Consider Buying Callon Petroleum

About: Callon Petroleum Company (CPE)
by: Sarfaraz A. Khan

Callon Petroleum’s earnings and cash flows, which climbed significantly last year, will come under pressure in 2019 as oil prices stay well below last year’s average.

However, Callon is targeting more than 20% increase in production, has covered more than half of its future oil production with hedges, and has slashed CapEx by 12%.

Callon can significantly reduce cash flow deficit this year compared with 2018 and deliver free cash flows from 2020, even if oil continues to hover in the $50s a barrel.

Callon Petroleum in also in great financial health and can absorb a cash flow deficit.

Callon Petroleum (CPE) may report lower levels of earnings due to weakness in oil prices. However, strong production growth combined with decent hedge coverage will provide crucial support to the company’s cash flows in 2019. More importantly, Callon burned cash flows last year but could turn around in the near future even in a weak oil price environment of low-$50s a barrel.

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Oil prices have risen by around 20% this year. The rally has been driven by production cuts from the Organization of Petroleum Exporting Countries and its allies as well as sanctions against Iran and Venezuela. But surging production from the US to all-time highs combined with concerns regarding global economic growth has kept oil under $58 since Mid-February. The European Central Bank has recently slashed its Euro area growth forecast from 1.7% to 1.1%. The Paris-based Organization for Economic Cooperation and Development has also cut this year’s economic growth outlook by 0.2 percentage points to 3.3% and by 0.1 percentage points for 2020 to 3.4%. The US-China trade spat has heightened concerns regarding the slowdown in China.

In this backdrop, the oil prices may remain subdued. The US Energy Information Administration believes the US oil will average ~$55 a barrel in 2019, down from $65 last year. On the other hand, analysts at Raymond James are more optimistic and expect an average price of $62 a barrel for 2019. The industry’s consensus is that the average price of oil will be lower in 2019 as compared to last year.

The weakness in oil prices will hurt all oil producers, including Callon Petroleum. The production mix of the Permian Basin’s operator is heavily tilted towards crude oil. In fact, last year, the company produced 32,900 boe per day which was 79% crude oil. As such, it is exposed to weakness in oil prices. Last year, Callon Petroleum posted an 84% increase in adjusted profits to $0.79 per share as the company capitalized on the 14.4% increase in realized crude oil prices (unhedged) and a 43.5% increase in annual production to 12 million boe. Its cash flow from operations (ex. working cap. changes) also surged 69% to $420.8 million. But Callon Petroleum will find it difficult to meaningfully grow earnings and cash flows this year.

That being said, Callon Petroleum is targeting more than a 20% increase in production which should provide support to its cash flows and earnings by partly softening the blow coming from weak oil prices. The company expects to grow its total production by 23% to the range of 39,500-41,500 boe per day which will be 77% to 78% crude oil. The guidance implies a 21% increase in crude oil production at the mid-point to 31,388 bpd.

Callon Petroleum has also hedged a large chunk of its future oil production which limits its exposure to weak oil prices. The company has hedged more than 1.5 million barrels of oil production for the current quarter and slightly less than 1.6 million barrels for the second quarter. It has hedged more than 1.7 million barrels for the third quarter as well as the fourth quarter. Since Callon will produce 2.86 million barrels of oil on an average in each quarter, we can estimate that more than half of the company’s expected oil production for 2019 is backed by hedges. More importantly, Callon has been successful in locking decent prices as well with an average floor of a little over $58 a barrel and a ceiling of almost $67. This means that Callon will continue to receive a higher price for half of its oil volumes if prices stay low.

Callon, however, burned cash flows in 2018 as it spent $583 million as capital expenditure but generated $427.26 million of discretionary cash flows. As a result, it faced a cash flow deficit (or negative free cash flows) of $155.7 million ($583Mn-$427.26Mn). The deficit climbs to $239.7 million if we include capitalized interest of $84 million. In order to preserve its cash flows, Callon has made the sensible decision to reduce capital expenditure by around 12% in 2019 to the range of $500-$525 million. Additionally, the company can post a cash flow turnaround by achieving cash flow neutrality this year and generating free cash flows from 2020 in a weak oil price environment of low-$50s.

Callon is targeting capital efficiency and cost savings in 2019 which will help it in growing production while reducing costs. The company expects to benefit from drilling efficiencies, better well completion techniques, and infrastructure investments (such as water management) in 2019. Moreover, Callon will be expanding its mega-pads drilling program from the Midland Basin to the Permian Basin which should lower costs. I believe these measures will greatly help the company in aligning its capital expenditure with operating cash flows in 2019. We will likely witness a meaningful reduction in cash flow deficit this year.

In 2019, Callon expects to generate free cash flows in a flat $52.50 a barrel oil price environment aided by a 15% increase in production and lower CapEx as compared to 2018. The company may also receive support from additional asset sales of non-core acreage located in the Midland Basin and Delaware Basin.

What I also like about Callon is that it has a decent balance sheet and ample liquidity. This bolsters the company’s ability to withstand weak oil prices and absorb any cash flow deficits.

At the end of last year, Callon carried $1.2 billion of total debt which translates into a decent debt-to-equity ratio of 49%. By comparison, a number of Permian Basin operators, such as Devon Energy (DVN), Laredo Petroleum (LPI), and Matador Resources (MTDR), carry debt-to-equity ratio of more than 60%. Furthermore, Callon also has a favorable debt maturity profile. With the earliest debt maturing in 2023, the company doesn’t have to worry about any repayments in the near term.

Callon also has $648 million of liquidity, which mostly consists of funds available under the revolving credit facility. This could help the company in meeting any short-term funding requirements, although I believe the company will likely end up preserving most of its liquidity since it will likely use operating cash flows to finance capital expenditure.

Shares of Callon have fallen by 6.9% in the last three months and are currently trading just 6 times next year’s consensus earnings estimate, as per data from Thomson Reuters. I believe the company is well-positioned to withstand weak oil prices. Its stock will likely recover in the near future if oil prices remain stable in mid-$50s and the company reports a decline in cash flow deficit as it moves towards free cash flows next year. Investors should consider buying Callon shares.

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.

Additional disclosure: The article is for information purposes only. It is not intended to be investment advice. The performance of Callon Petroleum stock is heavily influenced by movements in oil prices and other factors. Weakness in oil prices may drag Callon Petroleum shares. Carefully consider your investment objectives, level of experience, and risk appetite before buying the company’s shares. Always perform your own research before making any investment decisions.