Strong Wattenberg Growth Means Downside Protection With Plenty Of Upside

| About: PDC Energy, (PDCE)
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Summary

PDC Energy is planning to spend 14% less next year relative to 2014 levels, yet management still sees its production climbing by 50%.

Strong drilling economics in the core part of the Wattenberg Field will yield decent returns for PDC even if crude hits $50 a barrel.

A combination of both of these factors has created downside protection for PDC Energy's stock price.

From the middle of June to the beginning of December, PDC Energy's (NASDAQ:PDCE) stock price fell from $70 a share all the way down to $28 a share. There are plenty of those who caught the proverbial "falling knife" on the way down, but it looks like PDC Energy may finally have bottomed out. On December 9, PDC Energy's stock price shot up from $28 to $35 and is currently trading at $33 a share (December 12) on the back of a very bullish guidance update from the company.

Strong returns, less spending, more production
Next year, PDC Energy plans to cut its capex budget by 14% relative to 2014, bringing it down to $557 million. To focus on growing its output from the Wattenberg, PDC is reducing its capex budget in the Utica to $38 million next year versus $190 million in 2014. This includes idling its only drilling rig in the area until prices improve. PDC Energy isn't abandoning the Utica, as it plans to analyze its recently completed wells to enhance its future drilling program.

By sharply cutting its Utica budget, PDC can boost the amount of capex it can spend developing the Wattenberg Field. In 2015, PDC Energy will spend $516 million targeting the Niobrara and Codell formations in the Wattenberg Field versus $443 million this year. Most of PDC's focus is going to go towards its Inner and Middle Niobrara regions, as its core drilling inventory brings wells online with better returns than in the outer portion of the Niobrara and a tiny bit better than those in the Codell formation.

As you can see in the chart below, PDC Energy can still generate strong returns in a lackluster pricing environment on its core acreage. If crude were to fall to $50 a barrel, PDC would still be able to bring wells online with a 33% IRR (internal rate of return) in the Inner Niobrara, even after factoring in a $10/Bbl pricing differential to NYMEX. 90% of PDC's wells in 2015 will be spud in the Inner and Middle regions of the Niobrara.

Updated Core Wattenberg Economics Niobrara Areas  
  Inner Middle Outer Codell
Gross 3-Phase EUR: 580 Mboe 400 Mboe 285 Mboe 370 Mboe

IRR Estimates: $90/Bbl & $4/Mcf

122% 83% 52% 79%
$80/Bbl & $4/Mcf 85% 60% 36% 58%
$70/Bbl & $4/Mcf 64% 42% 24% 41%
$60/Bbl & $4/Mcf 47% 28% 14% 28%
$50/Bbl & $4/Mcf 33% 16% 6% 16%
Assumes $4.0 million well completion cost, 4,200 foot lateral, 16-frac stages and reflect long-term differential of $10/Bbl for oil. Prices are NYMEX held flat. Doesn't factor in corporate or lease acquisition costs, or possible efficiency improvements.

Source: PDC Energy Press Release

Strong well economics justifies expanding production levels, which is just what PDC plans to do. Management is guiding for PDC to produce 9.3 million BOE - 9.5 million BOE this year, which will grow by 50.5% (midpoint) to 13.8 million BOE - 14.5 million BOE next year. In 2015, PDC Energy is forecasting it will have a production mix that is 45% oil, 20% NGLs, and 35% natural gas (similar to 2014 levels). High double digit output growth is very bullish considering PDC is spending 14% less over that period of time.

A large part of PDC's recent stock bounce can be attributed to its strong guidance, even in the face of low oil prices. Another big reason for its revival is management's reassurance that its wells would be able to yield a reasonable return in the current pricing environment. Also, having a strong hedging program substantially reduces PDC Energy's pricing risk.

PDC Energy has hedged 5.2 million barrels of crude (~80% of 2015E output) at an average price of $88.08 a barrel and 22.485 Bcf (~75% of 2015E output) at an average price of $4 per Mcf for 2015. In 2016, PDC has hedged 4.1 million barrels of crude at an average price of $85 a barrel and 27.5 Bcf of natural gas at an average price of $4 Mcf. A $10 a barrel move in oil prices will only change PDC's estimated 2015 cash flow by $20 million - $25 million.

Watch the outspend
PDC is forecasting that it will generate $392 million in cash flow in 2015, $165 million less than its capex budget. At the end of the third quarter of 2014, PDC Energy had $675.9 million in long-term debt. Pilling on more debt is problematic, just look at what other small shale producers are going through right now. To help fund its outspend, PDC Energy sold off its stake in the Marcellus shale which was officially closed in October, raising $190 million before factoring in taxes.

With $789 million in liquidity, PDC has access to enough cash to plug its outspend for a few years. Leveraged growth leads to more production, but it comes at the price of a worsening balance sheet. Sometime in the future, PDC is going to need to bring production up to levels that generate FCF (free cash flow), reduce costs to levels that generate FCF, or a combination of both in order to pay down its debt. In order to pay off its debt without issuing out more debt (effectively pushing back the maturity date), PDC needs to be able to build up its cash reserves. A 50% boost in its production should help it get closer to that goal.

Final thoughts
Delaying investment into the Utica is a good move, as PDC doesn't have the funds to adequately develop both plays at once. PDC Energy will get more bang for its leveraged buck by investing in the Wattenberg, making it the right play to go all in on. Lower oil prices will weigh against PDC Energy's stock, but management has asserted that its growth story won't stop in the face of $60 crude. Investors looking for a beaten up, high flying shale operator to play a rebound in prices should take a look at PDC Energy, as its recent update has created downside protection for investors.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.