Callon Petroleum company (CPE) is an independent oil and gas exploration & production [E&P] company operating both offshore and onshore in the United States. The company generates the majority of its free cash flow from its offshore fields in the U.S. Gulf of Mexico, both on the shelf and in the deepwater regions. Callon has a non-operated interest in two deepwater fields - Medusa and Habanero, which produce the majority of the company's cash flow that Callon is reinvesting onshore into the Permian Basin for growing oil production and reserves.
A short history lesson is helpful in understanding Callon's position today. In 2009, management and the Board decided to reinvest the free cash flow generated from its offshore producing fields into onshore assets. The move onshore was intended to reduce reinvestment risk, increase visible growth potential and increase exposure to crude oil. To execute its diversification strategy, Callon entered two onshore areas, the Permian Basin of West Texas and the Haynesville natural gas shale in Louisiana. Over the past two years the company has placed increased emphasis on its oil-prone Permian assets and deemphasized its natural gas exposure in the Haynesville (Callon's Haynesville acreage is held by production and the company previously indicated that it has no plans to drill the remaining five locations until natural gas commodity prices improve).
Growing Oil Exposure in the Permian Basin
The company operates all of its Permian acreage and has positions in both the Delaware Basin portion on the western side of the Permian and in the Midland Basin east of the Central Basin Platform. Callon first entered the Permian Basin in 2009, with the acquisition of approximately 8,202 net acres in the Delaware Basin, which included proved reserves of 1.5 MMBOE, four recompletion targets, 11 proved undeveloped drilling locations and 61 unproved drilling locations and then production of 475 BOEPD. The primary focus of this initial entry into the Permian was, and continues to be, the Wolfberry oil formation. Below is a stratigraphic depiction of the Wolfberry formation.
Since its initial entry into the Permian, Callon lifted itself up by its own bootstraps with a drilling program that helped drive onshore oil production to an exit rate of 1,335 BOEPD as of year-end 2011 from only 470 BOEPD when the company first entered the region in 2009.
Callon strengthened its growth platform in the Permian with its most recent acquisition of 9,539 net acres announced on February 15, 2012, bringing CPE's total exposure to this multi-pay, multi-play oil-prone region to just over 24,000 net acres. The primary targets in the new acreage, located mainly in the Midland Basin, include the emerging oil-prone Wolfcamp B and Cline formations. Callon plans to develop these potential pay zones with horizontal drilling and multi-stage fracture completion methods, following in the footsteps of leading operators like Laredo Petroleum, El Paso Approach and Pioneer Natural Resources.
Callon plans to strengthen its Permian drilling program by going to full-time two rigs, up from one. The new rig, provided by Helmerich & Payne under a two-year agreement commencing most likely in the second quarter of 2012, is a new-generation rig, capable of efficiently drilling horizontal wells. The rig will most likely be put to work first in the company's East Bloxom Field in Upton County, where CPE has identified 24 horizontal drilling locations prospective for the Wolfcamp B.
In the north part of the Midland Basin, CPE acquired approximately 14,500 net acres in Borden County, which the company believes is prospective for the Cline Shale.
For the Cline, Callon is modeling well economics based on results from other operators and estimating EUR of 420 MBOE per well, 60% crude oil, 30-day IP of 578 BOEPD (75% oil). These estimates assume 160-acre spacing, a 4,000-foot lateral leg and a 15-stage fracture completion. When we input the variables, we estimate a Cline well is capable of generating an IRR of 26% at commodity prices of $90.00 per Bbl and $2.00 per Mcf. Assuming gas reinjection and no revenue generated from produced natural gas, the breakeven point for a Cline well based on our well economics is $62.01 per Bbl.
For more information about the Cline Shale which includes a rate of return commodity price sensitivity analysis on horizontal Cline wells, please see Laredo Petroleum's investor presentation.
Callon produced 1.8 MMBOE in 2011, an increase of 10% over 2010 and 54% of the company's production stream consisted of oil and natural gas liquids. Driving the production increase was the company's Permian drilling program. CPE drilled 36 gross (33 net) vertical Wolfberry wells in 2011, which increased net production to 965 BOEPD in 2011, up from 411 BOEPD in 2010. The company exited the year producing 1,335 BOEPD from the Permian. Total onshore production in 2011 was 454 MBOE, up 96% higher from the previous year, and in 2011 approximately 58% of total onshore production volumes consisted of oil, as compared to 51% in 2010. Clearly, the company's focus on the Permian has helped Callon become more oily.
