Cimarex Energy: A Great Oil Stock To Consider

Summary

• Cimarex Energy, like other shale drillers, struggled last year but the company remained profitable and delivered free cash flows.
• The company has a low cash flow breakeven point of under $35 per barrel and will report strong levels of free cash flows in 2021.
• With nearly half of its future oil production covered with hedges and a decent balance sheet, the company can stand firm if oil prices drop.

Cimarex Energy (XEC) struggled in 2020 but it will bounce back this year as it benefits from the increase in oil prices. The Denver-based shale oil producer will likely deliver strong levels of free cash flows in 2021, even as it increases capital expenditures. It will then use the excess cash to create value for shareholders through dividend growth and other measures. Furthermore, Cimarex Energy can also withstand any potential oil price shocks. In my opinion, this is a great oil stock for investors to consider.

Data by YCharts

A Tough 2020

Last year was one of the most challenging periods ever for the US shale oil drillers and Cimarex Energy was no exception. Although the company fared better than the vast majority of its peers, its earnings and cash flows still came under pressure while its financial health got worse. The company released its financial results last month. Cimarex realized oil prices of just $35.59 per barrel in 2020, down from $52.77 in 2019. The company, along with other shale drillers, curtailed drilling activity in the first half of 2020 after oil prices crashed to historic lows, with the WTI futures briefly dropping into the negative territory. Cimarex, which gets a majority of its output from the Permian Basin, produced around 252,500 boe per day in 2020, down 9.3% from 2019. Its oil production fell by 11% to 76,740 barrels per day.

Due to the large drop in realized prices and declining production, Cimarex’s net profits (as adjusted) plunged by almost 70% to $1.39 per share. The drop in earnings also pushed the company’s leverage (measured in terms of debt-to-adjusted EBITDA ratio) higher to 2.1x by the end of 2020 from 1.4x in 2019. The company’s received support from the crude oil hedges but its cash flow from operations (ahead of working capital changes) still fell by 36% to $944.2 million. Its free cash flows, however, expanded from $157.9 million to $371.7 million but this growth came only after the company chopped its CapEx in half to $594.8 million.

Solid Free Cash Flows Ahead

Since then, however, oil prices have improved sharply, with the US oil price climbing from $48 a barrel at the start of the year to $62 at the time of this writing. That’s significantly improved Cimarex’s outlook. In my view, the strength in oil prices can be attributed to the actual reduction in crude oil supplies from the OPEC+ group and other nations and the expected increase in demand.

The US oil production fell to 9.7 million bpd in the third week of February from 13 million bpd a year earlier, according to the US Energy Information Administration’s estimates, as shale oil producers like Cimarex Energy reduced drilling activity. The energy alliance consisting of OPEC and its partners cut oil supplies by 9.7 million bpd last year to prop up the commodity’s price. The production cut was scaled down to 7.2 million bpd in January while Saudi Arabia has withheld a million bpd of supplies for February and March. The OPEC+ group will meet this week and could further ease production cuts. The Saudi barrels might also return to the market from next month. Although this can have a negative impact on prices, an increase in demand could absorb the additional volumes and prevent a major slide in prices.

Oil consumption will likely increase in the coming quarters as governments around the world vaccinate millions of people and begin to contain the pandemic, business activity climbs back to normalized levels, global trade recovers, and the world’s economy gets back on the growth trajectory. The global economy contracted by 3.5% last year but could expand by 5.5% in 2021, according to the IMF’s estimate. That’s going to play a big role in supporting oil prices.

I expect Cimarex Energy to deliver higher profits and strong levels of free cash flows than 2020 with oil hovering in the high-$50s to low-$60s a barrel range. Note that Cimarex Energy has said that in a $35 per barrel oil price environment, its free cash flows after dividends will be “9% of our total cash flows.” In my view, this is a fair assessment, considering it is backed by a strong track record. I think the company has shown in its recently released annual results that it is a low-cost operator that can generate decent returns in a weak oil price environment. At $35 oil, it can generate enough free cash flows to fully fund its dividends, which indicates its cash flow breakeven point lies well below $35 per barrel. The company generated $371.7 million of free cash flows in 2020 which covered its dividends expenses of almost $93 million, enabling Cimarex Energy to end the year with nearly $279 million of excess cash (after accounting for CapEx and dividends). In the current $60 a barrel oil scenario, I expect Cimarex Energy to deliver robust free cash flows.

