Despite Santa's late rally in the oil zone this week, perhaps it's time to realize that we are about to reset the outlook for the oil sector in a potentially developing 2024 price environment for WTI and Brent. We are one stock away from the trip back to the $60 WTI and low $70 Brent levels. Are we staying there long? I doubt it, and I'll discuss why in this article, but it may happen. In this article I will discuss what I consider to be the most likely scenario for 2024.
The impact of falling prices on activity
The most likely scenario in my book is that lower prices lead to a sharp curtailment of drilling and a moderate decline in completion activity in shale. Most shale drillers have a strong inventory of drilling sites with capital expenditures funded by $40 WTI. But this is a rainy day…or “rainy year” scenario, and it doesn't mean the CEOs of these companies won't pull their money out if the current weakness continues. In my view, if there is ever a moment of significance in the $60 WTI price, capex budgets will start to tighten. Below sixty, they will be cut off. Investors who have grown accustomed to huge dividends, huge debt and stock count reductions over the past couple of years will demand this. The old saying “the cure for low prices is low prices” still holds true.
I discussed some of the challenges facing the US shale industry in an OilPrice article published mid-year. So far, improvements in technology and efficiency have prevented this from happening, but investors should view this extension as overdue rather than cancelled. Industry sources tell me we are about to balance out the old declines in shale, drilling enough to gradually lift production higher. We've seen that over the last few months, as the Permian Basin and Bakken have only added net barrels incrementally.
For example, the chart above is from the latest version of Environmental Impact Assessment-DPR, shows a Permian net addition of 760,000 boe in 2023. That's good, right? A closer examination shows that much of this happened in the first quarter of the year when the rig count was 20% higher than it is today. Since July, the number has been 100 rigs short of that number, and since August it has averaged about 150 rigs fewer than the 779 rigs we started the year with. To confirm this idea, we can cite the December 2023 Permian increase of 5 thousand barrels per day. This gives me confidence in my sources. RELATED: Oil prices head for first annual decline since 2020
Thank heavens for the last couple of years though. Balance sheets are repaired, debt maturity ladders are better, and companies have cash on the books, for the most part. More importantly, they have reshaped themselves to survive a sub-$60 oil price scenario. They will survive to see another day if that happens.
The first place where capital expenditures will be reduced is drilling. Earlier this year, some people predicted a pickup of around 50 rigs in 2024 to somewhere in the 680 range. I think that's off the table in the short term, as we could be heading towards a sub-600 rig scenario. This will also have an impact on fracking companies, but not as extreme, at least in the near term as there is incomplete drilling to be brought in. This will not be on the trajectory it was in 2020/22, as DUC numbers remain low, with the industry only adding for a few months, before returning to withdrawals. From late 2020 to mid-2022, the DUC count dropped from the mid-8,000s to the mid-4,000s — pretty much where it is now.
Incomplete digs are unlikely to be the complete panacea they were in 2021-202. Remember, we're starting with half of 2021's DUC stock. There's also the “quality” issue to contend with. Today's DUCs are probably not as prolific as those converted to the TIL'd line in 21-22. I've had conversations with production engineers that were somewhat disdainful toward the remaining DUC inventory. We may see!
In the chart above, notice the rise in DUC withdrawals starting in early 2023 as the number of rigs began to decline.
I noted above that I felt drilling would take the big hit as operators struggle to maintain production and cash flow at sub-$60.00 oil. In line with this belief, I believe the major onshore drilling companies, Helmerich & Payne, (NYSE:HP), and Patterson UTI, (NYSE:PTEN) could see the weakness they saw in Q4 2023 continue into Q1 2024. The shares of these two companies fell by about 30% during this period, and as I said, they may be exposed to further weakness, and depend to some extent on oil prices as we discussed. My purchasing goals for PTEN and HP are under $10 and under $30 respectively.
So I'm cautious about drilling companies right now, looking for short-term growth? The first place is US frackers, where Liberty Energy ( NYSE:LBRT ) is a top pick at current levels. Liberty is a leader and innovator in the sector and holds around 20% market share according to industry sources.
Liberty crushes it with its industry-leading return on capital employed, reported at 44%. S-3, 2023 Deposit. Other profit metrics are discussed in the slide below. One key statistic is that earnings before interest, taxes, depreciation, and amortization (EBITDA) have risen over time as it has consolidated to become a multi-service company.
The company has a number of potential catalysts going into 2024. One in particular that I'll highlight is that Liberty has just opened a new segment that I believe has the potential to grow revenues and margins in the new year.
I'm referring to Freedom Energy Innovations here. This is just an idea whose time has come. With the focus on fracking-related emissions, delivering CNG to the drilling site to power the pumps is a great idea and should pay off in the near future. The point worth noting is that they transform from a refined product that has been transported several times by the time it reaches the rig, to a locally produced material that requires relatively little processing before being compressed. There is efficiency in this alone.
Consider that a One frac fleet can consume 6-7 million gallons of diesel per year, and you start to get an idea of how much liquid fuel can be replaced by CNG. The linked article notes that 1 MMcf of gas replaces about 8 gallons of diesel, a huge direct savings with gas selling for 2.5 MMcf and diesel for $5.00 a gallon. It's early days and I can't generate revenue or EBITDA in this business. However, it is a natural progression given the overall emissions reduction picture, and in my way of thinking it comes with a moat. I don't think this can be easily replicated by other hydraulic fracturing companies. Chris Wright, CEO comments on the course he sees for LPI:
“Firstly to power our hydraulic fracturing fleets. But of course it will also power other people's drilling rigs, other operations in that space. There are other oilfield applications for that. And ultimately, as you look forward, what is Liberty generating expertise in. We “Regenerating expertise, getting the highest thermal efficiency on wheels, mobile power generation, we're generating expertise in how to transport natural gas, how to process natural gas remotely or on-site to deliver natural gas, where it's needed and how it's needed.”
With Liberty's margins, innovations, and market bias toward its services sector, I feel the company's stock is undervalued at current levels.
Liberty currently trades at an EV/EBITDA multiple of 2.5X based on a Q-3 run ratio. Analysts rate the company as Overweight with price targets ranging from $20-27.00 per share. The company has a history of beating analysts' targets over the past year, and only seasonal weakness could prevent that from happening during the fourth quarter. EPS forecast is $0.60 per share in Q4, rising to $0.71 in Q1 2024. It easily beats estimates for Q4 2022 and Q1 2023, so the trend is in place. If Liberty can beat the Q-4, I think the company's multiple should rise. 3X would easily provide the lower range of price targets, and 3.5X would put them within sight of the upper range.
None of these estimates take into account any revenue or margin growth that the company has consistently shown over the past several years. With that in mind, I have freedom as the best choice. I believe that investors with modest risk tolerance should carefully consider whether the company achieves their goals.
Written by David Missler for Oilprice.com
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