The sun was shining and wind filled the sails of the 44 major U.S. exploration and production (E&P) companies we track in the third quarter of 2018 as they collectively reported a 35% increase in pre-tax operating income over the previous quarter. It’s been an up-and-down year. Increased efficiency and rising output from the transformation to large-scale, manufacturing-style exploitation of premier resource plays moved the E&P sector solidly into the black in early 2018 after three years of losses. But profits stagnated in the second quarter on a decline in revenues as widening differentials, primarily in the Permian Basin, negated the impact of higher NYMEX prices. Today, we explain how producers overcame the headwinds to resume profit growth in the third quarter, but warn that future returns for certain E&Ps could be jeopardized by the sudden plunge in oil prices.
How We Got Here
As we detailed in our Better blog series, after $160 billion in pre-tax operating losses in 2015-16, oil and gas producers implemented a strategic and operational transformation to pull themselves out of the red in 2017 and put themselves in position to benefit from rising commodity prices in 2018. And, as we described in the I Feel Good series, our universe of 44 E&P companies cashed in on higher realizations in the first quarter, reporting the highest pre-tax net operating profits and cash flows since 2014. But second quarter 2018 profits were flat at $10.7 billion, and revenues fell 2% to $34.39 per barrel of oil equivalent (boe) compared with the first quarter despite NYMEX and Cushing oil prices increasing by about $5/bbl (see our Big Machine series). A major driver was a blowout in the Midland, TX, to Cushing, OK, oil price basis differential –– from $0.40/bbl in the first quarter, on average, to about $8/bbl in the second quarter because of pipeline takeaway constraints. This dampened the revenues of the two-thirds of the companies in our Oil-Weighted and Diversified peer group that produce from the Permian Basin and resulted in a cautious outlook for the remainder of the year.
However, as shown in Figure 1, E&P pre-tax operating earnings surged 35% to $14.7 billion in the third quarter (light-blue bar in graph to left) over the previous quarter and a seven-fold increase over a year earlier on rising revenues and lower costs in nearly every expense category. All but one of the 44 E&Ps we track were profitable in the July-through-September period, with only EQT Resources posting a loss. The primary impetus for the higher income in the third quarter was stronger realized prices, which were 7% higher than the previous quarter ($36.65/boe vs. $34.23/boe) and 28% higher than the year-ago period ($28.66/boe) –– despite still-wide Permian differentials. Also, after rising in the second quarter, total costs ($23.65/boe) were 2% lower quarter over quarter and nearly 12% below a year ago. Compared with the second quarter of 2018, lifting costs were up $0.14/boe because of an $0.18 increase in price-sensitive production taxes, while impairment charges were down nearly $1/boe. Total costs were down mainly because of the plunge in impairment charges. Depreciation, depletion and amortization (DD&A) expenses and exploration charges were also lower. Finally, the gain in production costs was solely due to the rise in production taxes.