Bill Barrett's Transformation Can Fuel Further Gains

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Timing is everything in the market; had I written what I'm about to write in February of this year, I'd have come off looking pretty good. Be that as it may, while missing the 60% move in Bill Barrett (BBG) stings a bit, I have confidence that the company can continue to deliver the sort of results that will move the stock even higher in the coming years. More to the point, the company's ongoing transformation from a high-cost producer of natural gas to a competitive producer of oil with a deep drilling inventory makes this a name to watch.

Following The Money

When Bill Barrett was founded about 11 years ago, the company was a natural-gas focused E&P operating in the Rockies, with a particular focus on the Uinta Basin, a pretty desolate part of eastern Utah. In fact, as recently as 2010, the company's reserve base and production were roughly 90% skewed to natural gas.

With the collapse in natural gas prices and the company's high-cost operating structure, that plan wasn't going to work and management began a shift towards prioritizing oil and liquids development. The results have been striking - between year-end 2010 and 2012, the company nearly tripled the percentage of its reserves made up of oil (with overall reserves basically flat). No less striking is the shift in production - from about 7% oil in 2010 to 23% in the second quarter of this year (with another 10% of production coming in the form of natural gas liquids (NGLS).

Now the company operates in two quality areas, with potential upside in other acreage positions. The Uinta Basin is still the core of the company's operations, with about 150,000 net acres amidst other E&Ps like Anadarko (NYSE:APC), EOG (NYSE:EOG), and Newfield (NYSE:NFX). Although Bill Barrett's Uinta oil production in the second quarter was disappointing (due in large part to production-enhancing completion techniques that didn't meet expectations) and wells in this region tend to be small (so companies need more of them), the well returns have compared pretty favorably to other North American formations.

The more promising part of the Bill Barrett story will likely be the company's acreage in the Wattenberg area of the DJ Basin. The company owns about 14,000 net acres in the core Wattenberg area and another 40,00 net acres in the Northeast Wattenberg, an area that has attracted the attention of E&Ps like Whiting (NYSE:WLL), Anadarko, Noble (NYSE:NBL), and Bonanza Creek (NYSE:BCEI) among others. The company is still working to delineate this acreage and I believe there could be significant upside as the company moves on to the Niobrara B and C benches. Controlling well costs will be a challenge, but the company is making progress and skimping on wells is often a good example of "penny wise, pound foolish" planning.

Those aren't the only opportunities for the company. The company has sold down some of its interest in the liquids-rich Gibson Gulch area of the Piceance, and this is not a near-term priority. On the other hand, the company's 68,000 net acres in the Powder River is more of a priority and the company has completed 10 wells in the area so far.

Drilling Success, Capital, And Capacity Remain Risks

Bill Barrett's operations are certainly not at a point where shareholders can just take it for granted that they've found easy money. Exploration and production success are still important, and the news hasn't been completely positive. As I mentioned earlier, second quarter oil production disappointed due to new completion techniques not working as well as hoped.

I think it's also worth noting that the drilling efforts in the Powder River have been mixed - five Shannon test wells showed 30-day rates of 516 boepd, but other wells in the area drilled by rivals like Devon (NYSE:DVN) and EOG have produced 30-day rates of 541 to 1,423 boepd. I'm not suggesting that the Powder River results can't or won't get better, just that it's not a sure thing.

I also believe it is worthwhile to mention that there's a pretty strong correlation (over the long term) between E&P production growth, debt, and stock performance - the more companies have to rely upon debt to fund their growth, the worse the multiples and stock performances tend to be. So while Bill Barrett's recent presentation that its debt per Mcfe of production isn't bad on a relative basis is true, the trend is also important. Second quarter debt/production rose about 12% from the first quarter of 2013 and stood about 55% and 200% higher than the levels in the second quarters of 2012 and 2011, respectively. Again, I understand that it takes money to make money and that Bill Barrett has to invest in developing resources like the Uinta and Wattenberg; I'm just giving investors a metric to watch as the story rolls on.

Last and not least is the question of capacity. Because Uinta Basin oil has a high wax content, it's not really suited for pipelines and that leaves producers somewhat vulnerable to shortages in takeaway capacity. Differentials are pretty low now (about 16% to 18% to WTI), but they have been as high as 25% in the past. Luckily, both Tesoro (TSO) and HollyFrontier (NYSE:HFC) are expanding their refinery capacity in the area. I expect less capacity noise or trouble in the DJ Basin and Powder River areas, as pipeline plans in place should be adequate.

A Good Runway For Growth

I do believe that Bill Barrett has multiple levers to pull to drive good results. The company's board formally named R. Scot Woodall as CEO back in April, and I've seen/heard nothing from him that gives me much pause or concern regarding the company's approach. To that end, I like the potential of the company's downspacing efforts in the Uinta and the delineation efforts in the Wattenberg to meaningfully increase both oil production and reserves. I'd also mention that the company is likely to exit 2013 with 25% of its production from oil - a level of oil production that more than one sell-side analyst doubted (if not outright scoffed at) only a year or so ago.

At the same time, while the growth of debt relative to production is something to watch, I think management's capital plans have been reasonable. The company has kept its costs and activities under control, and has also sold off or sold down non-core assets (particularly gassy assets).

The Bottom Line

With the average smaller E&P trading at about 6x 2014 EBITDA estimates, I think Bill Barrett holds appeal even outside of its potentially superior acreage and production/reserve growth profile. A 6x multiple to today's current average estimate for 2014 works out to a fair value of $29.50, and roughly 15% upside from here. I can understand that some investors may be hesitant to buy in after such a strong run, but waiting for a significant pullback could be a long wait - particularly if oil production growth rebounds in the third quarter.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.