2023 Capex Outlook: A Wake-Up Call for All?

Early indications of 2023 spending show that producers are planning for growth of up to 20%, mostly to beat back rising inflation costs.

COVID-19 severely reduced consumption of petroleum products worldwide for most of 2020. According to the U.S. Energy Information Administration (EIA), WTI spot price bottomed at an average of $16.55/bbl in April 2020 and strengthened to an average of $52/bbl in January of 2021. This trend continued and reached a peak average price of $114.84/bbl in June.

This improvement in crude prices was driven by a world economy that began to recover from COVID-19 and as such, energy consumption also began to recover accordingly. But a lack of investment in the oil patch led to anemic production growth, and this mismatch drove energy costs higher and continues to contribute to inflation.

Russia’s invasion of Ukraine in early 2022 induced further price spikes and created an energy crisis in Europe. Subsequent dislocations of various commodity markets still cast a long shadow on the European economy and on global energy security well beyond the continent. Case and point: U.S. natural gas.

U.S. Henry Hub natural gas spot price averaged at a low of $1.63/MMBtu in June 2020, according to the EIA, and gradually improved to an average of $4.38/MMbtu in January of 2022. As Russian supply of natural gas to Europe became restricted as the war progressed during the spring, demand for LNG in Europe spiked.

The U.S. is one of the largest exporters of LNG, and the incremental demand for LNG led to a spike in U.S. natural gas price. Henry Hub average gas price peaked at $8.14/MMbtu in May of 2022.

Despite prolific shale oil and gas reserves and production that has made the U.S. a net total energy exporter since 2019, the country’s producers and consumers are not immune to commodity price volatility.

U.S. consumers and businesses have enjoyed an unprecedented period of secure and affordable energy for almost a decade. But higher energy prices and higher interest rates meant to quell inflationary pressure are dragging down the economy and hitting consumers’ pocketbooks directly.

“Resurgent demand following the fading of the pandemic lockdown has run into a constrained supply side. Somewhat surprisingly, the oil and gas extraction and petroleum industry has shown the least amount of recovery of any sector in the economy, producing at 60% of their pre-pandemic levels,” said Esther L. George, president and CEO of Federal Reserve Kansas City Branch, during a November conference in Houston organized by the Federal Reserve teams in Dallas and Kansas City.

“That performance was worse than the recovery in the automotive sector where output is running at about 70% of pre-pandemic levels,” she said. “It comes as no surprise that the imbalance between supply and demand in the oil and gas sectors has pushed up prices.”

But muted oil and gas investment is different this time, she said.

“It has been the case that the negative effect of higher energy prices on consumption in the past would be offset by a positive effect on capital investment in the energy sector,” George said. “In this cycle, however, the response of energy investment to higher prices has been lackluster and is offering less of an offset to those negative consumption effects.”

Compounding capital

Barton “Bart” Brookman, Jr., president and CEO of PDC Energy Inc., runs a $7 billion market cap E&P. The Denver-based company holds 255,000 net acres combined in Wattenberg Field in Colorado and the Delaware Basin in West Texas. As of the third quarter of 2022, PDC Energy produced 250,000 boe/d with a production mix of 32% crude oil.

The production level represents 23% year-over-year growth, partially driven by acquisition. The company ended third-quarter 2022 with trailing 12-month net debt ratio of 0.5X to EBITDA— a record low for the firm. PDC Energy is poised to generate approximately $1.5 billion of free cash flow in 2022 and is on track to return more than 60% of this to shareholders in the form of share buybacks and dividends, management said.

Toby Rice is the president and CEO of EQT Corp., the largest natural gas producer in the U.S. with a market capitalization of $15 billion. This Pittsburgh-based company holds about 1.1 million net acres in the Marcellus and the Utica plays in the Appalachia. The company produced 5.3 Bcfe/d in the third quarter of 2022. The firm also ended the quarter with trailing 12 months net debt ratio of 1.2x EBITDA.

Billy Bailey, founder of Dallas-based Saltstone Capital Management (SCM) said the traditional energy business in the past 36 months has been through an incredibly dynamic period of time for a myriad of reasons.

“Rewinding to 2014, 2015, 2016, an abundance of capital was raised for exploration and production companies. Investors were ecstatic about the opportunity that U.S. shale could provide,” he said. “This exuberance created a massive supply overhang, translated into poor returns on capital, poor performing stock prices and ultimately, a consolidation and restructuring phase. Just before COVID shocked the world, investors began honing in on their desire for shareholder returns rather than growth. The global shutdown commingled with investor demands was the enforcement mechanism for management team discipline.”

The downturn hastened consolidations

Both EQT. and PDC Energy have emerged as consolidators. PDC Energy closed the SRC Energy merger in January 2020, right before COVID-19-related lock-downs. Management said the success of the transaction was overshadowed by the depths of the pandemic.

