In an environment where E&P companies are "hunkering down," it is not surprising that Laredo Petroleum (NYSE:LPI) intends to do the same. Its 2016 capital expenditure budget of $345 million reflects a significant decline from the $521 million spent on exploration and development activities and the $160 million spent on infrastructure, including the Medallion pipeline, in 2015. Naturally, this reduction in spending will negatively affect production. Management is guiding to production ranging from 15.3 MMBoe to 15.7 MMBoe as compared to 2015's 16.3 MMBoe. However, despite these diminished production expectations, LPI essentially expects to maintain cash flow from operations comparable with 2015.
What will allow LPI to succeed in maintaining flat cash flow in 2016 are two factors. The first is its derivatives book. Based on management guidance of a +/- 48% oil cut and the midpoint of its production expectations, I calculate that LPI has hedges in place for almost 88% of its crude oil production at an average weighted price of $70.84/Bbl. Based on these same production expectations and assuming 1 Mcf of production is equal to 1 MMBtu, I calculate that LPI has hedged approximately 77% of its natural gas production in 2016 at $3/MMBtu.
Second, LPI will focus its 2016 drilling campaign in a region where it benefits from its significant historical infrastructure, which has allowed it to realize savings range in the hundreds of thousands per well in terms of water utilization, etc. In addition, I calculate LPI will need to borrow less than $100 million on its revolving credit facility given management's expectation of funding up to 80% of its capital expenditure budget with cash flow.
Based on the current borrowing base of $1 billion with $170 million outstanding, this implies that LPI will end 2016 with less than $270 million outstanding under the facility and plenty of liquidity if the borrowing base remains unchanged. That is the extent of the good news in 2016 as calculated cash flow ($258.8 million to $276.0 million based on management's cash flow funded capital spending estimate plus my $92.6 million estimate for interest expense) is less than the $472.3 million in adjusted EBITDA reported by the company for 2015. So slightly more debt with what I assume to be reduced EBITDA implies that either the value of LPI's equity declines or the Enterprise Value/EBITDA (EV/EBITDA) multiple increases.
Beyond 2016, my first concern is with what happens in 2017 on the derivatives front. In 2017, should industry conditions persist, LPI will have oil hedges in place sufficient to cover only 2.6 MMBbls, down from 6.5 MMBbls in 2016 (or 35% of its production based on its production expectations for 2016) at a price of $77.22/Bbl. For the remainder, it will be forced to accept NYMEX pricing as affected by differentials. Note in this regard management's guidance for the first quarter of 2016 where it projects pre-hedge realizations for its crude oil production at 80% of NYMEX, as can be seen below.
On the natural gas side, its 2017 derivatives coverage falls to 56% based on its 2016 production expectations at a price of $2.70/MMBtu while pre-hedge realizations for natural gas would be at 67% if LPI's expectations for the first quarter of 2016 persist.
Using management's assumptions, I calculate that LPI's blended price for crude oil would fall from $64.83/Bbl (88% at $70.24 and 12% at market) to $49.21 (35% at 77.22/Bbl and 65% at the December 2017 futures price), or a decline of 24%. On the natural gas side, the falloff would not be as dramatic as I calculate a decline from $2.76/MMBtu to $2.37/MMBtu, or 14%.
If these assumptions hold and commodity pricing does not change dramatically for the better, I would expect LPI's cash flow in 2017 to drop markedly on production volumes comparable to those expected for 2016 and assuming no significant additional expense savings.
The next area of concern is that of LPI's reserves. LPI wrote off (or re-characterized) 124.2 million in reserves, as can be seen below.
|Beginning of year - December 31, 2014||140.2||-||642.8||247.3|
|Revisions of previous estimates||(88.9||)||35.5||(424.5||)||(124.2||)|
|Extensions, discoveries and other additions||10.5||5.9||36.1||22.4|
|Purchases of reserves in place||-||-||-||-|
|Sales of reserves in place||(1.6||)||(1.0||)||(5.6||)||(3.5||)|
|End of year - December 31, 2015||52.6||36.1||222.0||125.7|
While this write-off affected primarily PUDs, it also very modestly affected some vertical well PDP reserves. What is remarkable, though, is that the reserves written off or re-characterized constituted over 50% of the company's reserves at the beginning of the year. While other companies have undertaken significant reserve revisions at year-end 2015, this appears to be one of the largest such revisions.
The scale of this revision should have significant implications for valuation, but it will also have other effects. Most notably, in terms of potential negative impact, is the possibility that the company's borrowing base could be reduced. The last redetermination of the borrowing base, as reported in the third quarter 10-Q, occurred at the end of October 2015 and saw a reduction in the borrowing base from $1.25 billion to $1.15 billion. Conditions since then have materially worsened and the question is whether the banks have become sufficiently restive to require additional borrowing base reductions. The next scheduled redetermination will likely occur at the end of April 2016.
Finally, it is worth noting that based on TRACE pricing (as reflected on Bloomberg), LPI's publicly traded debt securities trade at +/- 60. This implies a valuation for this debt in the range of $786 million. Add to this the $170 million in outstanding bank debt and you have $956 million in debt. While the use of PV-10 as a valuation tool is fraught with issues, it is worth noting that LPI's PV-10 value is only $830.7 million.
Succinctly, it appears that LPI is overvalued. Using management's assumptions, debt will likely increase and cash flow will likely decrease in 2016. For the equity value to remain constant suggests that the EV/EBITDA multiple increases. I think this is unlikely.
In 2017, LPI will become more dependent on the market price. In its Short Term Energy Outlook, the EIA is projecting a 2017 average crude oil price of $50/Bbl. On the other hand, the futures market has markedly lower expectations for 2017. Based on CME trading activity on Feb. 19, 2016, the futures price remains below $40/Bbl for the first quarter of 2017 before rising modestly to $42.65/Bbl at year-end. Using this futures price, all other things being equal, suggests that cash flow will decline again in 2017. As I believe multiple expansion to be unlikely at this time, a reduction in cash flow suggests a reduction in equity value.
On a market-adjusted basis (with the stock trading at $4.10/share), LPI's EV is approximately $1,832.4 million. At the midpoint of its guidance, LPI will produce 15.5 MMBoe. Using the company's 1Q16 guidance and 12-month strip prices, I calculate full year EBITDA at $342.0 million. This implies a market-adjusted EV/EBITDA multiple of 5.36x which may not appear unreasonable but for the fact that LPI's outstanding debt securities trade at approximately +/- 60.
Using the book value of debt ($1,470 million), I estimate the EV/EBITDA multiple at 6.9x using my estimate of 2016 EBITDA of $342.0 million (which compares to the Bloomberg consensus EBITDA for 2016 of $344.1 million). If 5.36x is the correct multiple, I develop the following simple waterfall analysis:
|LPI Simplified Valuation Analysis|
|2016 Estimated EBITDA||$342.0|
|Implied value per share||$1.68|
An alternative to this formulation is to develop a sum-of-the-parts analysis:
|Fair value of derivatives (from 10-K)||276.2|
|Value of reserves||1,508.4|
|Value of Medallion Pipeline 50% stake||179.0|
|Value of debt||$1,470.0|
|Implied value per share||$2.31|
In either case, I believe that LPI shares still have significant downside risk.
Disclosure: I/we 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.