Wood Mackenzie: Is Tight Oil inc on the verge of sustained free cash flow generation?

In late 2018, many CAPEX budgets were depleted and the WTI price was sinking just as companies were putting together 2019 capital budgets. Activity was reduced, putting downward pressure on service pricing. The increase in WTI at the start of the year presented a rare opportunity for companies to accelerate activity in the midst of relatively low service pricing.

Cost inflation was expected to return in 2Q19. But, as the WTI price started to fall again, service pricing failed to gain any strong momentum. As a result, companies may outspend again in 2Q19.

But 2H19 could finally mark a free cash flow inflection. The extra activity in the first half of the year should support production, revenue and cash flow in the second half of the year once these wells are onstream.

The tight oil companies that are further along in the development cycle have already started to turn the corner and generate consistent cash flow. We expect this trend to gather momentum. The main tight oil players generate over US$15 billion of combined free cash flow before dividends in 2020 and 2021 at US$54/bbl WTI.

Why did tight oil outspend in 1Q19?

Free cash flow generation from tight oil is always a choice. At the extreme end of the spectrum, an operator could choose to spend nothing on CAPEX, electing to not drill any wells and let production decline, and generate significant cash flow for distribution to shareholders. But reduced investment would reduce the future value of the assets. Tight oil players face a delicate balancing game between investing to maximise NPV while also achieving cash flow neutrality or better.

Over the past year, investors have been pressuring US tight oil companies to focus on capital discipline, free cash flow generation and shareholder distributions. US Independents have responded by modifying budgets to balance the books at US$50/bbl WTI. Yet free cash flow generation actually deteriorated over 4Q18 and 1Q19.

In 1Q19, tight oil reported -US$1.58 billion of free cash flow (cash flow from operations – CAPEX). This was worse than the -US$0.72 billion reported in 4Q18 and the -US$0.36 billion reported in the same quarter a year ago. It represents the largest outspend of cash flow since 3Q17 when the WTI oil price averaged US$48/bbl.

WTI averaged US$54/bbl in 1Q19, above the cash flow breakeven point most players are targeting. So, what's going on?

We think 1Q19 may have been an exceptional quarter, influenced by the following factors:

• Activity increased as companies tried to take advantage of favourable service pricing that was viewed as temporary. Overall investment from our peer group of tight oil companies was up 20% quarter-on-quarter in Q1 (excluding US$1.5 billion in Acquisition of Leasehold spend by Diamondback in 4Q18.).
• Most hedge books contributed to the loss as prices recovered to nearly US$60/bbl at the end of the quarter.
• Permian oil and gas differentials remained strained throughout the quarter. It was an especially brutal quarter for gas (which typically makes up 10-20% of revenue in the Permian), with pricing netbacks actually negative at some points during Q1.

Companies with more mature portfolios are outperforming

Will tight oil ever generate consistent free cash flow? A deep dive into the data suggests that the companies that are further along in the development cycle are much closer to consistently generating positive free cash flow.

EOG and Continental are prime examples of companies that have been able to make it work. Both have more exposure to well-developed plays such as the Bakken and Eagle Ford. Over the previous two years, oil production has been relatively stable in these two plays, which is a more favourable situation for cash flow generation and returns.

Shifting from growth to free cash flow: From the start of 2014, EOG and Continental have reported cumulative FCF of –US$1.5 billion or (-US$0.9/boe) compared to –US$18.9 billion (-US$6.7/boe) for the Permian-focused companies (Concho, Diamondback, Devon, Encana, Pioneer). Free cash flow declines reversed in 3Q17 for these more mature tight oil players, whereas the trend continued for companies with earlier-life portfolios.

Is positive free cash flow still on the horizon?

Yes. The promise of massive cash flow from tight oil has always been just around the corner, but what makes today different is the level of capital discipline exhibited across the industry, a much larger base of production generating cash flow, a depressed service pricing environment, and an unwillingness of the public capital markets to fund tight oil.

Tight oil inc locked in lower costs in Q1. This will boost returns and NPV. The US Independents may choose to continue to invest heavily in Q2 since the window to lock in lower costs is still open. The investment strategy should help support free cash flow generation in the second half of the year, assuming investment is subsequently dialled back.

EOG and Continental clearly highlight how the legacy cash generation base has strengthened over the last two years. Cash flow generation from tight oil wells that are producing is much greater than back in 1Q17, even though the WTI assumption is US$6/bbl lower. Tight Oil Inc's producing base will continue to strengthen as production grows, providing more flexibility for companies to adjust their investment budgets to ensure free cash flow at US$50/bbl WTI.

Tight Oil Inc. is committed to spending within cash flow, even if it comes at the expense of production growth. Investment budgets are being adapted to target free cash flow neutrality around US$50/bbl WTI.

These structural and strategic changes should allow tight oil inc to get back on the front foot. The poor financial performance in 1Q19 may mark a blip in a return to sustained free cash flow generation. Free cash flow before dividends rises over the next two years in our base-case, which assumes an average WTI price of US$54/bbl. Cash flow jumps even higher in 2022 when the price assumption increases to US$61/bbl. This reflects the maturing nature of tight oil portfolios and more disciplined investment strategies.

Delivering on these projections will be vital to winning back investors. Continental and EOG are the only tight oil specialists that trade at a premium to our base-case valuation – the improving outlook for free cash flow generation is undoubtedly a key factor.

The remaining big tight oil names are among the most heavily discounted companies in our coverage. This suggests there doesn't seem to be much belief from investors that these players can turn financial performance around. It will take a year or two of consistent positive free cash flow to convince investors of the value proposition of US tight oil. This will require sustained investment discipline and come at the expense of higher growth rates.

Read the article online at: https://www.oilfieldtechnology.com/special-reports/30072019/wood-mackenzie-is-tight-oil-inc-on-the-verge-of-sustained-free-cash-flow-generation/