The Permian Basin has been producing black gold for over 80 years, but it has been the focal point of the U.S. oil production over the last few years thanks to its industry-leading break-even costs and its multi-stacked oil pay zones that promise significant upside potential.
“Permania” is here and as a result, it’s not surprising that the most expensive energy deals in the U.S. have taken place in the Permian Basin since 2014. However, high acreage costs affect economics and the surge in land costs is leaving little room for investors to profit from the Permian deals. There is also a growing indication that increased drilling density has reduced well productivity.
Therefore, energy investors who want to have exposure to the Permian Basin through profitable firms that have not overpaid for their acreage are advised to check out Ring Energy (REI) at the current price of approximately $6 per share.
Management Team With Proven Track Record
We will start with REI’s management team because we are firm believers that a competent manager can work wonders even when the company’s energy assets are not Tier 1, while an incompetent manager can ruin a company and make it file for bankruptcy even when it owns high quality assets. An excellent management team adds value to a company and investors pay for this, while a mediocre one can significantly limit a company’s upside potential.
That said, REI is managed by a team that has built and sold two junior producers, recording huge profits from their investments.
Specifically, REI’s Co-Founder and Chairman Tim Rochford along with Co-Founder Stan McCabe took their last venture, Arena Resources from $0.13 cents per share in 2001 to $43 per share in 2010 when it was acquired by Sandridge Energy. This was a 35,000% return in less than a decade, as illustrated below:
Additionally, REI’s CEO, Kelly Hoffman, founded and finally sold his AOCO to LOMAK which eventually became part of Range Resources (RRC).
On top of this, the insiders have skin in the game; REI’s insider ownership is approximately 6.5% based on the latest annual report, so their interests are fully aligned with shareholders’.
When it comes to the prolific Permian Basin, the vast majority of energy investors focus on the Midland or the Delaware Basins where the acreage costs have skyrocketed lately often exceeding $30,000 per acre. But REI’s core operating area is located in the Central Basin Platform (CBP) that separates the Midland Basin from the Delaware Basin, as illustrated below:
Specifically, REI has so far assembled approximately 75,000 net acres of land in Andrews and Gaines Counties in the CBP, close to the Texas-New Mexico border. Given that most energy investors focus on the Delaware and Midland Basins, REI managed to pick up acres at a low cost in the CBP containing legacy conventional vertical wells primarily from the San Andres formation.
On the one hand, these wells provided a base of low decline production that generated cash flow. On the other hand, they had largely delineated and de-risked the land package while all the infrastructure like electricity, saltwater disposal wells, and pipelines were already there. Simply put, these wells had proved that the oil was there, so REI had to find ways to extract more from it and improve the recovery factor.
It must be noted here that REI’s core acreage in the CBP is only 10 miles north of where the core production of Arena Resources, the CEO’s previous business, was located. This shows that REI’s management team does know the area very well. This experience and the relationships in this region have allowed REI to gradually build up its CBP acreage through a steady stream of bolt-on acquisitions of small leases acquired from different landowners.
Operational expertise drives top quartile capital efficiencies in the energy sector. And Kelly Hoffman’s team drilled horizontal wells on the shallow conventional San Andres play proving that horizontal drilling does work despite the discontinuous nature of this formation. From a geological standpoint, the San Andres is not similar to a typical blanket shale reservoir like Wolfcamp or Bone Spring and therefore, by saying “discontinuous nature,” we mean that the hydrocarbon-bearing rock in this formation isn’t all found at the same depth.
However, REI isn’t a pure CBP play. It also has significant exposure to the prolific Delaware Basin, as illustrated below. This adds some important diversification.
Acreage Expansion Continues
REI has been building its Permian acreage since 2013:
Payments to purchase oil and natural gas properties in 2015, 2016, and 2017 were $77.9 million, $10.2 million and $28.7 million respectively, according to its annual reports. REI continued its expansion strategy in 2018, spending $4.1 million for the first nine months, and made a few more deals, including one with the Carlyle Group (CG), in Q4 2018.
