Pioneer Natural Resources: A Survivor Amid The Oil Onslaught

West Texas Intermediate crude oil is now down to $61 a barrel, and the bloodbath continues for oil company investors. According to data from U.S. Capital Advisors, as of early this week shares in the average large-cap U.S. independent oil and gas company is down 36% from its 52-week high. For mid-caps the average drop is 53%. Small-caps' losses average 70%.

Shares could definitely fall further; don't expect any buying from insitutional portfolio managers until January. But it's time for the rest of us to start building an oil stock wish list. The two key elements: good rocks and low debt. You want to own companies with established positions in the "core of the core" of America's oil plays -- the juiciest acreage that should still be profitable to drill even at prices that force weaker competitors into bankruptcy (we're almost there).

One of the best positioned is Pioneer Natural Resources . Analyst Ed Westlake of Credit Suisse wrote in a report last week that Pioneer has a premier position in the core of the Midland Basin, within the much larger Permian Basin. Pioneer boasts a strong balance sheet with about $2 billion in debt against roughly $20 billion in equity, excellent oil price hedges and a likelihood of not just surviving the downturn, but actually growing its output 21% next year.

Even after falling 40% from its summer highs to $133 per share, Pioneer trades a slight premium to the other solid shale operators like EOG Resources , Anadarko and Apache . Analyst Eli Kantor at Cannacord Genuity thinks that at an average oil price of $75 per barrel Pioneer will generate earnings of $5.13 per share in 2015 (and $6.20 in 2016). That 2015 number is about 50 cents below consensus, but would imply a forward P/E multiple of 26.

Over the summer, back when oil was at $100 a barrel, I interviewed Scott Sheffield, the chief executive of Pioneer Natural Resources (and wrote this magazine story focused on his son Bryan's Parsley Energy). At the time, Sheffield was extraordinarily bullish on the Permian Basin of west Texas, where wildcatters started drilling for oil some 90 years ago and have been going at it ever since.

Thanks to advances in horizontal drilling and hydraulic fracturing, the Permian has seen not just a resurgence, but an explosion of new drilling in recent years.

"I see the field now becoming the largest in North America and one of the largest in the world," said Sheffield then. He predicted that in time the basin will produce upwards of 100 billion barrels.

Pioneer is the biggest operator in the Permian basin, and expects to maintain that strength. Sheffield told me that Pioneer has identified more than 20,000 drilling spots on its 800,000 acres in the Permian and planned to grow production there from 132,000 bpd now to 1 million bpd by 2024. (It was doing just 45,000 bpd there in 2011.)

That's astonishing growth potential. And Pioneer is just one company. Chevron , Occidental Petroleum and Exxon Mobil have just as much acreage to drill as Pioneer, if not more. If Pioneer can boost its Permian production by 1 million bpd, then another 2 million bpd from the other guys wouldn't be out of the question.

This is the kind of vision for the future that grabs the attention of Saudi Arabia and the rest of OPEC. Despite falling prices, America's oil production is on track to keep growing enough to hit a record 10 million bpd in 2015. And the rebirth of the Permian is just getting started.

And yet, Sheffield gave me his 1 million bpd by 2027 prediction during the summer, before oil prices plunged. Over the past three months shares in Pioneer have fallen 30% (though many other Permian pure players have fared even worse).

So has Sheffield changed his tune? To some extent, yes. According to the company's recent investor presentations, if lower oil prices endure, Pioneer will likely grow its Permian output "only" five-fold in a decade (to about 500,000 bpd) instead of 10-fold.

That's still some pretty sweet growth. And although many drillers have already announced deep cuts in capital spending for 2015, Pioneer expects to maintain its capex levels thanks to hedges it has in place on 85% of its volumes that ensure it will get $15 more per barrel than NYMEX pricing.

What's more, Pioneer's costs will be lower than most. Because Pioneer has been sitting on its Permian acreage for decades its land costs are practically nil. The economics will be much tougher for carpetbaggers like Encana , which in September agreed to pay $7 billion to acquire Permian-focused Athlon Resources, at an implied value of $37,000 per acre. For most operators, the sweet spots of this play will make good money at less than $60 per barrel, figures John White, analyst at Roth Capital Partners.

In November Sheffield told the Odessa American newspaper:

“What’s changed versus other downturns in this city is that this field is probably one of the best fields in the world,” Sheffield said. “It will work at $60. It will work at $80. You just can’t drill as many wells at $60. Where before you might have the rigs drop down to a very very low level, now they are just going to drop 10 to 15 percent. Now it’s still very economical for producers to be able to drill. So it’s very different from past boom-bust cycles.”

That makes sense. After all, there was oodles of oil produced out of the Permian in the decades before prices hit $100 and horizontal drilling was invented. Indeed over the decades Sheffield and his crews (first at Parker & Parsley, then at Pioneer) have drilled thousands of simple vertical wells down 8,000 feet into the Sprayberry zone. This part of Texas lives and breathes oil -- if you ever see anti-fracking protesters here, you can bet they've been bused in.

