No one’s written an article on Occidental Petroleum, (OXY) in a couple of days, so I thought I would. I know I am late to the game (on the public article side of things anyway), and you’re probably sick of hearing about them, OXY that is. Bear with me just a bit, and read past the opening and I hope to justify why I am in favor of the deal that went down. Got your attention now, right? I said, “I like the deal.”
Just as a point of interest, OXY is a company that didn’t get a lot of ink until a couple of months ago. Prior to April, one article every couple of months was what this solid 5.0%+ dividend payer rated from the Seeking Alpha writing community. What was there to say really? Every quarter they announced increased cash flow and production, and you were left wishing you’d bought in the quarter before, when the stock price was a little lower.
Chevron changed everything in early April with it’s out-of-the-blue offer to buy Anadarko, (APC). A nano-second later speculation began to percolate about OXY, which had made little secret of its desire to acquire APC’s choice Delaware basin acreage over the past couple of years. Articles began to flow forth, with about 6 from mid-April to the 30th. When OXY’s deal with Buffett was announced, another dozen or so followed. Many of them mostly negative on the tie up between OXY and APC.
So my plan in this article is to give some context and rationale as to why this is a great deal for OXY that will yield big dividends for share holders in the years to come.
The maturing of shale fracking in the Permian basin
I like to start out at the macro level and then work down. In this case it means looking at the OXY deal through the lens of classic business consolidation models. Are there any ready analogues to review? Halliburton’s (HAL) failed run at Baker Hughes, (BHI) comes to mind, as an example.
Hally had grown organically about all it could over the years, but was still only half the size of Schlumberger, (SLB). The combination with Baker would have yielded an oilfield colossus that eclipsed SLB, only just barely though.
What was Hally after in this desperate attempt to grow? In a word, Scale. They wanted the purchasing and plant logistics advantages that would come with size. The rationalization, of the back office work force-IT, HR, and DP staff, that would save hundreds of millions in payroll costs. Baker also had assets that Hally didn’t, like well heads and submersible pumps, so the combined company would have had a broader scope. Take the labels off this initiative and what do you have?
- Lower unit costs per unit of production
- Increased market share
I would argue that this is the scenario in which shale drillers now find themselves. Consolidate, or be consolidated. Like all mergers, only time will tell if OXY and APC make a good match. But, the business of consolidation is necessary and normal.
Being a Hah-vuhd study the energy industry appears nowhere on the curve below, but most others do. The diversity of businesses covered by this graph bolsters the argument that this cycle is a fundamental truth of business, though. Sort of like gravity, you can’t taste it or feel it, but step off a bridge and you are abruptly reminded of its presence. Fundamental truths are like that.
For the purpose of this article we are going to take the advent of horizontal drilling and fracking as the formation of the Opening, or Stage-1 of the shale business.
You can see in the graphic above that around 2005, the number and productivity of horizontal wells began a sharp incline. An incline driven by the rapid proliferation of companies drilling and fracking shale beginning around that time.
In stage 1 the industry moves from just a few players dominating the business, to many as the attraction of easy profits draw in newcomers.
Something I have discussed in the Daily Drilling Report at some length over the past couple of months, is scale and technology. Scale means being able to leverage your key advantages-technology, over a larger asset, as being a significant driver for shale going forward. Recent moves by ExxonMobil, (XOM), with its large Bass acreage pickup in late 2017, and BP’s pick up of BHP’s shale assets are emblematic of this stage beginning to accelerate. It is noteworthy also, that because of their size the moves by XOM and BP got a lot of reportage, but there were a lot of smaller deals in shale as well as the table below illustrates.
Source: The message being sent by these companies is that economy of production will be paramount for success.
What’s happening in this stage? For one thing it becomes more difficult to rake in easy money. Market forces like the drop in crude prices we observed from mid-2014 also play a role. We saw companies that could only make money in a $100 oil price environment, get pummeled in a wave of bankruptcies in 2015.
Nowhere was this worse than in the service industry, which had staffed up to serve an ever-expanding cadre oil explorers. Intriguingly, while the oil producers have largely erased losses, the service industry continues to struggle. This fact will be the topic of another article soon.
