The Permian Basin in western Texas has been the big story in the oil patch over the past few years. Thanks to advances in drilling technologies, oil producers have been able to quickly and cheaply unlock the region's vast supply of oil and gas, earning significant returns even at low oil prices. However, after growing production at breakneck speed, drillers are about to reach the limit of the region's pipeline capacity. The industry is starting to feel some pain as production in the Permian hits a wall.
A victim of its own success
While there has been speculation about the extent of the impact that the Permian's infrastructure problems would have on the industry for a few months now, oil-field service giant Halliburton's (NYSE:HAL) second-quarter report made it clear that there's trouble ahead. "In some ways, we're a victim of our own success," said Halliburton CEO Jeff Miller on the accompanying conference call. He said that as the company "develop[s] longer laterals with better production," output has grown at a faster pace than infrastructure can keep up. "As a result, we expect this area to have temporary softness in the back half of 2018."
However, Halliburton's CEO emphasized that he sees "a moderation in growth as opposed to a pullback." He also believes the region is "poised to regain activity as the calendar turns to 2019 and additional pipeline capacity is available." That seems a bit too optimistic in my opinion, considering that most of the major pipelines under development in the region won't come on line until the second half of next year. That looming infrastructure issue has already led to a 90% uptick in unfinished wells in the last month, according to a recent analysis by Bloomberg. Meanwhile, one driller has already cut its drilling fleet by 25%, while others are contemplating reallocating capital to different shale plays. With these factors at play, the slowdown could potentially stretch even deeper into 2019.
To buy, sell, or hold
Not only is the drilling pace poised to moderate in the coming months, but mergers and acquisitions activity could freeze up. Oil companies had been making a lot of deals in the region over the past few years, buying up as much land as they could get their hands on as they tried to expand their resource base. Many thought a new M&A wave would ignite this year after Concho Resources (NYSE:CXO) made a bold bet to buy regional driller RSP Permian in a $9.5 billion deal in March. Concho offered a huge premium for control of the company, which it saw as a "road map" for in-basin consolidation since it could capture significant synergies by combining the two companies.
Instead, the Permian has been eerily quiet even though companies like Diamondback Energy (NASDAQ:FANG) are known to be on the prowl. On its first-quarter call, CEO Travis Stice said that "M&A activity is as fundamental to Diamondback Energy as the air that we breathe." The company has already completed $5 billion in deals since its IPO in 2012 and continues to seek out its next target. So a recent Bloomberg report that it was in on the bidding for RSP Permian came as no surprise.
However, with infrastructure issues coming to the forefront in the last couple of months, uncertainty in the Permian has grown. That has increased stock-price volatility, making it harder for companies like Diamondback to make deals. Both buyers and sellers aren't sure how bad things will get, nor how long it will take the industry to address the infrastructure bottlenecks. In this climate, sellers likely won't get a premium value for their assets, which is why M&A activity could remain on hold as oil companies wait for those new pipelines to come on line.
The painful pause
The oil industry had high hopes that 2018 would be a banner year thanks to improving oil market fundamentals and the growth prospects of the Permian. Unfortunately, companies vastly underestimated how this growth would impact the region's infrastructure. They will likely be forced to slow their drilling pace over at least the next several months. M&A activity, meanwhile, could remain in a frozen state until there's more clarity on when the industry can return to growth.
However, with new pipelines coming soon, the Permian should reaccelerate at some point next year. That means investors will need to act sooner rather than later if they want to take advantage of the current pause and buy their own piece of the Permian growth engine before it heats up again.