~8x 2022 PE at $64 oil, nearly debt free
EBIT Break even at ~$30 WTI
75% payout, so about 10% 2022 dividend yield
15% of Permian production
20-30 year A+ drilling inventory
Returning 50% of market cap in next 5 years in dividends assuming slowly declining oil prices
I am quite deep in natural gas equities, Mesa Royalty Trust and Tourmaline. Together more than 10% of my portfolio. The main obstacle against good returns in these two stocks is a better than expected oil market, which will result in significant shale (and especially Permian) oil and especially associated gas production growth. So I went looking at oil stocks, to see if there were any bargains laying around to hedge my bet.
And after doing quite a bit of research I found that oil stocks are actually just as cheap. And I have this sneaking suspicion that we might have a bull market of epic proportions in either oil or gas over the next 5 years judging by the supply/demand balance.
But first why Pioneer (PXD) is cheap. A couple years back Einhorn had written a short report on it, claiming it would never make sustainable profits. yet here we are in a $50-60 oil environment, and it is expected to pay out 50% of its market cap in dividends in the next 5 years, generating 33% EBIT in 2022. With depreciation likely overstated, instead of understated due to sizable well drilling productivity gains. This does not even include potentially substantial synergies from sharing expertise from their recent acquisitions on how to drill even more efficient wells. And this assumes that oil will slowly slump from an average of about $64 to $52 per barrel from 2022 into 2026.
So really in a oil bear market, PXD pays out nearly half its market cap in dividends over 5 years, and would then trade at a PE of 8-10x with a 15-20 year reserve life, assuming oil is then trading at $52/barrel. And assuming they grow production 5% a year. If oil would spike to an average of $80 for just one year, PXD would pay out 15-20% in one year just in dividends. And even in a Armageddon scenario like in 2020, risk would be limited to a (potentially temporary) 40-50% draw down.
In the past 5-6 years, with a higher cost base (drilling costs per BOE have decreased by 40% in the past 5 years), and much lower dividend payout, and more debt, it was trading at 15-20x NTM earnings.
So really any sizable increase in oil prices is just icing on the cake here.
Why oil is set up for a bull market in the coming decade
The US Permian is one of the largests US oil fields, with low break even costs in the $20-30 range (probably lower than Russia). This field has also been the main culprit that caused lower oil prices. It increased production from about 500k barrels/day in 2014 to 4.3m/day in late 2019. And this caused the collapse in oil prices. And has provided a large proportion of US growth in oil production in that period. But there are very strong indications that the period of aggressive growth is behind us.
PXD has 15% market share, and even at $100 oil will only grow production by 5%. This compares to a 40% CAGR in overal Permian production growth since 2014. Furthermore it appears overall shelf life of shale reserves is on the low side. According to PXD CEO at 2021 Barclays energy conference:
Scott Sheffield
So -- and now what's going to be interesting is, over the next 5 years, I predict that there's probably only 5 companies or less that have an inventory that will last 15 to 20 years plus in the entire U.S. shale.
And EOG CEO on overall US well productivity in Q2 call:
William Thomas
Yes. We see -- we run the numbers on all the different groups from the private to the public to the majors. And then generally, particularly in the private, we see definitely well productivity is going down, not up. So it takes a lot more wells for that group to maintain production or even think about growing it. And overall, in the other groups, not specific to EOG, but we generally see well productive -- well production to be flat, to not improving over time.
And so I think that is a function of resource maturity. I think when you get in down spacing and spacing and in timing and all that, I think it's going to subdue the productivity. And so literally, the biggest factor, of course, is in the capital discipline where you're spending tremendously amount of less cash flow than we've been spending in the previous year. So when you put all that together, we do not see -- we think the discipline will remain with the group. We do not see the U.S. growing significantly next year. So that's a very positive, I think, for shareholders and positive for the macro.
PXD CEO again on growing production:
Scott Sheffield
No, I don't think -- I mean, at this point in time, I mean, we're limiting our growth. So we've been very adamant about our growth rate. And any time we see any type of dislocation in commodity prices, that growth rate could go to 0. So we're always going to fluctuate between that 0 and 5 over the next several years.
