Back from a week in Midland. The good news is our enthusiasm is rising as numerous discussions point to higher activity while service cost discussions featured prominently in every meeting. We elaborate below. Looking forward, our team will divide and conquer this week. Research heads to Denver while Sales heads to OKC. I have a couple extra tickets to the Rockies game on June 17th if anyone is around.
Rig Count Moving Up. Big takeaway from Midland is confirmation of our expectation for rising activity. Specifically, the drilling rig count will continue its ascent, although completion activity likely remains stable. Discussions with both publics and privates, both big and small point to higher drilling plans. Namely, we anticipate the Permian will witness a 30%+ rig count increase from now until early Q1. Per BKR, the Permian rig count is ~236 rigs today. Our small industry sample indicates +18 to +20 rigs. That’s from less than 10 E&P companies. Therefore, a 75+ rig count gain within the next three quarters seems plausible when one considers the entirety of the Permian E&P landscape. If we were betting folk, we would take the over. As always, our forecast is based on discussions with both rig contractors and E&P’s. This matters since the discussions with E&P contacts help avoid the risk of “double-counting” quoting activity.
Rig contractor friends report healthy inquiries, enough so that they are counseling customers to not wait until new budgets arrive in January, but rather to lock in 2022 needs in 2H’21. Recall, that was our view extoled back in March. And why will this happen? First, herd mentality is developing as E&P’s will soon realize the emerging reality that rigs won’t magically be available and ready to deploy on January 1st. We submit many rig contractors, like most others in OFS, cannibalized equipment in recent quarters. Therefore, spending to make equipment field ready will be required before reactivation. With lead times on equipment and parts elongating, this means rig deployments won’t be as swift as in recent quarters. Meanwhile, labor is hard to find. Everyone knows this, but a tight labor market means higher labor costs. For the industry to ramp harder, a structural increase in wages will be required, in our view. Package these two factors together and this will support material dayrate improvement later this year. We’ve already heard of increases ranging from $2,000/day to as much as $4,000/day – the magnitude largely depends on the prior rate that is repricing.
Why do we envision a herd movement developing? Because messaging from most contacts is uniform. Returns are excellent and E&P’s claiming Tier 2 and Tier 3 acreage is highly economic at ~$70 oil. As for rig addition anecdotes, we visited with multiple E&P contacts and nearly all see higher activity. Some players cite expectations to ramp their respective rig counts by as little as 4 rigs to potentially as many as 7 rigs. Generally, that equates to a 40%+ move. Smaller players also report plans to add as well. One company running one rig today will go to two rigs in 2022, a 100% increase. Another who drilled a few one-off wells will transition to a fully dedicated rig, let’s call that a 100% increase. Another player will add 1-2 rigs, a potentially 25-33% increase in its activity. Only one company claimed an expectation of flat activity; however, the company also noted the 2022 budget isn’t complete. We wonder how this company will react if its production/EBITDA growth begins to lag its peers.
Completion Activity. Permian frac crew count stands at roughly 95 fleets based on in-person updates this past week (we believe the U.S. active count is in the 210 vicinity). Local contacts generally see little movement in this figure near-term, but most see a Q4 uplift as opposed to a Q4 holiday slowdown. The working theory is a desire by some to secure completion equipment before the start of 2022. With respect to pricing, most frac companies still report an ongoing knife-fight – a consistent refrain from our last trip. While conventional wisdom holds the Permian market is too fragmented; therefore, leading to no pricing leverage, we are beginning to question this theory. Here’s why. First, many of the private frac companies are essentially sold out. Second, the public companies generally convey an intent to withhold capacity to allow pricing to rally. We’ll believe point #2 when we see it. But, if one were to put a degree of faith into point #2, the Permian frac market should see an activity uplift in 2022 if our Permian rig expectation plays out. Perhaps, one could see the Permian frac demand rally to ~105 fleets. When one considers most private companies generally lack incremental ready-to-work spare capacity, the notion of larger players withholding capacity would seem a potential pricing catalyst – that is assuming they opt for returns vs. market share.
Real quick take on Permian frac market share. We track 20 providers with 95 active fleets. Of the 20 providers, 10 are private with ~24 active fleets. Of the 10 privates, we believe nine have fleets which are either fully marketed and/or lack incremental capacity. Many of these players have legacy Tier 2 fleets. With respect to the public players, all have idle capacity, but most convey an intent to manage capacity in order to allow pricing to recover. If there is a call for more fleets, the incremental capacity largely rests with the larger players. Therefore, should these companies put forth a similar degree of capital/pricing discipline as that of their public E&P customers, we would then anticipate upward pricing momentum. Moreover, a modicum of consolidation amongst the larger players would accelerate the pricing recovery. Of course, our synopsis is not without risks. Namely, there is a growing reality some frac companies will build new eFleets, thus incremental capacity. Some public players are providing less granularity into their financial/operational metrics, thus it’s harder for investors to hold these companies accountable. Third, we continue to see an active market for used equipment sales. In fact, the used equipment market should see more activity as a frac company which recently shutdown is purportedly about to see its assets go to auction.
