Gearing Up for Energy Earnings Season
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Earnings season for the energy sector for the second quarter of 2012 is set to start in a few weeks and as usual these reports, along with the associated management commentary, will provide information on the current drilling cycle in North America. Here are some issues and trends that should be monitored by those investors that are active in this sector.
Tripping Point
One important topic for investors in the energy sector is the impact that falling crude oil and natural gas liquid prices are having on announced 2012 capital budgets, as many of these were set late last year or early in 2012 based on higher assumed oil prices.
Some exploration and production companies don’t have the financial resources or borrowing capacity to sustain these capital budgets if lower than expected oil prices reduce cash flow for a significant period of time. This may lead to cuts in spending and lower oil and gas production forecasts in 2012. Forest Oil (NYSE: FST) was one of the first operators to lower capital spending for the second half of 2012 and will spend between $190 million and $210 million as it lowers and redirects capital away from “lower return liquids projects in East Texas and the Panhandle area.” The company’s goal is to reduce capital spending to match anticipated cash flow.
Investors have seen this trend in companies with large exposure to natural gas as these operators have announced significant cuts in dry gas drilling as prices dropped over the last few years.
Shaky Economics
Lower commodity prices will also make some crude oil and liquid plays less economic to drill and may lead to additional cuts in drilling in North America. Apache Corp. (NYSE: APA) is active in many onshore plays, including ones in the Permian Basin, and reported returns of 27% and 30% for vertical wells drilled and completed into various formations in the Midland Basin. The returns for horizontal wells drilled into the Cline Shale, Avalon Shale and Bone Spring formations were also reported at 30%. These returns were based on the forward curve as of late May 2012 and any further drop in prices may make these wells marginal to drill on an economic basis.
Offsetting Trends
There are several trends and forces that may offset these drilling reductions.
Some exploration and production operators have hedged production through the use of derivative instruments and will continue to realize above market oil and natural gas liquids prices for the balance of 2012 and 2013. Denbury Resources (NYSE: DNR) reported in its June 2012 investment presentation that 85% of its crude oil production in the second half of 2012 was hedged at a floor price of $80 per barrel. The company also has significant hedges in place for crude oil in 2013.
ExxonMobil (NYSE: XOM), Chevron Corp. (NYSE: CVX) and other major integrated oil and gas companies are involved in North America to a much greater extent than in previous cycles. These operators have huge financial resources in the form of cash and debt capacity and can sustain drilling and work through a dip in prices if they feel it is temporary.
Several operators reported reduced oil service costs in the first half of 2012 as the slowdown in dry gas drilling spilled over into plays where companies are developing crude oil and natural gas liquid resources. If this trend continues there may be real reductions in drilling and completions costs, which will offset lower commodity prices and keep returns stable.
Halliburton (NYSE: HAL), Schlumberger (NYSE: SLB) and Basic Energy Services (NYSE: BAS) confirmed this pricing pressure when they reported first quarter of 2012 earnings in April 2012.
Schlumberger reported that pricing weakness seen in dry gas basins “reached the liquids-rich basins” while Halliburton saw “challenging” pricing when rolling over contracts for fracturing services and mentioned the Eagle Ford Shale as one area seeing this pressure. Basic Energy Services experienced higher competition in its pressure pumping segment and lower margins in the quarter.
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