Over the past several years, investing in upstream oil and gas development has been a fool’s errand. Despite incredible growth in production here in the United States, the vast majority of the value – and by value I mean retained profits – has fallen into the hands of the midstream and downstream asset operators. Any company that has managed to succeed in generating returns above its cost of capital has most often plowed that money back into the business.
That operational viewpoint is changing and perhaps with that change the balance of power will shift. With upstream operators so battered, there might some value to be found. Ring Energy (REI) has crossed the radar of many that focus on small cap oil development: decent balance sheet, great well projections, “Permian”, and a management with a track record. What’s not to like? A lot more than one might think once you work below the surface. I don’t necessarily have a view that the stock is not undervalued today – it might be – but there are some deep questions bulls have to ask themselves.
Overview, Bull Thesis Recap
Ring Energy is a Permian-based exploration and production (“E&P”) company headquartered in Midland. While it has its headquarters in the hottest area of the Permian Basin, it has no owned acreage t here. Instead, it focuses heavily on the Central Basin Platform (81k net acres) alongside the adjacent Northwest Shelf (38k net acres) and the Delaware Basin (20k net acres). The bulk of current oil production is in what is called the San Andres, an area where most oil is produced using conventional horizontal drilling techniques. This has been a growth-oriented E&P, substantially improving both its proved reserves and net production aggressively over the past several years. Perhaps luckily for potential new long investors, much of that growth has been funded with stock issuance at – at least compared to today – extremely attractive valuations.
I think the bull thesis can Ring Energy can be compressed down pretty easily into an elevator pitch. No question it is a compelling one before digging in deep. In my view, I think it’s a large reason why the company has attracted a lot of retail investor interest even at much higher share prices.
- Founded by Tim Rochford and Stan McCabe, Ring Energy is trying to replicate the success the two had with Arena Resources, a prior company that both founded. Arena Resources was sold to Sandridge Energy in 2010 for $1,600mm, unlocking massive returns for shareholders well over 3,000% in ten years. Ring Energy is operating in the same geographical area: Andrews County in the Central Basin Platform (“CBP”). Lightning can strike twice.
- The Permian Basin is hot. Red hot. San Andres rock looks to have a lot of advantages: great internal rates of return (“IRR”), medium grade API, low rates of well decline. Why shouldn’t the company be able to flip itself for a tidy profit, particularly given where it trades on stated proved SEC PV-10 and other measures of net asset value?
- Leverage appears under control at first glance. Even after the Wishbone acquisition, there does not appear to be many problems: interest coverage is alright, debt/EBITDAX is manageable. Free cash flow neutrality has been targeted as attainable by end of year with leverage creeping down into the end of 2020.
Interested? Sounds mighty tempting. At a high level, this looks like a clear story of an undervalued asset base, great breakevens, a manageable leverage profile, and an asset base with a long runway. So why has the valuation collapsed by more than 80% since Q4 of last year?
A Look At The Central Basin Platform
First, let’s start with the Arena Resources sale that is supposed to show that Ring Energy has a path to success. Whatever happened to those assets sold to Sandridge Energy (SD)? The company was plagued with some little annoying problems regarding the assets (lack of takeaway capacity, lawsuits) from the get-go. Many of those problems, along with the rally in oil prices, led to the decision to sell those assets in 2012 to Sheridan Production Partners II, a private equity fund focused on mature oil-producing assets. While private, high leverage coupled with weaker results have led to distress with Moody’s calling the structure “unsustainable” due to poor cash flow and weakening reserves (Source: Moody’s Credit Opinion). The sale by Sandridge, while infusing the company with capital to invest in its other market areas, only pushed off its inevitable downfall. While it exists today, it endured a painful pre-arranged reorganization after filing for bankruptcy. It sold its remaining Central Basin Platform (“CBP”) wells in late November for just $40mm as part of its strategic review, with new management clearly having no interest in developing or purchasing additional acreage and interests in the area. While the past is the past, I think the mixed history of success on what was Arena Resources after the fact does speak somewhat to repeatability. If the assets were doing well, my opinion might not be so negative.
But what is exactly is the Central Basin Platform (“CBP”)? Vertical conventional drilling in the Permian Basin has been taking place for many decades; San Andres has been at the forefront of that. As a result, quite a bit of the high-porosity rock has been exploited already so its difficult to find contiguous acreage. Hit rate on wells tends to be poor, with more than a few dry wells being drilled. Unconventional wells just do not have that problem. Still, there are some areas where technology and finding improvements create some optionality.
For Ring Energy, well costs are relatively low, decline rates are better than unconventional plays the Permian, and stated breakevens more than make sense in the current environment. Management claims 80% IRR and those rates of return look attractive, even versus other areas of the Permian because the wells are shallower than in the Midland or Delaware Basins, requiring smaller equipment that is not in as much demand in unconventional development. .On balance, it is important to remember that recoverable barrels per well are very low so constant drilling has to take place and economics can change quickly. Plus, there are some pain points on extraction in this area – nasty poisonous gas releases for one.
