Estimating The Impact Of Different Oil Price Scenarios On Large U.S. Independents

Crude oil prices have been extremely volatile of late. After falling sharply by more than 60% in a short period of slightly over six months, oil prices have risen by over 40% from their lows over the past few months. In hindsight, the sharp decline in oil prices makes sense because of slowing demand growth and surging tight oil production in the U.S., but the billion dollar question is, what will they do next, and how would that impact the valuation of oil companies. We currently expect oil prices (Brent) to average around $75 per barrel for this year, below the global marginal cost of production due to the current oversupply scenario, and increase gradually towards the $85 per barrel mark over the next two years, as the supply becomes tighter due to the recent cutbacks in capital spending by almost all major oil companies and the growth in demand picks up to more normalized levels.

But there could be a much sharper, V-shaped recovery in global oil prices if the growth in demand for oil products picks up significantly on the back of lower oil prices and simultaneously, tight oil production in the U.S. declines because of a sharp, sustained slowdown in drilling activity. However, we believe that oil prices cannot sustain above the $100 per barrel mark for long under normal geopolitical conditions, unless the Organization of Petroleum Exporting Countries (OPEC) decides to sacrifice some of its market share for better prices. This is because oil production in the U.S. can quickly start growing again at an annual rate of around 1 million barrels per day if oil prices sustain above the $100 mark, and that would once again create an oversupply scenario, which will weigh on benchmark oil prices. But if for some reason there is a change in the OPEC’s stance and it takes some of its oil off of the market, that would provide a significant boost to oil prices and large independent oil and gas players in the U.S. like ConocoPhillips (NYSE:COP), EOG Resources (NYSE:EOG), Anadarko Petroleum (NYSE:APC), and Chesapeake Energy (NYSE:CHK) would gain significantly from that.

On the other hand, if the OPEC maintains its current stance and the growth in demand for crude oil does not pick up because of a continued slowdown in economic activity in China — the world’s second largest oil consuming nation and the key driver of demand growth over the past few years – or because of a rapid increase in the penetration of alternative fuels due to advancements in biofuels or fuel cell technologies, the recent decline in oil prices could sustain for a much longer period. In addition, the expected service cost deflation, which would reduce the average cost structure of the oil industry, could also result in a more robust non-OPEC supply growth despite the slump in oil prices. If this comes true and the demand growth remains weak, oil companies could be in for a prolonged period of depressed commodity prices, at least until the U.S. shale oil boom subsides. The chart below reflects our assumptions regarding how these two extreme oil price scenarios could impact Anadarko’s average crude oil and condensates price realization. We have developed similar potential scenarios for all four of the U.S.-based independent oil and gas production companies we cover.

See our detailed analysis of the potential impact of these scenarios on ConocoPhillips | EOG Resources | Anadarko Petroleum | Chesapeake Energy

Impact On Profitability

Apart from average price realization for crude oil and natural gas liquids, global benchmark crude oil prices also impact the profitability of an oil company’s exploration and production operations. However, the magnitude of the impact largely depends on the company’s sales volume mix. As in, what percentage of its total hydrocarbon sales volume is comprised of liquids (crude oil and natural gas liquids), versus dry natural gas. This is because in some markets, especially in the U.S., natural gas prices are decoupled from crude oil prices and depend on the local demand-supply dynamics. Of the large U.S. independent exploration and production companies we cover, EOG Resources has the highest liquids volume percentage, while Chesapeake Energy has the highest dry natural gas volume percentage. Therefore, EOG Resources’ revenue and cash operating margins are more sensitive to the variation in global crude oil prices than Chesapeake Energy. The chart below summarizes our estimates for all of the four company’s 2015 upstream profitability under various crude oil price scenarios. ^[1]

Capex and Growth Impact

In addition to average price realization and profitability, crude oil prices also impact an oil company’s capital expenditure and growth plans. This is because better (worse) crude oil prices mean higher (lower) profitability, which drives higher (lower) returns and increased (decreased) capital expenditures by an oil company. Now, lower capital investments in the oil business means slower or even negative production growth because the output from existing wells declines naturally with time. So there is a constant need to develop new reserves just in order to maintain net production. For example, last year, Anadarko’s crude oil sales volume grew by almost 17% y-o-y, but it plans to grow oil production by just around 5% this year, employing 33% less capital. ^[2] Similarly, the mid point of EOG Resources’ projected net crude oil production for the year is almost in line with what it did last year, around 288 MBD. The company plans to spend more than 50% less on the addition and development of oil and gas properties this year. ^[3] ConocoPhillips also announced during the first quarter earnings call that it now has just around 15 operated rigs active in the Lower 48 states of the U.S., down more than 50% from the end of last year. As a result of fewer active rigs, the company expects its net production growth from the region to also start slowing down and eventually turn negative in the second half of the year. Therefore, despite a 5% growth in the first quarter itself, ConocoPhillips maintained a 2-3% overall net production growth guidance for the full year. ^[4] Chesapeake Energy also plans to cut its gross capital expenditures by half this year. ^[5] Because of similar investment cuts across the U.S. oil industry, the number of active oil rigs in the U.S. has fallen sharply over the past few months. The chart below highlights the trend in the number of active oil rigs in the U.S. and the WTI crude oil price.

Now, we forecast net capital expenditures as a % of revenue for these companies, so the absolute net capex figure increases (decreases) automatically with increase (decrease) in oil prices and production because that pushes revenues higher (lower). Therefore, there is only a slight increase (decrease) in our net capex driver in both the scenarios, reflecting the long-term shift in oil price dynamics and return projections. The charts below summarize our estimates of the impact of the two extreme oil price scenarios on net crude oil production and earnings per share of these companies for this year.

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1. COP, EOG, APC, CHK latest annual SEC Filings, sec.gov [↩]
2. Anadarko Announces First-Quarter 2015 Results, anadarko.com [↩]
3. EOG Resources Reports First Quarter 2015 Results and Provides Operational Update, eogresources.com [↩]
4. ConocoPhillips Reports First-Quarter 2015 Results; Strong Operational Performance Offset by Weak Commodity Prices, conocophillips.com [↩]
5. Chesapeake Energy Reports 2015 First Quarter Financial And Operational Results, chk.com [↩]