This is a story that has been making the rounds over the last few days, but for the energy-initiated, there is no surprise here. I actually touched on this topic back toward the end of March in a post titled “Here’s the Thing About Energy Markets…”, in which I spoke on the negative impact that the MLP model would eventually have on Permian asset prices. The idea was that MLPs were forced to shed debt and assets after the oil rout, using most of their FCF to do so, which prevented any meaningful infrastructure development going forward. This all happened in concert with private equity capital piling into prime, Permian acreage at fire sale prices. I posited that while acreage value and production were reaching all time highs, there would inevitably be logistical constraints around moving product to refineries, which would force producers to begin discounting their product to ensure it was sold downstream.
So where do we stand, just three months later? Here’s Bloomberg:
“We will reach capacity in the next 3 to 4 months,” Scott Sheffield, the chairman of Pioneer Natural Resources Co. said in an interview at an OPEC conference in Vienna. “Some companies will have to shut in production, some companies will move rigs away, and some companies will be able to continue growing because they have firm transportation.”
While nothing Sheffield said is overly concerning regarding how producers will manage capacity constraints, it is a notable admission from the CEO of a company who announced a plan to divest all non-Permian assets and invest heavily in West Texas, that not all is well in America’s super basin. They say necessity is the mother of all invention, and wouldn’t you know it upstream production is no different:
“The problem has grown so bad that oil companies have been forced to load crude on to trucks and drive it hundreds of miles to pipelines in other parts of the state.”
Truthfully, shipping crude via rail and truck isn’t that unorthodox. In fact, this was a primary method of transport when the Bakken exploded in popularity, as North Dakota was never really known for its logistical prowess. What is unorthodox is that the most prolific play in American history has resorted to such an elementary solution because nobody was a prudent enough thinker to understand the correlation between production increases and infrastructure.
The issue now becomes what the impacts of capacity constraints are on price and how that will impact the broader oil markets. Scott Sheffield thinks that “…West Texas Intermediate crude at Midland in the Permian is likely to trade at a $25-a-barrel discount to price at the industry’s hub in Cushing, Oklahoma.” – great news for arb guys. While I haven’t done the work on a specific discount price, Mr. Sheffield is likely correct directionally. However, that’s a relatively micro-economic answer from my perspective, as I think there is potential for more disruption than tighter cash flows.
Depending on how long the constraints persist, less and less Permian product making its way downstream will be bullish for the overall oil and distillate markets (crack spread traders, rejoice), but bearish for Permian acreage. While I wouldn’t be concerned by the market’s ability to weather logistical problems and the pricing issues that come with them, I would be concerned about how any cash flow disruptions would impact heavily indebted private equity acreage assets. Should lower Permian prices be around for the long haul, the problem for PE firms (and their investment committees) becomes twofold: the first being that their cash flow profile is deteriorating, impacting their ability to service debt. The second is that the lower prices and inability to sell product into the market is killing their acreage value. The first indication that funds are looking for the exits could result in a mea culpa moment for everyone that plowed into Permian acreage in 2016, forcing a fire sale across the basin as nobody wants to be left holding the bag.
I don’t think this is a terribly likely scenario, but coming from a guy that worked in energy private equity from 2014-2017, I wouldn’t write it off, either. We’ll see what happens going forward, at the very least it’ll be interesting.