Last month we noted that both the commodity and group stock price underperformance contradicted a positive read of February’s sentiment indicators (link). Our March update suggests a shift in sentiment, albeit a modest one, that captures a neutral to modestly negative delta from February.
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We hosted a Permian basin bus tour March 8-10 with several Tier 1 operators including EOG (OP), OXY (OP), and PXD (OP) covered by Paul Sankey, and OP rated CXO and XEC from our SMID-cap coverage.
We are hosting CXO and XEC management teams as part of a broader Wolfe Research Permian basin bus tour March 8-10. CXO and XEC remain our preferred ways to invest in SMID-cap oil growth. We believe both provide the right balance between offense (high oil production growth rates) and defense (lower break-evens, strong balance sheets and liquidity). Ultimately this translates to higher returns and cash flows underpinning their premium multiples. Stay defensive and differentiated. Reiterate OP on both stocks.
With the Permian buzz reaching a creshendo, it is no surprise that EPE management has focused its growth ambitions around its Wolfcamp drilling program in Reagan and Crockett Ctys, in the TX Permian. Management now believes their Permian wells represent the highest rate of return in the portfolio (over the Eagle Ford) with oil in the low-$50s and as it highlights similar industry trends incorporating higher sand loadings, tighter stage spacing, and efficiency gains from shorter drilling times. Clearly EPE is making progress, although with such high rates of return and an improved balance sheet, we are a little surprised by the recently announced drilling carry, with its sliding scale around working interest based on well IRRs. We think it will be difficult to track proportional contribution of the JV wells (disproportionate amount of ’17 program) as a result and therefore make comparisons vs. consensus on production and capex problematic. Moreover, given the recent pullback in SM shares (-26% YTD, -16% from our upgrade), we see much greater value vs. EPE. We prefer SM’s Upton and Howard Cty. assets vs. EPE’s Reagan/Crockett and believe you get better returns starting with the ’18 growth profile and with better leverage metrics and a lower valuation. See valuation table in the body of the note for a comparison. Reiterate our UP rating.
AR connects a number of key dots impacting valuation (1) production growth (within cash flows/strip); (2) lower unit costs thru increased efficiencies from cycle time improvement and economies of scale around higher recoveries per 1k ft., (3) protecting realized prices by hedging (100% of ’17 natgas at $3.63/mcf and 100% of ’18 at $3.91/mcf; note, NYMEX front month natgas settled today at $2.77/mcf) and firm transport including a critical drop in 4Q16 net marketing expense; and (4) securing additional processing, fractionation, and takeaway to address improved liquids pricing outlook. Sure the rub is higher leverage (3x at ’16 YE) vs. Appalachia peers, but we would expect management to address this on the call. At a 1-turn discount (8.2x ‘17E EV/EBITDAx vs. 9.2x group avg.), we like the risk/reward and reiterate our OP rating.
YTD, COG has modestly outperformed the SPSIOP, -4% vs. -7%, benefitting from a recent rally in shares post FERC’s certificate approval for the Atlantic Sunrise pipeline (1bcfd FT/FS; 40% of our ‘19E production) on Feb.3. With this update, we got another look under the hood of the ‘Ferrari,’ aka COG’s Susquehanna County acreage. Just when you thought the Dimock field hit its technical limit, COG comes back with another bump up to its EUR post its fourth generation completions 4.4bcf/1k ft., vs. prior 3.8 and vs. industry averages for the broader Marcellus play of 1.7 – 2.3. With this level of well recovery, it is not difficult to see in our view, how it arrives at peer leading cash unit operating costs of $1.16/mcfe and all sources Marcellus F&D of $0.26/mcfe. Moreover, it is also why COG has the capacity to be a FCF machine once its regional takeaway issues are resolved.
