Permian E&P:Let’s Get Technical About the GORControversy

Putting Some Technical Context Around the GOR Controversy

    PXD's result last week, notably the higher gas content of the productionstream, kicked off an investor debate around the long-term implications/risksto Permian production and resource value. The resulting 21%/9% decline inPXD/Permian group share price took on an increasingly "technical" nature, withthe implications largely misunderstood and fears wildly overblown. Within, weattempt to put some technical (engineer's) context around key investorquestions in what is really a fairly normal situation. We view the group, andparticularly PXD, as significantly oversold and see increasingly attractive riskreward. BUY.

    Addressing technical misunderstandings and concerns in the PermianAt the heart of the conversation is the two part question of: is the productiongetting gassier? And is that a problem? The spectre of more “gassy”production in the Permian has given rise to growing investor concerns, manyof them of an increasingly “technical” nature (ie. GOR and pressure depletion,bubble point, etc). Much of the confusion, in our view, is due to amisunderstanding of some of the fundamental drivers of reservoirperformance. After conversations with industry personnel, including reservoirengineers and reserves auditors, as well as published technical research, wehave attempted to provide some context around some key questions,including: Are increasing GORs normal? (Yes); What is bubble point and istransitioning through the bubble point a risk? (No; All wells do it and it is anecessary and important part of the drive mechanism); is rising gas a risk to oilproduction (No); How could a company underestimate gas production and canHz wells/modern completions really increase pace of drawdown? (Yes).

    Permian pullback? We are buyers; PXD especially oversold

    While the fundamental value of the assets remains unchanged, in our view, ifanything, the choppy and slightly underwhelming 2Q results of the group todate should be a reminder that there is execution risk in the development ofunconventional resource…particularly on a quarterly basis. Despite the noise,our 2017/18DACF/share expectations for the group have declined by only2%/1%, with PXD seeing a 7%/11% hit, driven by the deferral of 30wellcompletions (11% of prior 2017forecast). Not only do we not view theadditional gas as a problem, we estimate that the NAV impact of the extra gasis a positive ~7%. Even without the gas-driven NAV uplift, we see anincreasingly positive risk reward for the group, with PXD showing 8%/62%upside to NAV at $50/$60/bbl long-term, and much of the Permian-exposedgroup showing attractive upside, and view this as an attractive buyingopportunity.

    Valuation and Risk

    We value the E&Ps primarily on NAV at long-term $60/bbl, $3/mcf. Primaryrisks to our outlook include lower than expected oil price on weaker globaldemand or positive surprise to global oil production.