Extraction Oil & Gas: Still A Great Prospect

Jan. 01, 2020 3:15 AM ETCivitas Resources, Inc. (CIVI)7 Comments2 Likes

Summary

  • Extraction Oil & Gas still makes for a great prospect for the right kind of investor in this space.
  • Debt levels are high, but we are ignoring Elevation Midstream in this analysis.
  • In all, the company is a good prospect, but context is needed.
  • When weighing the risk/reward, there are better prospects out there, but I can understand why investors might like the business.
  • This idea was discussed in more depth with members of my private investing community, Crude Value Insights. Get started today »

Previously, one of the oil and gas E&P (exploration and production) firms I dug into was Extraction Oil & Gas (XOG). A small-cap player in the space, Extraction makes for an interesting prospect for market participants to keep in mind, and with midstream assets to add to the mix, the firm could provide shareholders with significant upside in the months and years to come. With new guidance out covering next year, the picture is even more clear today than in the recent past, and as a result, it makes sense to take a fresh look into the enterprise. In all, my opinion on the firm has not changed, and I believe investors getting in now could be setting themselves up for nice returns down the road.

Disclosures

In writing this article, I had to utilize a number of assumptions. Some of these were provided by management, while others were based on a review of the company’s fundamentals and current market conditions. In my cash flow deep dive for Extraction, published as part of my Marketplace Service, Crude Value Insights, I laid these details out, and I recommend you consider signing up for the service to get a comprehensive analysis of the firm. Before I move on, though, there is one assumption that I do believe warrants some disclosure, since omitting it would be materially misleading.

Just like in my prior analysis of Extraction, I have made the tough decision to exclude from this analysis all prospects associated with the company’s ownership over Elevation Midstream. This is due to the fact that, besides capex, management has not offered any substantive guidance recently. In all likelihood, this asset should be worth several hundred million dollars (this year alone, the company spent $250 million on it). Instead of guessing what this asset might generate and extrapolate value from there, investors should view it as a cherry on top that only improves the prospects offered by the firm.

Cash flow should grow over time

*Created by Author

With this water under the bridge, it’s time to dive in and see what kind of upside Extraction might warrant. In the table above, you can see just how free cash flow should look for Extraction for this year and for its 2020 fiscal year if we assume that oil averages $55 per barrel and natural gas averages $2.50 per Mcf. Free cash flow this year, because of management’s heavy midstream spending, should be about -$321.68 million. As this decreases from $250 million to $35 million (at the mid-point) next year, and as production grows, free cash flow will come closer to -$76.41 million for 2020. Very recently, crude prices have risen, so in the spirit of things, I also provided a table below that illustrates what $60 oil would entail. Under this scenario, free cash flow this year would improve to -$282.94 million, while for next year it would come in at -$31.41 million.

*Created by Author

While free cash flow is super important, it’s not the only metric we should be paying attention to. In the table below, for instance, you can see its EBITDA and operating cash flow spread over time as well. Under the first table, EBITDA should grow from $553.51 million this year to $561.73 million next year. Operating cash flow, meanwhile, would come in at $461.50 million this year and $466.77 million next year. Under the second table, EBITDA for 2019 would be a bit higher at $592.25 million, while for 2020 it would grow to $606.73 million. Operating cash flow over the same period of time would rise from $500.24 million this year to $511.77 million next year.

*Created by Author

*Created by Author

Before we move on to our final valuation section, we should discuss leverage some. In the table below, you can see two different measures of leverage: one where the preferred units end up converting into common, and another where they are essentially the same as debt. One reason why shares of Extraction are trading low today might be because of how the market perceives the firm’s debt load. Though the data shows the picture improving over the next couple of years, net leverage ratios well above 2 are considered undesirable territory as far as investors are concerned. These ratios aren’t so high that I consider them dangerous, but they are high enough that I understand, particularly under the preferred being counted as debt scenario, why the market may discount Extraction relative to some of its peers and/or the broader market.

*Created by Author

Upside is still strong

*Created by Author

Keeping all else the same, Extraction probably should trade at a modest discount to its peers if you ignore the potential associated with Elevation Midstream. However, even with that, upside is significant. In the table above, you can see a hypothetical range of EV/EBITDA values of between 4 and 10. The table also illustrates the implied share price and share upside of the firm under these different multiples. All of this is for the current 2019 fiscal year under a $55 oil environment. As an example, if the EV/EBITDA multiple of Extraction were to rise to 4, shares would have upside of 55.8%. At a multiple of 6, this would shoot up to 451.1%.

*Created by Author

In the next table, shown above, I decided to use my model to look at the firm’s 2020 fiscal year figures as well. I believe this would be a more appropriate way to look at the picture. The short story here is that upside potential, due to the growth expectations next year, should be even better for investors. However, once again, this picture is not without its risks, both with regard to what energy prices might do and because leverage is elevated some.

Takeaway

Right now, Extraction, in my opinion, makes a lot of sense for investors to keep in mind. The company is certainly not the best prospect I have seen, but it is appealing. Add to its cash flow profile the potential value associated with its midstream operations, and I could see even greater upside for investors over the next few years. If midstream cash flow potential is truly significant, I could even see myself buying into Extraction, but until I have more details on that front, I believe there are a few better prospects out there. Not many, but a few.

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This article was written by

Daniel Jones profile picture
23.22K Followers
Robust cash flow analyses of oil and gas companies

Daniel is currently the manager of Avaring Capital Advisors, LLC, a registered investment advisor that oversees one hedge fund, and he runs Crude Value Insights, a value-oriented newsletter aimed at analyzing the cash flows and assessing the value of companies in the oil and gas space. His primary focus is on finding businesses that are trading at a significant discount to their intrinsic value by employing a combination of Benjamin Graham's investment philosophy and a contrarian approach to the market and the securities therein.

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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.

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