Summary
- Western Midstream has unlocked potential in the DJ Basin with little competition from the big midstream companies such as Enterprise, Energy Transfer, Magellan, and Plains All American.
- Occidental's 50% stake in WES creates a winning partnership now that new drilling is being permitted in the DJ Basin.
- Expansion in the DJ Basin has the potential to boost an already compelling return profile for WES.
The Thesis
Thanks to the 50% ownership of Western Midstream ( WES ) by Occidental Petroleum ( OXY ), the midstream company will benefit from the proposed expansion in the DJ Basin. The DJ Basin's largest producers are Chevron and Occidental, while the midstream space is generally vacant of the big players (Enterprise, Energy Transfer, Plains, etc.). OXY has been granted approval on over 120 wells since April 2022 with 74 of those since December 2022. The locations of these wells are located in the heart of WES acreage.
The DJ basin has a low-cost profile compared to the Permian and Midland basins. This combined with a mutual financial relationship makes this a logical win-win for both companies. Due to its small size, WES has the potential to see a large increase in revenue from the DJ Basin. I'll show how the DJ Basin provides a runway for 2024 to be a growth year that WES is specifically positioned to capture. This should equate to 8 to 10% FCF growth for investors when considering only OXY operated wells as the base case. Additional producers will boost this number even higher.
What We Know
WES stock already has a shareholder return program that is very compelling for the average investor. $2.00/share of distributions, $461 million spent in buybacks ($1.20/share), and a discretionary variable dividend make the current payout very appetizing. This works out to returns of 7% cash, 4% equity, and some icing on top if the discretionary dividend pays out. This alone can attract investors to this smaller company versus the very safe and diversified 7%-9% return that can be achieved from the big names like Enterprise, Energy Transfer, Magellan, and Plains All American.
Most readers are probably familiar with the Delaware and Midland basins in Texas or the Marcellus Shale in the Northeast United States. The DJ Basin is located in Weld County, just outside of Boulder, Colorado. This basin doesn't get talked about much since the bulk of the activity in the US is focused on the Midland and Delaware basins of Texas. The DJ has fallen into the background as of late due to it seeing declining volumes over the past year as a result of a lack of new wells coming online. The lack of activity has stemmed from regulation changes that have made it harder for the oil and gas industry to receive permits for drilling (Bill SB-181). SB-181 was originally passed in 2019 but was delayed until 2021 due to the COVID pandemic. Finally, after more than a year, permits have begun to work their way through the new process and have been granted final approval.
The Play
Occidental (who owns 50% of WES) is one of the major producers in the DJ Basin. OXY is projecting 200 wells to be brought online by the company in this region now that the permitting process has been navigated. 189 wells have been approved by the Colorado Oil and Gas Conservation Commission (COGCC) since December 1st, 2022, 74 of which are associated with subsidiaries of OXY. A total of 122 OXY wells have been approved since April 2022 according to the COGCC database.
OXY is highly incentivized to use WES pipelines to transport their products, thanks to having a significant stake in the company. This is exactly what the company has planned, as can be seen, if the locations of these wells are plotted on a map and compared to the existing infrastructure that WES has developed. I have plotted the new OXY well sites (which can be as large as 21 wells per site) that have been approved by the COGCC in the image below using Google Earth.
Created by Author with Google Earth
Now overlap that with the WES service territory. It is easy to see that OXY's plans will fit nicely into the WES network. This is backed by the following statement by WES's management during the Q3 conference call .
Turning towards the DJ Basin, we continue to be encouraged by the success producers are seeing with both the approvals of oil and gas development plans or OGDPs as well as large comprehensive area programs by the COGCC. 50% of the total well count, receiving permit approvals in OGDPs this quarter, are located on acreage we service, of which we predominantly expect to benefit from in 2024 and beyond. We will continue to keep a close eye on the permitting environment and producer forecast as we head into 2023. - Western Midstream Partners Q3 Conference Call
DJ's Competitive Advantage
OXY's expansion in the region is not by mistake. The DJ has some of the lowest production cost wells in the country. These costs are roughly 1/2 and 1/3 of the Midland and Delaware Basins respectively, as shown by OXY's Q3 earnings call presentation . Now that the major hurdles look to be in the rearview mirror, the molecules should start to flow. Producers will also be looking to exploit the low upfront costs to develop a well thanks to pressures on prices in the last three to four months.
