Clayton Williams Energy: Superior Land Position In The Permian Basin, Significant Upside

| About: Clayton Williams (CWEI)

Summary

CWEI has a substantial land position in the Permian Basin.

CWEI trades at a significant discount to its peers on an enterprise value to leased acre basis.

CWEI should be valued at $500 per share, implying an increase of 285% vs. the current stock price of $129.92 (as of July 10, 2014).

By Andre Kovensky and Alyjan Daya

Investment Summary: The Permian Basin is potentially the largest oil and gas basin in the United States. Clayton Williams Energy (NASDAQ:CWEI) has a substantial land position in the Permian Basin (Wolfbone in the Delaware Basin and Wolfberry in the Midland Basin) but trades at a significant discount to its peers on an enterprise value ("EV") to leased acre basis. We believe that CWEI should be valued at $500 per share, implying an increase of 285% versus the current stock price of $129.92.

Valuation Analysis: In the analysis, we compare CWEI to pure play Permian Basin E&P companies with comparable market capitalizations: Diamondback Energy (NASDAQ:FANG), Athlon Energy (NYSE:ATHL), RSP Permian (NYSE:RSPP) and Parsley Energy (NYSE:PE) (collectively, "the Comparables"). We will analyze CWEI and the Comparables based on acreage leased, proved reserves, composition of the proved reserves, production, composition of the production, profitability of the production and finally the valuation investors are paying for these metrics. What becomes very clear, very quickly is that CWEI is valued at a huge discount to these Permian pure-plays despite the fact that CWEI's metrics are equal to or better than the Comparables.

Throughout the analysis, when appropriate we use pro forma numbers for CWEI and the Comparables to take into account historical purchases and/or sales of cash flow producing assets. By doing so, historical growth rates are more comparable and assets/income statement data represent the true current financial condition. For those interested in understanding the adjustments, footnotes are provided at the end of the article describing in detail the changes made to generate the pro forma numbers.

1. Leased Acreage

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We start with leased acreage because ultimately leased acreage is an E&P company's primary asset; the quality of the land positions heavily influences the amount of oil and gas that can be produced and the cost of extraction. CWEI has a total of 685,907 net leased acres, which is orders of magnitudes more than the Comparables. That said, CWEI is currently planning to develop 355,000 of these acres, so for our analysis we only give credit to the 355,000 acres. Of the 355,000 acres, 170,000 are in the Permian Basin, which is substantially more acreage than the Comparables' Permian net leased acres. If you apply the average EV to leased acre of the Comparables to CWEI's Permian leased acres, CWEI's stock price would be $481.94, a 271.0% increase over the current stock price.

And this does not take into account CWEI's East Eagle Ford leased acres. Applying the Comparables' Permian net leased acre valuation to CWEI's total net leased acres would result in a CWEI stock price of $1,056.53, a 713.2% increase over the current stock price. We will discuss this later in the article, but Eagle Ford focused comparables actually trade at $52,653 of EV per net leased acre, so applying the Comparables $37,785 EV per net leased acre is a conservative estimate.

But, how good are CWEI's acres? Let's look at a few metrics. First, we will evaluate the profitability of production. Based on the below table, CWEI generates EBITDA per BOE of Production in line with the Comparables, thus CWEI's acreage is of comparable profitability. Also, CWEI's most recent IP-30 Peak Production Rates are in line with the Comparables. So, CWEI's leased acres are producing similarly to the Comparables.

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One key difference between CWEI and the Comparables is that CWEI's leases are focused more on the Wolfbone plays in the Delaware Basin in the western Permian versus the Comparables, which are more focused on the Wolfberry plays in the Midland Basin in the central Permian. CWEI has 80,000 net acres in the Wolfbone (Reeves (65,000 acres), Winkler, Loving and Ward counties), 35,000 in the Wolfberry (Glasscock and Sterling counties) and the remaining balance of 55,000 acres in various locations in the Permian. Based on analysis by Drilling Info in an article dated July 2, 2013, the Wolfbone is as attractive or more than the Wolfberry. Here are a few charts from the article which make the point regarding EURs (Estimated Ultimate Recoveries of oil and gas) and IP-30 rates of production.

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Also, don't forget that CWEI's recent IP-30 production results are comparable to the Comparables' recent IP-30 production results.

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Another way to value acreage is via recent private sale transactions. The above table lists prices recently paid by the Comparables for acreage. These prices on average are the same as the valuation being applied by the public markets to the Comparables. Applying private sale valuations to CWEI's Permian acreage results in a CWEI stock price of $504.18, a 288.1% increase over CWEI's current stock price.

2. Proved Reserves

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We believe proved reserves can be used as a floor valuation methodology. Here again, CWEI is trading at a material discount to the Comparables. CWEI's proved reserves are 70% oil, much better than all but FANG. Applying the Comparable's average EV to Proved Reserves to CWEI results in a stock price for CWEI of $191.63, a 47.5% increase over the current stock price.

3. Production

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We believe investors should be careful in using production growth as a key valuation metric. On the one hand, it does validate the value of leased acreage and the skill of the operator to extract oil and gas. But, at the same time, it can simply measure the amount of capital a company is willing to spend on drilling new wells. Thus, the productivity of the drilling and completion capital expenditures ("D&C") is important. On this front, CWEI's 2014 D&C budget of $368.7 million is forecast to result in added BOE/day production at a cost of $118,000 per BOE/Day. This is pretty much in line with ATHL and RSPP but much higher than FANG (PE has not provided a 2014 forecast). The implication is that CWEI's 2014 production growth may be lower than FANG, ATHL and RSPP, but its more a function of the D&C budget being lower. CWEI's incremental BOE production per $ of D&C spending is in line with the Comparables.

