Cimarex Is Transitioning To Large Scale Development As Planned

Summary

• Cimarex has been thrown out with the bath water during the recent market selloff.
• The company is setting production records with their optimized completions strategies, and is transitioning to large scale development, much like many other top E&Ps.
• As a result, XEC is showing an attractive risk/reward energy point to re-enter the stock at.

Cimarex (XEC) has pulled back significantly with the overall market on fears of a global slowdown caused by rising interest rates. While U.S. GDP is expected to slow, growth will still be moderate at around 2%.

Consequently, I don’t see demand for oil falling as much as prices were previously forecasting, and the dip in oil prices is just providing an opportunity to reload on top E&Ps like Ximarex.

We reported on XEC’s previous Q2 call that their optimized drilling and completions strategies were driving efficiencies and revenues. XEC even beat the upper end of their guidance range of 206,000 to 215,000 BOEs per day in the third quarter, in large part, because of these completions strategies, which set a company record.

But, this latest earnings call seemed to focus more on their transition to large scale development, which is fully underway. Large scale development will boost revenues significantly, needless to say, and provide a consistency to earnings not seen previously.

As a result of this transition, the previous drop in XEC’s share prices is offering investors a attractive risk/reward setup to add to long positions.

Permian And Anadarko Basin To Drive Year-End Production

Third quarter production numbers were strong for XEC, as the they brought 46 wells online and even set a production record. Their fourth quarter is expected to be strong as well since production is ramping, reportedly increasing oil production by 21% to 23% year-over-year.

Much of the increase in activity is occurring in the Permian for XEC where the company operates 12 rigs, as well as in certain pockets of the Anadarko Basin in Oklahoma, where XEC is using 4 rigs. They also cut their completion crew count in half to three, but I expect this is because of efficiencies outpacing crews, and is seen more as a sign of strength.

In addition, certain wells in XEC’s Snowshoe project, as well as the Animal Kingdom, will drive second half production for 2018. The Animal Kingdom wells in Culberson County are quite large, as they are being drilled with 10,000 foot laterals. So, production from these wells should be a significant contributor to fourth quarter earnings.

Oklahoma will also be contributing to XEC’s year-end production ramp. In the Woodford, the Shelly and JD Hoppinscotch, pilots recently began and were accompanied by shorter, 5,000 foot laterals. Shorter laterals don’t necessarily translate to more expensive or less production.

In fact, the results can be stellar for shorter laterals if the pressure and geology in the region permits it. In short, expect certain projects in both the Permian and Oklahoma to drive year-end earnings for XEC, no matter the size of the projects.

Consistent, Large Scale Production Is Coming

It takes time to transition to large scale development mode. All necessary reserves need to be identified, they need to be planned extensively for full development on larger scales, and there needs to be the proper pipeline and processing infrastructure in place to support such endeavors.

Thankfully for E&Ps like XEC, these items have been checked off the list, and the transition from wildcatting to manufacturing mode can now begin. This will start with mega projects like the Meramec Steve-O, where 8 wells are being tested per section spacing using 10,000 foot laterals. Meramec is similar to the Animal Kingdom wells in the Permian, where large pads are being drilled with extensive laterals.

But, now investors can expect these sizes of projects to continue at a more repeatable rate since the items needed to allow for scaled mega-pad development are now in place (i.e., takeaway/processing infrastructure, abundant proppant supply, water gathering systems, etc.).

Lower sand costs are not to be scoffed at and are a major reason mega-pad development is even possible. Since XEC can now get local sand from, both, the Permian and Mid-Con basins, more wells can be completed simultaneously which is needed for large scale development to work properly.

Costs are also falling significantly from the previous quarter to about $200,000 per well using sourced local sands. So, not only are these developments cutting costs, but they are allowing for large scale to be a possibility now that were out of the question in 2016.

Large Scale Development Means Longer Cycle Investments

Because the necessary infrastructure and oilfield services are now available in basins where XEC operates, large scale development can now take place.

For the record, XEC claims that they have had the ability to scale up operations like this but would never commit to long term plans because of the vast unknowns that remained before.

Regardless, these projects will require thoughtful planning, and will also eliminate some of the benefits that short cycle drilling investments provide, such as quicker payback periods. However, investors should be encouraged by this development because it means more consistency and visibility will come in XEC’s earnings.

Projects will be based on $55 WTI, assuming flat oil prices for years out, which means XEC will have an indifference to oil price volatility, redefining what it means to be a commodity company. So, not only is production set to grow significantly with large scale development, but boom bust cycles will occur less in the E&P industry.

Financials

Cimarex beat estimates for the third quarter, posting $591.5 million in revenues, and net income of $148.4 million. This compares to net income of $91.4 million from a year ago period, proving that production is increasing at a substantial rate.

Of course, higher oil prices helped. But, production growth is up double digits year-over-year, as stated above. This double-digit growth in production also means that their P/E multiple of under 12x earnings is cheap on a PEG basis.

For a more thorough analysis of XEC’s leverage and balance sheet, please see our previous article on Seeking Alpha. But, in brief summary, XEC’s debt to equity stood at under .5x, which is on the low side compared to peers, and total assets still outnumber total liabilities by almost half, which means the company should have no trouble receiving financing for certain moves like acquisitions, or paying interest on debt.

Risks

Risks for E&Ps like XEC used to be high, as a slowing economy would hurt demand for petroleum products, causing widespread volatility for stock prices. However, due to large scale projects being executed regardless of oil price movement now (unless oil falls below $40), earnings should be less lumpy for XEC than in times past.

Higher rig costs have been seen but are being offset by the efficiencies they provide. Other costs are rising, such as saltwater disposal, diesel, and oil-based mud, but those are being offset by savings seen from sourcing local sand, and employing less completion crews, for example.

Differentials have also narrowed due to more takeaway capacity coming to the Permian as well as E&Ps in the surrounding area slowed completions into the year-end. So, while risks are present for XEC, they are being offset, in one way or another, by larger scale production which bodes well for XEC’s investors in the future.

Conclusion

XEC is making all of the right moves to complete its transition towards large scale development. While they have had the technology for mega-pads here and there, tying those operations together for long term consistency could not have been possible without infrastructure and oilfield services improvements.

Whereas more sporadic projects like Avalon and Bone Springs served them well in the past, mega projects like the Meramec and Snowshoe should carry them into their next developmental phase in 2019, providing XEC with unmatched earnings consistency that it could not achieve in years past.

As a result, due to recent market weakness and improved fundamentals for XEC, investors are now being presented an attractive risk/reward opportunity to load up on shares of a company who will see a step change in earnings due to large scale development for years to come.

Disclosure: I am/we are long GUSH. 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.