Third-quarter earnings from oil companies were much stronger than expected, especially in light of the 20%-plus plunge the price of crude took during the quarter. There were three key trends driving these surprisingly strong results. However, none of them appear to have much left in the tank.
1. Production growth
Shale producers drove strong production growth during the quarter, with Whiting Petroleum (NYSE:WLL), Laredo Petroleum (NYSE:LPI), and Devon Energy (NYSE:DVN) growing production 38%, 16%, and 6% year over year, respectively. Devon Energy's production was especially strong after its oil production exceeded the top end of its own guidance range for the fifth consecutive quarter. This strong production growth helped these companies make up some of the cash flow lost to lower prices by delivering higher volumes.
However, growth appears to have hit its high-water mark, with many shale producers expecting production to be flat or even fall in 2016. Whiting Petroleum, for example, is planning to reduce its spending from $2.15 billion to about $1 billion next year. That's about all it can afford to spend assuming a $50 oil price, though that should be just enough capex spending to keep production roughly flat. Meanwhile, Devon expects to pull back its spending from $4.5 billion this year to a range of $3 billion to $3.5 billion next year, with production growth moderating to the low single digits.
2. Cost reductions
Oil companies were also able to capture very significant cost reductions over the past year, with Laredo Petroleum's unit cash costs down 28% year over year to $12.15 per BOE. Well costs are also coming down, with Whiting Petroleum noting that the cost of drilling wells in the Bakken had fallen to $6.6 million last quarter compared to $8 million in 2015.
While there is still some downside to costs, suffice it to say that it will be tough for Laredo Petroleum to push another 28% out of its operating costs next year. Likewise, well costs could start to hit bottom because most of the low-hanging fruit, so to speak, from efficiency gains has already been picked.
3. Gain from oil and gas hedges
Gains on oil and gas hedges added a significant amount of money to producers' pockets during the third quarter. Devon Energy had 70% of its production hedged during the quarter enabling it to capture a full $10 per BOE more than it would have realized without those hedges. Meanwhile, Laredo Petroleum's hedges increased its realized oil price by $33.86 per barrel bringing the total to $76.74 per barrel. Even more stunning was Halcon Resources (NYSE:HK), which nearly doubled its price realizations because of hedge gains. The company boosted its realized oil price by $40.71 per barrel to $78.44 and consequently received nearly $115 million from realized oil and gas hedges during the quarter, almost double the $129 million in revenue it pulled in from oil and gas production.
Those gains won't be there to the same degree in 2016. Halcon Resources has only 78% of its oil production hedged next year at $80.59 per barrel, compared with 95% of fourth-quarter production hedged at $90.21 per barrel. Meanwhile, Laredo's oil hedges will also drop off, with the company having 85% of its production hedged next year, but at just over $70 per barrel.
This is one reason capex spending and therefore production growth will come down next year. With fewer hedge gains to be had in 2016, producers will have less cash flow to spend, necessitating lower budgets to match capex with cash flow. That's a big reason both Devon Energy and Whiting Petroleum expect to spend about $1 billion less next year, which will deliver meager, if any, production growth.
Three key trends fueled third-quarter earnings in the oil patch: higher production, lower costs, and hedging gains. All will be under pressure next year, which suggests that these three fuels won't be there to drive earnings for oil producers in 2016.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.