The last few months have been rough for shale oil stocks, with most big names declining by at least the mid single-digits. But for companies operating in the newer, less developed shale plays, such as the Wolfcamp Shale in Texas and the Tuscaloosa Marine Shale in Louisiana, this decline has been amplified. As domestic oil prices have dropped from about $100 to the low $90s, stocks operating in these nascent shale plays, where commercial viability is less certain, have seen their stock prices drop the most.
This chart shows the decline of both EOG and Continental Resources, in red and yellow, compared with a much steeper decline from Rosetta Resources (NASDAQ:ROSE) in blue. EOG and Continental are each the biggest producers in the Eagle Ford and Bakken, respectively. Rosetta Resources, also a shale driller, has lost nearly a quarter of its value because the company now has a very significant portion of its acreage in the Wolfcamp, where horizontal drilling has not yet begun on a large scale.
We already know that the better Bakken acreage can produce with a reasonable profit with domestic oil prices as low as the high $60 range. In the Eagle Ford, the better acreage can produce profitably down to about the mid $70s. But the unconventional drilling in the Wolfcamp is still in its test phase and we don't really know whether it will be profitable on a large scale. This uncertainty has caused investors to file for the exits in the face of declining domestic oil prices.
This article will take a closer look at Rosetta Resources, which is now one of the more focused ways to play unconventional shale drilling in West Texas. Despite the uncertainty, many of the biggest names in oil, both producers and servicers, believe that the Wolfcamp's unconventional oil resources will be commercially viable. Therefore, I believe that Rosetta Resources is a great opportunity here.
Eagle Ford Base
The Eagle Ford of southern Texas still represents Rosetta's largest acreage position, at over 64,000 acres. Unfortunately, Rosetta focused mostly on dry gas and natural gas liquids when it began acquiring acreage here. Of Rosetta's Eagle Ford reserves, only about 32% are made up of oil when considered on an MBOE basis. This number is quite a bit lower than major Eagle Ford producers such as EOG and ConocoPhillips. But Rosetta's Eagle Ford acreage is still quite profitable, with all of the company's major acreage parcels yielding a rate of return somewhere between 34% and 172%. Well costs are also fairly low, with costs between $6.5 and $7 million on most Eagle Ford wells.
And there's plenty of drilling left to do here. In fact, about 80% of the company's Eagle Ford acreage is still untouched. In the fourth quarter of 2013 Rosetta grew its Eagle Ford production by 35%, and that pace of growth is expected to continue into this year.
Turning an Oilier Leaf
In the latter part of 2013, Rosetta announced that it had acquired over 50,000 acres from Comstock Resources in Reeves County and Gaines County in the Permian Basin of West Texas. The acquisition was for $768 million, or almost a fourth of Rosetta's entire market cap. Management made this acquisition in order to get an early, front row seat for the development of the Wolfcamp shale.
On the surface, that Rosetta paid $680 per barrel of first year annual oil production from proved reserves, and that it will take over seven years just to break even at $90 per barrel oil, it seems that the company paid way too much for this acreage. However, this acquisition is more about shale reserves, most of which are still unproven.
Courtesy of Pioneer Resources Investor Relations
The chart above, based on estimates from Pioneer Resources (NYSE:PXD), estimates that if shale oil reserves are considered, the Wolfcamp Shale in the Permian Basin would be the second largest oil field in the world. This gives us an idea of just how much potential the Wolfcamp has. If the Wolfcamp Shale ends up being commercially viable, as one of the earliest movers, Rosetta will be among the greatest beneficiaries.
2014 Capital Program
Last month Rosetta announced that it would spend a huge $1.1 billion in developing its acreage in 2014, much more than last year's capital spending program of $622 million. Most of that capital, 67%, will be spent in the Eagle Ford. However, a significant 24%, or over $250 million, will be spent on drilling in the Permian Basin. This year Rosetta will have six rigs operating in the Permian.
Four of those rigs will be allocated to drilling some 25 horizontal test wells to be dispersed over the company's 50,000 acre position. 2014 will be an important year in determining the Permian's horizontal drilling viability. But do keep one thing in mind: It will take awhile to develop this shale. For example, the Eagle Ford was discovered in 2008, but development of that shale play did not begin in earnest until about 2012. Chatter about the Wolfcamp Shale play did not start until late 2012 and early 2013, and the test phase will last for at least a couple of years.
Data from Morningstar
In light of the company's high capital spending over the last few years, it should come as no surprise that Rosetta's debt levels are steadily rising. Yet, as we can see above, total debt is still not quite 2.5 times operating cash flow. Rosetta likely has much more capacity with which to add debt before the markets become concerned. Like many oil and gas companies this size, Rosetta has two forms of debt: fixed rate loans and a revolving line of credit. Of the company's fixed debt, no notes are due until 2018. Rosetta has plenty of time to capitalize on its acreage before any big payments become due.
Free cash flow, which refers to operational cash flow less capital expenditure, has been deeply negative for the last few years, and will drop even further in 2014 due to Rosetta's unprecedentedly large capital spending plans. This capital will be used to grow production by over 35% on an MBOE basis in the Eagle Ford, and also to drill test wells in the Wolfcamp Shale. Given the company's high return rates in the Eagle Ford, it makes sense to see Rosetta pour most of its capital expenditure into this geography. The Wolfcamp, for its part, could provide an even greater return if horizontal drilling turns out to be profitable there. Both of these endeavors, therefore, are worthwhile.
When evaluating a company's operations and capital structure, one important question to ask is whether the company is creating economic value above the cost of its debt. In the case of Rosetta, the answer is an emphatic "yes." For example, the company's weighted average cost of debt is about 6.4%. Yet, the company's enterprise value is only 6.78 times its EBITDA, giving us an earnings "yield" of 14.75%. Roughly speaking, Rosetta is bringing 8.35 percentage points, or 835 basis points, of economic value above the company's cost of debt.
From a valuation standpoint, Rosetta is among the most reasonably priced shale players today. Earlier in this article I mentioned that Rosetta has declined by nearly 25% since last October, far more than that of the big players in established fields. Rosetta now trades at 2.23 times its book value, which is quite reasonable when compared to EOG at 3.11 times, Continental Resources at 5.33 times, and fellow mid-cap shale driller Carrizo at 2.65 times book.
Make no mistake, Rosetta is cheaper than these names for a reason. EOG, Continental Resources and Carrizo all have bigger, oilier operations anchored to either the Eagle Ford or the Bakken, both of which have well-known prospects. As an younger shale, the Wolfcamp is decidedly less certain. Yet, some estimates point to the Wolfcamp having far greater reserves than either the Eagle Ford or the Bakken. If those estimates are proven right, you'll be glad you picked up Rosetta Resources 25% off its peak.
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.