens as we go from Q-4, 2022 into Q-1, 2023.
What changed? I asked an industry source about this and learned that pumping companies have been broadly successful in reintegrating sand supplies with pumping services. This is a link that was broken a few years ago during an adverse price movement in WTI. Another company I follow, U.S. Silica, (NYSE:SLCA) reported spot sand prices in the $40s per ton and contribution margins of $28 per ton for Q-1. Three years ago SLCA reported a contribution margin of $10 per ton, so things have improved dramatically. This is a harbinger metric for the entire shale industry as treatment concentrations are rising.
This topic was the subject last week of a bullish Morningstar article on LBRT, by Katherine Olexa. In it, she comments about the pricing power LBRT appears to have-
“In our view, most of Liberty’s first-quarter performance is attributable to favorable pricing rather than active frac spread count. Estimates from Rystad Energy indicate Liberty operated 39 active rigs, four less than last quarter. Yet, first-quarter revenue increased 3% sequentially, implying service prices jumped 15% by our estimate. Pricing gains continue to boost profitability as well. For the third consecutive quarter, firmwide adjusted EBITDA margin increased 200 basis points to 26%, well above the firm’s prepandemic average in the high teens.”
Ms. Olexa goes on to note that fracking companies like LBRT will have a steady market utilization-wise for the next few quarters into 2024, with pricing gains coming from deploying new technology, like DigiFleet that features all-electric pump spreads.
Summing up the two leading fracking companies
Halliburton and Liberty are off their January highs by ~25% and ~13% respectively, at levels not seen since mid-2022. Analysts are bullish on both companies rating HAL as a buy, and LBRT as Overweight. The price target range for Halliburton is $32-$58, with a median of $49. Analyst’s price range for LBRT is from $14-$28 with a median of $19.50.
Now a quick peek at PTEN and H&P
After trending sharply higher for most of 2022 the slope for both of these top land drillers has flattened considerably. What’s going on?
It’s fairly straightforward. The rig count is dropping. Since November of last year, we have dropped about 30 rigs. John Lindsey, CEO of land driller giant, Helmerich & Payne summarized in their Q-2 call-
“Natural gas price declines this calendar year coupled with macroeconomic uncertainties have resulted in current moderated rig demand. Our rigs and I’m sure other competitor rigs are being released as a result of low gas prices.”
With these companies losing rigs and fighting to maintain pricing, there is a good chance the EBITDA curve could bend down until we get a strong buy signal from the markets. Accordingly, we are passing on the land drillers at this time.
The six-month-long weakness in oil and gas prices has taken down the prices of key shale drillers like Devon Energy, (NYSE:DVN) by about 30% from June highs in the upper $70s. By comparison, the OFS companies we have discussed have been hit much harder on the assumption oil companies would rein in spending and possibly cut capex.
That hasn’t been the case. These companies-with the exception of companies targeting gas primarily, and maintaining and even slightly increasing their budgets for 2023. This graphic from RBN makes the point. (Note how the production-orange curve, follows capex-blue bars,)
Based on all of this we expect a strong year for the top three OFS companies, Halliburton, Schlumberger, and Baker Hughes, as well as well-managed second-tier companies like Liberty Energy. These companies are good values at current prices, with EBITDA growth that will drive share repurchases and dividends. Pure play drillers probably have a couple of tough quarters ahead but should be monitored for entry points in expectation of the harsh reality coming home that if we don’t drill faster than the decline rate for shale, production will drop. That’s an outcome no one wants!
By David Messler for Oilprice.com
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