Approach Resources: Keep An Eye Out For This

| About: Approach Resources (AREX)

Summary

As earnings near, I decided to look back at Approach Resources and outline a few things that I believe investors should keep a close eye out for this quarter.

In addition to seeing some cost categories improve, investors should hope to see debt reduced, especially if that debt relates to the firm's credit facility.

Additional well completions should also be watched for thanks to the fact that natural gas prices have soared lately.

After the market closes on August 3rd, the management team at Approach Resources (NASDAQ:AREX) is due to report revenue and earnings results for the second quarter of the company's 2016 fiscal year. In preparation for this earnings release, I decided to look at three key factors that I believe investors should keep a close watch for. While reporting data that is the opposite of these three predictions would be pretty bad for the business, reporting data in line with what I'm thinking would certainly prove bullish for the business moving forward.

Costs need to fall

One of the great things about Approach, and the first aspect of the business that I was driven to, is the fact that it's a pretty low cost producer in the Permian. According to management's expectations, the firm should see its lease operating expenses come in this year around $5.50 per boe (barrel of oil equivalent) and we're looking at total cash costs for the year, based on my own estimates, of about $9.33 per boe.

Probably the single largest contributor to this, however, is the fact that only 1.35 million boe of their output should be attributable to oil, accounting for just 30.8% of total production, while natural gas and natural gas liquids make up the rest. This actually runs contrary to many other companies in the energy space that I've seen, which tend to get most of their output (by volume) from oil. Given oil's higher price point and higher cost of extraction, this is a major contributor to Approach's seemingly small costs.

Having said all of this, there is one key area that I believe management should be trying to prove itself on. I cannot expect much room for improvement on lease operating costs without a drop in oil production, but cash-based general and administrative costs currently stand at $3.75 per boe. This comes out to about $16.43 million per year at current levels. But with a market capitalization of $68.96 million as of the time of this writing, and with revenue expected to be $105.67 million this year if oil prices average $41.60 per barrel this year while natural gas prices average $2.843 per Mcf, it seems as though there's some fat that should be focused on.

Obviously, if management can get other cost items down in addition to this or instead of this, that's a net positive as well; but it should be mentioned that, even at current levels and no hedging, Approach should generate free cash flow (assuming $20 million per year in capital expenditures) of $7.66 million.

Expect debt to fall... modestly

One fear that investors have regarding Approach relates to the firm's debt levels. While its picture is nowhere near as bad as now-defunct oil and natural gas companies like Linn Energy (NASDAQ:LINEQ) / LinnCo (OTCPK:LNCOQ) and Breitburn Energy Partners (OTCPK:BBEPQ), it's still higher than I'd like (given modest cash flow at current energy prices) at $495.96 million. As of the time of this writing, $272 million of this is in the form of a credit facility, while the remaining amount is in the form of Senior Notes that come due in 2021.

At $0.66 on the dollar, it would be nice to see management buy back some Senior Notes if it can (or it can use an already-approved $150 million in Second Lien Notes that could be issued in the form of a swap), but I find this to be unlikely. Rather, I suspect management will (and it should) pay down some on its credit facility, which currently affords $53 million in excess capacity; but with unpredictability in the energy market, combined with a Fall redetermination coming up in a few months, paying this down as much as possible should be expected.

Oil completions may be bumped forward

In its first quarter release, Approach announced that it had been drilling new wells. During the quarter, the firm drilled four horizontal wells but did not complete any of these. Nor did it complete the five other wells it had previously been drilling leading up to that point, but it did announce plans to complete two wells during the second quarter. While oil prices are actually slightly lower than they were at the time this news broke (May 4th of this year), natural gas prices are up an impressive 39.6%. I would imagine that such a move higher would either entice management to increase its completions during the quarter and/or it would encourage management to complete more of its wells moving forward, hopefully (though unlikely) with meaningful hedges being put in place to ensure their profitability.

Takeaway

Based on the data regarding Approach, I must say that it appears as though investors have a few things that they should be looking forward to. While I cannot guarantee that the firm is going to fare well during the quarter or that it will achieve any of these three items, I do believe that progress on them is both likely and bullish if completed.

Disclosure: I am/we are long AREX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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