Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the disclaimer at the end of this article.
Stock prices for a group of Permian-focused E&P operators have been remarkably resilient. By looking at stock price trajectories over the past year and half, one would be challenged to discern that a major correction in oil prices has actually occurred.
The average decline for an ad hoc group of six Permian-focused stocks shown on the chart below was just ~10% from their pre-correction levels (based on performance from May 30, 2014).
(Source: Google Finance)
As one would expect, companies with extra-strong equity currencies have been incentivized to issue new equity and have used the proceeds to pursue acreage acquisitions, maintain spending at above-cash flow level and repay debt. Since the beginning of the oil correction, leading E&P operators in the Permian Basin have issued several billion dollars in new common stock.
Strong equity prices may be a mixed blessing as they can make equity raising the driving element of the business model. In the longer run, if the big equity raises are not supported by drilling returns, the increased share counts may become a burden from a valuation perspective.
Stratospheric acreage valuations have been one of the side effects of "easy" equity capital, with prices in some recent transactions in the core-of-the-core areas exceeding $40,000 per undeveloped acre.
Parsley Energy Case Study
Parsley Energy (NYSE:PE) is an example of how equity market's appetite for Permian assets has fueled the company's growth through acquisitions.
Parsley is mid-capitalization company, with an enterprise value of ~$3.7 billion. Parsley issued new equity three times in the past six months, for a total of $0.7 billion in gross proceeds. The funds were used to repay debt accumulated in several high-price acreage acquisitions and to fund capital spending at a level significantly exceeding organic cash flow.
Let's look at the history of Parsley's acreage purchases. As one can see from the table below, approximately 40% of the company's current ~60,000 net acre Midland Basin Core position was assembled via acquisitions in the past eighteen months at an average price of ~$26,000 per undeveloped acre (the value of existing production is excluded).
These acquisitions have been "accretive." Based on my analysis, Parsley's current price of $21.83 per share implies a valuation per undeveloped acre of ~$40,000+ per acre, assuming strip pricing for oil and natural gas. In other words, if one were to look at the valuation of the acquired acreage via the prism of Parsley's current stock price, the acreage experienced a 50% "appreciation."
(Source: Zeits Energy Analytics, March 2016)
However, by acquiring acreage at high prices, Parsley effectively set the bar very high for its well performance.
Consider the following illustration. Let's assume that Parsley's entire Midland Basin Core acreage can yield 1,000 net high-graded drilling locations. This translates into an average of ~15 high-graded well locations (~7,000-foot laterals) per drilling unit across the entire position. Let's also assume that the company will have financial resources to drill all of those locations over a ten-year period (which is probably an optimistic assumption, as such plan would imply an average annual capex of roughly $600 million, vastly above the current discretionary cash flow).
Assuming further that 80% of the present value of the acreage is associated with the high-graded inventory and applying an average valuation of $26k per acre, the cost per location comes out at ~$1.25 million, if the location can be drilled immediately. However, given that in this illustration the inventory has an average shelf life of five years, the cost of carrying the inventory adds significantly to the effective cost per location. Assuming a 15% annual cost of carry for idle undrilled acreage, the average cost per location at the time of drilling increases to ~$2.5 million.
The following slide from Parsley's presentation illustrates the impact of a $2.5 million increase in the well's cost on drilling returns (the blue and yellow bars and curves on the slide). The higher cost ($8 million per well versus $5.5 million per well) leads to a roughly 20% reduction in the well-level drilling return. Another way of looking at it, a shift in oil price that would be required to offset such reduction in return can be as high as $20 per barrel (or even higher, if one takes into account cost re-inflation in the higher oil price environment).
(Source: Parsley Energy, February 2016)
The higher effective well cost is not the only consequence of acquiring acreage at a high price.
If the drilling inventory gets too large, the "idle carry" period for the acreage gets longer, increasing the cost per location. Please also note that the incremental inventory acquired in a new transaction is being effectively added at the end of the queue (unless the acquired acreage is of superior quality as compared to the existing acreage), whereas capital available for drilling is reduced by the outlay on the acreage acquisition.
In order to prevent the cost of carrying idle drilling locations from exploding, the operator must raise significant capital to scale up the development program, on top of the capital required to fund the actual acreage acquisition. In the current environment, such funding must come from new equity issuances.
The cost of purchased acreage is obviously a sunk cost. However, on a pre-acquisition basis, it is difficult to expect that the operator - Parsley, in this example - can create value by acquiring acreage at these top prices without assuming a stand-out well performance or a strong improvement in oil prices. For Parsley, the hurdle oil price for a 20% well-level return, after including the cost of acreage, appears to be above $60 per barrel, and assuming some cost re-inflation, likely above $70 per barrel.
In other words, while it may appear that Permian operators have been using the arbitrage between their stock prices and the cost of land to "grow into" their trading multiples, the strategy only works under the assumption of higher oil prices.
In many cases, undeveloped inventories account for the larger portion of stock valuations for the largest publicly traded Permian operators. As I highlighted in my previous note, even using the SEC year-end 2015 price case, proved developed producing reserves accounted for just a fraction of Pioneer Natural Resources' (NYSE:PXD) enterprise value. The company's current enterprise value is ~$23 billion, as compared to the reported year-end 2015 PV-10 of proved reserves of just $3.2 billion.
Valuation gaps between the current enterprise values and reported PV-10 values are also quite significant for several other Permian-focused stocks, including Concho Resources (NYSE:CXO), RSP Permian (NYSE:RSPP), Diamondback Energy (NASDAQ:FANG) and several others.
In Parsley's case, for example, the company's current stock price effectively discounts acreage prices that exceed the prices seen in recent private market transactions.
What happens if one were to mark Parsley's acreage "to market?" For illustration, let's use a valuation of ~$26k per acre for the company's Midland Core acreage - the average price paid by Parsley in its most recent significant acquisitions - instead of the ~$40k per acre implied by the stock's current price per share. The implied impact on the market capitalization would be ~$900 million. On a per share basis, this would translate into ~$5.30 per share, or a quarter of the stock's current price.
One might also debate what the current market price for acreage in the Permian Core is. The Permian is obviously viewed as a resource treasury that will ultimately be developed. So far, investors have been willing to endorse the very high prices paid by operators for Permian assets, despite the severe downcycle in oil. I would argue that such endorsement would not be possible unless investors were prepared to "look through" the downcycle to an assumed $70+ per barrel future price environment.
What would happen if lower oil prices - let's say, sub-$60 per barrel - were to persist for another year or two? There is a risk that equity capital would become less available to sponsor acreage purchases at high prices, which would in turn lead to a deflation of acreage prices in the Permian and an even greater implied "mark-to-market" impact on stock prices.
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Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.
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.