Executive Q&A: Parsley Energy Paves the Way

[Editor's note: A version of this story appears in the April 2020 edition of Oil and Gas Investor. Subscribe to the magazine here.]

 Parsley Energy Inc. CEO Matt Gallagher is the epitome of a next generation oil and gas company executive. He’s young—shy of 40, sports a hipster beard and is attuned to the concerns of climate change. He’s reserved a red 2021 Ford Mustang Mach-E, the first Ford Motor Co. all-electric vehicle, for delivery later this year. He lives in Austin, Texas, which may not be an oil and gas headquartering trend but speaks to Gallagher’s environmental tastes.

But most importantly he heads a 12-year-old, $7 billion market cap company operating in the Permian Basin that is on the rise. Gallagher, who joined Parsley in 2010, took over as CEO in January 2019 and spent the past year transforming the company strategy from a growth model (which it had mastered) to a returns model as market sentiment for E&Ps underwent a polar shift. That revamp is now complete, with free cash flow achieved and a shareholder friendly dividend implemented in August.

In January, Parsley completed a $2.27 billion, all-stock merger with Jagged Peak Energy Inc., a contiguous neighbor in the Delaware Basin in West Texas, which demonstrated the type of combination many in the investment community say they want to see more of. The Jagged Peak assets bolster Parsley’s 120,000-net-acre, pro forma position in the southern Delaware Basin, complementing its 146,000 net acres in the Midland Basin. Pre-deal, the company produced an average 140 million barrels of oil equivalent per day (MMboe/d) in 2019, with guidance to achieve 200 MMboe/d in 2020.

Gallagher, who holds a petroleum engineering degree from Colorado School of Mines, is leading by example to be an environmentally and socially conscious producer. The company established a board-directed ESG (environmental, social and governance) committee last year and released its first sustainability report in December. Parsley in 2019 reduced its flaring rate to less than 3%, a highly visible and publicized topic, and is committed to lowering flare rates on the Jagged Peak assets from near 30% to 5% by year-end.

Gallagher spoke with Oil and Gas Investor Feb. 21, a month after closing the Jagged Peak acquisition.

Investor: You came into this deal at a period in time where many mergers were being punished in the marketplace. Why did this one work?

Gallagher: It was at the bottom of sentiment coming off of two [mergers] that weren’t received favorably. It just constrained the deal structure box in early 2019. We had to look to accretive valuations that had to fit within the model of accretive cash flow immediately in the next 12 months. People didn’t want step outs into other basins; they wanted known operating areas.

We were able to come to agreement on a deal that checked all of those boxes. The first [trading] day was a little bit of a shock, but it recovered nicely in the rest of that first week and after that it solidified. The logic made a lot of sense, and we didn’t over promise on the synergies. All of those things combined left a pretty palpable deal for people to understand. They didn’t have to take a giant leap to get to the strategic justification.

Investor: What was your motivation to acquire at this time?

Gallagher: We were looking at our internal operations and allocating capital based on our rate of return approach across our portfolio, and we saw a rate of change improvement occurring on our Delaware Basin operations. We saw it move from the third quartile into the upper portion of the second quartile in our inventory stack. The teams had jelled on a new approach in lowering the cost structure, not to mention sourcing in-basin sand, which addressed one of the key cost pressures of 2018.

Any time you can increase the top half of portfolio returns, you should evaluate it. That was the catalyst for us. So we looked across the landscape of what could potentially make sense, and the Jagged Peak deal clearly made the most sense for us.

Investor: Was raising your market cap a motivator?

Gallagher: I wouldn’t say it was the primary motivator, but when you have all of the other things going on, I would venture to say that it helped the other side come to the discussion table. Clearly, you’ve seen a divergence in multiples between large caps and small caps, and we sit in kind of a bubble area. For small caps, an opportunity to team up and get larger has quite a bit of potential improvements. I do think it helps facilitate the discussion.

Investor: How do you convince a company like Jagged Peak to be acquired with little to no premium if they have to lose their jobs for this so-called G&A synergy?

Gallagher: That’s probably the most sensitive point in the possibilities of mergers in the future. It’s been the case throughout history in multiple industries, and it’s no different here. Given large [insider] ownership in Jagged Peak, there’s an ability to see the benefits. The board’s fiduciary responsibility is to the shareholder, and they could see the benefits of the combination when we approached the board.

The sentiment was that it’s a challenged time. We’re in a time of long supply currently, and so they had to evaluate it as a fiduciary, and that was the starting point.