SWN shares have significantly underperformed YTD, down -23% vs. -7% for the SPSIOP, due to, in our view, its higher portfolio break - even vs. its Appalachia peers, and its significant natgas leverage (90% of production). Thus, with its stated goal of living within discretionary cash flow, we were not surprised by its more conservative 3% production growth rate for ’17, factoring a $835mm D&C budget as natgas prices corrected over these past few months. We are starting to see some green shoots including the 20% ramp in SW Appalachia, with a tilt toward liquids rich completions, better cost controls with modest D&C inflation as a byproduct of owning rigs and frac spreads, flattish unit operating costs, and higher expected liquids realizations. From the call, we would expect an update on its deep Utica dry gas tests, type curve updates across the plays (we miss having them in the press release), and handicapping of takeaway capacity given its exposure to Rover (200mmcfd FT; 9% of our ‘18E production) and to a smaller extent Constitution pipelines (we found the natgas realization guidance to be more conservative vs. its Appalachia peers). Given its much improved balance sheet, liquidity and operating cost structure, we believe there is a risk of market disappoint over the more conservative ’17 growth target, but we would expect management to walk through scenarios for a more aggressive ’18 plan, especially with its expected 60 well DUC inventory at ‘17YE and the company-owned frac spreads.
YTD, RRC shares are down -13% vs. -7% for the SPSIOP. Shares have struggled in recent weeks post worries over Rover pipeline (400mmcfd FT) start-up and weaker natgas/NGL pricing due to warmer temperatures. To their credit, management directly addressed these concerns highlighting the inclusion of N. Louisiana production (22% of 4Q natgas production receiving GC pricing), 400mmcfd of combined takeaway in late ’17 from Adair Southwest and Leach and Rayne Express, and improved ethane/propane supply/demand balance due to a combination of contracted volumes and colder European weather attracting greater exports.
RICE shares have modestly underperformed the group YTD, down -8% vs. -7% for the SPSIOP and, in the absence of material news flow reflected the recent weakness in NYMEX HH, in our view. On balance this is a solid update with momentum in both the E&P and midstream businesses, one the Street should like despite a very high bar. Post the Vantage close, RICE benefits from additional ‘core of the core’ contiguous Marcellus acreage that responds well to longer laterals and more intense completions (note). So no surprise to us that lateral lengths are up on average 20% in the Marcellus to 8.5k ft. and ~13% in the Utica to 10.5k ft., leading to both higher recoveries and very strong well economics in both areas – IRRs of 100% and 80% respectively at the current strip. We suspect this is how RICE was able to keep its ’17 capex target/production outlook largely unchanged, despite 10-15% cost inflation. Unit op cost guide is down -7% to $0.94/mcfe (midpt.) benefitting from both higher well recoveries and self-help cost initiatives. Moreover, with the recent tightening of the basis differentials and its strong hedge book, RICE is also expecting some material improvements in ‘17/18 price realizations. For midstream, EBITDA is expected to more than double to $100mm on the RMH side (OH Utica gathering system) benefitting from a 63% Y/Y increase in gathering throughput and 22% in RMP (NC) to $193mm capturing a more integrated water business. Finally, the update was light on reserves details, but according to the release, future development costs for PUD conversion is $0.58/mcfe, down -24% from ’15 and vs. $0.95/mcfe avg. 3-yr drill bit F&D.
We get the market’s interest in the Permian core – multi-zone/multi-bench prospects, high well productivities/EURs, low break-evens, etc. In 2016, the interest reached fever pitch with multiple M&A transactions above $40k/acre with 2-3 turn multiples to match. But, make no mistake, not all positions in the Permian are created equal and in our view new/smaller entrants will be challenged not only to grow production cost effectively in a potentially rising price environment, but, more importantly, to identify enough well locations that can underpin long term production growth. We would expect the bump in capex/production growth/oil growth (within cash flow) for ’17 to be viewed favorably by the market, but we would encourage investors trying to distinguish long term value proposition across the growing universe of Permian stocks to evaluate a few more items, in particular CXO’s slide on resource capture. In a short 3 years, CXO has grown its net resource outlook from 3bn boe to 8bn boe (49% CAGR) and its gross horizontal drilling locations from 14.3k to 19.4k (11% CAGR). If you find ‘resource’ assessment too squishy, what about proved reserves. We would note CXO replaced 226% of ’16 production through the drill bit at $9.21/boe vs. 3-year avg. of $13.81/boe. Don’t like outspend, CXO at YE had $234mm of FCF. Like strong balance sheet and liquidity, CXO exits ’16 with both – net debt/EBITDAx of 1.2x and pro forma (post ACC sale) of $3.2bn ($2.5bn undrawn revolver). Stay defensive and differentiated. Reiterate OP.
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