We hope everyone had a happy and relaxing 4th of July weekend.
This week the DEP team hits the road again with members of the team heading to Dallas on Wednesday/Thursday. Next week, we return to Fort Worth and then up to Oklahoma as we hit the DUG Permian and then host our Steak & Baseball outing in OKC on July 15th. Finally, we intend to drive back to Midland the week of July 19th for a few days of meetings, with a focus this trip on the water midstream sector. Let us know if you are around in any of those venues.
Electrification Accelerating. Big news from U.S. Well Services and ProFrac Services. First, USWS announced a recapitalization plan which provided liquidity to fund the $35M cash portion of its legal settlement with Smart Sand as well as to provide capital to expand the company’s electric fleet portfolio from five fleets to eleven fleets. Per the recapitalization, USWS is permitted to build four fleets as well as purchase critical components for two other fleets.
Aside from a somewhat complicated recapitalization, what makes the USWS announcement interesting is the company’s plan to license its electric frac technology to ProFrac Services. The licensing fee will cost ProFrac $7.5M/fleet for the first ten fleets with the next ten fleets having a $9M/fleet licensing fee. The USWS press release indicates ProFrac will move ahead with three licenses initially, but given ProFrac’s successful history of rapid development, it would seem reasonable to assume ProFrac utilizes more than just the initial three licenses.
This announcement is a big deal. The move by both USWS and ProFrac are a further validation of the bifurcation of the U.S. frac market. The announcement follows the BJ Energy Solutions emission-friendly fleet expansion announcement from last week. Further, it supports our theory that private players will be more assertive (on a relative basis) vs. their public brethren with respect to fleet expansion efforts. Yes, some of the public players have announced upgrade/electric programs, but the committed capital announced to date lags that of the private peer group (again, on a relative basis).
Importantly, at our Telluride Executive Series, there was incremental chatter about top-shelf fleets now securing a price premium with some frac constituents reporting accelerating customer interest in new technology. Recall, from prior field trip recaps, we reported limited pricing uplift in the spot market from new technology investments. That reluctance to pay more seems to be fading as herd mentality vis-à-vis new equipment is taking shape. This means we would expect to see positive pricing anecdotes/expectations emerge in the coming weeks, particularly on Q2 earnings calls. The challenge, however, is the growing supply of old equipment returning to market. We have previously profiled emerging companies to the frac market. We would expect this trend to continue as more second-hand equipment is sold. For example, on July 15th we will be attending another Superior Energy Auctioneers event in Oklahoma City. This auction will feature 75 BJ pumps or ~3 complete spreads. We are aware of one frac company recently purchasing an idle fleet with all the accompanying assets for under $10M. Meanwhile, we would expect the Legend Energy Services frac fleets to hit the auction block shortly as well and don’t forget USWS is unloading its legacy diesel fleet assets. This collective recirculated supply will foster new competition which, all else being equal, likely means more competitive pricing for Tier 2 legacy equipment.
Smart Sand Legal Win. Smart Sand received a $35M legal settlement from USWS. In addition, the settlement includes a two-year right of first refusal to SND covering all purchases of Northern White frac sand by USWS. Good outcome for SND as the cash infusion is material to the company. Recall at 3/31/21, SND had cash balances of $11M with total debt equal to $28M. The 3x improvement to cash gives SND greater operational flexibility. Will be interesting to hear the company’s views on cash deployment on the Q2 call.
Telluride Observations. The inaugural Daniel Energy Partners Telluride Executive Series just concluded. We would like to extend a sincere thank you to all who agreed to join us for this unique conclave of industry leadership and thought leaders. While much was discussed during our two-day event, we provide a brief highlight of salient takeaways. Also, we are presently targeting June 28-30th for the 2nd Annual Telluride Executive Series. Details will be distributed to select clients in the coming weeks.
E&P Capital Spending – Anecdotes Point to Higher Activity (Not a Surprise). We would love to report large numbers of E&P budget announcements were conveyed this week, but that was not the case. Publics largely stuck with the capital discipline messaging, but private companies offered a few interesting nuggets. First, rig count will nudge higher with two attendees each noting plans to add one rig. For these two companies, a one rig addition equals a 50% increase in rig activity. One nat-gas public player conveyed an intent to stick to free cash flow generation with capex spending largely representing a maintenance budget. Activity increases, however, are not off the table, but the company requires strength in the two-years futures curve, not just the one-year forward curve. Specifically, if the 24-month curve exceeds $3.00/MMBtu, then more growth-directed spending would be probable. A Permian E&P claims paybacks are well under a year at current commodity prices thus it plans to flex up. Meanwhile a PE participant noted a very wide range with respect to its future drilling activity stating a flat-to-up ~50%, all subject to commodity prices.