New Frac Equipment Sales. Not coming in droves but pay attention to recent announcements – some of which aren’t a huge surprise. Recall from Q1 earnings that Comstock contracted a BJ fleet in 2022. This will be a new Titan fleet. Last week NexTier announced it will deploy its first Ideal eFleet in 2022. Liberty will host its Analyst Day this week. One would assume we’ll hear more about its plans to upgrade/electrify. Finally, we visited with an industry contact who confirmed it is building at least one new fleet for another player. This is all confirmation about the frac industry’s efforts to electrify and meet the needs of E&P customers seeking to reduce emissions. Little has been quantified, however, about the returns of these fleets, something on which we would encourage the industry to postulate. By the way, we also visited with a private company seeking to enter the frac market via the purchase of legacy equipment. Time will tell if this decision is made, but the ongoing disposition of old equipment to new start-ups will simply perpetuate the competitive tensions in this business.
Service Cost Tension. Everyone knows service costs are poised to rise. Already, the cost of steel, diesel and trucking is up – that’s consensus. OFS worked priced back in 2H’20 rolled higher already. In other words, E&P’s who actively played the spot market in 2020 and benefitted from a career low service cost environment have already experienced inflation. No one disputes this. The real question is why the industry has failed to witness a more assertive effort by service companies to demand price relief. We know the demand backdrop is good. We also know the E&P industry is crushing it right now – just look at Q1 results and corporate outlooks.
After meeting with multiple OFS franchises, we are convinced the singular factor interfering with improved prices is the fear of losing work. We know this might not sound like such a bold proclamation, but here’s the deal. OFS managers are in a bit of a prisoner’s dilemma. Most feel a pronounced effort to move rates would lead to customer turnover. Generally, most claim a price increase by them would be met by a competitor’s tactical decision to maintain price and gain market share. Yet, in the same conversation when asked about their response to a competitor’s price increase, nearly all say they would follow. In other words, if these same contacts are telling the truth and would heed their own advice, then the OFS market is primed for a material uplift in pricing, particularly if OFS sector remains holds fast with a view of profitability over market share. To date this hasn’t happened which is why OFS financial results still stink, but with demand for services expected to rise, the opportunity to recoup pricing sacrificed last year seems probable.
Here’s another consideration. On Thursday, the U.S. Bureau of Labor Statistics issued the May CPI data, reporting a 0.6% m/m increase while the 12-month increase is +5.0%. The big driver in the y/y change is energy costs, up 28.5% on y/y basis. Presumably, most readers of this note have personally witnessed inflationary pressures on all goods & services. We like to BBQ and can report beef prices are up. This weekend we took our car in for service. Interesting to see no new trucks on the dealer’s lot. By the way, the CPI statistics show a sharp m/m increase in used and new vehicle prices in both April and May. Funny how supply/demand work. Now, put this inflationary backdrop into the world of OFS. Essentially all OFS companies continue to report pricing remains below pre-COVID levels. E&P contacts tend to agree. So, the OFS sector, like all consumers, is facing inflationary cost challenges, yet while costs are up y/y, pricing is down y/y. That’s a bad combo.
Take this thought step further and look at the latest OFS company to report earnings. KLXE reported its fiscal Q1 results on Friday (fiscal year end is Jan 31). Frankly, results were tough. Revenue was up 5% q/q, but adjusted EBITDA was negative – again. The KLXE results reflect a structurally broken OFS market where market fragmentation and weak pricing leave no room for error. The two big drivers for negative EBITDA this quarter were attributed to weather and customer delays. Now, we aren’t trying to pick on KLXE. They just happened to report this week. Thankfully, KLXE guided top line higher for fiscal Q2 and positive EBITDA is expected going forward. The improvement will be largely activity driven and from further efforts to cut costs, but there is only so much juice which can be squeezed out of an onion. For real improvement, pricing will be required. On that point, KLXE management used its conference call to emphasize this need – citing current pricing woes multiple times. For those willing to see the forest through the trees, it doesn’t make much sense that an OFS sector is essentially break-even when oil prices are ~$70/bbl. OFS industry contacts are finally embracing this notion and we suspect most will get more assertive with pricing sooner rather than later.