But it’s a huge challenge. You need to be cognizant of the value everybody’s brought to the table, the hard work and the families involved. So as this industry looks forward to M&A over the next two or three years, that key point is probably one of the barriers to open discussions.

Investor: Do you feel you need to gain further scale via consolidation, or are you where you want to be?

Gallagher: Our focus is on good operations and good returning properties. You see properties in the larger market cap size that have higher multiples given similar value drivers such as inventory length, margins and cash returns. So the math is still out there, but I don’t think that alone is going to drive any M&A decisions.

Investor: Is it an option?

Gallagher: We’ve been acquisitive since our inception, but we need to demonstrate a lock tight integration process and get through that.

Investor: Oil and gas companies represent a pretty small percent on Wall Street today. What can you do to attract investor capital today?

Gallagher: First we have to deliver quantifiable and steady profits. When you do that, then you can have a separate conversation about which companies are doing it the right way and in the right manner. If you look back over a decade, we have not been generating a profit as an industry. It’s been very challenging.

We found a truly world-changing resource in the U.S. oil shales, primarily in the Permian. The acreage grab was so large and so enduring, and not many people have much to show for it from an investor standpoint. So you have the outside world saying, “They found the best thing that they could have found, and they can’t generate a profit. Why am I investing in this sector?” And, in the meantime, they’ve been getting 20%-plus returns in the tech sector.

You’re starting to see in 2020 a true inflection year where companies are demonstrating what the shale model can deliver. At least the top 10 companies are showing healthy free cash flow, healthy growth and demonstrable cost controls. So we just have to stick to it. We can’t get caught as in January when oil was running up north to $65; nobody was reactivating their programs, everybody was staying steady because that helps drive a consistent cost structure.

It’s going to be a big challenge for everybody to stay steady over the next couple years because we will see upside shoots again, and that will be the real test. I think if we stay steady, we will draw our investors back.

Investor: Specifically, in your direct conversations with investors, what are they saying they want to see before they reengage?

Gallagher: They’re saying, “When I see four quarters of financials that I can pitch to my generalist portfolio manager, they can hang their hat on the backwards data.” And we say, “You don’t see the value in it now? Look how undervalued it is.” They say, “We will gladly miss the bottom to confirm that you can deliver on results.” They’re not looking to just scalp the absolute bottom; they want to see consistent results for four quarters.

Investor: When you shifted from a growth strategy to a sustainable free-cash-flow mindset, how did you change your approach to be able to execute on that?

Gallagher: As an industry, we are built from the bottom up to recover resource. That’s been the game plan for multiple decades. We were resource-short since the late ’70s with declining oil production in the U.S. It was hard to talk about this rate of return mindset when you’re not growing as fast as the resource would allow and you’re not recovering the quantum of resource that would be possible, but you’re actually generating a better profit. So project NPV [net present value] versus project rate of return, which one generates a better asset NAV [net asset value], and a risked NAV too?

First, we went through about six months of model analysis and sensitivity from our technical teams. We had competing teams in technical jam sessions on, “What is everybody worried about? Let’s run through this analysis and see.” We had a hunch, but we wanted the teams to go through their local development areas and try some things out.

The No. 1 concern was that we were going to lose physical inventory count. Okay, so let’s show why that’s okay and how over a decade it still plays out nicely. And I think once the numbers got printed on the screen, it was kind of black and white, especially if you just use modest risk factors on these volatile shocks. Then the teams didn’t want to go back to the other way. We could put in the corporate strategy of the free cash flow, rate of return focus, and we had a lot of great buy-in across the organization. In early 2019, we came out with an updated inventory range that showed the impact of the up space. And it was received well because it was explained well and showed improving results—the icing on the cake.

Investor: You are one of the early operators to instill a dividend thus far. Why is that important?

Gallagher: A dividend is important because it’s a prudent, disciplined approach to capital discipline. It’s kind of the canary [in the coal mine], where if you start seeing signs that your dividend is not coming out of free cash flow, then you really need to look at the rest of your capital program and see if you need to adjust activity levels. It’s really hard when you’re in outspend mode and growing to the tune of 50%-plus a year to justify that dividend, but the time was right for the company as we are committed to the free-cash-flow approach.

Investor: To be competitive in the larger market, where does your dividend need to be?

Gallagher A lot of people are looking at that 2% in the S&P 500. If we want to bring back generalist investors, we have to commit to a baseline return through a dividend. We have to commit to free cash that competes against multiple industries, get a stable program going that you can grow organically and then that allows something that investors can hang their hats on.

Investor: With your capex set at $50 WTI and oil perilously close to that thus far this year, will you be able to defend the dividend if oil trends below $50 for a sustained period?

