Is the Scorching Permian Basin About to Cool Off?

While most of the oil industry spent the past two years trying to get back up on its feet after getting bowled over by the oil market downturn, there have been a few notable exceptions. One such place is the Permian Basin in west Texas and southeast New Mexico, which has become a hot spot for drillers that found that its hydrocarbon-rich rocks can fuel jaw-dropping drilling returns at current oil prices. Because of that profit potential, oil companies have spent billions of dollars locking up drillable land in the region.

However, that land grab appears to be waning. Not only had land values started getting out of hand but drillers have already bought enough inventory to last them a decade. Meanwhile, investors seem to be less impressed with growth potential and more focused on seeing a return. Because of that, it appears like drillers are undergoing a strategic shift from resource accumulation to creating value from their previously acquired positions.

Red-hot real estate

The Permian land boom started heating up early last year. Basin-focused drillers Parsley Energy (NYSE: PE) and Concho Resources (NYSE: CXO) were two of the more active buyers. Parsley Energy started its shopping spree in April, scooping up 22,908 net acres of land adjacent to its existing properties in the southern Delaware and Midland Basins for $359 million. A month later the company announced a 30,000 acre deal for mineral rights in the southern Delaware for $280.5 million and in August it signed a $400 million deal for nearly 10,000 net acres in the Midland. Parsley Energy capped off that buying binge this February after agreeing to acquire Double Eagle Energy Permian for its land holdings in the Midland Basin for $2.8 billion. These deals combined to boost the company's position up to 231,000 acres, which have at least 8,200 future drilling locations, or a more than 12 years worth of inventory at its current production pace.

Concho Resources has been just as active. In January of 2016, the company completed a string of transactions to enhance its southern Delaware Basin position, including buying 12,000 acres for $360 million, consolidating 21,000 acres in a trade with a peer, and selling 14,000 non-core acres for $290 million. Concho then made its biggest splash in August after agreeing to spend $1.625 billion for 40,000 acres in the Midland. Meanwhile, it capped the year off with a $430 million deal for 16,400 acres in the northern Delaware in November.

Meanwhile, other producers like Diamondback Energy (NASDAQ: FANG) and RSP Permian (NYSE: RSPP) announced transformational deals last year. In Diamondback's case, it spent $2.43 billion to buy Brigham Resources for its more than 76,000 net acres, boosting its Permian position to 182,000 acres and giving it a "runway for unprecedented growth for years to come." RSP Permian, likewise, spent $2.4 billion in acquiring a Permian-focused rival, which boosted its scale in the basin and created a "compelling growth platform."

Shifting gears

That said, while M&A activity in the Basin had been scorching hot, drillers haven't been as active in recent months. One reason is that investors aren't rewarding Permian buyers with quite as rich stock premiums these days:

One of the drivers of that decline, according to Doug Suttles, the CEO of Encana (NYSE: ECA), is that investors just don't seem to be impressed with how much land a company can buy in the Permian or how quickly it can grow output. Because of that, drillers can't use their stock to make more deals without significantly diluting investors. That led Suttles to conclude that the "race for the land is kind of over." Instead, what the Encana CEO sees as the new focus going forward is "what are you going to do with the land."

In Encana's case, it's now boasting about how much it can increase cash flow by leveraging its resource base. Under the company's recently updated five-year plan, Encana pointed out that it could grow cash flow at a 25% compound annual growth rate through 2022, enabling it to produce $1.5 billion in cumulative free cash flow over that timeframe as long as oil averages $50 a barrel. As more drillers join Encana by shifting from a focus on growing production to boosting profitability, it will likely continue cooling the wild spending in the Permian.

Instead, what will fuel future deals is their ability to increase returns. For example, one of Parsley Energy's focuses this year has been on exchanging acreage with peers so it can drill longer wells, which yields higher drilling returns. Meanwhile, Concho recently spent $600 million to buy land bordering one of its core areas because it believes "one of the best ways to create value is by owning large, contiguous positions." That's because it's conducive to drilling longer wells and enables drillers to develop large sections at a time more efficiently.

Putting investors first again

Investors poured billions of dollars into Permian drillers over the past couple of years, giving them the cash needed to build impressive resource positions. However, they now want to see those drillers turn that land into not only oil but cash flow. Because of that, drillers might not grow as fast as they once boasted if that incremental output won't drive returns. While that could slow things down in the Permian, it might also be just the catalyst to light a fire under the stocks of Permian producers.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.