Supply Chain Stress. Lots of anecdotes out there on supply chain stresses, but it’s always good to see these in person. Case in point, we toured a well service rig builder’s facility this week. Plenty of work going on, largely rig upgrades. Two things stood out. We saw a mast which is almost ready to go back to service but is waiting on a small rubber part which is no longer in production. Thus, the mast has been sitting, ready to go for about three weeks. Similarly, we saw a drawworks ready for final assembly, but missing key bolts. Again, delays in production from suppliers are delaying the return of this equipment to service. Meanwhile, we are hearing growing chatter about frac engine delays with lead times potentially extending beyond 20 weeks. We’ll try to confirm this anecdote this week. We also hear from an OEM that any product coming in from China is also facing delays. From our perspective, seeing is believing and little things such as a ~$10 bolt can hold up a rig from returning to service.
KLXE Earnings. Revs +5% q/q to $91M, but adjusted EBITDA was a negative $9.4M. Winter weather and customer delays are the primary drivers of the EBITDA loss and weaker revenue generation (vis-à-vis the rig count which was up +20% q/q). Guidance. KLXE sees fiscal Q2 revenue up 15-20 % in fiscal Q2 with a “material” improvement in Q2 EBITDA. Balance sheet metrics remain elevated as net debt stands at $206M. Pricing was a key discussion topic on the call as was company efforts to reduce costs. On that point, KLXE is making huge strides with cost reduction. Fiscal Q1 G&A totaled $14.9M which represents a 45% reduction from pro forma Q1’20 G&A. Total cost reductions are roughly $46M while another $4M are expected.
E&P M&A Continues. More deals announced this week again. This time it’s another deal in the DJ as the Bonanza Creek/Extraction combo (Civitas”) announced it will acquire Crestone Peak for $1.3B. We listened to the call and reviewed the IR slide deck. Focus will be on free cash flow, low reinvestment rates and returning cash to shareholders. The company will run three rigs and three frac crews, but noted an additional rig is reasonable. Also in the M&A arena is a merger between Contango Oil & Gas and Independence Energy. The combined companies will have a market capitalization of ~$5B with the deal featuring G&A synergies of ~$20M. Similar messaging as the Civitas deal – the combined company will focus on FCF and announced the initiation of a dividend. Finally, Colgate Energy announced a ~$508M purchase of OXY acreage. At this point, there are way too many E&P deals which illustrate the rationalization of the industry, yet amazingly, service industry deals are nowhere to be found.
BKR Rig Count: Up 5 rigs w/w to 447 rigs. Gains largely in the Permian (+4). If the rig count were to hold exactly flat through the end of the month, the q/q rig count would be up about 15%, averaging ~437 rigs. That’s the current DEP Q2 estimate. One would think modest improvement will ensue in the coming weeks, thus a slight beat relative to what we had envisioned.
Well Service Addendum. Last week we updated some figures for the well service industry. On our trip to Midland, we learned of two players which we previously did not have in our tally. We also received additional figures from known companies, but whose rig count estimates we had which were stale. Based on the new information, we tally a total of 3,375 rigs of which 908 are working. The latest EWTC tally shows a total of 2,502 rigs with 936 working. Of note, in our tally, our 908 working rigs comes from owners of 2,225 rigs while our updated 24-hour active rig count now stands at 102 rigs.
Other News. Notwithstanding an exceedingly tough OFS market, we still see new companies emerging. Just this week, Gulf South Energy Services announced on social media its intent to commence wireline operations in the Permian. Snappy paint job on the equipment. During our Midland visit, we met an emerging well service company who is taking delivery of its third new rig. Meanwhile, a CT company will soon take delivery of new equipment. Just a few examples of new/existing players emerging/expanding and yet another sign of the need for OFS industry leaders to effect material consolidation.
Permian BBQ Cook-Off. Be sure to Save the Date for our BBQ Cook-Off. September 30th. Quick Update: We have 51 committed cooking teams, thus leaving 9 slots open for those willing to either subscribe to DEP or sponsor the BBQ – we’re happy to walk you through the details. Separately, there are many sponsorships opportunities still available. To the extent we can earn your business, we will do our very best to assemble the industry’s greatest event. Right now, interest from all of the upstream sectors is high. As a quick reminder, this will be an invite-only event for DEP clients, friends and sponsors.
Cooking teams are in the logos on our Save the Date (see below). Also, our list of E&P judges continues to grow. We expect to finalize our judges list before the end of the month, but for now, we expect the following companies to participate (in alphabetical order): Admiral Permian Resources, Ameridev, Apache Corporation, Birch Resources, Callon Petroleum, Centennial Resource Development, Colgate Energy, Chevron Corporation, ConocoPhillips, CrownQuest Operating, Devon Energy, Diamondback Energy, Double Eagle, Endeavor Energy Resources, ExxonMobil/XTO, Fasken Oil & Gas, Henry Resources, Hibernia Resources, Kaiser Francis Oil & Gas, Laredo Petroleum, Northern Oil & Gas, Ovintiv, Patriot Resources, Permian Basin Strategic Partnership, Pioneer Natural Resources and SM Energy. In addition, our judges will also include several elite institutional investors and financial services friends.