Remember that stated IRR on wells do not include the general and administrative (“G&A”) expenses, likely to run 15% of revenue this year. That is more than double rates found at larger E&Ps and a factor that really hurts some of the healthy economics of CBP development. Larger companies are looking for massive buys that expand reserves by many millions of barrels; it just isn’t worth it for a major player to make a purchase and push into this area of the Permian. Investors have to ask themselves the question: Why are large E&Ps so focused on unconventional development? Why are acreage costs so low relative to unconventional assets down the road? Larger E&Ps, by and large, are not stupid.
At the end of the day, bulls had been looking for a buyout most likely up until late last year. It won’t happen. Instead, Ring Energy has become one of the premiere consolidators in this area by remaining an buyerof private equity holdings in the CPB ( Tessara Petroleum Resources, Wishbone Energy). With the balance sheet where it is, that runway is exhausted.
Net Asset Value Per Share Equal To Fair Value?
I think we have to have a frank discussion about PV-10. The Securities and Exchange Commission (“SEC”) mandates that publicly-traded companies include reserve information in their annual filings – that includes the PV-10 calculation. While I view PV-10 as an important benchmark, there are quite a few management assumptions that have to be made and real cash costs that are excluded. In order to calculate PV-10, E&Ps like Ring Energy have to determine a few things to comply with SEC rules:
- It must estimate its proven reserves – both developed and undeveloped. This is defined by the SEC as “those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible…”. What is economically producible can vary year by year even if what is actually under the ground and found does not change. This can be a moving target.
- Pricing is calculated based on applying pricing based on the twelve month historical average of beginning of month prices. This was a shift away from just using end of year spot pricing – the norm until 2008. Using more datapoints has significantly reduced volatility and improve the value of the PV-10 metric in my opinion.
- Future cash flows are reduced by estimated production costs, costs to develop and produce assets that are not yet flowing, and abandonment costs. An estimate must be made on well decline rates and how much production will be generated each year. This matters quite a bit due to the discount rate being applied. Cash flows in 2019 are much more valuable than those in 20230.
- G&A costs are excluded as well as interest expense. Two companies can have the same PV-10 valuation with substantially different capital structures and management teams when it comes to efficiency that dramatically shifts the cash flow available to shareholders.
- Income taxes are applied based on management’s best estimate of its future tax burden. Tax rates can often shift with time and it is not always at the Federal level. States might hike royalty or drilling taxes for instance. Future net cash flows are discounted to present value by applying a discount rate of 10% per year.
While there are many estimates that have to be made by management teams that are up to interpretation (and therefore exploitation), the SEC has been on a mission to protect investors and improve market efficiencies. Standardizing PV-10 is a clear step in that direction. However, there are caveats to this metric beyond potentially nefarious CEOs and CFOs.
- Every company estimates proven developed and proved undeveloped reserves. These are treated equally under PV-10 which is obviously not apples to apples even when estimates on costs of bringing assets into production are applied. E&Ps tend to underestimate these costs versus overestimate in my experience. Companies with higher proved reserves should fetch higher valuations, all else equal.
- Pricing is based on twelve month historical pricing; historical pricing is not necessarily future pricing. While many E&Ps provide additional PV-10 based on strip pricing, these tend to miraculously disappear or reappear depending on whether it casts the company in a favorable light.
- Projected operating costs tend to be extrapolated forward and are held constant. This could change as well depending on the pursuit of less economic production in non-core acreage, higher shipping costs in the future, wider differentials, or just general inflation. By no means is this an exact science.
Some of these factors work against Ring Energy. The company acknowledges that a substantial percentage of proven properties are undeveloped versus proved developed producing (Source: Ring Energy, 2018 10-K, Page 8). As mentioned, G&A costs are quite high. This creates issues on valuation. In fact, signs that PV-10 is not equal to fair market value are right in front of investor’s faces.
The most clear one is the Wishbone acquisition. The transaction roughly doubled production, proved reserves, and likely future EBITDA (Source: Ring Energy,Wishbone Acquisition Presentation, Slide 3). Despite operating on substantially less acreage, Wishbone has substantially current production. However, Wishbone was acquired at 51% of PV-10 ($300mm purchase price, $582mm management stated PV-10).
Source: Ring Energy, Wishbone Acquisition Presentation, Slide 11
Wouldn’t it be nice to buy something for $300mm and immediately have it valued at double that price within your own balance sheet, or even more once including probable and unproven reserves? Either you believe that management are some crafty guys that found acreage on sale for half off in the Permian or you call into question whether PV-10 should be used to value this firm.