Gallagher: We would be able to. About 30% of the free cash flow at $50 goes to the dividend, so we have quite a bit of cushion there. But in the low $40s, we would need to look at activity adjustments to keep a sufficient cushion for the dividend. [Editor’s note: In mid-March, Parsley announced it would slash its 2020 capex by 40% and executive salaries by 50%.]

Investor: What will Parsley do with any free-cash-flow surplus if prices average above expectations?

Gallagher: Hopefully, we have that challenge. When we look out over a five-year period, you can see billions of dollars of potential free cash. We’re working on these gated measures of where to deploy the free cash. There would be cash on the balance sheet to prepare for debt reductions over time. There’d be modest activity increases, just pro rata to keep a steady production growth, not an accelerated production growth. At that point there’s quite a bit left over and you’re able to evaluate additional shareholder friendly activities and also opportunistic acquisitions for other companies that aren’t able to have that type of business model.

Investor: If oil prices actually trended upward sustainably, would you consider accelerating activity beyond that targeted 10% growth rate?

Gallagher: No, we don’t see anything beyond that 10% to 15% growth rate.

Investor: Why not a lower growth rate? Why not just go flat and make everybody happy with more free cash flow, more dividends and less supply on the market?

Gallagher: We’re in a returns focused strategy, but no doubt it’s a dynamic environment. I’m assuming when I mentioned all of these that our project returns are healthy. What goes into that is the capital structure and then the oil price on the other side. If you see degrading project returns, you’re exactly right, you shouldn’t stick to the growth at all costs measures and you should moderate until you can regain your return profile.

We have a large enough data set behind us now that we know these uniform areas; we know what the return profile should be over a stabilized environment. And if we’re seeing those cash returns and we’re able to deliver our targets, then we’re perfectly comfortable meeting these types of growth rates. The higher-cost players would be bumped out of the growth equation.

Investor: Climate change is a dominant topic in America and globally these days. How should independent oil and gas companies be responding to this pushback on fossil fuel production and usage?

Gallagher: Step one is we should be proactive on levering up on our operations regarding pollution. It’s all of our emissions, and one of the most visible is obviously flaring. We also have general methane leaks and greenhouse gas intensity, and we have liquid leaks that we need to monitor and reduce. And our safety component. So let’s start as a community to agree to be worldwide leaders on these fronts.

Separately, we have a perception issue. We don’t have advertising groups in our companies. For 20 years or even longer, we’ve been behind on engaging with consumers. We’ve never had to do it in the past. We think we’re in a commodity business and that commodities don’t have substitutes, but today we have substitutes. They’re much more costly, and they have their own trade-offs, but those substitutes have plenty of advertising and engagement with the consumer. We need to engage with the consumer and say what the benefits of our product are.

So I think being proactive and not knocking new technologies and new alternative competition and renewables [is important]. We need all of this in the energy equation.

Imagine if, eight years ago, a horizontal well in the Permian didn’t yield good results. What do we think oil prices would be right now? And do we think there’d be enough oil to sustain the world’s energy growth? I think there are really good reasons to continue to look at energy substitutes, but we have a great product; the U.S. producer is uniquely advantaged to deliver that product and we need to refine and promote our message.

Investor: Do you think the industry is losing the messaging battle?

Gallagher: I don’t even think it’s a question. It’s a shut out right now, and we’ve got to put the pads on and get on the playing field.

Investor: What should the message be?

Gallagher: The message should be that American energy is doing things the right way at the highest employment standards, social standards and operational standards with the lowest impact possible. But we’ve got to make sure that’s true. So all companies need to look inward and demand that amongst our employees and amongst our planning teams that that becomes true. I do believe American innovation is second to none. When tested with a challenge, we always rally.

Then the next point is, where are you getting your energy from? Not only the source such as coal, natural gas, solar or wind, but where’s the origin and what is the full-cycle impact? Origin matters, based on human rights conditions. If you’re already top of line operationally with lower relative greenhouse gas, then you’re protecting hundreds of thousands of jobs across the country. We’re displacing foreign oil from governments that may or may not be friendly to our way of life.

Investor: How important is ESG from an investor’s perspective?

Gallagher: It used to be that they would check operations first and your profitability, and then they would check where you stand on the ESG component. We’ve been hearing about this growing now for probably 24 months, but in the last six months the screening has changed to “Where are you on ESG? And only if you meet my requirements will I then look at your operational business.”

Investor: Do you think capital will dry up if E&Ps don’t focus on this?

