Pride of the Permian
In last week’s Energy Letter, I mentioned that my day job had brought me to the Permian Basin. Last October I had similar business in the Bakken. Today, I will elaborate on last week’s Permian Basin trip, and talk about some of the companies operating in the region.
Introduction to the Permian Basin
The Permian Basin is located in West Texas and eastern New Mexico. Even though crude oil has been produced there since 1921, the Permian still produces almost as much of it as the Bakken and the Eagle Ford combined. It is by far the most prolific oil producer among the oil- and gas-producing regions shown below:
Source: Energy Information Administration
The Permian Basin has commercial deposits of oil and gas in stacked layers, at depths ranging from 1,000 feet to more than 25,000 feet. One horizontal pay zone within the Permian called Wolfcamp is estimated to contain 2 to 4 times the estimated oil reserves of the Eagle Ford or Bakken. And there are multiple commercially viable layers of oil and gas both above and below Wolfcamp.
Thanks to these stacked layers, the Permian is one of the most cost-effective oil plays in the U.S. According to the Texas Railroad Commission, it has already produced more than 29 billion barrels of oil and 75 trillion cubic feet of natural gas — volumes equivalent to 3-4 years of current U.S. consumption.
Over a third of the land rigs drilling for oil in the U.S. are deployed in the Permian, but as with other areas there has been a steep dropoff in drilling in response to low oil prices:
Flaring in the Permian
In my day job I serve as director of alternative fuels technology for a small Arizona technology company. One of our core technologies is aimed at reducing natural gas flaring in oil fields. As shale oil production in the U.S. boomed, so did the volumes of associated natural gas. But there was often no infrastructure to process it. As a result, that natural gas was often flared.
In response to this problem, my company developed a unit that conditions flared gas to efficiently fuel a generator. If a site is using diesel for power — as many are — our solution can cut the flaring while reducing or eliminating diesel consumption. We deployed our first demonstration unit to the Eagle Ford in Texas last year. The second unit went to the Bakken, and I reported on a visit there in Addressing the World’s Flare Gas Problem. Our third unit is deployed in the Permian Basin in West Texas, and last week I made a visit to see it:
Me at a well site in the Permian Basin, south of Pecos, Texas on Jan. 26.
Yes, that is snow on the ground and in my hair. Our target is that flare behind me.
Trips to the key oil and gas regions of the U.S. give me a chance to talk not only with the men and women who extract oil and gas but also with people up and down the supply chain: oilfield services providers, midstream companies, etc. I even sat down with officials from the Bureau of Land Management in Carlsbad, New Mexico to get their take on the current oil and gas markets — especially as it relates to the Permian Basin.
One of the things I do on these trips is to note the companies most actively engaged in a region. Occidental Petroleum (NYSE: OXY) is the most prolific producer of crude oil in the Permian. Large, diversified oil and gas drillers like Oxy, Apache (NYSE: APA), EOG Resources (NYSE: EOG) and ConocoPhillips (NYSE: COP) are all among the region’s leading producers.
But the most visible explorer in the parts I visited last week was Concho Resources (NYSE: CXO). Concho is a pure Permian play with core operating areas spanning 1.1 million gross acres within three different areas of the Permian Basin. Concho is one of the top oil producers on the Texas side of the Permian, but is the top producer of oil and third-largest producer of natural gas in New Mexico. The company operates more than 5,500 wells in the Permian and has more than 22,000 future drilling locations.
Concho has been one of the fastest-growing producers in the region, and has the largest reserves of any of the pure play Permian producers. At the end of 2014 it had 637 million barrels of oil equivalent (BOE) in proved reserves. Just behind it was Cimarex Energy (NYSE: XEC), another pure play and ubiquitous Permian producer, with 522 million BOE in proved reserves. (Expect those proved reserves numbers to drop when year-end 2015 numbers are released because of the much lower oil prices.)
Concho doesn’t release Q4 2015 earnings until Feb. 24, but its bottom line is expected to be sharply lower like those of its peers. During Q3 2015, Concho averaged 15 drilling rigs in the Permian, and for the quarter it produced ~149,300 BOE/day (65% oil) — a year-over-year increase of 32%.
Concho’s average realized price for oil and natural gas during Q3 2015 was only $33.74/BOE, compared with $67.07/BOE a year earlier. As a result net income for the quarter was $179.7 million, down from $305.2 million a year ago.
With lower commodity prices, Concho faces a cash flow deficit that it is working to plug. It recently announced three new transactions that it says will enhance its position in the Permian Basin, improve its portfolio and reduce net debt.