Callon is transitioning its onshore drilling program to focus on horizontal wells, namely the Wolfcamp B in its legacy East Bloxom Field in Upton County and then the Cline formation in Borden County. CPE plans to drill up to seven gross (6.7 net) horizontal wells with the new generation rig, which is scheduled to be delivered in the second quarter of 2012. In addition, Callon plans to drill 21 gross (14.7 net) new vertical wells targeting the Wolfberry formation on its legacy Permian acreage.
At Habanero, the operator [Shell U.S. (RDS.B)] expects to commence drilling a sidetrack to the #2 well in the fourth quarter of 2012, targeting up-dip proved undeveloped reserves. The company reported that it had been notified that the Habanero Field will be temporarily shut-in for maintenance for a total of approximately 60 days during the second and third quarters of 2012.
At Medusa, the operator [Murphy Oil (MUR)] has indicated that the platform will be shut-in for approximately 25 days during the second quarter of 2012 for construction work on the West Delta 143 oil pipeline, through which Medusa produces.
Combined, scheduled downtime at its offshore fields combined with the transition to horizontal drilling in the Permian Basin are expected to result in a relatively flat production forecast for 2012. Callon anticipates it will produce approximately between 1.7 and 1.9 MMBOE in 2012, essentially flat when compared to 2011. Although total company production may be flat in 2012, onshore production from the Permian Basin is expected to double over 2011, driving further increases in oil production and the percentage of proved reserves located onshore.
Visible Growth Potential
In total, we estimate that Callon has an inventory of approximately 220 unrisked drilling locations in the Permian Basin, which represents more than six years of visible growth potential at 2011 activity rates (Callon drilled 33 net wells in 2011).
In its legacy Wolfberry acreage, where the company drilled 65 wells by year-end 2011, Callon has 129 remaining unrisked drilling locations on 40-acre spacing. By year-end 2012, CPE expects to have all 9,500 net acres held by production. The industry is experimenting with 20-acre spacing and if results are economic, then there is upside for additional drilling inventory from high density drilling.
On the company's recently acquired leasehold in Borden County, Callon is targeting the Cline Shale. With approximately 14,500 net acres in the play and assuming 160-acre spacing, Callon could have as many of 91 net unrisked drilling locations prospective for the Cline.
In 2012, Callon's focus is on horizontal drilling in the Midland Basin, the Cline oil shale to the north and the Wolfcamp B formation in the south part of the company's position.
A Stronger Balance Sheet, Improved Profitability and Liquidity
Since 2009, Callon strengthened its balance sheet by reducing debt to $107 million at year-end 2011, down from $249 million at year-end 2009. The 57% reduction in debt outstanding was achieved through a combination of restructurings and pay downs. Today, Callon's primary debt piece is $107 million in 13% notes that mature on September 15, 2016. The company has a $45 million revolving credit facility, and at year-end 2011 the company had no borrowings outstanding on the line.
Reducing debt and adding new onshore reserves improved Callon's debt metrics. At April 20, 2012, Callon's debt-to-market capitalization ratio was 52%, as compared to an average and median of 130% and 50%, respectively for the 24-company micro-cap E&P group in EnerCom's database. Debt reduction combined with increasing proved reserves cut Callon's debt-to-proved reserves to $6.72 per BOE at year-end 2011, down from $28.96 per BOE at year-end 2009.
Along with having a track record of lowering debt in the last three years, profitability has simultaneously trended upward. Callon's trailing twelve month operating cash margin per BOE, an operations-based metric which measures the amount of money generated from a company's core operations per production, is defined as oil and gas sales minus realized derivatives, lease operating expenses, production taxes, transportations expenses, general and administrative expenses and net interest, all divided by production. As of April 20, 2012, Callon's operating cash margin increased to $47.95 per BOE, up from $26.88 per BOE as of year-end 2009.
Callon's total liquidity at December 31, 2011 was $89 million, which consisted of $44 million in cash and $45 million in borrowing capacity on the company's revolving credit facility. The company did not disclose how much it paid for its newly-acquired assets in the Permian Basin; however, CPE did announce that the lease bonus payments were made out of existing cash balances, which implies a cost per acre of less than $3,000 per acre, assuming the company used all of its available cash. We do not, however, estimate that the company paid that much as recent transactions have been in the range of $1,300 per acre and if that is any guide, Callon more likely spent approximately $18.9 million in its most recent Permian acquisition.
