Q3 2022 Research Theme: Reality Is Setting In | The Oil & Gas Sector Enjoys Renewed Support



In a blunt intervention at a recent congressional hearing, potentially to ease further political pressure from Republican-led fossil fuel states, JPMorgan Chase CEO Jamie Dimon declared that his bank would not refrain from making new investments in major oil and gas developments, stating that “(ceasing such investments) would be the road to hell for America … Investing in the oil and gas complex is good for reducing CO2. Because of the high price of oil and gas, everyone (is) going back to coal. Not just poor nations but wealthy nations like Germany, France and the Netherlands.”


Not the most diplomatic response given the august surroundings but a timely reality check by the CEO of a major lending bank. Investment strategies that solely focus on ESG with no consideration for financial returns can have unintended negative consequences with regard to energy security but also, ironically, GHG emissions as well.


By way of example, the fallacy of Germany’s long addiction to imported Russian gas alongside an obsessive pursuit of wind and solar energy (while shutting down nuclear plants) has been exposed. We now have the paradox of a German onshore wind farm being dismantled by utility RWE to make way for the expansion of the Garzweiler open-pit lignite coal mine, in keeping with government demands to increase domestic coal-fired power generation to better ensure energy security.


Energy Fundamentals Remain Positive – From E&P & OFS To Midstream & Downstream …


Global macroeconomic concerns abound amid growing threats of economic recession as central banks worldwide ratchet up interest rates to tame strong inflationary headwinds, the latter fanned internationally by the significant relative strength of the US dollar. China’s frequent, draconian zero-COVID lockdowns also continue to whipsaw domestic Chinese demand and global supply chains.


However, despite such macroeconomic fears, the fundamentals of the entire energy value chain – from upstream E&P and oilfield services to midstream and downstream refining – remain very positive with the prospect of continued strength given the heightened geopolitical threats.


Recent supply disruptions – Gazprom’s shutdown of European gas exports via the Nordstream I gas trunkline and the subsequent subsea sabotage of both Nordstream I and II gas trunklines – underpin the belated recognition by Western governments that true energy security will require significant multi-year investment to rebalance markets, ensure supply redundancy and restore spare capacity.


Recent OPEC+ actions to support commodity pricing alongside appropriate fiscal incentives for the energy sector should likely shield such supply-side investments from near-term demand volatility.


The global energy market remains fragile due to historically low levels of spare production capacity, commercial and strategic oil and gas stocks, while supply disruptions drive increased global competition for oil and LNG. No wonder that international traders and investors alike increasingly seek the relative security of the North American energy sector given its preeminence as the largest global oil and gas producer and one of the largest exporters – be it crude oil, LNG or oil products.


… Particularly Within The US Energy Sector


Despite ongoing supply chain issues, labour shortages and rising costs, US crude oil production recently hit 12 mmbopd. Albeit below the brief pre-pandemic 13 mmbopd peak of late 2019, US crude oil output stands well ahead of Saudi Arabia as well as Russia prior to its invasion of Ukraine.


For 2023, the EIA now forecasts that annual US crude oil output will increase year-on-year by ca. 500 kbopd to reach 12.3 mmbopd. Although such year-on-year growth is modest when compared with the prior ‘golden’ years of soaring US shale oil output, the US remains the single largest contributor to overall global oil production growth, the latter forecast to grow from 99.9 mmbopd in 2022 to 100.7 mmbopd in 2023.


Already the largest natural gas producer worldwide, US dry gas production hit a new record of almost 100 bcf/day in August, up 4% year-on-year. In tandem, driven by increased global demand, LNG pricing and export capacity, the US became the world’s largest LNG exporter during H1 2022, averaging 11.2 bcf/day, equivalent to 84 million tonnes of LNG on an annualized basis, ahead of both Qatar and Australia.


Furthermore, according to Deloitte LLP, US shale producers are on course to generate nearly US$200 billion in cash flow this year, potentially accumulating sufficient cash by 2024 to erase all industry debt, maintain dividends and invest in further growth to meet the growing worldwide demand for US oil and gas.


The conspicuous health of the North American energy sector – high activity levels, firmer commodity and service pricing, stronger balance sheets and fast-growing levels of free cash flow – has rightly prompted renewed interest from pragmatic investors willing to suffer the inevitable ESG brickbats.


The S&P US Energy Index is up 61% year-to-date and now represents some 5% of the overall S&P Index (down 20% year-to-date) by capitalization – more than double that of the nadir of 2020. The TSX Canadian Energy Index is likewise up 60% year-to-date. As the only S&P or TSX sub-sector in positive territory this year, generalist investors increasingly ignore the energy sector at their peril.


The OFS Sector – Pricing Power Has Returned On The Back Of Tight OFS Market


The OFS sector – the focus of PillarFour’s investment strategy – has just delivered the strongest set of Q3 results in many years, beating market expectations with market leader SLB reporting its strongest quarterly profit since 2015.