The DJ may not be the massive reservoir that the Texas basins are, but WES can be the big fish in a smaller pond without competition from the big guys like EPD, ET, MMP, or PAA. There is very little competing infrastructure in the Colorado area associated with these big-time players, so I believe WES has room to expand and increase profits.
Occidental Petroleum Q3 Earnings Presentation
OXY is expanding its footprint by forecasting for over 200 wells to come online in the next several years, on the best acreage in the DJ Basin. These wells are economically viable in a range of price points, and the best acreage is also in WES's service territory. A vast majority of the basin is breakeven at WTI less than $30 as confirmed by the 2021 study conducted by BTU analytics. This will drive the molecules from the DJ even on depressed energy prices. When you figure in that OXY owns 50% of the transportation costs, those wells will be even more economically advantaged.
Shareholder Cash Flows
Referencing an old slide from Anadarko (purchased by OXY in 2019), the average production of a well in the DJ can be estimated to be about 500 BOE/day over its lifetime. More information about well economies in the DJ Basin can be found in this article . If we assume that only 150 wells (75% of what is projected by OXY alone) are brought online, total volumes (and revenues) will pick up by 25% in the DJ (additional 75 MBbls/d). Looking at the Q3 financial statements , revenue is getting converted into FCF at a rate of about 39%. I will adjust this conversion down to 35% due to increases in CAPEX that will be needed to accommodate the higher volumes.
Anadarko Earnings Presentation
Using Q3 revenues, these new wells coming online will generate approximately $103 million of additional FCF per annum to spend on base dividends, buybacks or the annual variable dividend. This equates to an additional $0.268 (increase of 8.4%) to distribute to shareholders without impacting the balance sheet. The increase in cash flow is supported by the fact that 80% to 85% of WES's revenue is fee-based to limit exposure to commodity prices, and therefore can meaningfully contribute to the expansion of the base dividend.
Risks
This projection may not play out if there is a meaningful disruption to the oil and gas markets. A cutback by producers in the DJ basin would result in the potential growth discussed in this article, not materializing. Additionally, since the DJ has been underdeveloped for the last several years, existing wells are on declining production profiles. This will lead to lower volumes out of the DJ Basin and negatively affect revenues and cash flows.
Additionally, WES's revenue is partially exposed to commodity pricing in the amount of 15%-20%. If the recent drop in Natural Gas and NGL pricing continues, this will negatively impact FCF as well as discourage further development in both the DJ and Delaware Basins. It is expected that some of this near-term pressure will be alleviated (at least in part) if operations are allowed to resume at the Freeport LNG terminal .
Summary
Western Midstream has the opportunity to capture on new drilling activities in the DJ Basin that will be emerging at the end of 2023 and the beginning of 2024. The prime acreage that is owned by WES combined with Occidental Petroleum's 50% stake in the partnership will allow a strategic advantage to bring highly competitive wells online. The increased activity is already positioned in the heart of WES's service territory and should be a capital-efficient expansion project. In the medium term, this will drive WES to funnel some of its capital spending toward the DJ basin to capitalize on this growth opportunity.
Even neglecting the impact of any other producers, WES will be set up to capture a sizable increase in FCF in this basin with minimal competition from the other large-cap midstream companies like Enterprise, Energy Transfer, Magellan, or Plains All American. Buying on dips allows access to a healthy, cash flowing company with a unique growth opportunity in the next 12 to 18 months. At today's prices, the return to investors is roughly 11%. I have outlined how this could increase due to expansion efforts in the DJ Basin. Further upside is provided by additional producers in the area connecting to the WES system. Buying below $28/share is an attractive entry point for a long position in the partnership.
For further details see:
Western Midstream: Untapped Potential