Specifically, REI paid approximately $3,200 per net acre to add 5,313 net acres and 55 new gross horizontal drilling locations that are in, around, and contiguous to the company’s core assets on the CBP, offset from the majority of the company’s top-producing wells and provide opportunity for extended lateral development that results in improved acreage efficiency, as shown below:
Excellent Drilling Results
In 2018, REI drilled, tested and filed IPs on 57 new horizontal San Andres wells with one-mile laterals in the CBP Basin. To-date, the drilling results have been excellent with the average IP on these 57 wells being 432 boepd (barrels of oil equivalent per day), or 103 boe (barrels of oil) per 1,000 feet.
Meanwhile, drilling, completion, equipping and tie-in costs (DCET) is about $2.3 million per well with one-mile laterals, which results in above 70% IRRs and fast paybacks under a year at $50 WTI, as demonstrated below:
The combination of low-cost wells (at or below $2 million each) with high IRRs (at or above 50%) is a key success factor when it comes to a junior producer. Specifically, the junior producers usually have limited liquidity, which translates into limited cash and a small credit facility. However, they can grow their production on a YoY basis while largely living within operating cash flow by drilling low cost, high productivity wells. And this is the case with REI.
Some might argue that REI’s horizontal San Andres wells on the CBP have only one pay zone (i.e., one commercially viable geologic zone), while the Midland and Delaware producers target a “multilayer” cake with multiple stacked pay zones (e.g., Wolfcamp, Spraberry, Avalon, and Bone Spring intervals) that could significantly increase their returns per well. This is not true, because REI is still at the beginning of its development plan and other pay zones could come later.
It’s also noteworthy that to date, REI’s horizontal San Andres wells on the CBP have experienced moderate decline rates (approximately 40% after 12 months) that are lower than the typical decline rates of the horizontal wells drilled in the Midland and Delaware Basins targeting the Wolfcamp and Bone Spring formations (approximately 55% after 12 months).
And the good news doesn’t end here. REI has also drilled four horizontal wells so far in its acreage in the Delaware Basin targeting the Brushy Canyon formation. As linked above, the company is very pleased with the early results while planning additional development in 2019.
Specifically, the Hugin 1H was completed in mid-December and preliminary production results showed approximately 290 bopd and 485,000 cubic feet per day (485 mcf/d) or approximately 371 boepd, which is more than double the oil production REI saw from its first horizontal well in the Delaware Basin, the Phoenix 1H. Testing on the other two wells, Hippogriff 4H and Phoenix 2H wells, has not been completed yet.
Strong YoY Growth On All Fronts
Thanks to the combination of a competent management team with Permian land base and low cost, high IRR wells, REI has experienced robust growth since 2012. Specifically, its growth CAGRs of 52% and 122% in proved reserves and net production respectively are illustrated below:
Some investors might be concerned about the fact that Q4 2018 production dropped slightly on a sequential basis. But this should not concern them because this is not “the big picture.” First, the company deferred the completion of some wells because of the extremely low oil prices given that WTI hit $42 in Q4 2018. Also, REI announced that “In late November, early December, we began experiencing delays on a few of the new wells during the completion process and clean-up prior to going into production. Historically, this process varies from well to well, taking anywhere from 30 to 90 days.”
That said, the “big picture” remains unchanged. As a result, both revenue and net income have been in uptrend over the last years while, in contrast, many other oil-weighted producers in the U.S. have been losing money since 2014 when oil crashed such as Sanchez Energy (SN), Gastar Exploration (GST), Contango Oil and Gas (MCF), SM Energy (SM), Approach Resources (AREX), WPX Energy (WPX), EP Energy (EPE), to name some.
REI has been consistently making money over the last years because its average cost per acre in the less “sexy” CBP is considerably less than the recently announced Permian transactions.
