Which Is The Best Shale Giant To Buy This Christmas?

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U.S. shale drilling companies have become noteworthy for a couple of things this year. The first has come to be known as capital restraint and means essentially the companies no longer allocate capital for double-digit production growth annually. Instead, they have plowed the excess capital that has flowed into their coffers from higher oil and gas prices into debt reduction, share repurchase, and higher dividends.

The second is their focus on gaining market share and scale through acquisition and “bolt-on” acreage - acreage that complements existing acreage footprint in a given area - purchases. Focusing on the best plays, like the Permian basin, there has been a lot of activity of this type in this area over the last year. Large multi-billion dollar companies have chosen to merge with larger rivals to form a combined enterprise best suited to deliver shareholder returns in the coming years. Thankfully for shareholders, most of these mergers have been stock-swaps that led to no new debt or have been done with cash on the books.

The two companies we will be comparing this month have both been active acquirers since the oil crash of 2020. A pure-play Permian driller, Pioneer Natural Resources, (NYSE:PXD) has merged with privately-held DoublePoint Energy, a move that boosted PXD’s output.

ConocoPhillips, (NYSE:COP) had taken a similar approach to the Permian with its acquisition of Concho Resources in October of last year. Then the company quickly pivoted with news of a successful deal that netted Shell's (NYSE:RDS.A) (NYSE:RDS.B) premium Delaware basin acreage. Quickly scaling up its footprint in the Permian to offset a setback with its Willow project in Alaska.  

In this article, we will look at the key aspects of each company and pick one in which we think investors should carefully consider taking a stake. It should be noted that both of these companies are doing well, and an excellent case can be made for investing in either company. That said, we will pick the one that we feel represents the best dollar-for-dollar value in the present market.

Things that the market doesn't generally take into account

Those who don’t work in the industry might have difficulty understanding why these companies were willing to spend billions to enhance their existing acreage positions. Before we go on to look at the individual financial characteristics of each company we will dig a little deeper into the impact these mergers and bolt-on acquisitions have on the companies involved.

Reservoir management

Oil companies can now realistically construct a "picture" of the subterranean strata from which they plan the most efficient draining of the reservoir(s). Big, blocky acreage enables well design that plans efficiently for the natural characteristics of the rock, without being overly concerned about arbitrary lease lines. Among the advantages this confers:

• Avoiding faults in the reservoir that may cause drilling delays/problems. Faults are associated with geosteering difficulties-keeping the bottom-hole assembly headed toward the target, loss-circulation, and hole collapse. Anyone of which can be catastrophic and result in flat time or redrilling.
• Minimizing tortuosity. Curves and bends in a well path increase the mechanical risk exponentially. Blocky, connected acreage promotes minimization of these "doglegs."
• Optimal well path targeting for maximum drainage of the reservoir. Visualize the reservoir in 3D and you will see the impact this might have on ultimate recovery from the zone.

Permeability and Porosity

Permeability is the flow characteristic that describes the rock's ability to flow fluids toward the well bore. More perm is always better than less perm. Porosity is a measure of the void space in the rock that enables hydrocarbons to accumulate. More porosity is always better than less porosity. The relevance to the value that bolt-on acreage can bring is the ability to plan the well path in the maximum permeability and porosity areas of the reservoir. This will enhance ultimate recovery in addition to any stimulation treatment applied.

Casing exits

Wells start out vertically - most of the time anyway. When they reach a certain depth there is a kick-off point to where they begin the horizontal leg. This is referred to as the casing exit, from which point the rest of the well is referred to as the "open-hole." Commonly the casing exit occurs in the sweet spot of the reservoir and puts the best part of the reservoir closest to the vertical section. This reduces mechanical risk and helps to ensure the best part of the reservoir will remain available regardless of how the well is produced. Wells are opened selectively to encourage maximum drainage from the farthest point and to minimize water intrusion that can shut off hydrocarbons. There are other factors that engineers may use to determine casing exits and, for simplicity's sake, we will just note that fact without a lot of further explanation.

