The Shale Industry’s “Black Cow” Phase

David Messler

Mr. Messler is an oilfield veteran, recently retired from a major service company. During his thirty-eight year career he worked on six-continents in field and…

More Info

Premium Content

• Shale E&P companies are demonstrating financial resilience and the ability to generate strong cash flows, even at lower oil prices.
• Increased drilling efficiency and cost reductions are contributing to improved profitability in the shale industry.
• Despite market pessimism, shale E&P stocks offer attractive potential for growth and income investors due to their strong cash flow generation and commitment to shareholder returns.

Shale focused E&P’s have sold off dramatically over the last year. There are a number of reasons for this, but the one we will address in this article concerns shareholder returns, and investors perception that they are not sustainable at current commodity prices. With most of them, this is simply not the case, barring a crash in oil prices below $40.00, and we will cite some examples as we go through this article.

In 2022 and in the first half of 2023 shareholders of large E&P’s as increased cash flow from the Ukraine war oil price spike quickly became accustomed to out-sized quarterly checks that featured yields in the double-digits. As these companies exited 2023, cash flow began to fall and the dividends fell commensurately. Investors headed for the hills, driving down share prices further.

In many cases this was an over-reaction as these companies were generating more than adequate cash to cover capex, dividends, share buybacks, and pay down debt. Still EV/EBITDA multiples compressed as commodity prices dithered and cast aura of impending doom over the business. Investors remained on the sidelines. The graph below illustrates this point.

So what happened?

Part of the answer-a big part, of how these companies have been able to sustain adequate cash flow to self-fund capex and meet other corporate objectives lies in the ability of the industry to do more with less. Linhua Guan, CEO of privately held Permian shale operator, Surge Energy, commented in a direct communication to me that-

“At $70 WTI price, Surge Energy will continue to generate substantial free cash flow and do not see any significant change to our current CAPEX program.”

Over this period, rigs searching for oil and gas have declined from 622 to 585, but production has continued to rise incrementally, as per the EIA 914. How is this possible? There are a lot of reasons for this. Front loading of Top Tier acreage, increased lateral length and increased frac intensity-higher sand loadings and more stages, have all contributed. Add to that as we have advanced through the year-cost deflation. Service providers like drilling contractors, and fracking companies have also noted the effect the shrinking market has on revenues and margins. In their Q-3 quarterly call ProFrac Holdings, (NYSE:ACDC), a leading U.S. fracking company, management mentioned 33% lower EBITDA margins, driven by lower activity than they had anticipated. Money out of their pockets puts it back in the pockets of the E&P’s.

Finally, Leen Weijers, VP of Engineering for Liberty Energy, (NYSE:LBRT), the top U.S. independent fracking company, sent me a graph highlighting how efficiencies in drilling and fracking have combined to reduce the time to do a foot of new hole.

This means the industry is using capital more efficiently in time’s past. So in 2024, we have an industry that has made amazing strides at reducing cost, and successfully maintaining output, all while returning capital to shareholders. And, still can’t get any respect from Wall Street.

The Business cycle

RBN Energy, an energy consulting and market analysis firm, put out some commentary in a recent edition of their newsletter discussing the phases of the business cycle as they relate to upstream energy. The graph below illustrates this concept.

“Volume growth can instead be achieved through M&A activity and, right now, the industry is in the throes of a massive wave of upstream and midstream consolidation (which we’ve chronicled in numerous blogs), just as predicted by the product life cycle curve. In the upstream, that consolidation has been accompanied by the rationalization of producing assets with companies prioritizing efficiency and maximizing cash flows from their assets. 

There’s an economic term we can shoehorn in here, too. A cash cow is an asset in a mature, slow-growth industry where producers focus on returns on assets rather than re-investment. In the energy upstream proved, developed, producing wells (PUDs) are cash cows producers seek to milk — or, since we’re talking oil, perhaps Black Cow is more appropriate.”

I think RBN has it right. The consolidation phase is slowing and about to crest. What remains is harvesting profits from the cash cow, driving out cost as the industry begins to “manufacture” wells, and rewarding shareholders.

An example of a company doing just fine at $70 WTI

Let’s look at a recent report from a prominent public shale driller to get a deeper perspective of how they are managing in a $70 WTI price environment. Devon Energy, (NYSE:DVN) turned in a solid report for the quarter meeting EPS estimates-($1.10) and beating substantially on the top line-($473 mm). Composite field cash margins per BOE fell slightly as WTI and gas declined through the quarter.

In their Q-3, 2024 report, Devon noted reaching an all-time quarterly record of total production averaging 728,000 barrels of oil equivalent per day, including 335,000 barrels of oil per day. On a production per share basis, this represents a 12% year-over-year growth. CEO Rick Muncrief, CEO commented-

“We now expect to produce about 730,000 BOE per day for 2024, an increase of 12% to this year’s budget. This phenomenal performance enabled us to generate $786 million of free cash flow in the third quarter and return $431 million of it back to shareholders. As a result, Jeff will be providing preliminary 2025 guidance that is actually better than we had previously communicated.”

The Delaware Basin delivers project after project to DVN. On a quarterly basis we hear about a multi-well developments knocking down 3-4,000 BOEPD. The Delaware was again the primary contributor this quarter to the company’s earnings, garnering approximately 60% investment capital was allocated to this basin. 

As the company slide below notes, the company’s progress in increasing efficiency-boosting oil production while making double digit improvements in reducing drilling and completions cost/time. The company notes in its investor slide packet for the quarter-

“Production volumes hit record levels in the basin, achieving steady production volumes of 488,000 BOE per day, representing a 6% growth rate compared to the previous quarter. 55 new wells were hooked up, primarily targeting the Wolfcamp formation, with a subset of Bone Spring and Avalon wells included in the mix. Collectively, these projects exceeded expectations, achieving average 30-day rates of more than 3,100 BOE per day per well.”

Your takeaway

At today’s depressed stock prices many shale operators are trading at double digit cash flow yields. In the case of Devon, while their dividend yield is in mid-single digit range, when you add the stock buybacks, shareholder returns are approaching 15% on a NTM basis. With the strong business model they have adopted these companies are attractively priced for initiating new positions for potential growth, and strong, well-funded income through the cycle.

Download The Free Oilprice App Today