With oil prices at or near their highest level for some eight years, strong and growing customer demand for equipment and services has combined with capital constraints, labour shortages, supply chain issues and inflation – the result being that OFS pricing power has been restored.


Better pricing and burgeoning customer demand for oilfield products and services has driven global revenues for the Big Three – SLB, Halliburton and Baker Hughes – up by 35% since Q1 2021. But, with high US upstream activity levels, Big Three US revenues are up by 60% over the same period.


Notably, pure-play drilling and fraccing companies within our sample, such as Nabors, Patterson-UTI and Liberty Oilfield Services, have seen revenues double or triple since Q1 2021 as day rates ‘flywheel’ higher as asset utilizations increase and, in the case of fraccers, approach effective fleet capacity.


OFS Sector: Overall & US Revenue Growth – Q1 2021 To Q3 2022 (%)



Increased activity and pricing have seen EBITDA margins expand materially since Q1 2021, particularly for those pure-play drilling and fraccing companies that solely operate within the US market.


Over this same period, the Big Three increased their EBITDA margins by 360 basis points on average, SLB maintaining an absolute lead over its Big Three peers with a 23.5% EBITDA margin.


OFS Sector: EBITDA Margin Expansion – Q1 2021 To Q3 2022 (Basis Points)



Positive market fundamentals, high commodity pricing and the numerous national initiatives to restore energy security would alone underpin the current upcycle of global upstream spending.


However, in tandem, E&P operators worldwide must also invest to reduce Scope 1 and 2 emissions across their operations to meet more exacting ESG requirements.

Combined, the current upcycle in upstream spending and the secular trend to eliminate emissions should support many years of growth for the OFS sector, particularly for those OFS companies that offer innovative, disruptive technologies or services that address well construction, completion, production and maintenance processes in a far more sustainable manner than the incumbents.


To date, this sector upcycle has clearly been accompanied by more disciplined capital allocation across the OFS sector – no doubt due to the ‘scars’ of the recent industry downturn – overcapacity and layoffs – as well as the growing clamor from investors for higher returns.


Pricing Power & Operating Leverage Will See The OFS Sector Outperform Upstream E&P


Continued capital discipline within the OFS sector will therefore remain key. On that basis, pricing power will likely continue to strengthen into 2023, allowing OFS companies to continue to expand margins despite further input cost inflation.


The E&P sector is likewise also exhibiting greater capital discipline – recent windfall profits driving higher share buybacks, dividends and debt repayment despite President Biden imploring US companies to increase production.


But, as mere price-takers within commodity markets, E&P companies ultimately enjoy no pricing power for their oil and gas output.


We therefore concur with JPMorgan Chase’s recent forecast of “OFS outperformance relative to the broader market, but also relative to other energy sub-sectors including E&Ps.”

Indeed, for 2023, JPMorgan Chase contrasts its forecast of a mere 1% year-on-year increase in EBITDA for the US E&P sector with the 31% year-on-year forecast growth in EBITDA for the OFS sector, citing “more disciplined capital allocation … that should sustain pricing momentum and strong earnings growth in 2023, even if activity gains slow.”


As we discuss later, a prime example where greater capital discipline has improved returns would be the US pressure pumping market where industry consolidation has ensured that the top 5 OFS players now control over 70% of frac spread capacity – the result being that margin gains are prioritised over fleet growth … currently.


At their recent Q3 2022 results, the Big Three OFS players – albeit talking their own book – spoke of:


• “Double-digit international growth in 2023, ... across virtually all geographic regions” (BKR);

• “North American D&C spending growth in mid-to-high double digits in 2023” (BKR);

• “Very encouraged about the outlook for 2023 in North America” (HAL);

• “It’s not a build cycle, it’s a margin cycle … we’re going to be the real beneficiaries ...” (HAL);

• “(The) fundamentals of energy as a critical resource remain very constructive.” (SLB);

• “Significant margin expansion illustrates the benefits of the pricing momentum.” (SLB).


Moving on from recent market and financial outperformance of the OFS sector, let’s take a look at underlying upstream field activity, in particular US drilling and completion activity.


US Rig Count Plateaus As US E&Ps Focus On Returns Over Growth Amid Tight OFS Market


Capital discipline is the new mantra: an important tenet for any US shale E&P company seeking fresh capital from investors burnt by the sector’s prior ‘pump-at-any-cost’ model. Most E&P operators, particularly those that are publicly-listed, now embrace the delivery of returns over growth.


US shale operators are now wrestling with ongoing supply chain constraints, labour shortages and significant cost inflation for well construction and completion. US land rig day rates and steel tubular prices are up 25% and 51% on average year-on-year respectively; pressure pump revenues per job are up almost 70% year-on-year while sand proppant pricing spiked 150% mid-year on shortages within the Permian Basin.