Cube Style development

I doubt this term is foreign to you as over the last five years it's become a commonplace reservoir drainage strategy. We'll cover it here briefly for the sake of completeness and for those of you who may be new to these concepts. The cube enables the design of well paths to minimize well-to-well impacts-frac hits, and harmonics from one well to another chiefly.

Cubes also provide for multi-lateral opportunities as shown in the graphic above.

Lateral length

Just a brief word here as this concept is pretty well understood by now. A few years back Permian laterals were 5-6,000' in length. Today they run 9, 10, 11, 12,000 feet commonly and in some cases go to 15,000 feet. It should be easily evident to you as to how the blocky, connected acreage can positively impact this aspect of reservoir development for operator asset teams.

Scale

Scale is a word that gets used a lot when oil companies “Drill” on Wall Street. What does it mean? It can have a number of impacts from contracting with suppliers for pumping, sand, water services etc., supply base centralization. Oil and gas volumes as well. Carriers are looking to fill up their lines, so having additional production and the promise of more as new wells are developed big operators can gain an advantage in negotiations. I'll stop here. At this stage of maturity, the trend is asset consolidation that lends itself to an "oil manufacturing" state, where processes are streamlined, and inputs standardized. Sort of like car manufacturing when you think about it.

Tier I acreage

Finally, there is the matter of rock quality. All rock is not created equal in terms of drillability, reservoir connectedness and thickness, oil quality, pressure, and the other characteristics that establish the tier of a reservoir. For example, take the Wolfcamp A in the Permian. It sits above the Wolfcamp B, C, and D. These are generally classed as lower tier than the A, as they require additional drilling to tap. They may also lack some of the attributes of the A, as well as having lower porosity and permeability due to diagenesis. Foot for foot of interval these horizons will typically yield less than the Wolfcamp A, extending payouts and perhaps making them less economic to drill.

ConocoPhillips

The $9.5 bn cash deal between COP and Shell for Shell's Permian acreage was a classic bolt-on to COP's already sizeable shale portfolio in the Delaware. Simple math - 225K acres works out to $42K and change per acre. A little steep these days, but COP defended it on the basis of existing production. It's not too hard to follow their logic, but we will stick to simple math.

COP

COP stock rocketed higher on the news and was further boosted by the gains made in WTI in early October. The deal has been generally lauded by the market and COP stock is up 25% in a week, outpacing many others. It should be noted this was a pretty good couple of weeks for the oil market where the news feed generally focused on declines in supply here and in Europe, and the associated high prices that scarcity inflicts on commodity prices.

We think this will add value to COP over and above the linear addition of acreage and present production to its previous portfolio. The Shell acreage makes its former Delaware position that much more valuable as we have discussed in the preceding section.

Q-3, ConocoPhillips

In buying the Shell acreage, COP picked up additional Tier I acreage. This will keep their costs down relative to peers and enable them to continue operations in times of lower prices. In the period we just exited where low prices dominated, mostly only Tier I acreage was drilled.

ConocoPhillips, (COP) turned in a pretty good quarter in Q-3. Some metrics are off because of some asset dispositions in the quarter and some nonrecurring items from Q-2. What matters to us? Dividend security and stock growth of course.

The Dividend. The quarterly was raised modestly-7%, which reduced the coverage by a minimal amount. Not to an extent that would cause us to worry, however. Cash flow was off slightly QoQ, again owing to some nonrecurring items from Q-2. Capex will remain flat but the company is guiding to slightly higher liftings-1504-1507000 MBOPD due to the conversion of Concho Resources flows from 2-stream to 3-stream-oil, gas, NGL's.

COP was trading at an EV/EBITDA of 5.9X using Q-2 numbers. With the potential of the new acreage we see this multiple moving higher. The 200K BOEPD this acreage already brings, probably adds $3.0 bn of EBITDA driving the multiple down still further toward 5X.

Given the momentum that energy companies are displaying at present, we can easily see a 7X multiple being obtained when the Shell deal closes. This would land the stock in the $95-$100 range. The analysts are also bullish on COP with 21 of 28 rating it a buy, with a price target range from $74 (about where it is now) to $117 a share.