Lead Times Extending. Two leading OEMs participated at our conference. An observation raised in a prior DEP note was growing evidence of extending lead times. We asked each panelist for their respective views and both concurred. No specific quantification was provided, but demand from other industries (i.e. mining, rail and marine) is placing a strain on select OEM product. Moreover, the race for equipment upgrades is now underway, but the timing to actually receive this equipment is somewhat in question. Perhaps that’s why USWS announced in a separate release last week its plans to purchase 120 electric motors totaling 360,000hp. Best to get in the front of the line and first-mover’s presumably will have the best chance to secure contracted work. Given these lead time constraints, we would expect some OFS companies to highlight advanced orders/upgrades during Q2 earnings season. This could, perhaps, lead to some upwardly revised capex budgets.
M&A Prospects Rising. M&A is expected to remain robust, particularly for E&P. New capital is entering the sector from non-traditional E&P investors while benefits from large-scale transactions are hard to ignore. Within the OFS space, one banking panelist noted lots of attempts at stock deals, but issues surrounding relative valuation and social considerations have thus far proved challenging. That said, conversations amongst OFS enterprises abound which should lead to M&A announcements before year-end. Further, with financial results improving, it will be easier to establish valuation metrics. The concern, however, is whether rising commodity prices and hopes for higher activity will lead some companies to hold off on deals in hopes the cycle will bail them out. We hope not as the OFS market remains desperately fragmented. That said, one panelist foresees companies continuing to spin-off non-core business segments. Our take: It’s hard not to see more M&A develop. There are too many investments by private-equity players – both OFS and E&P – that need to be monetized given the length of the investment. We would envision the best-in-class privates – both E&P and OFS – being the likely targets with equity as the primary form of consideration. This would provide necessary deleveraging benefits while buyers can advertise the purchase of top-flight private companies/equipment. In the case of the service industry, we continue to believe those companies with newer relative equipment with sound local market positions make the most attractive acquisition candidates. Key, though, is how one retains the people. Lastly, there is no shortage of micro-cap OFS enterprises that would benefit greatly from the elimination of duplicate overhead.
Electric Commentary. The timing of the USWS announcement coincided well with the Telluride event as we had multiple attendees tied to the electrification process in attendance. Suffice it to say, optimism with these companies is growing. Unfortunately, granular discussions were verboten as companies are “covered up in NDAs”. No worries as that tells the story. The push to enhance fleets is gaining steam particularly now that E&P’s recognize the need to pay up for better technology. Makes sense as anyone truly committed to being green needs to compensate the provider that takes them there. Our bet is Q2 commentary from the smorgasbord of public frac companies will allude to nascent efforts to move price, but the $75/bbl backdrop will give more ammo for larger late 2H’21 increases.
Buyside Panel Gives Hope. Two leading energy investors shared their respective market observations. First, returns matter, thus PM’s who have shunned energy stocks have done so less about ESG, but instead because of weak returns. Therefore, if the capital discipline mantra persists and returns rise, it is reasonable to see generalist money return to the sector. This is good news as it supports our long-held belief that investors invest money to generate returns, less so to support a cause. That can be accomplished via charitable contributions. But, before one gets too gleeful, panelists did acknowledge the energy sector has a higher hurdle than other sectors, thus companies need to keep generating returns (as well as returning cash to shareholders). Investors also pointed out that we are finally starting to see large-cap OFS companies generate “E” thus allowing the stocks to be valued on a P/E basis. This matters. So, why do investors still shun energy? In many cases, it is due to fears of long-term oil demand, less about industry supply. There are those who fear long-term demand will contract, thus they reduce terminal values for estimates and multiples.
Telluride Conclusion. The preceding bullet points are just a mere snapshot of the event. What featured prominently to us was the clear and growing optimism across the upstream energy space. OFS companies will proceed with price increases (lots of +5-15% increases mentioned). E&P companies know this but will play the push-back game as long as possible. OFS companies, we believe, are approaching the point where they will walk if increases are not accepted. We also had one OFS-related player opine on the potential tightness of the power generation market as some E&P companies may opt to use power for bit-coin mining. Not sure we completely understand this, but could a rising call on power from non-OFS related enterprises lead to insufficient power supply for the OFS sector? Time will tell, but it appears there is interest from outside sectors, something OFS companies may wish to pay attention too.
BKR U.S. Land Rig Count. Another +5 rig improvement with the BKR U.S. land rig count exiting Q2 at 459 rigs. We’ll clean up our rig count forecast later this month once we do our usual industry surveys, but our gut tells us we’ll approach the 600-rig count level in 1H’22. Commodity prices are too tasty to pass up and companies can still return plenty of cash to shareholders and still ramp activity.