Despite a late Santa rally in the oil patch this week, it is probably time to recognize that we are on the verge of a realignment of expectations for the oil sector in the evolving WTI and Brent price environment expected to begin in 2024. We are only about one inventory build away from a return to the $60s for WTI and the low $70s for Brent. Are we staying there long? I doubt it and will discuss why in this article, but it could happen. In this article I will discuss what I believe is the most likely scenario for 2024.
The impact of lower prices on activity
In my opinion, the most likely scenario is that lower prices lead to a dramatic reduction in drilling and a moderate decline in shale completion activity. Most shale oil drillers have an extensive inventory of drilling sites where capital expenditures are financed with $40 WTI. But this is a rainy day or “rainy year” scenario and doesn't mean that the CEOs of these companies won't withdraw funds if the current weakness continues. In my view, if the $60 mark for WTI is significantly reached, investment budgets will be cut. Below sixty they are cut. Investors who have become accustomed to high dividends and massive debt and equity reductions in recent years will demand this. The old saying “low prices are the cure for low prices” still holds true.
I discussed some of the challenges facing the U.S. shale industry in an OilPrice article mid-year. Improvements in technology and efficiency have so far prevented this, but investors should expect this rollover to be delayed rather than reversed. Industry sources tell me that with the shale mining declines to date, we are just about in balance enough to drill just enough to gradually increase production. We've seen this in recent months, with only the Permian and Bakken adding incremental net barrels.
For example, the chart above from the latest edition of the EIA-DPR shows a net gain in the Permian of 760,000 BOEPD in 2023. That's good, right? A deeper examination shows that much of this occurred in the first quarter of the year, when the rig count was 20% higher than today. Since July the number has been 100 rigs below that number and since August it has averaged around 150 below the 779 we started the year with. To support this idea, we can cite the Permian rise for December 2023 with a measly BOPD of 5,000. This gives me confidence in my sources. Related: Oil prices set for first annual decline since 2020
But thank heavens for the last few years. Balance sheets are being repaired, debt maturity schedules are favorable, and companies mostly have cash on the books. More importantly, they have repositioned themselves to survive in a sub-$60 oil price scenario. If that happens, they will survive another day.
The investment costs are primarily reduced when drilling. Earlier this year, some people were predicting an increase of about 50 rigs in 2024 to somewhere in the range of 680. I think that's off the table in the short term that we could be heading towards a scenario with fewer than 600 rigs. This will also have an impact on the frackers, but not as extreme, at least in the short term, since there are DUCs to create. This won't do as well as 2020/22 as the DUC number is still way down and the industry only picked up for a few months before moving back to withdrawals. From the end of 2020 to mid-2022, the DUC number fell from mid-8,000 to mid-4,000 – almost at the current level.
DUCs are unlikely to be the panacea they were in 2021/2022. Remember, we are starting with half of the 2021 DUC inventory. There is also a DUC “quality issue” that we have to deal with. Today's DUCs are probably not as productive as the turned in-line TILs of '21-22. I've had conversations with production engineers who were pretty negative about the remaining DUC inventory. We might see it!
In the chart above, note the increase in DUC withdrawal from early 2023 as the rig count began to decline.
Your snack
I noted above that I believe drilling would suffer the most damage as operators struggled to maintain production and cash flow with oil prices below $60.00. Consistent with this belief, I think major land drillers Helmerich & Payne (NYSE: HP) and Patterson UTI (NYSE: PTEN) could extend the weakness they experienced in the fourth quarter of 2023 into the first quarter of 2024. The shares of these two Companies are down about 30% over this period and, as we've discussed, could face further weakness, to some extent dependent on oil prices. My purchase targets for PTEN and HP are under $10 and under $30 respectively.
That's why I'm cautious about drilling companies at the moment. Where do I look for short-term growth? One spot lies with U.S. land frac'ers, with Liberty Energy (NYSE:LBRT) a top pick at current levels. According to industry sources, Liberty is an industry leader and innovator with a market share of approximately 20%.
Liberty tops it with an industry-leading return on capital of 44%, as reported in its Q3 2023 filing. Additional earnings metrics are explained in the following slide. An important statistic is the increase in their EBITDA over time as they have evolved into a multi-service company.
The company has a number of potential catalysts heading into 2024. I would particularly like to highlight that Liberty has just opened a new segment that I believe has the potential to increase sales and margins in the new year.
I am referring to Liberty Power Innovations. This is just an idea whose time has come. With the focus on emissions associated with fracking, mobile delivery of CNG compressed natural gas to the drilling rig site to run the pumps is an excellent idea that should pay dividends in the near future. What's worth noting is that they are evolving from a refined product that was transported multiple times before reaching the rig to a locally produced material that requires relatively little treatment before compression. That alone is efficiency.
Consider that a single frac fleet can use 6 to 7 million gallons of diesel annually, and you begin to get an idea of how much liquid fuel could be replaced by CNG. The linked article points out that 1 MCF of gas replaces about 8 gallons of diesel, which is a huge direct savings since gasoline sells for 2.5 MCF and diesel for $5.00 per gallon. It's still early days and I can't quantify revenue or EBITDA for this business. However, given the macroeconomic reduction in emissions, it is a natural development that, in my opinion, has a divide. I don't think this can be easily reproduced by other frackers. Chris Wright, CEO, comments on the trajectory he sees for LPI:
“First, to power our frac fleets. But of course it will also supply other people's rigs and other local operations. There are other oilfield applications for this. And ultimately, as you look to the future, what does Liberty generate expertise for? We” We generate expertise and have the highest thermal efficiency on wheels, mobile power generation available. And we are generating expertise on how to transport natural gas, how to process natural gas remotely or on site, to deliver natural gas wherever it is needed, however it is needed.”
Given the margins Liberty is making, combined with the innovations they are introducing and a market focused on their services segment, I believe the company's shares are significantly undervalued at current levels.
Liberty is currently trading at an EV/EBITDA multiple of 2.5x based on the third quarter run rate. Analysts rate the company overweight with price targets between $20 and $27.00 per share. The company has a history of exceeding analyst targets last year, and only seasonal weakness could prevent that from happening in the fourth quarter. EPS forecasts are $0.60 per share in Q4 and rise to $0.71 in Q1 2024. They significantly exceed estimates in Q4 2022 and Q1 2023, so that a trend can be identified. If Liberty manages to outperform in Q4, I think the company's value should increase. A 3X would easily reach the lower range of price targets, and a 3.5X would put them within sight of the upper range.
None of these estimates take into account any revenue or margin growth that the company has consistently experienced over the past few years. With this in mind, Liberty is my first choice. In my opinion, investors with a moderate risk tolerance should carefully consider whether the company achieves their objectives.
By David Messler for Oilprice.com
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