Since mid-year, the US oil rig count has plateaued at ca. 600 rigs, well below pre-pandemic activity levels. Although WTI pricing remains well above $80/bbl, the near $40/bbl pullback from the Russia-Ukraine invasion highs coupled with such cost increases likely prompted this hiatus in operators’ drilling programs.


Beyond returns per se, an additional limiting factor on drilling activity may well be the current dearth of available fraccing crews and equipment. Overall US land rig utilization has certainly risen significantly, from 38% in 2021 to 54% this year, and by as much as 61% for those rigs capable of drilling deep wells. But, as we discuss shortly, with ca. 300 frac spreads currently active, the US fraccing market is now operating at close to full utilization of effective industry capacity.


US Oil Rig Count vs. WTI Oil Pricing, Jan 2018 To Date


Despite patriotic appeals by the US government for the US upstream oil and gas sector to ‘turn on the taps’ since Russia’s invasion of Ukraine, most US E&P players are not inclined to play ball, unwilling to jettison their new ‘low-growth, high-payout’ relationship with investors.


Put simply, the US shale oil E&P sector is no longer keen to play the ‘swing producer’ role, nimbly responding to higher pricing to rebalance the market.


Consequently, with US E&Ps clearly exhibiting capital discipline amid the tight OFS market and higher costs, the EIA has, since mid-year, gradually walked back its estimates of year-on-year 2022/2023 US oil production growth – from 1.05 mmbopd in June to just 0.5 mmbopd this month.


Typically, as onshore shale drilling activity increases, so the inventory of drilled-but-uncompleted (DUC) wells grows in lockstep, the latter essentially representing work-in-progress. However, since mid-2020, even as crude oil pricing and rig activity recovered in tandem, the pace of drilling new wells significantly lagged that of fresh well completions – the result being an unprecedented halving of DUC inventories across all major US basins to ca. 4,300 of late, the lowest level observed since 2013 when records began. In particular, within the Permian basin, responsible for ca. 60% of US crude oil production, DUC inventories shrank by 70% to just 1,100 – a six-year low.


US DUC (Drilled But UnCompleted) Well Inventory, 2013 To Date



This extraordinary two-year drawdown of the DUC inventory provided a cheap, low-risk and swift route for the US shale oil sector to kickstart production as oil prices rebounded mid-2020 onward.


The drawdown of this ‘surge capacity’ certainly provided a higher risk-adjusted incremental return on capital but it also perhaps flattered immediate rates of crude oil production growth. Without sustained drilling activity, this reduced DUC inventory may limit near-term growth in crude oil production.


Indeed, per the EIA’s recent forecasts, US crude oil production growth has been necessarily tempered as drilling and completion activity has plateaued over recent months.


In recent months, Permian crude oil production has hit new records, topping 5.4 mmbopd in October. However, since the majority of gas production within the Permian basin is associated gas – i.e., produced in tandem with crude oil – any gas export capacity limitations may also serve to cap Permian crude oil production output until resolved.


By way of example, ongoing repairs to the Gulf Coast Express gas trunkline and the mid-year blaze-related shutdown of the Freeport LNG export facility appear to be limiting current Permian gas pipeline exports, as evidenced by gas prices at the Waha Hub, located within the Permian Basin, turning negative in recent weeks


US Fraccing Activity Impeded By Supply Chain Issues And Fleet Capacity


Increased E&P capital discipline, supply chain issues and a growing shortage of field-ready frac spreads have combined to limit US oil and gas production growth this year. With 300-odd frac spreads currently active across the US, both Halliburton and Liberty Oilfield Services report that the US fraccing market nears full utilization of available capacity.


US Horizontal Oil Rig Count vs Frac Spread Count, Jan 2020 To Date



Given the limited inventory of idled pressure pumping equipment appropriate for reactivation and a shortage of trained field staff, demand for fraccing services will likely continue to exceed supply, potentially slowing US oil (and associated gas) production growth into 2023.


This shortfall in fraccing capacity is further exacerbated by relentless improvements in US shale well productivity. As shale wells set fresh records in lateral reach and multi-stage completions, so their ‘frac’ intensity increases. By way of example, a decade ago, a typical shale oil well might have required 12 frac pumps at the wellsite, versus the 20 or more frac pumps required today.


Proppant volumes are likewise up 35% on average (50% within the Permian basin) over the last five years, imposing further logistic demands on US frac service companies.

To date, the main players have prioritised the reconditioning of idled fraccing equipment over investment in new equipment, keen to avoid adding significant capacity amid investor demands for higher returns. Limited capital is being deployed to build next-generation pressure pumping capacity, but merely to match equipment scrappage rates or upgrading to electric fleets, rather than build net capacity.


In the face of continued strong demand, we expect the major players, which control over 70% of the active frac fleet, to maintain a tight pressure pumping market by continuing to prioritize further margin gains over growth.


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