Now we will have a look at Pioneer Natural Resources.

Pioneer

Pioneer is one of the premier shale fracking companies in the U.S. It is in an elite group of 4-5 companies that have been making smart acquisitions the last 8-9 months that "bolt-on" to existing acreage positions with Tier I locations ready to drill. These companies are getting ready to report massive cash flow increases, on top of relatively flat capex, that are going to rock the analysts' socks. Multiples and share prices will launch higher as a result.

The company has made two major acquisitions in the last year. The first being, the stock swap merger with Parsley Energy last fall, and the second being their cash and stock purchase of DoublePoint Energy in April of this year. Both of these transactions enhanced PXD's already strong position in the nation's premium shale play, the Midland sub-basin of the Permian Basin. They brought positive cash flow and 1,000's of additional drilling locations, giving a wide ramp for decades of sustainable production without further acquisitions. Richard Dealy, President and COO comments on the synergy provided in these acquisitions:

“One of the other significant benefits of combining Parsley and DoublePoint is really adding to our contiguous acreage position. And what this allows us to do, is we've successfully drilled longer laterals out to 15,000 feet, really up from the 9,000 to 10,000 feet that we've been drilling at, really allow for a lot of locations that we can drill longer laterals on, which is much more capital efficient and really adding essentially the same production by drilling fewer wells.”

PXD

With an outstanding inventory of Tier I acreage and some 15,000 identified Tier I drilling locations much of which in the Midland basin is privately held. This frees it from worries about fracking limitations that exist on federal lands. This high-quality acreage combined with superior logistics-PXD has dedicated frac fleets through ProPetro (NYSE:PUMP), local sand mine, and its own water distribution pipeline and recycling services, and leading-edge drilling and completion practices, creates a low cost of production and high capital efficiency. All of this gives PXD a breakeven cost in its core Midland area of $28 per barrel. This enabled the company to post nearly $700 mm of free cash flow for 2020, on price realizations below $40 per barrel.

Source

Recently the company announced the divestiture of its Delaware basin acreage documented in the slide above, to Continental Resources, (NYSE:CLR) for $3.25 bn in cash. This cash windfall will be used to strengthen the balance sheet and support the variable dividend.

We consider PXD to be an outstanding buy at present prices and investors with a moderate risk tolerance should consider hitting this one like a duck on a June bug. This price discount will not last long in our view, in the most realistic oil price scenarios.

Q-3 Pioneer Financials and liquidity

Increased cash flow enabled the company to raise its base and variable dividend by whopping amounts. Holders will receive $3.58 this quarter for each share, a yield of about 8% for the quarter. 8% money that is this well covered with cash flow is a rare breed. With the massive dividend increase, coverage fell QoQ, but by less than the amount of increase in the dividend. No problems there.

PXD

Could we be heading for a massive special dividend in the first half of 2022 with some of that $3.5 bn from divestitures? Once the CLR deal closes PXD is in a cash-rich position. Their $6.5 bn of debt is really of no consequence. They have already run around the acquisition tree with Parsley and DoublePoint. What's left? Increases in the variable dividend and possible stock buybacks come to mind. Scott Sheffield, CEO of PXD comments on the attention they are getting from the investment community because of their dividends-

”We're starting to see additional dividend funds invest. We're starting to see our ownership change more and more dividend funds are buying PXD stock for the dividends. Secondly, we're starting to see more retail come in. We're making all that effort to go into all the firms trying to get more retail to shift into PXD because of the dividend yield.”

Source

The company also has $1.1 bn of remaining capacity on its share repurchase authorization, but I really don't look for more of this anytime soon, as the stock has risen so rapidly. Perhaps in 2022 as noted in the comment below. Here is Scott Sheffield's, CEO of PXD, comment regarding share repurchases-

“We do think it's important over the next 5 years, if we do generate $25 to $35 billion of free cash flow, that we significantly reduce the share count over time. But it's going to be opportunistic and during market dislocations.

