Occidental Petroleum (NYSE: OXY) and Devon Energy (NYSE: DVN) continue to defy calls for production cuts
Back when oil was at $100 per barrel in 2014, it made complete financial sense for U.S. oil companies to aggressively increase production. Due to advancements in drilling technology, along with high prices, the U.S. saw a dramatic increase in domestic oil output that took production levels to highs not seen in decades. But this soon resulted in a huge downturn in the price of oil, to its current level near $30 per barrel. The natural response should have been for major U.S. oil producers like Devon Energy (NYSE: DVN) and Occidental Petroleum (NYSE: OXY) to then cut production.
The economics are fairly straightforward; the global supply glut which has caused the price of oil to go into free-fall needs meaningful cuts in supply, to bring the supply imbalance back in line with demand.
But that largely has not happened. Instead, U.S. oil producers are continuing to increase production, defying rational economic thinking. This has served only to exacerbate the low-price environment that is bringing Big Oil to its knees. Cutting production now can serve two main purposes. It can restore a higher price, and it can also be beneficial for the environment.
Big Oil’s self-inflicted wounds
U.S. oil majors like Devon and Occidental have defied calls for production cuts. In the third quarter, Devon’s total U.S. production reached 160,000 barrels per day. That represented 15 percent growth from the same quarter in 2014. Devon’s company-wide total production set a record for the company last quarter. Similarly, Occidental grew its own total company production by 16 percent in the same quarter, year over year. Occidental has significantly ramped up production last quarter, particularly at its Permian Basin operation, where oil production soared 72 percent year over year.
The rationale is that keeping production intact provides cash flow during a time when Big Oil badly needs revenue. And, a separate benefit is not giving OPEC nations like Saudi Arabia what they want, which is for U.S. oil production to drop, so that OPEC can capture additional market share just in time for higher prices. But there is no denying the stressful position these companies are in, directly as a result of their decisions to raise production levels.
All of this seems simply to be a case of oil companies cutting off their nose to spite their face. The decision to grow production has had a disastrous effect on Devon’s and Occidental’s respective financial conditions. As the following chart indicates, after years of steady earnings and billions of dollars in annual profit, both companies have suffered huge, accelerating losses in the past year.
Devon suffered a $9.9 billion net loss over the first three quarters of 2015, as operating revenue declined 24 percent in that time. Clearly, the massive loss is due to escalating production at lower prices. In the fourth quarter, Occidental’s adjusted loss was $0.17 per share. This was a wider loss than the $0.14 per share expected by analysts. On a reported basis, Occidental lost $7.8 billion for the full year, including a $5 billion net loss in the fourth quarter alone. These losses have had a dramatic impact on their stock prices. Shares of Devon and Occidental are down 60 percent and 15 percent in the past one year, respectively, which is a clear indication that investors do not agree with the strategic priorities of each management team.
Making the situation even more difficult to comprehend is that future losses may even get worse from here, because oil has continued to decline since these companies last reported earnings. Occidental’s average global realized oil price last quarter was $38 per barrel. The price of oil has continued to decline since then, and now barely teeters above $30 per barrel, meaning the company’s losses could widen further in the current quarter.
Analysts are already forecasting even worse results for these companies. Analysts expect Devon Energy’s revenue to decline another 6 percent in 2016. Occidental is expected to post a loss of $0.29 per share for the current quarter, and a loss of $0.31 per share for 2016. As a result, it is clear that the decision to keep production growing quarter after quarter is not helping these companies. They are simply racking up losses at a time when capital restraint is the better move.
Because of their uneconomic production practices, analysts are not very bullish. The median price target for Occidental Petroleum calls for just 14 percent upside from current levels. The investor takeaway is that until the exploration and production companies take a firmer stance on their capital spending, investors should avoid the stocks due to the potential for further downside.
Companies to Watch
Anadarko Petroleum (NYSE: APC) Investors should avoid the E&P firms that continue to accelerate production. The reverse of that thesis is that upstream firms employing financial restraint may be the best sector picks.
Anadarko lost $6.6 billion in 2015, as a result of over-production in a low-price environment. But Anadarko deserves credit because it has broken away from its industry peers and announced huge spending cuts for 2016. It will reduce capital expenditures by nearly 50 percent this year, which should help the company improve its financial position and trim its losses.
As a result, analysts are bullish on the stock. The median analyst price target of $58 per share represents 50 percent upside from Anadarko’s current stock price.
Apache Corp. (NYSE: APA) Apache is another significant exploration and production company in the spotlight. Apache grew production 2 percent in 2015, and it is possible the company will increase production again in 2016 due to recent exploration successes in major fields including Egypt and the North Sea. Continuing to increase production will only worsen the hit to Apache’s bottom line, which is why the average analyst price target for the stock is just 22 percent above its current price. Still, Apache is being more prudent than aggressive operators like Occidental and Devon, making it a more defensive stock pick.
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.