Whatever the reason or circumstances that drive a company’s decision, long term survival is only ensured by becoming the low cost producer. In the case of OXY, bolting on the APC Permian acreage that is located in their sweet spot of operations in the Delaware basin, applying their superior technology and logistics is a rational and necessary move going forward. On both an individual and macro scale.
In conservation of time, I am going to stop here and not go on in describing stages 3,4. The links are there if you would like to read more on this topic. My larger point is that the timing of the OXY deal to buy APC fits quite well within a maturing, Stage-2 consolidation environment for Permian operators.
Why is the Permian so special?
Simply put, the Permian is vast dried-up sea bed that favored the development of shaley sedimentation over the intervening eons since it was formed. The way these sediments accumulated created what are now reservoir intervals of tight rock with individual thicknesses of 1000’s of feet.
There’s a lot of oil in the Permian
Estimates vary but the U.S.G.S. recently opined that the Permian might be expected to contain as much as 46.3 bn barrels of oil, mostly in the prolific Wolfcamp and Bone Spring reservoirs. This sometimes referred to as a “stacked play,” What this means is there are multiple reservoir horizons, stacked vertically that give oil companies multiple drilling targets. I’ve heard some estimates that go as high as 75 bn barrels, an estimate that comes from Scott Sheffield, the recently retired CEO of Pioneer Exploration, (PXD). The truth is, no one really knows, but it is generally a good sign when estimates are being raised. Nor do comparisons to Saudi Arabia hurt.
At present rates of extraction, about 4 mm BOEPD, that could mean that there are between 30-40 years of exploration and development remaining in the Permian. A figure that’s likely to be boosted as time goes on.
The role of technology going forward is no great secret. I discussed this in my last article on OXY, raising a couple of key points.
- Tier I acreage, that contains high quality source rock and is relatively cheap to drill, is becoming scarce, thereby enhancing its value.
- Technology that focuses on a deep understanding of the reservoirs, and how best to exploit them will be a necessary tool going forward.
One of things that put a cap on expectations from the Permian were takeaway limitations from the export infrastructure (pipelines) that existed prior to the fracking boom. Those have been largely alleviated by the pipeline construction boom of the last couple of years, that is only just now reaching its probable height. By late 2019 several million bbl equivalent of liquid and gas export capacity will have been added to the Permian.
So the thesis for development in the Permian is fairly straight forward. There is a lot of oil in place. The technology to efficiently extract it is highly evolved, and there is sufficient export capacity in place to take production to market.
Three fairly strong pillars on which to base a business. But, is that all? Hardly. Let’s look at the macro environment for oil and demand for hydrocarbons globally.
Fun and Games: Is a barrel of oil in Saudi as secure as a barrel in the Permian?
Oil is seldom located in parts of the world that can be viewed as being relatively stable. Outside the North America, and in particular the U.S., you will have difficulty finding a significant source of oil, that isn’t going through social or military upheaval, or has the prospect of this type of disruption in its near future.
As I have italicized it, you may well infer that ‘disruption’ is a key word in the last sentence. It is the vulnerability of various means of transport to get oil from where it is produced to the point where it is needed. A distance often of thousands of miles, and sometimes through some very unsettled parts of the world as the recent attacks on ships in the Arabian gulf and the attack on a Saudi pipeline confirm. The Saudis, through a state-run news agency have politely suggested that perhaps the U.S. might just lob a few Tomahawks at Iran in payback for these attacks, attributed to Iran, since the Abraham Lincoln is in the area.
There are quite simply hundreds of billions of dollars of vulnerable oil infrastructure at risk in this scenario. Infrastructure that supplies about a third of the worlds oil. Oil that needs to go to Europe, India, and of course, the U.S.
You don’t have to go far to find another bee hive of discontent. The citizens of Libya, which has the capacity to produce a couple million barrels a day for export, have been having some profound disagreements among themselves as to whom should lead the country. This has had an adverse effect on their ability to sell oil. The EIA estimates that for April of 2019, they sold a mere 1.12 mm bbls.
Downtown Tripoli (Source: DW.com)
Are barrels of oil in Libya as secure as oil in the Permian?
