Energen_ a permian pure play – energen corporation (nyse_egn) _ seeking alpha

Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions – investors should conduct their own comprehensive research. Please read the disclaimer at the end of this article.

Among Permian Basin-focused operators, Energen Corporation (NYSE: EGN) is one of the less followed names. However, the company has meaningful acreage footprints in both the Midland and Delaware Sub-basins, significant oil production and a respectable equity market capitalization of ~$3.6 billion. This note will discuss the company’s assets, valuation, strategic challenges and operating outlook for 2016.

Key Financial Metrics

Energen stock has been an underperformer in the Permian-focused group, having declined by nearly 60% from its peak in June 2014. This compares to an average decline of ~13% for a group of select mid-capitalization peers, where I included – as an illustration of resilient performance – Concho Resources (NYSE: CXO), Diamondback Energy (NASDAQ: FANG), RSP Permian (NYSE: RSPP), Parsley Energy (NYSE: PE) and Callon Petroleum (NYSE: CPE). Driving Energen’s underperformance is the significant weight of high-cost mature properties in the company’s portfolio. In addition, Energen’s Midland Basin properties, which account for the lion’s share of the portfolio’s value, are a mix of top-quality acreage parcels as well as acreage in areas that are perceived to be Tier 1.

Energen has drilled some very impressive wells. However, the company still needs to prove that it has the ability to use its extensive acreage footprint to high-grade its drilling inventory and deliver consistently differentiated drilling returns similar to what some of its peers have been able to demonstrate, for example, in the Lower Spraberry in the Spanish Trail area.

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(Source: Google Finance)

For its enterprise value of ~$4.3 billion, Energen’s acreage footprint and existing production are significant. In 2015, the company produced 38,400 barrels of oil and ~103 MMcf/d of natural gas and NGLs. It is worth noting, however, that a portion of the company’s production is mature and is characterized by high operating costs and, therefore, thin margins in the current commodity price environment. Excluding hedge settlements, Energen’s 2015 discretionary cash flow (before changes in working capital) was just ~$266 million. High G&A expense of $149 million contributed to the week cash flow at the corporate level.

Including hedges, the company’s discretionary cash flow from continuing operations was ~$663 million and adjusted EBITDAX was ~$740 million. Net capital spending in 2015 was $1,040 million, of which a large part was dedicated to the delineation of the company’s acreage in the Midland and Delaware Basins.

I estimate the fair value of Energen’s PDP reserves of ~$2.0 billion, assuming a flat $50 per barrel oil price (please see Appendix A for a detailed calculation and assumptions). The implied valuation of the company’s undeveloped acreage is approximately $2.3 billion, at $50 per barrel oil. Assuming 100,000 core acres in the Midland and Delaware Basins and attributing $300 million valuation to all other acreage, the implied valuation is ~$20,000 per undeveloped acre. Such valuation is in line with recent market prices in the core areas of the Midland and Delaware Basins. (Please note that this calculation is a summary of the company’s trading multiples and not a conclusion with regard to the stock being under – or over-valued.)

Let’s Review Key Assets

The Midland Basin contains Energen’s most important assets. The northern acreage, which is located in Midland, Martin and Howard Counties, includes ~39,000 net acres and could yield 36 wells to 50 wells across all the prospective zones, according to the company’s estimate. The southern acreage, located mostly in Glasscock County, includes ~29,000 net acres with estimated potential for 36 wells to 50 wells across all the prospective zones.

Energen’s Delaware Basin position is also quite significant. The map below shows that a large portion of the acreage – particularly in Reeves and southern Loving Counties – falls within the core Wolfcamp and Bone Spring fairways. Please note that the map excludes the ~35,000 net acres that Energen has designated for sale.

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Given the size and location of Energen’s leases, there is no question in my mind that the acreage offers multi-decade development potential, making the company resource-rich. The acreage is diversified, which increases the chances of exposure to sweet spots. A significant portion of the acreage is blocked up, which allows for development with extended reach laterals and operational efficiencies. The real question, however, relates to the size of the core-of-the-core drilling inventory that would provide differentiated returns in a low-price oil environment (I will again use the Lower Spraberry in the Spanish Trail area as an example of such differentiated returns). In this regard, Energen’s well results to date give reasons for cautious optimism – while it is difficult to think of Energen’s average well results as stand-out, the company has reported some very strong wells.

The following slide shows cumulative production for Energen’s three Lower Spraberry wells that the company drilled earlier in 2015 in Martin and Howard Counties. The early-time well performance is encouraging and is comparable to Lower Spraberry results reported by peers. Importantly, the oil content is approximately 79%, based on the company’s EUR estimate.