However, Brookman said, it was the right deal for the company because it was accretive, strengthened inventory and made the company’s footprint more contiguous in the Denver-Julesburg (D-J) Basin.

“On top of that, you throw in the strength of our balance sheet, our hedge book, the quality and execution of our team and the resiliency of D-J Basin projects, and you have the foundation for a great deal, even with the backdrop of the pandemic which began shortly after closing the deal,” Brookman said.

“While it did not take away the pain and how tough 2020 was, not just for PDC Energy, but for everybody in this industry, it resulted in us being more resilient than most and propelled us into 2021 in a stronger fashion.”

Brookman said the company emerged more attractive as a consolidator in the D-J Basin and set PDC Energy up for the $1.3 billion acquisition of Great Western Petroleum (GWP), which was announced in February of 2022. This added significant scale to PDC Energy’s core Wattenberg Field position.

EQT took on the consolidator role in Appalachia in 2020. Guided by the new management team put in place in mid-2019, leveraging on its strong balance sheet and a valuable stock as currency, the company acquired the midstream and upstream operations of Alta Resources Development LLC in mid-2020 for about $2.9 billion. EQT’s production went from about 4 Bcfe/d (4% liquid) in the fourth quarter of 2019 to roughly 5.3 Bcfe/d (5% liquid) by the third quarter of 2022.

In September of 2022, EQT announced a $5.2 billion, bolt-on acquisition of Tug Hill and XCL Midstream, deals that should add 800 MMcf/d of production with a 20% liquid mix. The transaction was financed by half debt and half equity. Management anticipated the deal would boost EQT’s free cash flow yield significantly.

Working capital

For companies well-positioned to be consolidators, some of the cash flow generated in the past few years was deployed on strategic acquisitions. Some insiders expect that in 2023, more cash could be deployed toward gaining organic growth.

For EQT, despite a pro forma 2023 free cash flow estimate of more than $6 billion, the company leadership said its capital spending growth will be on the lower end of industry average of 10% to 20%.

In the third-quarter 2022 conference call, CFO David Khani said he expects inflation to be on the lower end of industry average because of EQT’s supply chain contracting strategy and its multiyear sand and frac crew contracts.

Given a commanding Appalachian footprint, strong balance sheet and higher free cash flow yield boosted by the merger, there is some question about why EQT is not ramping up activities.

 “You want more supply? We need more pipeline infrastructure. The environmental movement has been the reason why we are out of pipeline infrastructure capacity. Because of that, we are forced to stay in maintenance mode,” Rice said. “We are not growing production, despite having the price signal, despite having an inventory with an estimated 1 Tcf of economic projects.”

For PDC Energy, the management intended to end 2022 with approximately $1.075 billion spending at the high end of its guidance. Anticipating 2023, the company expects 10% to 12% spending growth after accounting for the increased activity associated with the GWP transaction. The company is targeting annualized production growth of 4% to 5% after accounting for the GWP merger.

In the past two years, capital discipline has been solid, and most overspending can be attributed to inflation, several executives told Hart Energy. That has impacted steel, tubular and oil service costs; labor supply has been a challenge in the past 12 months.

While ESG has become a key part of its operation, after two recent mergers, PDC Energy operates with greater scope and scale and is able to build in more ESG-related functions while minimizing impact to its per unit operating and general and administrative costs.

PDC Energy is hesitant to invest more money to rapidly increase organic growth.

“Right now, we have no tactical plans to accelerate. Even if the market was asking PDC for more growth through the drill bit, which it is not today, there would be some real constraints to work through,” Brookman said.

“We are not growing production, despite having the price signal, despite having an inventory with an estimated 1 Tcf of economic projects.”—Toby Rice, EQT Corp.

The regulatory environment is only a part of that equation, as experienced field labor and fit-for-purpose services may also prove to be a challenge.

“Sure, we may be able to go get another rig, but it may not be as efficient or as safe as the equipment that we have running in our steady state operations.”

The company is focused on running a safe operation, generating mid-single-digit production growth to maximize capital efficiency and free cash flow for its shareholder returns, Brookman said.

SCM’s Bailey said his expectations for industry spending being 10% to 15% higher.

“This is less driven by increased drilling, but inflationary pressure from oil service. This continues to be a theme. The oil service sector has been tattered, beaten, consolidated and needs pricing power to survive at today’s demand levels,” he said.

Producing the world’s cleanest molecules

For most producers, the operating environment has changed significantly in the past few years. ESG considerations have become more prominent in the planning and execution of capital spending plans.

ESG concerns are front and center for PDC Energy’s day-to-day operations and is well-integrated into its long-term plans. The company has committed to reducing greenhouse gas and methane intensity by 60% and 50%, respectively, from 2020 to 2025. The company is actively plugging vertical wells, monitoring emissions to ensure compliance within its operational footprint and identifying operational enhancements to help achieve its reduction targets.