And
Scott Sheffield
No, there's not a lot of difference. You have to get up in the 10% to 15%, which is where when I spoke at your '19 conference. But I think we had lowered it from 20% to 25% to 15%. You do generate much higher ROCEs. But obviously, the industry can't do that. We'll lead to growing 1 million barrels a day, and then we'll upset OPEC Plus and have another price dislocation. So that model doesn't work anymore, but it does generate much higher ROCE.
So between 0% and 5%, it doesn't change a lot. And so we're always going to be flexible whether we grow 5% a year for the next 5 years, whether we grow 3%, 4%, 1 year or maybe 6, it's just not that important. What's more important is generate the free cash flow and return it to shareholders.
So it looks like the main culprit for lower oil prices, the US shale, is basically done growing. Outside of the Permian, well productivity is going down, not up. It also seems like benefits from achieving further scale is going to be very limited, so there isn’t really an incentive to grow production, especially if your reserves are limited to begin with. CEO’s are incentivized to not preside over forced declining production, so whereas 5 years ago there was a strong incentive to drill more, now there is a strong incentive to keep production steady and payout as much cash as possible.
Furthermore, due to ESG pressure, oil majors aren’t really investing much in oil production growth either.
Essentially US shale production, the swing producer, has turned into a rational oligopoly of only a handful of producers who are really in the position to significantly grow production at all. This inflection seems to be masked by the remnants of the Covid crisis.
Now as for the overall demand and supply balance. Oil demand is expected to reach 2019 levels somewhere in H2 2022, which is around 100m barrels/day. 2021 demand is expected at 97.5 barrels a day. And real spare capacity is estimated at just over 4m barrels/day. Oil consumption in 2019 was just over 101m barrels/day. And oil storage levels have normalized as well.
While the more pessimistic estimates for peak oil demand are between 2025-2030. So that means that once the pandemic is behind us, oil demand will likely keep growing for another 5 years or more. And spare capacity will quickly be reached. And this time around, it won’t be drill baby drill for US producers when prices go above $70-80.
So while far from a certainty, it seems there is a real possibility of a oil supply shock somewhere in the next 5 years. And this does not seem to be priced into the oil equity market at the moment.
Free hedges baby
The beauty of buying Pioneer is that it hedges against a natural gas bear market as well. Since the US natural gas market will be supply constrained if oil stays low. Because 1/3 of natural gas comes with shale oil production. So if oil goes up, and shale grows more than expected to fill in supply gaps, PXD will do well. And natural gas equities might do ok. If oil prices stay muted, US Shale growth will stay muted, and we might see a multi year natural gas bull market with prices of $3-5/mcf. And equities like MTR and TOU doing really well. And PXD will do okish (they will partially benefit from this through their associated gas production).
If there is a oil shortage, and shale ramps up production to fill the gap, my natural gas bets will probably do barely better than break even (if that), but PXD will be a homerun.
Reason for this is that neither oil nor US and Canadian gas equities are really pricing in a bull market in either commodity. Even though the two commodities have become inversely correlated due to the large market share of associated natural gas in the US. And of course the US natural gas market is a closed market.
Now of course this hedge is not fool proof. If there is another demand crisis, both commodities will slump. So you can lose money here. But by being long both PXD and TOU, a significant portion of commodity price risk is eliminated. And due to the quality of the assets involved, and the cheap valuations and the high dividend yields, risk of lacking demand seems to be at least partially priced in here.
So I am long PXD at $151 per share. And I may sell it at any time so DYOW.
Further reading:
https://shaleprofile.com/us-tight-oil-gas-projection/
https://www.investorvillage.com/smbd.asp?mb=4923&mn=65753&pt=msg&mid=22155493
https://www.rigzone.com/news/wire/chevron_ceo_warns_of_high_energy_prices-16-sep-2021-166445-article/
https://www.10xebitda.com/wp-content/uploads/2016/11/Greenlight-Pioneer-Presentation-May-2015.pdf