Concho’s balance sheet is in pretty good shape with a Debt/EBITDA ratio of 1.7, and a current ratio of 1.0. That, along with its history of strong production growth in the region, has allowed Concho’s share price to outperform the Energy Select Sector SPDR ETF (XLE) by more than 8 percentage points over the past year. Concho Resources is one company that should do well for years to come as oil prices recover.
The Permian Basin has been producing oil since the 1920s, and today there are more than 1,500 oil and gas companies operating in the region. High oil prices in recent years resulted in a great deal of new drilling, so nearly 100 years after it first yielded crude the region is still producing at near record levels.
The Permian has been challenged by low oil prices like every other shale basin in the U.S., but history has proven this to be one of the most resilient areas for oil production in the country. Investors who seek to add to their energy holdings at these heavily reduced prices would do well to consider a Permian producer with a solid balance sheet. Join us at The Energy Strategist as we identify the Permian producers best-placed to ride out the current volatility.
Collateral Damage for CPLP
Very high yields don’t come without very high risk; the trick is finding those that will decline by means of capital appreciation rather than a distribution cut.
We think we have one of those in #9 Best Buy Capital Products Partners (NASDAQ: CPLP), the owner of refined product and crude tankers, as well as containerships and a bulker. The strong tanker markets have allowed CPLP to gradually increase its charter rates and distributable cash flow, a trend that continued in the fourth quarter reported by the partnership last week.
Cash flow coverage improved to 1.10x on a distribution that was kept level with the prior quarter, in a departure from the prior plan to grow it by 2-3% annually. Management cited recent market volatility, which has dropped the unit price 31% year-to-date and 48% over the last three months.
Coverage will improve further now that CPLP has chartered its two idle containerships at deeply discounted (but so far undisclosed) rates for the next year, and will again when the partnership takes delivery of the last containership it’s contracted to buy from its sponsor later this month. That vessel has already been chartered at an attractive rate for the next five years.
So why is the annualized yield back up to 25%, now that units have given up the better part of their 30% relief rally over the last two weeks of January?
One obvious reason is that the equity went ex-dividend on Feb. 3 ahead of a quarterly distribution of nearly 24 cents per unit payable Feb. 12.
Less helpfully, Navios Maritime Partners (NYSE: NMM) eliminated its recently reduced dividend entirely on Wednesday. While NMM operates bulkers and containerships and has none of the tanker exposure shielding CPLP from the current shipping slump, it too is a maritime master limited partnership.
Even less helpfully, the creditors of Hyundai Merchant Marine (HMM) reportedly demanded it negotiate cuts of 20-30% to its charter before they refinance debt maturing this year. The corporate parent of the heavily leveraged shipping line, South Korea’s second largest, has been restructuring for the last two years.
This matters to CPLP because HMM containership charters account for 22% of its current revenue (dropping to 20% or so by the second quarter.). A 30% reduction on those rates wouldn’t even use up all of CPLP’s most recent cash flow surplus. But there’s no guarantee that HMM will remain solvent this year, in 2017 or in any other year before its CPLP charters are scheduled to expire in 2025. And in the slumping container market’s current state the bulk of the revenue from those charters could not be replaced if they were broken.
If we were to write this revenue off entirely as the market seems to have done, as well as CPLP’s containership and bulker charters with far less troubled operators, we would be down to the tankers currently accounting for 60% of revenue and an effective 15% yield based on the current unit price.
So there is plenty of value apparent here even in a plausible worst-case scenario. But there are two additional risks to consider.
One is that the recently strong tanker rates could certainly head lower, as they’ve done so often in the past. There is still plenty of speculative money chasing hulls in the few still healthy shipping sectors, so that excess supply of ships remains a risk in 2017 and beyond.
A more insidious potential threat is that the management and the sponsor could, like those at Navios, simply decide that their current limited partners are not a useful source of capital any longer.
That seems to have transpired at NMM, which only three months ago said it had set a newly reduced payout at a level it could honor for the next five years. But as the unit price continued to go down, that tune changed to today’s complete elimination of the dividend despite plenty of excess coverage, so that management can pursue unspecified growth opportunities.
I don’t believe CPLP is on this path. Its balance sheet is in much better shape, and the sponsor has more of an incentive to preserve the partnership’s value and reputation.
But anyone dumbfounded that an investment with such risks can yield 25% in a market like this simply hasn’t been paying attention.
CPLP remains an Aggressive Portfolio buy below $5.50.
— Igor Greenwald