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(Source: Energen Corporation, March 2016)

Energen has also reported an encouraging Lower Spraberry test result in Glasscock County. The Daniel SN 7-6 04 #504H well is located approximately 5 miles north of the company’s first Lower Spraberry test wells in this area. The Daniel well had an IP-30 of 1,213 Boe/d, 70% oil. Energen commented:

…the Daniel well is performing much like our Lower Spraberry wells we’ve drilled on the northern half of our acreage position. It’s a 10,000-foot lateral. It’s tracking a 1 million BOE type curve through some 60 days.

In my view, it is premature to conclude that the Lower Spraberry is solidly economic in Glasscock County, given that the GOR for this well is noticeably lower than for the Lower Spraberry wells in the north and the cost of drilling a 10,000 lateral should be taken in consideration. However, the result is certainly a positive initial data point.

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(Source: Energen Corporation, March 2016)

Energen’s northern acreage generally appears more promising than the Glasscock block which is located in a gassier area. To illustrate, let’s compare Energen’s Wolfcamp A/B type curve for Glasscock acreage (normalized to 7,500 foot). The type curve has been reviewed by Ryder Scott and implies an EUR of 890 MBoe. The oil component of the EUR is estimated at 52%, or ~450,000 barrels. The type curve represents an average of the A and B benches, where the A bench is oilier and the B bench is gassier. The type curve is based on the company’s 19 latest Wolfcamp A and B development wells in Glasscock County.

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(Source: Energen Corporation, March 2016)

To understand the difference in productivity between “Core-or-the-Core” and “Tier 1” acreage, it may be instructive to compare the above type curve to the Lower Spraberry type curves provided by peers for the Spanish Trail area. For example, Diamondback has indicated that its Lower Spraberry wells are on track to yield EURs in the ~800,000 barrels of oil range, which is nearly twice the amount of oil implied by Energen’s Wolfcamp type curve in Glasscock County. Diamondback’s completed well cost is actually lower than Energen’s. Needless to say, the difference in drilling economics is very significant between the two sets of drilling opportunities.

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(Source: Diamondback Energy, March 2016)

In summary, Energen has a large acreage position in the Midland and Delaware Basins that appears to provide exposure to areas with “core type” drilling returns (particularly, portions of the northern Midland Basin acreage). Most of the acreage, however, is likely in the “tier 1” category in terms of expected returns.

Energen has some work to do delineating its multiple targets and optimizing extraction techniques. Thereafter, the company would need to demonstrate that it has a meaningful high-graded drilling inventory that can yield consistent, differentiated drilling economics that remain viable in a low-price oil environment.

In the event commodity price environment improves substantially, the company’s “tier 1” inventory may offer additional upside.

Let’s Review The Balance Sheet

With a large equity offering earlier this year, Energen addressed its liquidity needs for the immediate term. As a reminder, Energen had ~$778 million of debt outstanding at year-end 2015. The $381 million in net proceeds from the equity offering allowed Energen to pay down the balance under its credit facility and pre-fund the expected 2016 capital outspend.

However, given the persistently weak commodity price environment, the need to raise additional funds remains high on the agenda. The following slide implies an EBITDAX of just ~$225 million in 2016, assuming average oil price of $42.50 per barrel in March-December 2016. To avoid borrowing under the credit facility (which would expose Energen to covenant risks), the company needs to sell some assets. The company has also set a target of raising $400 million in non-core divestitures this year.

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(Source: Energen Corporation, March 2016)

Let’s Review Cash Flow Generation

As I have mentioned, Energen’s cash flow generation is weak relative to the company’s strong existing production volumes. Part of the problem is high lease operating costs associated with the company’s mature assets. Energen estimates its LOE for the Central Basin Platform and other mature assets in the $22 per BoE range (please note that this is not a per oil-barrel metric). Taking in consideration production and ad valorem taxes and basis differentials, cash netbacks on this portion of the company’s production are thin at the current prices. G&A expenses, which are estimated at $89 million in 2016, further reduce the company’s net cash flow.

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(Source: Energen Corporation, March 2016)

2016 Operating Plan And Expected Drilling Returns

Energen has layered in significant hedges for 2016. Approximately half of the company’s estimated oil production in 2016 is hedged at ~$45 per barrel and approximately one-third of the estimated natural gas volumes are hedged at $2.47 per MMBtu.

The company plans to invest roughly $250 million to $350 million of drilling and development capital in 2016. The $250 million plan allows Energen to hold its acreage in the Delaware and Midland Basins and complete 46 net DUC wells in the Midland Basin. The company will also drill and complete one additional Lower Spraberry well in Martin County in order to finish the pad and put in place production facilities. If oil prices increase, the company may invest capital closer to $350 million and resume drilling in the Midland Basin.

