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Energy Stocks: 1 Worrisome Trend to Watch

By Matthew DiLallo - Jan 31, 2018 at 1:22PM

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After keeping a lid on costs for several years, a number of oil and natural gas drillers blew past their budgets in 2017.

Drillers in the U.S. have worked hard to drive down costs so they could extract more oil and gas for less money. Many large producers have become masters of efficiency, which allowed them to cut their capital budgets last year even as they pushed their output above expectations.

However, some smaller energy companies have been pressed by an unwelcome headwind in recent months: a major uptick in prices for both services and equipment. That forced them to spend more than anticipated, while production came in below forecasts. If this trend continues, it could impact the ability of smaller drillers to grow, since they lack the scale to push back against these rising costs.

Oil field workers at a rig site.

Image source: Getty Images.

Putting the squeeze on capital spending

Devon Energy (DVN 2.24%) was one of several large drillers that became more efficient as the year wore on. The company initially expected to spend between $2 billion to $2.3 billion last year, which it thought would fuel 13% to 17% oil production growth by the end of the year. However, thanks to its capital efficiency gains, the company was able to cut its budget by $100 million in the second quarter to a range of $1.9 billion to $2.2 billion, even as it boosted its oil production outlook up to 18% to 23% growth by year-end. That trend continued in the third, as the company narrowed its spending range forecast to the $2 billion to $2.1 billion range, and said production would be at least 20% higher by year's end.

The year went similarly for Marathon Oil (MRO 1.36%) which initially planned to spend $2.4 billion en route to increasing its U.S. output by 15% to 20%. However, thanks to strong well results and efficiency gains, the company adjusted its forecast in the second quarter to predict that output from the U.S. would be up 23% to 27% for the year, even though its capital budget would be about 10% lower than initially expected. It further bolstered that production growth range to 25% to 30% after a strong showing in the third quarter, while noting that it planned to hold capex to $2.1 billion.

A person in gloved hands turning a valve.

Image source: Getty Images.

Spending more with less to show for it

However, over the past month, several smaller drillers have updated investors with spending plans and production guidance that have been going in the opposite direction. Range Resources (RRC 5.29%), for example, said that it spent $1.27 billion last year to drill more wells. That level, however, was 10% above its $1.15 billion budget. Fueling the increase were higher-than-expected costs on wells completed in the second half of the year on its acreage position in North Louisiana. In fact, drilling costs in that region have risen to the point where Range no longer plans to invest any capital to grow output there over the next five years. 

Similarly, Laredo Petroleum (LPI 5.02%) added $100 million to its annual budget in the third-quarter, boosting it to $630 million to "reflect service cost inflation" as well as some other additional expenses. Despite that, Laredo's production for the fourth quarter came in below the mid-point of its guidance range, because it also took the company longer to finish wells than expected. And Parsley Energy's (PE) spending came in above the high end of its forecast budget range. Overall, it spent $1.2 billion last year, when its capital budget had been between $1 billion to $1.15 billion. Further, the company noted that spending in 2018 would be at the high end of its $1.35 billion to $1.55 billion budget due to cost inflation. Yet despite those higher outlays, the company expects output to come in a bit below guidance. What's concerning is that expenses might keep rising, which could cause these companies to miss their budget and production forecasts again this year. 

The scale advantage

So far, large oil and gas producers like Devon and Marathon have been able to keep the pressure on costs. That has allowed them to produce more oil and gas for less money than smaller rivals, which have seen rising drilling costs inflate their budgets. If that trend continues, it could weigh on the growth prospects and stock prices of smaller drillers this year.


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Stocks Mentioned

Devon Energy Corporation Stock Quote
Devon Energy Corporation
$72.58 (2.24%) $1.59
Range Resources Corporation Stock Quote
Range Resources Corporation
$29.07 (5.29%) $1.46
Marathon Oil Corporation Stock Quote
Marathon Oil Corporation
$28.36 (1.36%) $0.38
Laredo Petroleum, Inc. Stock Quote
Laredo Petroleum, Inc.
$63.58 (5.02%) $3.04
Parsley Energy, Inc. Stock Quote
Parsley Energy, Inc.

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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