While the audience stays on the track

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As the term “energy security” returns to the public lexicon, the values ​​of American oil companies are rising. It makes some people happy and others sad. Either way, this represents a foreshadowing of a potential longer-term cycle; where US oil production capable of meeting energy demands will be increasingly important. Many believe that the United States is now the world’s producer of “swing” (although John Hess does not agree), and it is not due to the action (or inaction) of the government. Biden’s third SPR release in the past six months is largely symbolic and more of a political gesture than a meaningful macro needle move. Supply and demand were drifting apart before Russia invaded Ukraine and this geopolitical dynamic has only widened that gap. The market players best placed to seize this unexpected gap are private US operators.

Current oil price expectations make many reserves economically attractive. The rate of return on capital deployed for drilling will (if not already) exceed the demand for other capital deployment options such as dividends or debt repayment. However, most US public companies are not changing their strategies.

Domestic dynamics (not Russia’s) keep public valuations relatively anchored

As I have written before, shareholders have for years demanded returns from oil companies in forms other than production growth. The valuation of oil companies in its fundamental form is based on the present value of future cash flows. Therefore, if the capital available today is better used to drill more wells tomorrow, then production growth is the most efficient path to higher value. At historical prices a year ago, the decision to return more capital to shareholders (instead of deploying it in capex) made sense. It’s no longer the case now. However, public companies have not yet changed the course they have been setting for several years. This is partly why the public sector (using XOP as an approximation) have risen only 62% over the past year, while prices have almost doubled.

Demand is strong with the anticipated depletion of Russian oil on world markets. According to Wells Fargo, US investment budgets would need to quadruple by the end of 2024 for shale to replace Russian oil exports to mainland Europe. Moreover, equilibrium prices in most basins for new wells are still around what they were a year ago according to the Dallas Fed investigation. This cost is rising and will continue to rise, but there is still plenty of room for profitability at over $100 a barrel. Also, as I mentioned before, CIC sinks continue to shrink. In summary, many signals are being sent to public companies to “form baby drill”, but this is not the case.

To be fair, there are a few warning signs on the horizon that should be heeded and incorporated into these public assessments. First, the futures curve is always shifted, which means prices should go down (not up) going forward. However, even in the long run NYMEX Curve is still over $70 in four years, which still pays off for a lot of spare inventory. Second, new wells being drilled today appear to be less productive. The EIA’s Drilling Productivity Report shows new well production per rig is down (although they acknowledge the metric is “shaky” right now). Finally, oil services markets have become very tight:

“Labour and equipment shortages, along with oil country tubular goods inflation and shortages of key equipment and materials, will limit the growth of our business and oil production in United States. In particular, truckers are in critical shortage, perhaps due to competition from delivery services. – Dallas Fed survey respondent

Private companies take the lead

Enter private oil companies. While forecasts suggest the US can add between 600,000 and 800,000 barrels of oil by the end of the year (EIA says maybe 760,000), then the path to get there will be through the drill bits of private producers and backed by private equity. According to a Enverus report quoted by Hart Energythese types of operators have taken on the vast majority of new platform activity since the summer of 2020. With fewer external concerns, less ESG pressure and lower regulatory costs, the flexibility and agility of the sector private allow it to get ahead in search of the growth that economic fundamentals suggest is on the prowl.

For example, Mercer Capital’s latest investment discussion on mergers and acquisitions focused on Eagle Ford’s shale suggested the market signaled to potential buyers that now is the time to increase their footprint in South Texas while planning an exit for sellers who could either capitalize on the prospect of a continued rise in energy prices, or redeploy capital elsewhere.

Regardless of the exact incentives that may have driven M&A activity, the result was ten deals completed, mostly by private buyers or small-cap producers such as SilverBow Resources.

These valuation parameters implicit in the table above suggest that there are outsized returns to be made on additional new wells at this time. Many eyes are on American production, not only in the Permian, but also in southern Texas, Oklahoma and the Bakken. What they see right now are public companies staying anchored with their capital, while private companies could leave them behind – and quickly.

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