There are some quality issues with Wishbone. A large portion of that $582mm is made up of Proved Developed Non-Producing (“PDNP”) and Proved Undeveloped (“PUD”) wells; legacy Ring Energy acreage does not have that issue. But nonetheless, management has used this to spin a story of substantial NAV accretion.
Discounts to PV-10 upon sale are not uncommon. Arena Resources, once adjusted for oil price cyclicality, sold for 70% of PV-10 (Source: Sandridge Energy, Arena Resources Presentation, Slide 8): . Sandridge Energy in its own sale of the assets a couple of years later once oil prices recovered, was also pressed on selling below 2012 PV-10 (oil prices had moved higher in the months since then as well). See the below exchange during the Q4 2012 earnings call:
[Jessica Lee, JPMorgan] Good morning. This is Jessica Lee for Joe Allman. We’re trying to get an understanding of the Permian sale. I think you booked your year-end ’12 PV-10, proved reserves, of $3.2 billion, and from our understanding, that excludes any value for the unbooked reserves. So could you help us think through the decision to sell the Permian at a price below the proved reserves PV-10? [James Bennett, Sandridge Energy] You know, typically when you have a reserves value that includes a lot of PUDs. You typically won’t get full value for the PUDs. In this particular case, I think we got really good value for the Permian, based both on a dollars per barrel production per day and a multiple on cash flow. I think it’s one of the strongest sales here in recent time.
Sandridge specifically called out PUDs as an issue in valuation, something that has implications for Ring Energy today that carries nearly $500mm worth of stated net asset value on its balance sheet from PDP and PDNP. It also dents the value proposition of Wishbone in the first place.
Cutting Expectations, Shifts In Capital Priority
When the Wishbone deal was announced, those assets were supposedly throwing off 6,000 boe/d of oil. By April, that figure had been cut to 5,400 (Source: Ring Energy, Wishbone Closing Press Release). This is less than two months later.The shift is confusing to my eye and really off-putting. This is no error and was largely confirmed by Q2 net production figures of just 10,725 boe/d when the company was guiding for north of 12,000 boe/d at the time of acquisition. What happened to the 10%+ delta? Management, while not directly addressing it, blamed the fact that there was no active drilling on the acreage since September or October when the sales process started. That doesn’t address the fact that production was guided higher at deal close in February. These are supposed to be low decline rate wells and if those acquisition figures were just outright wrong it throws off PV-10 and expected cash flows. There is some fishy business afoot.
Likewise, on the Q1 conference call management alluded to a ramp into the back half of the year:
I think Danny did a great job of articulating the movements behind that, but the reality of it is, is that second rig isn’t really going to contribute at the earliest maybe the latter part of the second quarter. But I believe as we go into the third and fourth quarter kind of grab a seat, because I think it’s really going to be impactful. So I think we’re going to see some meaningful upswing at that point in time.
Grab a seat? Since then, investors got handed a revised capital expenditure budget that reduces the number of expected wells to be drilled by 36%. The company has gone back to operating one rig from two. While preliminary results were “exciting” and there would be clear value to be gained given those fat IRRs, management has instead pivoted to improving current production and efficiencies via reworks or upgraded equipment on its legacy wells. Post second quarter, there will be no active drilling rigs on the company’s old property, instead with well completions being directed towards the Northwest Shelf. I don’t believe the market is sold on the concept that declining well completions coupled with a less than one percent cut to 2019 capital expenditure guidance is a recipe for success. While the guidance is towards an easier means of achieving cash flow neutrality by year end this way, the market is skeptical on overall execution.
What we have here is a small E&P operating in a niche area of the Permian where it has become the consolidator of choice. Given that, the prior exit strategy (sale to a larger player) appears unlikely. Despite stated well economics with stratospheric returns (80% IRR), Ring Energy is still struggling to achieve cash flow neutrality and is redirecting capital towards upgrading equipment versus drilling. Those two points just do not jive in my view.
As the market embraces E&Ps moving towards free cash flow and self funding, that appears elusive here. A $152mm capital expenditure budget where production growth is only expected to be “modest” (meaning roughly about maintenance spend) is not getting it done. Meanwhile, questions revolve around how solid the Wishbone actually is. Does this one deserve to be south of $2.00/share? Possibly not. But there are enough question marks to justify staying away from it in my opinion.
Are you an investor looking for sustainable high income? The energy sector is filled with opportunities to do just that. At Energy Income Authority, the focus is on finding high quality companies with the asset footprints necessary to throw off dividends for years to come.
Tired of lackluster coverage that barely breaks the surface? Deep dive analysis forms the cornerstone of the platform. Hundreds of companies fall under the coverage universe, from pipelines to refiners to the producers themselves. Members receive actionable research to keep their portfolio thriving.
Sign up for a NO OBLIGATION FREE TRIAL today to find out more.
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.