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(Source: Energen Corporation, March 2016)

Energen plans to focus on the Wolfcamp A and Lower Spraberry targets that have higher returns. The company estimates internal rates of return for Wolfcamp A and Lower Spraberry wells with 7,500 foot lateral lengths in the low 20% range, assuming strip pricing of $36 per barrel in 2016 rising to $40 per barrel in 2020 and assuming current estimated drill and complete cost of $6 million to $6.5 million. Using the same pricing assumptions for Wolfcamp A and Lower Spraberry wells with 10,000 foot lateral lengths and assuming current estimated drilling and completion costs of $7 million to $7.5 million, returns are approximately 30%.

Adjusting for our planned asset sales, Energen estimates its production volumes to decline ~12% in 2016, exit-to-exit, assuming the $250 million budget scenario. Production growth coming from the company’s planned completion activities in the Midland Basin will be offset by natural declines in the vertical Wolfberry, 3rd Bone Spring Sands, Delaware Basin and Central Basin Platform programs where the company is not investing capital.

DUC completions are scheduled to occur during the first half of the year. Therefore, 2016 production is expected dip in Q1 2016, then increase in the following two quarters, to peak in Q3 2016.

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(Source: Energen Corporation, March 2016)

Asset Sales

Energen has sales processes underway to sell its remaining San Juan Basin assets as well as acreage in the Eastern Delaware Basin in Texas. The company hopes to receive cash proceeds in the $400 million range. No tax leakage is expected.

As a reminder, Energen sold approximately 70% of its San Juan Basin assets a year ago. The remaining assets are primarily natural gas production with some upside potential in the Mancos oil play. Based on the results of a Mancos exploratory well that was drilled in the second half of 2015 to test the oil play’s potential, Energen concluded that outside a small core area of the current Mancos production, the play would not be competitive with the company’s opportunities in the Midland and Delaware Basins.

Energen is also in the process of marketing ~35,000 net acres in the eastern Delaware Basin The package includes ~1,200-1,400 Mboe/d of existing production. The Delaware acreage is expected to account for the lion’s share of the $400 million of estimated potential proceeds.

Energen has also indicated that additional assets may be put on the market. The company has significant acreage in the Delaware Basin that it doesn’t consider “core of the core.” So selected acreage packages may be offered for sale. The Central Basin Platform asset is also a logical sale candidate. However, given its PDP nature, receiving attractive price in the current environment may be a challenge.

In Conclusion…

Energen has made significant progress in reducing its G&A and operating costs and narrowing down operational focus.

Following non-core divestitures (mature production in San Juan Basin and, possibly, Central Midland Platform), the company’s asset portfolio will include almost exclusively high-potential growth assets with meaningful exposure to core fairways in the northern Midland Basin and southern Delaware Basin. However, in the current commodity price environment, the real driver is the “high-graded core” of the asset portfolio. In Energen’s case, it may prove to be a relatively small part of the company’s existing total asset footprint.

Given Energen’s extensive acreage footprint, asset-based multiples are highly relevant to the understanding of the stock’s valuation. While these multiples appear within the range of reasonable when compared to the peer group, delineating acreage and identifying the most prolific areas and target intervals is critical to creating a high-graded inventory. Energen needs to explicitly demonstrate what those assets are, in order to support its stock price and bridge the valuation gap to the leading Permian-based peers.

As is the case with many E&P companies, the view on the stock’s risk/reward profile depends strongly on one’s view on the trajectory of oil prices. The stock’s current price appears to effectively imply a recovery in oil prices to above $65 per barrel (which is not dissimilar to other stocks in the sector).

APPENDIX: Estimating The Value Of Existing Production

In terms of reserves, Energen reported 2015 year-end proved developed reserves of 184 MMBoe, including 108 MMBoe of oil. Total proved reserves were 355 MMBoe. The pre-tax PV-10 value of the proved reserves was ~$2.5 billion, based on my calculation.

Energen does not break out the PV-10 value of the proved developed producing reserves. By assuming a PV-10 valuation for the PUDs at $3/Boe, I arrive at the PV-10 value for the PDP reserves of ~$2.0 billion. I apply the following adjustments to the PV-10 of the PDP reserves to arrive at an estimated fair market value of Energen’s existing production:

· Apply a 7%-9% discount rate, which I view as more appropriate than the SEC-mandated 10% discount rate in the context of the flat pricing and flat costs assumption – I arrive at a value range of $2.2-$2.35 billion.

· Allocate a portion of future SG&A expenses to the PDP reserves (not captured by the PV-10) – I estimate the present value of the allocated future corporate overheads at ~$0.26 billion.

· Include hedges: the impact of the company’s hedges on the PV-10 value is not material – I estimated at ~$35 million at for the SEC price case.

Using the midpoint, I arrive at an estimated fair value of Energen’s PDP reserves of ~$2.0 billion, assuming a flat $50 per barrel oil price.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.