The crude oil prices may remain weak and volatile in the near future, hurting the performance of many oil producers. The Permian Basin focused oil producer Parsley Energy (NYSE:PE), however, will likely continue generating profits and free cash flows as it reduces costs and realizes capital efficiencies. The company will also realize synergies and the associated cost savings as it completes the takeover of Jagged Peak Energy. Oil prices, however, can also come under additional pressure in 2020, but Parsley Energy is in good financial health and can withstand any unexpected drop in oil prices.
Image courtesy of Pixabay
Oil prices rose substantially in the recent past, with the US benchmark WTI crude climbing from $55 a barrel in late-November to above $63 earlier this month. The gains were driven in large part by OPEC and its allies who decided to deepen production cuts from early-2020 as well as by the reduction in trade tensions between the US and China after two of the world’s largest economies signed a preliminary deal, and the US-Iran crisis triggered by the killing of a top Iranian general and threatened to push the entire region towards a major conflict. But oil prices cooled quickly after the threat of war and the risk of supply-side disruptions in the Middle East receded as both the US and Iran backed away from open conflict. The WTI was at $58 a barrel at the time of this writing.
As the geopolitical tensions in the Middle East subside, the markets will once again re-focus on the US-China trade negotiations, OPEC’s future actions, and crude oil’s supply-demand fundamentals. The market currently remains well supplied, with strong production from non-OPEC countries such as the US, Canada, Norway, and Guyana. In the US, production growth is slowing down as several shale oil drillers dial back activity, but the country is still pumping more oil than last year. At the same time, the global economic slowdown can hurt crude oil demand. The US-China trade war has made things worse. Although the two countries have signed the Phase-1 trade deal, the economic conflict is nowhere near from over. I think these factors could continue to weigh on oil prices in the future.
The good thing is that Parsley Energy has already shown that it can generate profits and free cash flows in a low oil price environment. In Q3-2019, Parsley Energy realized an average sales price of $36.65 per boe (without derivatives), down from $47.58 per boe in Q3-2018. Its oil price realization fell to $55.16 per barrel from $62.78 a barrel in the year-ago quarter. This drop in commodity prices pushed the company’s earnings lower, but it still ended the period with an adjusted profit of $81.9 million, or $0.29 per share, and free cash flows of $20.8 million. The company has also initiated a quarterly dividend of $0.03 per share. Although this dividend translates into a modest dividend yield of just 0.65%, I think it is still a big step for the company and shows it’s confident about its ability to generate strong levels of cash flows in the future, even with low oil prices, which will be used to reward shareholders.
In 2020, however, Parsley Energy will complete the $2.27 billion all-stock acquisition of its rival Jagged Peak Energy (NYSE:JAG) (transaction expected to close in the current quarter). The takeover will increase Parsley Energy’s Permian Basin footprint from 189,000 to 267,000 net acres as well as the company’s production, drilling inventory, and enterprise value. This will further solidify Parsley Energy’s position among mid-cap Permian Basin pure-play oil producers.
Parsley Energy has been successful in reducing costs and capturing capital efficiencies in 2019. This has helped the company in generating free cash flows and producing more oil with less capital. In its third-quarter results, Parsley Energy showed that its lease operating expenses and general and administrative charges on a per-unit basis fell to historic lows. Its well costs at the Delaware Basin dropped by 12% in a year. The company is on track to report 14% to more than 16% improvement in capital efficiency in 2019, surpassing its 8% to more than 10% target.
In 2020, I expect Parsley Energy to continue targeting further cost reductions and capture additional capital efficiencies. The company will also likely increase its local sand usage (Jagged Peak used 100% local sand), continue improving cycle times, optimize facilities expenditures, and could benefit from service cost reductions. The company’s well costs, particularly in the Delaware Basin, will likely be meaningfully lower in 2020 from 2019.
On top of this, Parsley Energy will realize synergies and the associated cost savings by merging its legacy assets with Jagged Peak’s operations. The oil-producing acreage of both companies in the Delaware Basin is located right next to each other. The two companies can share all their resources, including energy infrastructure and technical knowledge since they are virtually drilling from the same rock, and drive down costs. Parsley Energy will also apply its scale advantage to push the acquired assets’ drilling, completion, and equipment costs lower.
Parsley Energy will also reduce drilling activity next year on a pro-forma basis. The combined company will run an average of 15 rigs in 2020. By comparison, the two companies operated a total of 16-19 rigs in the first nine months of 2019. Despite the low activity, the production will likely keep moving higher, thanks to the capital efficiency gains. Moreover, the lower activity will also help Parsley Energy in reducing its capital expenditure in 2020. The company has forecast a roughly 15% cut in CapEx for 2020 to between $1.6 billion and $1.9 billion. In my view, the reduced spending will help the company in generating free cash flows. The company has been outspending cash flows, but in Q3-2019, it swung to free cash flows (as indicated earlier), and I believe it will continue reporting strong levels of excess cash in the future.
The oil price environment, however, continues to look uncertain. The commodity prices can come under additional pressure if the OPEC and its partners show weak compliance with the production cuts, or if the 14-country OPEC bloc, Russia, and a host of other OPEC+ countries agree to increase output after the current agreement expires by the end of Q1-2020. With the global oil demand growth that is still languishing, even a threat of a modest increase in supplies can push the commodity prices lower. A dip in prices will push the profits and cash flows of virtually all oil producers lower. But the great thing about Parsley Energy is that the company is also well-positioned to withstand weakness in oil prices.
In my view, Parsley Energy’s financial health is in good shape. The two companies carried a total debt of $2.9 billion by the end of Q3-2019, which translates into a healthy debt-to-equity ratio of 38.7%. That’s lower than the median ratios of 55% of the large-cap and 64% of the mid-cap independent oil producers, as per my calculations. The combined company will also have a favorable debt maturity profile, with no significant (>$500MN) near-term debt maturities. This means that if Parsley Energy faces weaker-than-expected oil prices that drag its cash flows, then the company can raise additional debt to fund its operations without seriously damaging its balance sheet.
Note that Parsley Energy has borrowed a total of $230 million from the revolving credit facility, which matures in 2021. But the company has earmarked some non-core assets for sale (particularly the water infrastructure asset), and I think it will use the proceeds to repay the revolver and shore up its liquidity.
The new company will also have ample liquidity, which can come in handy if it faces a cash flow shortfall in a weak oil price environment. Parsley Energy has a total of $1 billion available under the revolving credit facility ($230Mn drawn) and the borrowing base can be extended to $2.7 billion. On top of this, Parsley Energy has also used hedges to mitigate oil price risks. Both Parsley Energy and Jagged Peak have already covered a majority of their expected oil production for 2020 with hedges. This will provide downside protection to the company’s cash flows if oil prices decline. As a result, Parsley Energy could continue generating robust levels of cash flows and preserve its liquidity, even if oil prices come under pressure.
For these reasons, I expect Parsley to continue doing well in 2020. The stock delivered a solid performance last year, with shares climbing by 18%, easily outperforming the broader exploration and production industry (XOP) which fell by 11% in the same period. I expect Parsley Energy’s stock to outperform in 2020 as the company reduces costs, improves capital efficiencies, grows production, and generates free cash flows. The shares are trading 5.76x on an EV/EBITDA (fwd) multiple, lower than the energy sector’s median of 7x, as per data from Seeking Alpha Essential. I think Parsley Energy is a great oil stock which investors should consider buying.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.