That said, production is a measure that investors evaluate. CWEI's current production is 73% oil, higher than all the Comparables except FANG at 79%. Regarding 2014 production growth, CWEI is a little below ATHL and RSPP and far below FANG. PE has not provided a 2014 production forecast yet. But, applying the Comparables' EV to Q1 2014 BOE/Day to CWEI implies a stock price of $265.15, a 104.1% increase over the current CWEI stock price. Similarly, applying the Comparables' EV to 2014E BOE/day to CWEI implies a stock price of $249.86, a 92.3% increase over the current CWEI stock price.

4. Public Trading Multiples

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Financial performance is largely a function of production volumes. That said, investors evaluate trading multiples in comparing companies. CWEI trades at about half the Comparable's EV to LQA EBITDA multiple and two-thirds the Comparable's P/E multiple on 2014 estimated EPS. Thus, CWEI trades at a material multiple discount to the Comparables.

5. Sum of the Parts Valuation

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Given CWEI's large land position relative to its operational and balance sheet sizes, it seems to make sense for a larger company, such as EOG Resources (NYSE:EOG), Pioneer Natural Resources (NYSE:PXD), Apache (NYSE:APA), ConocoPhillips (NYSE:COP), Chevron (NYSE:CVX), BHP Billiton (NYSE:BHP) or Occidental Petroleum (NYSE:OXY) to acquire CWEI. This larger company will have the resources to develop CWEI's massive land position. But, CWEI's 82-year-old founder, Clayton Williams, controls 51% of CWEI shares. Thus, he ultimately will decide CWEI's fate. But, if CWEI was willing to sell, we believe CWEI would be worth $931.72 per share, an increase of 617.2%. We came to this conclusion by assigning values to all of CWEI's 685,907 net leased acres.

We assigned the Permian leases values based on the private sale prices per acre already discussed. For the Eagle Ford leases, we applied a 50% discount to the Eagle Ford focused companies' EV to Eagle Ford leased acres valuations (see table above). Also, recognize that Halcon Resources (NYSE:HK) is very focused on the El Halcon play in the East Eagle Ford, which is exactly where CWEI's East Eagle Ford leases are located. HK is valued at an EV of $65,112 per Eagle Ford leased acre. For the remaining 330,907 acres, we applied a value of $1,000 per acre, which is a typical price for undeveloped acreage. Based on this analysis, the $931.72 is not unreasonable for a buyer to pay.

6. Balance Sheet and Trading Liquidity

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Two final metrics to evaluate are leverage and trading liquidity. Regarding leverage, CWEI is a bit lower than the Comparables. While ATHL and PE have high leverage and probably can't issue much more debt in the near term, they have large cash positions to fund their production programs. Thus, there does not seem to be any differentiation among the companies as it relates to leverage.

Regarding trading liquidity, this is one of CWEI's biggest challenges and a reason we believe CWEI trades at such a large valuation discount to the Comparables. CWEI only trades about $9 million of its shares per day, which is simply too small for many institutional investors and especially hedge funds which have restrictions on trading in stocks with too low a daily trading volume. Similarly, CWEI's $1.5 billion market capitalization and $750 million of free float are also too small for many institutional investors. At the same time, with a $129 stock price, retail investors have a more difficult time buying the shares. As a result, CWEI suffers from a lack of knowledge by both the institutional and retail investor classes.

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Source: Created by author from 13F and CWEI public filings.

This lack of knowledge is demonstrated in the above chart. Retail ownership is only 2.9% of shares outstanding. And, of the institutional ownership, 86.9% of institutional holdings are from traditional investment managers; hedge funds only make up 6.1%. Three of the four largest institutional holders of CWEI are T. Rowe Price, Blackrock and Vanguard, which implies CWEI is held by index funds (CWEI is included in the Russell 2000 and 3000 indices). As investors realize the merits of CWEI's investment thesis, we believe trading volumes will increase.

Conclusion: CWEI has 170,000 leased acres in the Permian that are of similar quality to those of the Comparables. Applying the Comparables' public trading valuation multiples on leased acres or prices paid by the Comparables for leased acreage to CWEI's Permian leased acres results in a stock price for CWEI of about $500, a 285% increase over the current stock price. This valuation ignores the value of CWEI's 185,000 net acres in the East Eagle Ford. CWEI's Permian wells are generating IP-30 rates in line with the Comparables. CWEI's proved reserves are larger than all of the Comparables other than ATHL, and CWEI's proved reserves are more oily than all of the Comparables other than FANG. CWEI has the lowest production growth forecast for 2014 but this is more a function of the spending program amounts than lack of drilling opportunities or D&C efficiency.

Taking everything into account, we believe CWEI's fair value is $500 per share. Finally, here is a table summarizing all the valuation metrics in this article.

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Footnotes:

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Disclosure: The author is long CWEI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Opinions expressed herein by the authors are not an investment recommendation and are not meant to be relied upon in investment decisions. The authors are not acting in an investment advisor capacity. This is not an investment research report. The authors' opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The authors recommend that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the authors cannot guarantee its accuracy. Any opinions or estimates constitute the authors' best judgment as of the date of publication, and are subject to change without notice.