The Permian Basin is attracting significant interest as delineation efforts prove successful. Producers are expanding the boundaries of existing horizontal oil plays (the Wolfcamp is moving north in the Midland and south in the Delaware basins, for example) and uncovering additional horizontal targets (the Jo Mill, Wolfcamp A/C/D, Spraberry and Leonard are close to being deemed legitimate). The stock performance of pure-play Permian E&Ps has ignited—Permian names have posted a 45%-plus average year-to-date return through September 5 of this year, outpacing the XOP's (S&P Oil and Gas E&P ETF) 16%-plus move.

E&Ps with exposure to the Northern/Central Midland Wolfcamp play have seen the strongest gains—Diamondback Energy (FANG) has soared by more than 128% and Pioneer Natural Resources (PXD) by more than 71% year to date. The increases aren't surprising given the strong performance of the initial horizontal wells completed in the area—mainly PXD's first three wells, which are expected to have 800,000 to 1 million barrels of oil equivalent (BOE) estimated ultimate recoveries (EURs). Here, we discuss why investors have been drawn to the basin, current themes, and what factors could keep the Permian party raging.

Compelling economics

Global Hunter Securities has compiled pieces of the critical economic variables for eight emerging horizontal plays in the Permian Basin: Bone Spring, Avalon/Leonard, Northern Wolfcamp and Southern/Central Wolfcamp on the Delaware side; and Southern Wolfcamp, Northern and Central Wolfcamp, Cline and Mississippi Lime on the Midland side. From this data, we ran single-well economics on each play, which, despite being preliminary and fraught with a number of unknowns, yield baseline assumptions for each area.

Overall, we see the average internally generated rate of return (IRR) for the eight plays mentioned above equaling 35% with oil prices at $90 per barrel and gas prices at $4 per million Btu. This is impressive when compared against our estimates for the average IRRs in both the Eagle Ford and Bakken shales. We see three of the Permian plays generating IRRs better than the average Eagle Ford well (34%) and four having IRRs better than the average Bakken well (30%).

Furthermore, the industry's shift to horizontal drilling in the Permian has added to the basin's appeal. We found that every one of the horizontal plays noted above has an IRR equal to or better than the typical vertical well (35% vs. 21% for vertical wells). In terms of what area of the Permian provides the most consistent returns, the honor goes to the Delaware Basin. We calculate that every play in that basin (Bone Spring, Avalon/Leonard, Northern Wolfcamp, Southern/Central Wolfcamp) provides a greater-than-30% IRR at $90 oil vs. only one play in the Midland Basin.

In the Midland Basin, where the Wolfcamp reigns supreme, we found that Northern/Central Wolfcamp returns (38%) are superior to returns generated in the southern portion of the basin (28%). PXD's early results, which appear to be tracking 800,000 to 1 million BOE EURs (substantially more than the 650,000-barrel type

curve) may provide the best economics in the basin (we estimate greater than 100% IRR).

Earlier this year, GHS Energy Research published its five-year oil-supply forecast, which included our estimate that domestic US crude oil production will increase to an exit rate of 9.4 million barrels of oil per day by 2017 vs. the 6.5 million per day seen in 2012. Over this time frame, we estimate the Permian will add 1.3 million barrels per day of new oil production, representing the largest incremental contribution going forward (approximately 36% of total onshore growth). This considerable uptick in Permian production assumes a steady increase in rig activity from 2013 to 2015, stabilizing over the last two years of the period. At that point we see efficiencies continuing to drive production growth in the basin.

Wolfcamp push

Wolfcamp activity continues to push north in the Midland Basin. Prior to 2013, the horizontal Wolfcamp play on the Midland side of the Permian was almost exclusively focused in the southern portion of the basin. However, Pioneer Natural Resources—the Midland Basin heavyweight with its industry-leading acreage position of 730,000 net acres—changed the game this year after reporting an initial production (IP) rate of 1,693 BOE per day on its first Central/Northern Midland Wolfcamp well, the Hutt, on February 14, followed by two additional wells that appear on trend to be 1-million-BOE-plus-potential wells. Results like that don't go unnoticed by investors or the industry, and second-quarter earnings calls were highlighted by other management teams eager to test their Northern Midland acreage.

Perhaps the biggest endorsement of the Northern Midland during the second quarter was Diamondback Energy's $165-million acquisition of 11,500 acres on the border of Martin and Dawson counties, which pushes the play farther north of PXD's success.

Going forward, look to Pioneer to continue to lead northern delineation efforts in the Midland Basin. The company now has two rigs at work on the Andrews/Martin border, approximately 15 miles northwest of its northern-most success, its 1,572-BOE-per-day Mabee 1H. Management expects to report results on six to 11 additional North/Central Midland Spraberry/Wolfcamp wells by its third-quarter earnings conference call.

