I was looking at SSE a while back as a potential long, and the previous hope was that regardless of the movement in oil (barring a recession or into the $70s), oil production will continue at full-force due to (1) fear of production efficiency loss by the E&P companies and (2) US Shale’s high IP & rapid decline type curve structure supports a manufacturing model. In such a scenario, CHK’s back support, longer lead time, and tier 1 rig growth into FY15 gives me the comfort that SSE can indeed hit its 550-600 mm EBITDA target, placing the stock essentially at 4.5x, or the lower end of historical spectrum. Assuming we are in a stable economic period, as long as oil stabilize and production continues as economics in the shale basins stays put, SSE should do well given its growth multiplied by higher leverage.
But I'm sure you have heard about oil price falling -- it's kind of plastered everywhere. So it's time to reaccess the land-driller thesis. I believe the assumption on fear of efficiency loss & production method has not changed, nor has my belief (you may disagree) that the general economy is doing okay without a looming crisis changed, so the real question is – will oil stabilize and will the production model continue?
On the production model first, increasing criticism emerges on how the US unconventional producers are too fragmented and too production-growth focused with little regard to shareholder value / capital return. I think it is very natural – what else would one expect when IRR is high, return-profile is quick, product is the definition of commodity, financing is easy, and the street awards them for doing so?
Hence, barring any activist pressure or serious consolidation that makes capital return a priority, drilling production growth shall continue until oil drops to the highest marginal cost in the unconventional basin. Anything lower, usage of horizontal rigs should dip and the drillers suffer operationally. Multiple sources seem to suggest that 1st point of contact is around $80-85 / barrel and, in fact, increasing efficiency gain could help push the boundary to $70-75 / barrel. I also expect a lag in reaction due to (1) expectation by the E&P themselves of a rebound, (2) it takes time to strategize the exit, and (3) hedging might have already occurred to some extent.
In other words, unless oil drops below $80 for an extended period before efficiency catches on, it is only drillers’ multiples that will get hit, not their numbers. I believe this assumption still holds.
- Then the key question becomes – will oil price dip below $80, or will it rebound?
- The situation is very similar in a way to what we saw in mid-2012: The European economy is showing weakness. Chinese economic activity is decelerating. Japan is in a bizarre, permanent recession. The U.S. economy appears to be okay. But the twist here is that the Fed is also exiting QE.
- Here are some context to the price of Oil Price:
On one hand, the price action almost compels me to say that we are deemed for a rebound for reasons unbeknownst to me simply due to technical.
On the other hand, the increasing paradigm shift of US producers (driven by capital interest and IRR) is increasing its share against OPEC that carries (a) less influence and (b) a bigger fixed cost that hamstrings its ability to cut production.
My question is, why would Saudi Arabia, the lowest economic cost marginal producer, curtail production to stabilize the market in face of demand weakness and US production at full pace? Similar goes for other Middle Eastern countries. It is even more difficult when they have a big fixed budget base to cover, no?
More importantly, knowing that a league of US producers are running the rigs hard & increasing supply is almost certain, will OPEC still cut supply? Any cuts they do are likely to temporarily boost price, only to see US producers capturing it in their economics, and increase supply to a point that drives price back down again, assuming demand stays the course.
A pessimistic scenario for us (which could happen) is that – oil falls to 80 quickly, something gets announced about supply cuts within the US & capital discipline, Saudi is muted, oil rallies back up, but Drillers gets hurt because numbers are now coming down.
Hence, by owning SSE, the marginal (due to low high-spec rigs), levered driller, I think we are essentially betting that a supply resolution won’t happen in the US.
In fact, since the fixed cost to sustain the budget is so high and the cost of actual oil production is so low, perhaps OPEC’s best course of action is to let the rigs run and let “operating leverage” do its work?
More On Saudi below
Deutsche Bank introduced this “breakeven budget” concept in 2012. For OPEC and other producers, which factors in the price needed to balance the overall budgets of the regimes that use state-owned oil revenues to pay for public sector wages and infrastructure and offer subsidies to their populations. By that reckoning the Saudi budget breakeven price for 2012 stands at US$78.30 and for the U.A.E. US$90 per barrel, which are comparable with the Canadian SAGD and upgrader breakeven price. Until 2006, Saudi Arabia’s breakeven budget price was US$38.70, but by 2011 it had shot up to US$82.20, according to Deutsche Bank estimates. The kingdom’s breakeven price escalated as it injected petrodollars to stimulate its limping economy after the global financial crisis; it also opened its coffers to appease its citizens as the Arab Spring movement swept across the region. As neighboring Egypt, Tunisia, Libya, Yemen and Bahrain were in the throes of popular revolts, Saudi’s King Abdullah bin Abdulaziz Al Saud pledged a US$131-billion spending and investment package — 30% of its GDP — which included public sector jobs for 60,000 citizens and double-digit wage hikes for existing government employees to keep dissent at bay.
Unlike investment spending which can be scaled back, current spending involves wage bills which are far more sensitive to changes, especially if they are revised downwards,” said Paul Gamble, head of research at Riyadh-based Jadwa Investments, adding that the government’s wage bill has risen 76% in six years
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