***

Descending into the Midland-Odessa International Airport it's clear what this town is all about. Surrounding Midland, for dozens of miles on every side, are thousands of oil wells, each of them topped with the iconic bobbing pump jack and connected to each other by a spindly lattice work of access roads. This portion of west Texas and southeastern New Mexico is dry and dusty and flat. But 200 million years ago, in the Permian era, it was a sea, teaming with life. In time, the seas retreated southward. Today fossilized coral reefs are covered by 8,000 feet of rock, while organic-rich sediments have been cooked into 1 trillion barrels of oil.

The Permian Basin is about 250 miles wide by 300 miles long. Since oil was first discovered there in the early 1920s there has been more than 80,000 wells drilled and more than 30 billion barrels recovered. Midland's heyday was in the early 1980s, when oil prices shot to record highs and everyone in west Texas became a millionaire -- until boom turned to bust.

For the past three decades the Permian has churned out a total about 800,000 barrels of oil per day. But the region had become an afterthought for Pioneer while its geologists pursued seemingly higher impact plays in the Gulf of Mexico, Argentina and Africa. "Most geologists just thought shales were boring," says Sheffield. Pioneer's Permian production in 2011 was just 50,000 bpd.

But the horizontal drilling and fracking revolution changed everything. First came the Barnett shale, followed by the Marcellus, Bakken, Fayetteville, Haynesville, Eagle Ford, Niobrara, Utica and more. As drillers perfected new methods of drilling and fracking rock once thought to be impenetrable, Sheffield realized about five years ago that Pioneer might just be sitting on a goldmine.

The company still operated thousands of old wells on 800,000 acres in the region, with the average pumping less than 10 barrels a day. Because Pioneer held all that acreage "by production" it didn't have to invest any new capital to lease it up. So testing out new techniques on the old fields would be a pretty low-cost proposition.

Their first wells, Sheffield told me, were discouraging. They drilled in the wrong spot and didn't use big enough fracks. Undeterred, Sheffield in 2010 instructed Pioneer's geoscientists to focus on figuring out the Permian. They created maps of every zone in the Midland Basin, deeper than they had ever looked before. "We had more than 7,000 well bores that we had drilled vertically over the years, so we had the most core data, the most well log data of anybody out there," says Sheffield. After two years of study Pioneer's scientists held a full day presentation on their findings. "That's when everybody's lights just went on."

With horizontal drilling they could tap a geological layer cake of distinct geologic strata with names like the Wolfcamp, Cline, Strawn, Atoka and Mississippi. All told there's about 12 different layers of oil-bearing rock between 8,500 feet deep and 13,000 feet deep. These were the so-called source rocks, in which the oil formed millions of years ago then ever so slowly seeped up to fill the shallower reservoirs that wildcatters first tapped nearly a century ago. That they could now tap the source rocks was an incredible realization, says Sheffield.

And while the Bakken and Eagle Ford had been getting all the headlines, Sheffield was convinced that the Permian could be bigger than either one. This, he says, "is like 12 Bakkens stacked on top of one another."

Pioneer has progressed to far more elaborate developments such as something called pad drilling, where from a single drilling pad a rig will bore maybe 8 individual wells targeting different horizons. It's expensive, with each horizontal well costing $7 million versus just $2 million for a vertical well. But over the long run this will be the best way to squeeze out as much oil as possible. Initial production from horizontal wells is anywhere from 800 to 1,250 per day.

In four years Permian basin oil output has gone asymptotal, surging to more than 1.8 million bpd. Midland's population has swelled from 100,000 a few years ago to roughly 160,000. Pioneer's Permian output more than doubled in two years. Prospects looked good enough that Sheffield even decided to tempt fate and build a beautiful new Midland headquarters.

At a cost of $76 million, the building was completed last month, and will have room to support what Sheffield expects will be a doubling of its 1,700 Midland workforce over the next decade.

Are there other limitations to Pioneer's growth? Not many. Sheffield long ago learned an aversion to debt, thus the company carries just $2 billion in long-term debt against a $20 billion equity market cap. It recently raised $1 billion selling new shares, and $500 million selling non-core oil and gas fields. Pioneer will raise an another $1 billion (roughly) selling its pipeline division in the Eagle Ford field.

To help prepare for that massive growth Sheffield has spent the past two years vertically integrating Pioneer. The company owns its own sand mine to provide about 2 million tons a year of sand for fracking. It is investing about $800 million to build a 100-mile water pipeline and storage network to use more than 300,000 bpd of reclaimed waste water from the nearby town of Midland and Odessa for its fracking operations. Over time, the water project will save an estimated $500,000 per well.

Sheffield has also been among the industry leaders pushing for the Obama administration to relax bans on domestic crude oil exports, and Pioneer has already begun exporting lightweight petroleum called condensate. Sheffield says he would even consider investing Pioneer capital to build simple refineries, called micro-skimmers, to process crude oil just enough to satisfy export rules.

The depression in oil prices will certainly slow Pioneer down. But just as OPEC and the Saudis are looking to consolidate their global market share, Pioneer is in position to take share in the Permian. As small, overleveraged, unhedged operators pack up and move out it will give Pioneer more elbow room to orchestrate a long-term plan while squeezing suppliers for better prices. Pioneer got its start in the Permian, and has every reason to stay in the Permian. As Sheffield says: "It's a playing ground for the next 100 years."