The prevailing view in the oil market is that U.S. shale is an unstoppable force. No matter what OPEC does to contain supplies, shale drillers will quickly unleash a flood of production, which will keep a tight lid on prices. Fueling that view is the perception that oil producers in the U.S. have a nearly unlimited supply of drilling locations, which can keep them growing for decades.
However, Mark Papa, the former chief executive of EOG Resources (NYSE: EOG) and current leader of Centennial Resource Development (NASDAQ: CDEV), sees things a bit differently. In his opinion, even in a rising oil price environment, there just aren't enough high-quality drilling locations remaining to meet the industry's currently optimistic view of production growth. Consequently, oil prices could rise significantly over the next few years once the market realizes that shale won't be able to keep up.
Image source: Getty Images.
Drilling down into Papa's comments
On Centennial Resource Development's third-quarter conference call, Papa offered his current thoughts on the macro picture for the oil market that's fueling his company's strategy. He started by noting that oil prices are up sharply over the past couple of months because "oil markets have recently responded to the combination of high global demand, rapidly reducing crude and product inventories, and tepid U.S. production growth." He then elaborated a bit on the sluggish production growth, saying:
Based on monthly [U.S. Energy Information Administration] EIA numbers, U.S. oil production has been essentially flat for the past seven months and I expect 2017 year-over-year production growth to be 330,000 barrels per day, much less than early year consensus estimates of 700,000 to 800,000 barrels per day, even though the oil rig count is currently 900, an increase of 500 rigs compared to May 19, 2016.
First, he notes that, contrary to popular belief, oil production in the country has barely budged. So, he believes that production growth will come in well below expectations even though the industry has more than doubled its rig count over the past year. He then stated:
Many people will ascribe the reason for this tepid growth to be cash flow or service company limitations, but I think it's the lack of remaining Tier-1 geologic quality drilling locations in two of the three major oil shale plays, the Eagle Ford and Bakken. Even in a constructive oil price environment, I expect that in 2018, total U.S. oil growth will be considerably less than the 1.2 million to 1.4 million barrels per day that many people are predicting.
Papa points out that many industry watchers credit the weaker-than-expected production growth to a desire by producers to live within cash flow or the result of a tight oil-field service market. For example, oil reservoir specialist Core Labs (NYSE: CLB) noted that both issues were holding back its results. In the second quarter, Core said that it was "experiencing the impact of the prevailing market and transitory industry shortages of U.S. labor and completion equipment, which is expected to continue through year-end." As a result, Core expects the industry to complete fewer wells this year than anticipated because it doesn't have the equipment and people to keep up with demand. Meanwhile, last quarter Core noted that more customers were focusing on drilling for returns and sending cash back to investors than production growth.
However, Papa believes that the tepid production growth lies not in those external factors but with internal issues in the underlying quality of industry's remaining drilling locations. He thinks that there just isn't enough top-quality inventory remaining to push supplies meaningfully higher, which is why he doesn't think production will grow as fast as many expect.
To put the difference in rock quality in perspective, last quarter Whiting Petroleum (NYSE: WLL) restarted its well completion program in the Niobrara shale of the Rockies. Whiting completed 58 wells, which boosted its output from the region 78% versus the prior quarter to 11,750 barrels of oil equivalent per day (BOE/D). Contrast that well productivity with that of Papa's former company, EOG Resources, which noted that the eight wells it completed in the formation just above the Eagle Ford last quarter delivered an average initial production rate of 4,440 BOE/D apiece. That one example shows the dramatic difference in production from top-quality rock and lesser-tier locations.
Image source: Getty Images.
Why this could be good bullish for oil prices
The lack of top-quality drilling locations leads Papa to believe that production in the U.S. will grow by half the rate currently predicted in 2018. That view causes him to think that there will be a significant tightening between supply and demand because OPEC's continued efforts to drain off excess supply will work since shale drillers won't be able to match those cuts with continued production increases. Those two factors, when combined with continued healthy demand growth, should drive oil prices higher.
As a result of that view, Centennial doesn't plan to hedge any of its oil production by locking in current prices via contracts with buyers. That decision leaves the company entirely open to capture the upside of higher oil prices. It's a choice that could fuel monster gains for investors in the coming years given that the company expects to more than triple its oil production rate from 18,000 barrels per day this year up to 60,000 barrels per day by 2020. It's growth Centennial believes it can achieve because the company holds a top-tier position in the Permian Basin, which has some of the highest-quality rock in the country.
Built for upside
If Papa is correct -- and he has an excellent track record -- oil prices could have much more upside than the market currently expects. That could fuel significant gains for investors in Centennial as well as in his former company EOG since they control some of the best remaining drillable lands in the country. In fact, Centennial's goal is to deliver the highest returns for investors in its peer group over the next few years, which Papa believes the company can achieve given the current strategy to grow oil output as quickly as it can to capture the upside of an improving oil market. That upside potential makes Centennial a compelling choice for oil bulls to consider.
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