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Big Machine, Part 2 - E&Ps Grind Out Production Growth Through Incremental Capex Increases

U.S. exploration and production companies (E&Ps) are generating such substantial output growth that the International Energy Agency (IEA) estimates their increase in 2018 liquids production could equal the entire growth in global demand. Remarkably, they’re accomplishing this with half the capital investment of 2014. The driver has been a shift to a manufacturing mode that has transformed the E&P industry as dramatically as Henry Ford’s moving assembly line changed the automobile industry in 1913. Geophysical and technological innovations, such as multi-well pad drilling, have allowed the industry to double output per well bore at half the previous cost. With oil prices and margins rising, you’d think the E&P industry, which historically has invested like “there’s never too much of a good thing,” would be pouring every available dollar into drilling more and more wells. But that isn’t the case. Instead, mid-year 2018 guidance shows that producers have adopted the long-term investment strategies usually associated with integrated oil majors, plotting incremental increases in investment to methodically accelerate production growth to 2020 and beyond.

As we explained in Part 1 of this blog series, the U.S. E&P sector in the first half of 2018 benefitted from the good-times trifecta of higher oil prices, higher output, and lower costs. As a result, the 44 E&Ps we track reported $21 billion in pre-tax operating profits, up from $6.2 billion in the first six months of 2017, and over $50 billion in operating cash flow, up from $39 billion a year ago. Most notably, these companies are on pace to garner an astonishing $30 billion in free cash flow. Yet, in their financial reports for the first half of 2018, our group of 44 E&Ps boosted total 2018 capital spending by only $3.9 billion, or 5%, over their initial guidance to $68.1 billion, which is 10% higher than their 2017 investment. In today’s blog, we’re drilling down to examine capital investment by peer group and company and to chart the impact on their expected production growth.

Oil-Weighted E&Ps

The Oil-Weighted E&Ps reported the largest mid-year increase in capital spending: $2.3 billion to $28.1 billion (blue rectangle in Figure 1), which is 9% higher than their original 2018 guidance and 19% higher than their 2017 outlays. (The “2018” column shows each company’s initial 2018 guidance, while the “2018 Q1” column incorporates any changes to guidance the companies made with their first-quarter reports and the “2018 Q2” column shows any further tweaks to guidance they made in advance of or with their second-quarter reports.) With oil prices rising, 13 of the 17 companies in this peer group raised their 2018 capital budgets. Despite widening regional price differentials resulting from infrastructure restraints, three major Permian producers were responsible for more than three-quarters of the increased investment. Half of the total increase stemmed from a $1.2 billion, or 40%, rise in spending by Occidental Petroleum. The company expects to realize an additional $5 billion in cash flow in 2018 — half from midstream asset sales and half from operating outperformance. Occidental decided to deploy $1.1 billion of that cash flow to high-return, short-cycle oil and gas projects in the Permian, raising its total investment in the unconventional play to $2.8 billion, two-thirds of its total capital outlays. Another $2 billion will be allocated to share repurchases, with the remainder targeting balance sheet improvement. EOG Resources is expected to be the largest spender in the group at nearly $4.7 billion (red rectangle), with over 40% of the budget targeted to the Permian Basin. The company did not alter its capital spending plans in the mid-year update. Pioneer Natural Resources increased its 2018 capital investment by 16% ($446 million) to $3.1 billion (yellow rectangle), after its initial guidance called for flat capex. The company has already received $500 million from the planned divestitures of all of its non-Permian assets and is allocating part of the proceeds to prepare for its 2019 operating plan by adding four rigs — two in August and two more during the fourth quarter of 2018. Parsley Energy, which also originally guided to flat capital investment, raised its guidance by 17% ($119 million) in the second quarter of 2018 to about $1.5 billion. Part of this increase covered higher service and equipment costs and another part funded higher drilling activity.

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