Other players to keep an eye on in this portion of the basin include Athlon Energy (ATHL), the newest public Permian player, which has only drilled vertical wells to date, but is getting its horizontal feet wet in Midland County (its first horizontal rig was delivered in August); Callon Petroleum (CPE), a Gulf of Mexico player turned almost 100% Permian that is adding a second horizontal and looking to accelerate the delineation of its northern acreage, in Midland County; and Devon Energy (DVN), whose management revealed during its second-quarter earnings call that its first two wells IP'd at more than 800 barrels per day in Ector County, and that it intends to further delineate its acreage position there.

Also in the mix are Apache (APA), whose second-quarter earnings conference call detailed its current drilling in the immediate vicinity of strong industry wells in Midland County (read: Pioneer's wells); and Energen (EGN) and Laredo Petroleum (LPI), both of which have posted strong results on the eastern edge of the Midland Basin and will be leading the delineation efforts northward in Glasscock County.

An oily Wolfcamp play is also starting to come together on the Delaware side of the basin. Perhaps our biggest take-away from second-quarter earnings reports was that the Wolf-camp in the Delaware Basin is likely to be a big deal—Concho Resources (CXO), EOG Resources (EOG), Anadarko Petroleum (APC), Cimarex Energy (XEC) and Energen all gave encouraging early Wolfcamp results in the Delaware. Concho has drilled 11 Wolfcamp wells with relatively short laterals (about 4,200 feet) in the southern portion of the Delaware play, averaging 691 BOE per day (78% oil), and management plans to accelerate the delineation of its 130,000 net acres. Anadarko released strong results from its first two Wolfcamp completions (24-hour IPs of 1,600 and 1,000 BOE per day, respectively) and is busy delineating its 350,000 net acres in Ward/Loving counties to determine the size of its resource play.

Cimarex, after two Wolfcamp A wells in Northern Reeves County tested at 925 BOE per day (63% oil) over 30 days, is moving to increase its lateral lengths. We expect results on a 10,000-foot-plus lateral drilled in Reeves County to be announced during the third quarter. EOG management laid out impressive economics on the company's 114,000 net Wolfcamp acres (more than 1,100 locations, 60% IRR) during its second-quarter earnings call. EOG's fourth Wolfcamp well, Phillips State, in Reeves County, IP'd at 2,000 BOE per day (72% liquids).

In the second half of this year, producers will move to delineate horizontal stacked-pay potential. The Permian has always been blessed with multiple oil-bearing reservoirs—largely the reason it became the most actively drilled US oil basin from a vertical standpoint over the past half century.

As activity now shifts to horizontal drilling, the industry is focused on solving which intervals warrant stand-alone horizontal development. This delineation effort is important to track, because derisking an additional zone essentially acts as an acreage multiplier. Pioneer laid this concept out for investors in its second-quarter earnings release, stating that its 600,000 gross acres in North and Central Midland are equivalent to 3 million net acres, given the five prospective zones it is targeting. During the second half of 2013, Pioneer will lead the charge in testing these new horizons. It expects to drill and complete 20 horizontals across five different reservoirs (eight Wolfcamp B, four Wolfcamp D, three Jo Mill, four Lower Spraberry, and one Middle Spraberry).

Other Midland operators testing less-proven horizontal intervals are Diamondback (Clear-fork), SM Energy, ticker SM (Leonard/Clear-fork), Laredo (Spraberry and Atoka) and Callon (Spraberry). On the other side of the Permian in the Delaware Basin, multizone horizontal development of the Bone Spring and Avalon has already been established in the northern portion; the focus here is on delineation of the Wolfcamp shale.

Cline shale activity is taking a back seat in the basin for now. A year ago, the Cline in the eastern portion of the Midland Basin was hot, with some believing its potential was great enough to rival or exceed that of the horizontal Wolfcamp. We believe industry enthusiasm has cooled considerably on the play, however, as evidenced by second-quarter earnings calls. Devon Energy, one of the largest Cline players (389,000 net acres) and an early vocal proponent of the play, stated that it has concerns about the Cline's variability and is decreasing its activity there (now down to two rigs). Laredo, which was originally thought of as a pure play on the Cline, also has de-emphasized development of the reservoir, with 85% of its horizontal capex plans for the second half of 2013 allocated to the Wolfcamp.

Meanwhile, excitement about the Permian Basin's potential overall is continuing at a fever pitch, with further results eagerly anticipated.

Mike Kelly, CFA, is a vice president and senior E&P analyst with Global Hunter Securities. He is based in Houston.

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