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Morningstar, Inc.

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Event-Driven

<div class="content-highlight"><h2>Occidental delivers stellar initial production rates in the Permian, but much of the benefit is offset by above-average declines.</h2></div><hr><p><a href="https://www.smartkarma.com/entities/occidental-petroleum-corp" target="_blank" data-smartkarma-citation="entities:17075:1">Occidental Petroleum (OXY US)</a> is widely considered to be one of the best Permian Basin operators, and that's justified to some extent by the impressive initial production rates it consistently delivers. It typically extracts more oil than any other operator in the first few months of a well's life. However, the benefit is partly offset by steep up-front declines. After 18 months on line, the cumulative oil recovery from a typical Oxy well is still slightly better than the basin average, but the firm no longer ranks among the top performers. We previously gave the firm credit for its sizzling initial rates but didn't capture the downside of its above-average declines, so when Oxy announced the pending acquisition of <a href="https://www.smartkarma.com/entities/anadarko-petroleum-corp" target="_blank" data-smartkarma-citation="entities:5048:1">Anadarko Petroleum (APC US)</a> for $57 billion, we saw more potential to unlock value by applying its expertise in the Permian than we now think there is. Anadarko's initial rates there are weak, but the firm compensates with below-average decline rates. This, combined with the concurrent agreement to sell Anadarko's Africa assets to Total for $8 billion (a premium to our intrinsic value estimate), resulted in the May 10 increase in our Oxy fair value estimate to $64 per share. But after a more detailed look at Permian decline rates, this now looks optimistic. On May 28, we lowered our fair value estimate to $50 per share, in line with the market.</p><figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/089/726/original/1.JPG?1559795621" class="editor-image img-responsive" data-smartkarma-image-id="89726"></figure><hr><h2>Key Takeaways</h2><ul>
<li>
<strong>Our initial take on the Anadarko deal was positive due to the potential for unlocking value.</strong> When the dust settled from the bidding war between Occidental and Chevron, with the former now set to acquire Anadarko Petroleum for $57 billion, we initially increased our Oxy fair value estimate to $64 per share. We believed Anadarko's Permian assets would be worth more in the hands of Occidental, as the latter enjoys much stronger initial production rates in the Delaware Basin, where Anadarko's Permian acreage is concentrated. In addition, the agreement to sell Anadarko's Africa assets to Total not only cushioned the blow financially for Oxy but was directly accretive to our valuation, because the $8.8 billion sale price was much higher than our estimate of the intrinsic value of these assets.</li>
<li>
<strong>Oxy really is one of the better Permian operators, but not to the degree that we thought.</strong> A closer look at Oxy's Permian Basin well performance revealed above-average decline rates that partially offset the benefit of the eye-popping initial production rates that the firm consistently delivers. We now know that Oxy's Permian performance edge only lasts for about six months. The firm still enjoys enviable economics overall, as recovering more oil up front brings forward the resulting revenue and cash flows. However, by giving the firm credit for high initial production rates but not modeling above-average declines, we overestimated the potential for unlocking value from Anadarko's Permian acreage.</li>
<li>
<strong>Anadarko was a lone wolf in the Permian (but not necessarily an ugly duckling).</strong> The average production curves for most Permian operators are generally clustered, albeit with considerable variability in both initial and decline rates. Anadarko bucks the trend entirely. Its Permian wells start out way below the basin average, but there is no decline at all in the first six months, and when volumes do start dropping off, the decline rate is relatively shallow. As a result, after 18 months of production, the average cumulative oil output from Anadarko ranks above that of every other producer in our upstream coverage.</li>
<li>
<strong>Well productivity has been declining in the DJ Basin.</strong> Our updated decline curve for the DJ Basin is consistent with Anadarko's most recent results. In the last few years, the firm has been gravitating toward longer laterals, which yield higher volumes overall but are less productive on a per-foot basis. We believe Oxy will continue to develop this asset with long laterals, and as it has no prior expertise in this particular basin, we do not expect it can dramatically boost performance there.</li>
</ul>

Occidental delivers stellar initial production rates in the Permian, but much of the benefit is offset by above-average declines.Occidental Petroleum (OXY US) is widely considered to be one of the best Permian Basin operators, and that's justified to some extent by the impressive initial production rates it consistently delivers. It typically extracts more oil than any other operator in the first few months of a well's life. However, the benefit is partly offset by steep up-front declines. After 18 months on line, the cumulative oil recovery from a typical Oxy well is still slightly better than the basin average, but the firm no longer ranks among the top performers. We previously gave the firm credit for its sizzling initial rates but didn't capture the downside of its above-average declines, so when Oxy announced the pending acquisition of Anadarko Petroleum (APC US) for $57 billion, we saw more potential to unlock value by applying its expertise in the Permian than we now think there is. Anadarko's initial rates there are weak, but the firm compensates with below-average decline rates. This, combined with the concurrent agreement to sell Anadarko's Africa assets to Total for $8 billion (a premium to our intrinsic value estimate), resulted in the May 10 increase in our Oxy fair value estimate to $64 per share. But after a more detailed look at Permian decline rates, this now looks optimistic. On May 28, we lowered our fair value estimate to $50 per share, in line with the market.Key Takeaways

Our initial take on the Anadarko deal was positive due to the potential for unlocking value. When the dust settled from the bidding war between Occidental and Chevron, with the former now set to acquire Anadarko Petroleum for $57 billion, we initially increased our Oxy fair value estimate to $64 per share. We believed Anadarko's Permian assets would be worth more in the hands of Occidental, as the latter enjoys much stronger initial production rates in the Delaware Basin, where Anadarko's Permian acreage is concentrated. In addition, the agreement to sell Anadarko's Africa assets to Total not only cushioned the blow financially for Oxy but was directly accretive to our valuation, because the $8.8 billion sale price was much higher than our estimate of the intrinsic value of these assets.

Oxy really is one of the better Permian operators, but not to the degree that we thought. A closer look at Oxy's Permian Basin well performance revealed above-average decline rates that partially offset the benefit of the eye-popping initial production rates that the firm consistently delivers. We now know that Oxy's Permian performance edge only lasts for about six months. The firm still enjoys enviable economics overall, as recovering more oil up front brings forward the resulting revenue and cash flows. However, by giving the firm credit for high initial production rates but not modeling above-average declines, we overestimated the potential for unlocking value from Anadarko's Permian acreage.

Anadarko was a lone wolf in the Permian (but not necessarily an ugly duckling). The average production curves for most Permian operators are generally clustered, albeit with considerable variability in both initial and decline rates. Anadarko bucks the trend entirely. Its Permian wells start out way below the basin average, but there is no decline at all in the first six months, and when volumes do start dropping off, the decline rate is relatively shallow. As a result, after 18 months of production, the average cumulative oil output from Anadarko ranks above that of every other producer in our upstream coverage.

Well productivity has been declining in the DJ Basin. Our updated decline curve for the DJ Basin is consistent with Anadarko's most recent results. In the last few years, the firm has been gravitating toward longer laterals, which yield higher volumes overall but are less productive on a per-foot basis. We believe Oxy will continue to develop this asset with long laterals, and as it has no prior expertise in this particular basin, we do not expect it can dramatically boost performance there.


Reversing Our Enthusiasm for Oxy After Decline Rate Deep Dive