Remember, Cimarex Energy is increasing capital expenses as it slowly ramps up drilling activity, which means its cash outflows will be higher in 2021 than last year. It has forecast a capital budget of $650 to $750 million for this year, up from $577 million spent in 2020. But this increased spending will not only stem the natural field declines but also help push oil production slightly higher by around 2% from last year to the range of 75,000 to 81,000 bpd. Cimarex Energy isn’t targeting aggressive production growth anymore. This shows that the company’s focus remains on generating healthy returns and free cash flows.

What I also like about Cimarex Energy is that it continues to find ways to improve well productivity and push well costs lower. The company drilled 46 net wells in the Permian Basin last year at an average well cost of $944 per lateral foot, down from $1,106 in 2019. For 2021, it expects to complete 65 net wells with a cost of between $800 and $850 per foot. Cimarex Energy has already been successful in pushing its costs down to the $800 range by late-2020, which should give confidence to investors about the company’s ability to deliver on its promise in 2021. The cost reduction should have a positive impact on profit margins and cash flow breakeven levels. This also means that even though Cimarex Energy’s capital expenses will increase in 2021 as compared to 2020, it can still generate more bang for the buck.

On the other hand, cash flow growth will be driven mainly by the increase in oil prices. The company sold oil at mid-$30s a barrel in 2020 but the commodity’s price could average $50.21 per barrel this year, as per the EIA’s February report, although analysts at the Bank of America and Goldman Sachs are expecting higher prices. This healthy oil price climate should give a boost to Cimarex Energy’s cash flows, allowing the company to generate strong free cash flows in 2021.

I expect the company to use the excess cash to create value for shareholders by reducing debt and funding dividend growth. Last month, Cimarex Energy announced a 23% increase in the quarterly dividend to $0.27 per share which translates into an annualized yield of 1.83%. That’s higher than the S&P 500’s average dividend yield of 1.5%. I expect Cimarex Energy to further increase dividends in 2021 which can push the yield to 2% or higher, as long as it keeps getting support from oil prices.

Downside Protection

Cimarex Energy, like all of its peers, is exposed to the risks related to adverse movements in oil prices. We have seen a strong bullish run in oil in the past few months. It hasn’t been a smooth ride but whenever there’s been a sell-off, buyers have stepped in and pulled oil back up again. Nonetheless, the commodity is still facing some headwinds. Despite the optimism, it is important to remember that we are still going through exceptional times where a pandemic is affecting lives and livelihoods around the world on an unprecedented scale. Renewed infection waves and new COVID-19 variants pose a threat to the global economic recovery and, by that extension, oil demand. If, for instance, OPEC+ brings additional barrels to the market and the anticipated demand recovery fails to materialize, then oil prices might come under pressure again. This will dampen Cimarex Energy’s prospects.

However, Cimarex Energy has hedged a large chunk of its future oil production with derivatives which will minimize the negative impact on its cash flows, in case oil prices fall. The company has hedged an average of 38,500 bpd of its oil production for the rest of the year using two-way collars at various prices ranging from a floor of $34.62 to a ceiling of $46.45 a barrel. This hedge coverage is equivalent to a little less than 50% of the company’s forecasted oil production for the full year. I think this coverage gives ample protection to the company’s cash flows while allowing it to capitalize on any strength in oil prices. I think due to its hedge book, Cimarex Energy will still generate free cash flows if it sees a tough oil price environment in 2021, just like it did last year.

In my opinion, Cimarex Energy’s financial health is also in decent shape. Although the company’s leverage (debt/EBITDA) increased in 2020, that was driven by a decrease in earnings as opposed to an increase in debt. The company’s long-term debt remained unchanged at a little under $2 billion. The improvement in oil prices should help bring the leverage down again. But even if the company doesn’t get a lot of support from oil prices, it should still stand firm in a difficult period since it has ample liquidity and faces no significant near-term debt maturities. The company ended the year with $1.25 billion of liquidity, including funds available under the revolving credit facility and $273 million of cash. Its earliest debt maturity relates to $750 million of 4.375% notes due in 2024.

Takeaway

For these reasons, I think Cimarex Energy is a great oil stock to consider. It will benefit from the increase in oil prices and it can also withstand any potential oil price shocks. Its shares have surged by nearly 60% in 2021 but the stock is still priced 5.51x in terms of EV/EBITDA (forward) multiple, below the sector median of 8x, according to data from Seeking Alpha Essential. I believe investors should consider buying this oil stock.

Analyst’s 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.