Nor is unrest limited to the Middle East and the North African continent. You can almost throw a dart at any place but North America, and find reasons to doubt the ability of the region to reliably produce oil for sale. Venezuela, and Nigeria are two places that come easily to mind when questioning the short term potential for domestic oil supplies. Are barrels in those places as secure as barrels in the Permian?
The truth is that oil is under threat from all sides, but I would submit to you that barrels in the Permian, for the foreseeable future, are considerably more secure than barrels any place else on earth.
That brings value that the market doesn’t presently recognize in shares of domestic producers, like OXY. That could change in a day.
Nowhere on earth, including the massive infrastructure in the Middle East, is there petroleum dedicated equipment and processing facilities, as exists in the Texas/Louisiana area. Whether you’re talking refining, pipelines, cryogenic plants, or petrochemical complexes, this infrastructure represents trillions of dollar of capex built up over the last 100+ years. It has no equal, and can’t be duplicated.
A question has been often asked, if other countries could replicate the miracle that has been wrought in the Permian. The answer is generally no, for a lot of reasons. Chief among them lies the quality of rock in question, but access to markets, understanding of the reservoirs, and processing infrastructure are all significant reasons why you don’t see this happening around the world.
Just recently, as an example BP suspended shale drilling activity in China due to poor drilling results. There were reasons other than poor rock, as this IHS report documents.
Source: IHS Markit report on China unconventional basins
The IHS report lists some of the deficiencies it sees in China for shale development.
Furthermore, a scaling up of the activity to required levels would require more rigs for gas-directed drilling – rigs with top-drives to enable directional/horizontal drilling. This would also require more materials and equipment – more water, proppant, pumping equipment, trucks, etc. – to enable a more than doubling of the present activity levels and drilling campaigns. This also would likely require a much greater participation by, and access to, international services companies. It would also necessitate more, and more 3rd-party access to, gathering lines, take-away capacity, and gas processing capacity.
One thing about oil and gas that is true the world over. Drilling and completion is just part of the task of bringing it to market. It takes often billions of dollars of infrastructure to do this safely and efficiently. This is not to say that there won’t be shale activity in other areas. There is and will continue to be other areas for shale. But, none of them will ever come close to matching the infrastructure located in the Southern part of the U.S.
Bottom line- The most efficient and massive petroleum processing facilities on earth are right in our backyard. That adds value to barrels located within the contiguous 48 states of America.
The type of oil generated from shale
Another thing I have discussed in past articles is the quality of the oil produced from the Permian, and other shale basins. Shale production tends to be light, and gassy. Let’s focus on the ‘gassy’ part of that for the moment.
The move by China, India, and other Asian countries toward the use of LNG as a fuel source for transportation, power generation, and to reduce air pollution is pretty well documented. Hardly a day goes by that you don’t read about another FID for a new LNG plant to meet unmet future demand. Where is all that gassy feedstock going to come from?
Well, a bunch of it is coming from us, U.S. The massive increase in gas production in the U.S., that is a byproduct of the shale revolution, has meant that instead of having to import gas as was thought would be the case just a few short years ago, we are now the world’s low cost producer.
In a single year ending in 2017, proved U.S. shale gas reserves grew by 50%. Gas reserves from all sources grew by 123 TCF to 464 TCF at the end of 2017. I expect similar results when figures for 2018 are released.
A point that is seldom being made, but one I will make now, is that the type of production from shale is going to grow in demand over the next few years. Making barrels-equivalent in the Permian worth more than barrels-equivalent in other countries. A fact not represented in stock prices as yet.
The Wolfcamp reservoir
The EIA describes the Wolfcamp formation, as being organic-rich and as having four main benches, or compartments known as A, B, C, and D. These benches all have their own characteristics, but commonly have the following attributes.
- Porosity- between 2 and 12%, with 6% being an average.
- Permeability- 10-20 millidarcies typically.
- TOC ranges of 1-8% by volume, depending on the lithology of the rock.
The EIA estimates that the best reservoir quality rock is located in the Upper Wolfcamp where the rock facies are primarily calcareous, fine grained siliclastic turbidites with inter-bedded dolomites, and distal turbidites and mudstones. In this northern section of the Delaware the Wolfcamp exhibits the following features that attract drilling.