The company's 2012 capital expenditure budget of $139 million is 32% higher than CPE's 2011 budget and 80% of it is earmarked to drilling in the Permian Basin. Callon guided to a drilling program consisting of 21 (gross) vertical and seven (gross) horizontal Permian oil wells, acquisition of additional acreage (the budget is inclusive of the recent Permian leasehold acquisition) and seismic data acquisition and interpretation work. Approximately $28 million is allocated to the planned Habanero #2 sidetrack well (operated by Shell) and capitalized costs. Management indicated that the 2012 capital budget would be funded entirely from cash flow generated from operations, existing cash and borrowing capacity on the company's revolving credit facility.
We looked at the company's valuation based on two methodologies including a Sum-of-the-Parts Net Asset Valuation and EnerCom's Five Factor Model [5FM]. We note that as of market close on April 20, 2012, shares of CPE were trading at $5.21 per share. Using a weighted average valuation for both of our methodologies, we estimate the per-share value of Callon to range between $6.18 and $14.44. Our composite valuation, consisting of the weighted average of three valuation estimates, is $10.56 per share.
Sum-of-the-Parts Net Asset Valuation
For the year-ended December 31, 2011, production averaged 30,280 thousand cubic feet equivalence per day (Mcfe/d) for CPE. For our valuation, we compiled a list of comparable peers for CPE and applied a low/high enterprise value to trailing twelve month production per day (EV/P). We used the 25th percentile peer group EV/P of $9,920 Mcfe/d to represent the low end of our production valuation and the 75th percentile peer group EV/P of $20,661 to represent the high end of our production valuation. Applying total shares outstanding of 39.4 million as of December 31, 2011, we assess the production value per share to range between $7.62 and $15.88.
Inclusive of the announced Permian acquisition on February 15, 2012, Callon's total undeveloped acreage in the Permian Basin is 17,691 net acres. Although the transaction value was not disclosed, we assess the fair market value of the Permian acreage at $1,239 per acre based on recent Permian transactions. On a per share basis, we assess the value of the Permian undeveloped acreage at $0.56.
Callon recognizes a carrying value of $2.3 million as of December 31, 2011 for its Federal onshore properties and we assess a per share value of $0.06. A carrying value is not recognized for any of the undeveloped acreage associated with the Federal offshore blocks as no development plans to develop this acreage has been recognized by Callon. As such, we do not assess any value to the associated acreage.
After adjusting for net debt and estimated acquisition costs for the Permian acreage transaction on February 15, 2012, we assess the value of Callon's shares to range between $6.18 and $14.44.
EnerCom's Five Factor Model
Using EnerCom's proprietary Five Factor Model [5FM], on April 20, 2012, CPE's 2012 P/CFPS ratio should be 5.7X, rather than the 2.7X that it presently trades, a difference of 108%. This would imply a share price of $10.82 per share.
This 5FM analysis compares CPE's 2012 estimated price to cash flow per share to EnerCom's 24-company micro cap peer group. EnerCom's 5FM was designed to be used as a starting point for evaluating E&P and OilService relative valuation - against a large group of companies or a selected set of operating or market cap peers. The Five Factors are metrics that we believe management teams have the most control over - costs/expenses and growth. The table below compares CPE's ECI Value Drivers to EnerCom's 24-company small cap peer group (as of April 20, 2012).
By focusing on the key variables that management can control, the 5FM helps identify the strongest teams most capable of creating value at any point of the energy cycle, making one's view of commodity prices a separate decision. When a company is evaluated using the 5FM versus a selected set of peers, we find that the resulting Predictive Value can explain more than 87% of the variability in a company's forward price to cash flow per share. We believe the 5FM can be an early signpost in identifying potential disconnects between company value and market perception.
Assuming a weighted average to the two valuation methodologies, we estimate the shares of CPE to be valued at $10.56 per basic and diluted share. While both methodologies point to an undervalued situation, additional upside exists from the 14,470 net Permian acres recently acquired in February 2012. Our sum-of-the-parts net asset value provides no value per share after deducing acquisition costs to this acreage. As Callon commences development in the new acreage, we expect the added value of development to provide upside potential to the $10.56 per share.
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