Gallagher: Yes, and I think rightfully so. There are going to be people out there that we’re never going to be able to appease, and they just want a full shut off. That’s the dangerous approach to it. That doesn’t capture full consequences and the benefits of what our product can deliver. So that’s probably not the most productive area to have a conversation around. But as far as really making improvements on the ESG measures, that’s something very important that I think is the right call from the investment community to be pushing on these fronts.

Investor: What is Parsley doing to address ESG concerns?

Gallagher: We’ve enhanced the focus on it from the top level. We have a dedicated ESG committee on our board. We have an internal dedicated committee that is employee-based, run by our COO. We’ve outreached to multiple stakeholders to put a framework together for what’s important to all stakeholders. We’ve set baseline measurements in our initial corporate responsibility report, but that’s only a baseline; it’s going to grow from here. We’ve taken a leadership position on this.

A good example is flaring. You look across multiple operators in the basin and there’s anywhere from 1% flaring to 30% flaring. There’s no reason for that high of a flaring percentage when there are technical solutions to solve this.

We are aggressively going to get that down below two and a half percent by the end of this year. But we’re working on all measures at the same time. We’re working on reducing greenhouse gas intensity through the possibility of dual fuel engines on a lot of our frack fleets. We’re looking at air actuated control valves. Our real time monitoring systems are really improving [leak] response times. It’s across the board, and it takes a lot of focus.

Also, I think through the ESG efforts, we are going to come up with some out-of-the-box solutions that actually help economics and productivity along the way too.

Investor: Flaring has been a routine and accepted practice of doing business, and particularly in Texas where you are, there are not really any regulations that are constraining you from doing it as needed in your business. Does the industry need to change its thinking even though it’s not required to shut down flares?

Gallagher: Yes. I think this is a great example of a place where the industry and the operators need to get out in front of a baseline requirement. There are operational conditions and test areas where you don’t know the proper sizing, so you need to look at this pragmatically, but we have to get our arms around this in a much more aggressive manner. We need to collaborate with the regulatory bodies and help them come up with a potentially better system, but we don’t need to wait for them to reduce this effort.

Investor: What’s the solution to that problem then?

Gallagher: Money. There are businesses on the other side that build these pipelines and gathering networks, but these are multibillion-dollar projects. It makes the economics very difficult for these standalone businesses if the product is being sold at a very low price. Then you have to look at things in a more integrated manner. You have to modify contracts, and you have to share expenses.

For example, we’ve already modified about 94 gas gathering contracts proactively to a minimum margin contract. That’s a financial hit to us in low prices, and that was intentional to give the processors an ability to build out through multiple price cycles.

Investor: Do you think the world is approaching a point of peak demand due to an energy transition?

Gallagher: I don’t see it happening in the next decade. It just depends on the worldwide GDP growth, I believe. You continue to see India or Southeast Asia or Africa come up the poverty curve, and there’s going to be a huge demand for energy. That right now cannot be overtaken fast enough by renewables to send hydrocarbons into decline.

Investor: With all the pressure to decarbonize, do you think the industry will be in a position to actually meet future demand?

Gallagher: It’s something I’m very worried about for the first time in my professional career. We’re looking at no replacement to the Permian, and with the Permian slowing its growth. I also don’t think that there are major productivity improvements coming in the Permian per well. So now we’ve got ourselves in a potential pickle, where you’re really constraining opportunity for billions of people and low-cost energy may not be as abundant as it has been in the last decade.

I think we’ll be able to meet demand for decades to come, but the cost structure would be much different when you have to go back offshore and go back to international environments that take a lot longer to develop with a lot more regulatory challenges.

Investor: Why did you choose to go into the industry?

Gallagher: I was born into it. I am a third-generation oilman. Both my father and grandfather were petroleum engineers, but when I was deciding what to do in the late ’90s my dad sat me down at the kitchen table and he said, “Matt, whatever you do, don’t become a petroleum engineer.” That was 1998, almost at the bottom at that point for the industry. 1999 was much worse. That broke a lot of operators’ backs. My family had to sell all of their rigs in ’99. But what he was trying to do was protect against the volatility he had seen in his career, the highs and lows, the ups and downs. He didn’t want me to have to go through them.

Well, I actually loved what he did, and I’ve been told I’m a little hardheaded at times so, of course, I did exactly what he told me not to do. It’s worked out.

And what a great industry. I’m truly proud to be part of this industry. I know it can seem tough at times in our stocks. We have activists that push against our industry. The media is constantly pushing against our industry. But I do love this industry, even though there are some challenges that we’re facing. Perception is a long-term problem. Let’s reduce our emissions and our spills and our injury rates. Let’s turn a profit this year. No excuses.