- Thicknesses of >1,000′
- Subsea depth to the formation top is more than 3,000 feet
- Neutron porosity ranges from 4.0% to 8.0%
- Pressure regimes >0.6 SG
- Estimated total organic carbon ranges from 1.0% to 8.0%
- Deep resistivity ranges from 10 Ohm-meter to 80 Ohm-meter
What all of the gobbledegook above means, is that the Wolfcamp has the potential to be a prolific reservoir as it has significant accumulations-thickness, sufficient void space-porosity for attractive amount of oil and gas to be contained in the rock pores, pressure that helps to bring hydrocarbons to the surface, TOC-which represents the oil content of the rock, and resistivity that tells among other things, the oil or water saturation of the surrounding rock. More is always better.
I have juxtaposed the two graphics for a reason. If you look at the upper graphic put together by the EIA, you see the thickness variances of the Wolfcamp shale across the Delaware basin. The darker the purple shading here, the thicker the Wolfcamp in this area. Got that? Good.
Now, scroll down to where APC’s acreage is in the Delaware and you can see that the bulk of it is right in the sweet spot of the Wolfcamp. I expect it is this one aspect of OXY’s ironclad determination to obtain APC. Rock like this, known as Tier I rock, is getting scarcer and scarcer.
Worth mentioning here, is the Bone Spring reservoir which factors heavily into drilling plans for OXY. It has characteristics similar to those described for the Wolfcamp, and sometimes the Permian Delaware play is referred to as the “Wolfbone.”
The market currently hates this deal and is driving down the price of OXY’s stock as a punishment. If it wasn’t enough that it was obsessing about the $10 bn that they borrowed from the Oracle to cinch this deal, now a penguin from Argus has downgraded them to a hold in the low $50’s as he has concerns about their ability to achieve the $3.5 bn in cost synergies forecast. He must not read press releases before issuing opinions, as he also worries that APC’s LNG assets, which have already been sold to Total, are not a “good fit” for OXY.
A number of articles have come out since the deal was finalized, taking OXY to task, and their CEO, Vicki Hollub in particular. You’ve probably read them. They all have common threads,
My question then, if the market is right, and this is the case, how did a seasoned oil executive like Vicki Hollub ever come to the determination that this deal made sense for the company she has grown up in? Was she “socially promoted” to the CEO chair? Certainly not. She is an experienced petroleum engineer, with almost 35 years in the business. The thought she doesn’t understand the ramifications of the deal are simply ludicrous.
In order to buy into these bearish arguments, that rehash mostly some pretty obvious issues with which the company will have to deal going forward…in order to buy in, you have to believe that the entire OXY management team and board, are a bunch of complete idiots. A notion that the recent history of the company doesn’t support.
Then, you have to also believe that they hornswoggled Warren Buffett on key aspects of this deal, to get his money. Something that doesn’t happen too often, or we wouldn’t be calling Warren, “The Oracle.” Let’s be clear, Warren would not have given this money to company he thought was in the process of making a bad deal. He doesn’t do that. Sure, he’s collecting $800 mm/year for the loan, but he also has warrants to buy 80 mm preferred shares at a fixed price. If the stock is less than that, his warrants are not as valuable. Bottom-line- Warren did not just sink $10 bn into a company that is going to be less valuable.
Warren Buffett is known for playing the long game– taking positions in good companies, and holding them…forever. Two things occur to me about his endorsement of the OXY deal with APC. One, he likes the oil business again, something he’s disdained since selling his stake in XOM. Two, he thinks OXY’s current management is doing a good job with currently held assets. Warren is a bear for good management!
Finally, it is also worth mentioning again, that Chevron, (CVX) wanted this acreage as well, albeit at a lower price for a lot of reason. I will guarantee you that it was about the Permian, where CVX has promised investors to grow production by 53% by 2020. This also will become a future article.
I hope you found this article to be interesting and informative. I have focused primary here on the macro business, and geologic underpinnings of this deal, and will put over the discussion of its financial aspects and how OXY will move to lower its debt to a later article. I think OXY is on sale at current prices and have recently added to my position.
Disclosure: I am/we are long OXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not an accountant or CPA or CFA. This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.