For instance, REI spent approximately $3,200 per net acre in its latest deal with CG noted above, while the other Permian players have been paying more than $20,000 per acre to expand their acreage in the hot Delaware and Midland basins, as illustrated below:
Source: Earthstone (ESTE) presentation
Source: Abraxas Petroleum (AXAS) presentation
Source: Contango Oil (MCF) presentation
Actually, the Delaware and Midland basins are beginning to become victims of their own success. In other words, when it comes to the full-cycle economics of the wells in these two basins, the internal rates of return are low due to the high cost of land. However, not many operators discuss this profitability with shareholders. Instead, they focus on the half-cycle economics that excludes the land costs and is more favorable for their marketing campaign.
Healthy Balance Sheet With Attractive Key Metrics
Ring Energy has not sacrificed its balance sheet to achieve the aforementioned growth. As of September 2018, Ring Energy had ample liquidity with $3.8 million in cash and a $500 million credit facility with a $175 million borrowing base and $17 million of outstanding debt, which translates into leverage (net debt-to-EBITDA) below 1x.
From a cash flow standpoint, the company recently announced its intent to become cash flow neutral/positive in the second half of 2019, while still providing double-digit annualized production growth by initiating a one-rig drilling and development program for 2019, as quoted below:
“The management team, as well as our Board of Directors, have never lost sight of our goal of becoming cash flow positive as rapidly as possible without sacrificing growth. With a one-rig drilling program, we project turning cash flow neutral/positive in the second half of 2019, while still growing production an estimated 20+% for 2019. This is based on the following assumptions, 1) Drilling approximately 28 new horizontal wells, 2) Receiving a realized price of $50 per boe and 3) Controlling our costs. We continue to demonstrate our ability to drill and develop as efficiently as any operator and will do everything to maintain and control our costs. By maintaining a strong balance sheet and preserving the integrity of our senior credit facility, we eliminate our reliance on the current uncertainty of the capital markets.”
Meanwhile, its current Enterprise Value is approximately $427 million. Therefore, REI trades approximately $60,000 per boepd and 5.8 times 2018 EBITDA, based on 7,100 boepd production and estimated 2018 EBITDA of approximately $73 million. These key metrics are low for a consistently profitable company with a pristine balance sheet and a competent management team in the hottest oil producing Basin in the U.S.
The reserves report has not yet been released and will be out by the end of March. Once this happens, we will have the chance to calculate additional key metrics such as the value per boe of PDP reserves and the value per boe of 1P reserves.
First, this is a commodity play and therefore, its performance is largely dependent on oil prices. Wild swings in oil prices will definitely affect its top and bottom lines. No question about it.
Second, REI is a junior producer which gradually switches from lease aggregation, de-risking acreage, and testing stage to production ramp-up. As a result, it might drill some wells whose results are below the average type curve and would negatively impact its production profile.
Third, operational hiccups are part of the game and some of them could be beyond the company’s control such as midstream issues (e.g., plant turnarounds, scheduled shutdowns, and plant outages) and pipeline bottlenecks that last longer than originally anticipated.
During the last years, Ring Energy has utilized geologic and operational “know-how” to move off the beaten path and pin point strategic land opportunities with an eye on full-cycle economics. As a result, it has managed to acquire significant acreage at reasonable prices in the Permian Basin.
Additionally, it has managed to unlock the previously vertically drilled San Andres formation through horizontal drilling maximizing the recoverable resource while maintaining a pristine balance sheet.
We project that the combination of proven management team, contiguous land base, stellar well economics, significant inventory and balance sheet health will drive sustainable growth for years to come while also protecting REI from hostile industry conditions during the inevitable oil price downturns.
In short, we believe that Ring Energy has the whole package. And this package currently is very attractively priced for the investors with medium to long-term investment horizon. Don’t miss it.
Disclaimer: The opinions expressed here are solely my opinion and should not be construed in any way, shape, or form as a formal investment recommendation. The author does not accept any liability for any loss or damage whatsoever caused in reliance upon such information. Investors are advised that the material contained herein should be used solely for informational purposes. Investors are reminded that before making any securities and/or derivatives transaction, you should perform your own due diligence. Investors should also consider consulting with their broker and/or a financial adviser before making any investment decisions.