Investors Question Oil Output in Permian Basin, America's Fastest-Growing Field

By Alison Sider Features Dow Jones Newswires

Investors helped turn West Texas' Permian Basin into America's fastest-growing oil field, but their confidence is cracking over whether drillers can keep production rising.

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Questions mounted last week after Pioneer Natural Resources Co. reported that its Permian wells are producing more gas and natural gas liquids such as propane than expected. That worried investors, who care a lot more about oil.

Shares of Pioneer and other Permian producers tumbled as a result. Pioneer ended the week down 16%, while Parsley Energy Inc. and Concho Resources Inc. both declined more than 9% over that stretch.

The main issue for Wall Street is whether the Permian, where nearly half the rigs drilling for oil in the U.S. are located, will continue apace or will fall short of the expectations of investors, who in recent years crowded into companies drilling there.

"The Permian is going to have some growing pains," Scott Hanold, an analyst at RBC Capital Markets, said this week.

The concerns aren't universal, and some say they are overblown. "I don't think anything has changed in the Permian. It's the lowest cost, best basin to be in, with the best rock," said Bill Costello, portfolio manager at investment firm Westwood Holdings Group. "If people are going to give me the opportunity to buy more, I'm going to buy more all day long."

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Some Permian stocks have partly recovered since last week's plunge. Cimarex Energy Co. was the S&P 500's biggest gainer Wednesday, rising about 7.5% after it reported more oil production than expected.

But the selloff, and analyst notes that followed, reveal that some investors are questioning whether they were overly confident in the resilience of the Permian, and perhaps overpaid for it.

Most wells produce natural gas as a byproduct alongside oil, and that gas output tends to rise over time. That is because as a reservoir is depleted, its pressure drops and gas vapors separate from liquid -- reaching the "bubble point" at which natural-gas production accelerates.

Pioneer last week indicated that some of its Permian wells are reaching this point sooner than it anticipated.

"Why everyone's so concerned is that it could mean at some point in the future, that oil declines are steeper than what company and the investment community thought they would be," said Ben Shattuck, research director at consultancy Wood Mackenzie. "It raised that big question mark."

John Groton, director of equity research at Thrivent Financial, which owns shares of Pioneer, said the issues were a hiccup, "not a harbinger of the end for the Permian." Still, he said, "It never goes as smoothly as people think it will." He added: "There were a lot more people who had priced Pioneer for perfection than I had realized."

Some skeptics have long suspected that the ultimate recoverability rates of oil from tightly packed U.S. shale rocks might be lower than many drillers were forecasting, and that the process to extract it would ultimately be too expensive a proposition.

U.S. shale producers use a process known as fracking -- blasting water and sand through rock to unleash vast quantities of oil and natural gas. Because of the unusual geology in the Permian, which consists of stacked layers of oil-bearing rock that can be tapped simultaneously from a single site, Wall Street widely believed these companies could turn a profit even at lower oil prices. Shares of companies in the Permian held up better than their peers while oil prices plummeted starting in 2014.

Quarter after quarter, producers demonstrated that they could break even there at lower and lower oil prices as they learned to extract more oil from each well. They drilled sideways through the rock layers -- in some cases as long as 2 miles.

Their success meant they were able to tap investors for more cash when they needed it. Companies that weren't in the Permian wanted to be there, and were willing to pay up for land.

Producers in the region have raised $27.5 billion since the start of 2015 by selling new shares -- 44% of the cash raised that way by North American oil-and-gas companies since then.

The premium for shares of Permian producers compared with oil companies that focus on other regions shrank by 14% after Pioneer reported its results, Morgan Stanley analysts said Monday.

"Investors didn't receive the beat-and-raise quarter that they saw in" the first quarter, Cowen analysts wrote in a note this week, describing the selloff as a "Permian Panic: When 'safe stocks' fail."

Even before second-quarter results, there were signs that investors' enthusiasm was ebbing. When QEP Resources Inc. last month announced a deal to spend $732 million to buy drilling land in Martin County, Texas, its shares fell.

Also last month, someone who described himself as a former Pioneer petrophysicist raised alarms in a post on LinkedIn, predicting that "ALL oil shale wells...will die a disappointing and gassy death."

Pioneer didn't respond to requests for comment on the post.

It is up for debate what Pioneer's announcement last week that its Permian wells were producing more gas means for future oil production.

Scott Rees, chief executive of Netherland, Sewell & Associates, Inc., an independent engineering consulting firm that has Pioneer as a client, said that when production reaches this point, it doesn't mean that oil production is about to drop off.

So far, Pioneer said the oil output from its wells isn't dropping -- it is on track with what its engineers predicted. Analysts and some investors say all that gas is basically a free byproduct that will make the wells more valuable.

Parsley Chief Executive Bryan Sheffield echoed that point when he said last week that the company's wells were still producing as much oil as expected.

"Oil volumes are in-line with expectations, so the extra gas is truly additive."

Pioneer Chief Executive Tim Dove told analysts that oil was "absolutely meeting our expectations on a per-well basis, and adding more gas and [natural gas liquids] to the mix is a positive in terms of revenues and reserves without even affecting oil."

"This is a good thing," he said.

The explanation didn't seem to help.

"While it is only one day of trading, the underperformance of high-quality Permian stocks has left some [portfolio managers] asking about where to reallocate capital within the sector," Goldman Sachs analysts wrote last week as share prices tumbled.

--Ryan Dezember contributed to this article.

Write to Alison Sider at alison.sider@wsj.com

(END) Dow Jones Newswires

August 09, 2017 20:57 ET (00:57 GMT)