I think going forward, we stated our new debt targets that used to run debt - to-EBITDA 0.75, we lowered it to 0.5 and I'd prefer to have 0 debt long-term. It gives us a lot of options. I've stated already on the buybacks, we'll like to reduce shares significantly, but I'd like to do it at a good price. We think definitely we will be buying back cheap. And we've had several dislocations during 2021. It wouldn't surprise me if we have some dislocations during 2022. So you'll see us be buying shares in the marketplace during 2022.”

Source

PXD joins the companies funneling excess cash back to shareholders with its variable dividend policy, discussed in the slide below. It's noteworthy that the variable dividend is triggered at WTI prices above $42 bbl.

Scott Sheffield, Exec Chmn of PXD commented on the new dividend policy and its objectives in the Q-1 call, comparing their metrics to Devon Energy's (NYSE:DVN):

“Pioneer will move to second place next year, moving over 4, and then moving up to the top spot above Devon. And the primary driver is really just our low -- our margins in the high 20s, our low-cost basis in addition to the fact that we're paying out 75% of our cash flow versus Devon's 50%. When you look at -- including the base dividend, approximately 80% of the company's free cash flow is expected to be returned to shareholders. Between the base and the variable dividend, shareholders next year will -- should expect 8 separate dividend checks per year.”

Source

I will argue that this sort of shareholder focus is unusual these days, although becoming more common as the cash rolls into these companies. As noted it is a variable dividend that rewards shareholder when times are good, and can be minimized when the cycle turns down. When a company sets stockholder expectations as high as PXD has they’ve also set a high bar for performance.

As you might expect the analysts are high on PXD, with 26 of 32 rating it as a buy at present prices. The range runs from a low of $179 to a high of $305 per share. The median is $222, indicating a modest upside from its present level.

The company is trading at an EV/EBITDA multiple of 6.25X at present. I think this deserves to ratchet higher based on the 5% growth projected for 2022. What would deliver that $305 share price? It would take a multiple expansion to 9X EBITDA, which is aggressive but not out of line for a company generating the cash PXD is at present.

Your takeaway

As I said at the outset, there is no loser in this group. Both companies have outstanding prospects in the current energy environment, but this is a competition for your investing dollar and we must pick one. I like PXD for a couple of reasons in spite of its already hefty share price. 

The first is its pure-play focus on the Permian Basin. I like the scalability and the cost control that brings as well as the security of being internal to the U.S. In spite of the current governmental disdain for domestic energy, we still need what PXD produces and that won’t change. In fact, as I noted in a recent OilPrice article I think the “chickens are going to come home to roost,” as regards the upstream underinvestment I discussed in the linked article. ConocoPhillips, by comparison, has global operations, which heightens risks in my book as some these operations are in areas of the world where there is civil unrest. They also have considerable exposure to environmentalist pushback in Alaska, for some key projects as we have noted. They have exposure to the “stranded asset,” conundrum as a result and returns could be impaired in future quarters with an asset write down. A risk I would like to avoid.

Second, holders of PXD shares are simply going to receive some amazing dividends over the next few years. (It could be longer but I refuse to project out more than a couple of years.) If the company applies that 80% of cash returns to shareholders in the form of a variable quarterly dividend the impact could be an $8.09 per share bonus on top of the company’s $060.05 regular dividend, resulting in a final quarterly payout of $8.69 per share. That’s a 4.5% yield on cost-YOC, for the quarter. If you average out the variable dividend over the course of the year, you could be seeing another $12-20.00 on top of regular $2.42 annualized payout. A potential YOC of nearly 12% at today’s PXD price.

Nor does that account for a significant share count reduction. Their float currently is 244 mm shares. With the present plan to allocate a $ billion to share repurchase, that could be knocked down to 239 mm pretty easily over the next year. That’s another $2.02 annually for the regular dividend for the remaining shares. It all adds up.

We think for the reasons we have discussed both growth and income-seeking investors would do well to consider a position in Pioneer Natural Resources at present prices.