“Scale in the E&P sector is absolutely necessary in today’s world.”—Barton “Bart” Brookman, Jr., PDC Energy Inc.

“Scale in the E&P sector is absolutely necessary in today’s world. Scale allows us to realize efficiencies across our cost structure as well as appropriately build on our ESG program,” Brookman said. “Our ESG journey has been one characterized by thoughtful and incremental progress, and it’s clear that 2021 and early 2022 marked a significant leap forward in our emergence as a forward-looking leader in this space.”

When Rice took over at EQT, his team launched an ambitious plan to simplify its corporate structure, overhaul its operations and restructure its debt in addition to integrating ESG into its entire operation.

“I don’t care what type of energy you are producing. Energy needs to be cheap, reliable and clean. This is really important. We have lowered our emissions significantly,” he told Hart Energy. “But all of the things that we are doing to address the public concerns over emissions associated with the production of our products are going to be encapsulated by a net-zero commitment by 2025.”

All of the above

Bailey started his buy-side career working for the late T. Boone Pickens, an industry icon who believed that the world needs to use every single resource. Bailey said that the current energy crisis is a wakeup call: The world still uses fossil fuels to supply 82% of its power generation, transportation and industrial activities.

 “Energy is the lifeblood of the world – not just fossil fuels, but solar and wind too,” Bailey said. “I think all sources are fantastic. I think we need everything.”

Rice said the U.S. has largely been on the sidelines of the energy transition. The signs are clear that change is coming, but the new mix will include fossils, not exclude them.

“Solar and wind cannot handle this transition themselves. In the last 12 months, coal emission has skyrocketed over 500 million tons because of solar and wind inability to meet the need for energy,” Rice said. “In just 12 months, our inability to address foreign coal has wiped out all the environmental benefits of solar and wind for the last 15 years. Clearly emissions are a big issue. You need a big champion to solve this. The champion is the oil and gas industry taking over transition.”

Reaching out to the consumers

Public perception matters in policymaking, and energy is a complicated sector for much of the general public to grasp.

“Nobody is going to take the time to learn it until it hurts their bottom line. Nobody is going to take the time to learn about it until it hurts their back pocket. Nobody cares to learn how they’re able to pump gasoline into their car,” Bailey said. “But they’ll definitely be complaining once the cost of pumping hurts them financially. Once that financial burden sets in, it is easier to chastise the industry rather than learn about it.”

Bailey said, “At some point in the future when the valuation is there, and when the energy markets are screaming for more U.S. barrels, only then will there be a massive reinvestment cycle happening globally led by the U.S.”

For multiple reasons, Bailey said he’s expecting oil and gas prices to be higher for longer.

“Things are coming together and are coalescing toward a constructive period in energy. We are going through a period of underinvestment, which sets the stage for a sustainable cycle. In the last five years in North America versus the previous five years before that, spending is down by 40%. We are in an undersupply situation with limited global spare capacity. OPEC is protecting their downside, which is good for the bottom line.”

That will translate into likely investment in the future.

“Things are coming together and are coalescing toward a constructive period in energy. We are going through a period of underinvestment, which sets the stage for a sustainable cycle.”—Billy Bailey, Saltstone Capital Management

“As more and more investors start to realize the amount of free cash flows that these companies are generating and how enticing that yield is relative to the yield on treasuries, a tsunami of cash being rotated into the traditional energy sector will occur. Dollars flowing into the oil and gas sector, with a finite number of publicly traded companies to choose from, should bode well for higher stock prices. We are in the early innings,” Bailey said. “Free cash flow and returns of capital are pivotal for enticing the incremental dollar to the energy sector.”

At the precipice of a new regime

The reasons for subdued 2023 spending increases despite higher prices and cash flows are multiple and complex. The reasons seem to have little to do with a lack of funding.

 “The anemic responses of the U.S. oil and gas sector to higher prices reflects years of relatively low investment due partly to a shift in investment toward other sources of energy, as well as increased capital discipline following the industry’s poor returns during the previous boom-bust cycle,” the Kansas City’s Fed CEO George said.

In addition to capital discipline and a focus on return to shareholders, other factors such as a tight labor market and the consolidation to fewer operating entities also play a part.

Environmental concerns amid the energy transition also impacts how efficiently producers can operate:

• Environmental activism that constrains infrastructure capacity growth;
• The need to meet regulatory compliance or voluntary targets; and
• ESG performance levels.

Coming out of this period of market turmoil, the industry is adapting, insiders say. Companies are emerging more resilient, more disciplined and more proactive on environmental challenges. Multiple factors contributed to muted spending growth and muted supply growth, which should lend support to the thesis of “higher prices for longer,” providing that global demand does not deteriorate.