Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

It was a big day for the shale patch on Wednesday. And by big, I mean dreadful:

Hump Day
Two Permian bellwethers sold off heavily on Wednesday morning -- but one fared much worse
Source: Bloomberg
Note: Intraday prices are for ET.

Pioneer Natural Resources Co. and EOG Resources Inc., two bellwethers of the bellwether Permian shale basin, reported results on Tuesday evening. Pioneer beat earnings estimates handsomely, while EOG lagged them by 33 percent, according to data compiled by Bloomberg. One look at the chart above, along with the fact that both companies trade on 2017 earnings multiples of more than 100 times, tells you all you need to know about how much investors in this sector tend to focus on earnings.

Growth and efficiency are what count, especially in a $50-ish oil world. I wrote here about how Pioneer's cut to its production growth target for the year -- especially with regards to oil -- largely explains the drubbing it got on Wednesday morning. EOG, in contrast, actually raised its forecast, with oil output now expected to rise by 20 percent versus the earlier target of 18 percent (Pioneer's fell about nine percentage points to around 17 percent). This discrepancy is the narrative of that chart.

When it comes to efficiency, there's actually little to choose between them, at least in terms of cash costs. Pioneer has slightly lower unit costs at the operational level, but EOG keeps a tighter lid on general and administrative overhead:

Neck And Neck
Both of these Permian bellwethers have reduced their cash production costs to around $14 per barrel of oil equivalent
Source: Company filings
Note: Lease operating costs; gathering, processing and transportation costs; non-income taxes, general and administrative costs; and interest costs per barrel of oil equivalent. 'LTM' is last 12 months through June 2017.

But, with the numbers now in, EOG can claim a legitimate edge in two respects.

First, it has pulled away from Pioneer in terms of free cash flow:

Positive Difference
EOG has edged back into positive free cash flow generation while Pioneer's deficit has widened
Source: Bloomberg
Note: Cash flow from operations less capital expenditure. Trailing four quarters data.

Second, EOG has pulled further ahead in terms of credibility. Its Big-Data approach to leasing, drilling and fracking -- which the company never knowingly undersells -- makes for a compelling, tech-like story, backed up by rising production targets and tight cost control.

In contrast, Pioneer has to re-establish some lost confidence. CEO Tim Dove was at pains on Wednesday's call to emphasize that the rising cut of natural gas and natural-gas liquids in some Permian wells represented additional volume, rather than a portent of decreasing crude-oil barrels, pointing to data on wells drilled this year. If true, then that makes wells more rather than less valuable.

The problem is, Pioneer disclosed this at the same time it was cutting guidance because technical problems in a number of other wells backed up its drilling schedule. So while there is every chance Pioneer will overcome those difficulties -- based on its track record -- the jury will remain out to some degree for at least the next three months.

After Wednesday's sell-off, Pioneer's stock is back to where it was in mid-April 2016, when oil was bobbing around the $40 level in the run-up to the failed OPEC freeze in Doha. That seems harsh given the progress Pioneer has made since then in terms of cost control and production gains. That sounds bullish, but should also serve as a warning.

Permian valuations are both high and fragile. With earnings seemingly irrelevant, investors focus on net asset valuations; these being discounted models of future cash flows that are highly sensitive to assumptions around well productivity, reserves, costs and, of course, forecasts of oil and gas prices. For example, using its own expectations for oil and gas prices, Evercore ISI values Pioneer at $188 a share, 30 percent higher than the current price. Using current futures prices, though, that drops to $107, 26 percent below the current price.

The point isn't that futures prices are the best predictors of where the oil and gas markets are going (they aren't). Instead, rather like some high-flying technology stocks, the shares of shale producers are inherently bets on the success of a new and evolving model predicated on growth and a pay-off (in terms of sustainable free cash flow) that is some ways down the road. On that score, even EOG was reluctant on Wednesday's earnings call to put specific timing on when it might get to a double-digit return on capital employed at $50 oil.

Growth remains the shale sector's priority because that's what investors, by and large, want. Certainly, any signs of weakness on that front, more than anything as mundane as profits, will prompt a swift and punishing response.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net