While the market as a whole appears to be reaching peak complacency, the energy investment market remains in a state of despondency. Crude oil prices recently hit all-time lows. While prices have since recovered, crude oil is still below production costs for just about all U.S consumers.
Indeed, it is the boom in crude oil production in the U.S that is to blame for the industry’s ongoing depression. Fueled by cheap credit as opposed to profits, crude oil producers such as those in the Oil & Gas ETF (XOP) have essentially doubled production over the past six years. This glut has caused XOP to lose over 85% of its value since 2014.
Late last year, the situation seemed to be reaching an equilibrium wherein crude oil production would level off and the glut would finally clear. Unfortunately, COVID struck and caused one of the largest production gluts on record. Production has declined, but demand has fallen much more. This has led to an increase in bankruptcies among energy producers and widespread fear among investors.
With despondency and fear at an extreme, energy producer equities are extremely cheap. They are perhaps the riskiest segment of the equity market. But where risk is high, so too is potential rewards. With crude oil seemingly returning to the $40-$50 range, this may be a great buying opportunity for a few of these “Cigar Butt” equities. In fact, financial risks seem to be a bit lower than perceived in many of these firms.
Talos Energy is a leading offshore oil and gas exploration and production company situated in the Gulf of Mexico. Talos is one of the largest independent oil producers in the Gulf and has operations that range from deepwater to shallow-water in both the United States and Mexico.
The company currently has a market capitalization of $823M and an enterprise value of $1.7B. As of its last annual report, it had 181 MMBOE in proven reserves and produced around 52K barrels/equivalent per day. The company also generated about $400M in operating cash flows last year at a high margin despite continued weakness in the market.
Without a doubt, this year will be difficult as oil prices are now below breakeven rates. That said, Talos does have nearly $200M in working capital with large enough cash reserves to get through a difficult period. The company is still producing and has adopted general health practices and did not have COVID cases as of its earnings call.
In order to maintain cash flows, the company’s capital budget has declined by 40% and operating costs were down 15%. Luckily, the company had a large hedge book going into the year which helped it sustain a very strong EBITDA margin of 80% over the past 12 months. As of its earnings call, it still had 10.3M barrels hedged (over 80% of production) for the rest of 2020 at a weighted average price of $47.3 per barrel. This means the company will actually continue to see strong cash flow this year.
In my opinion, given its high reserves and opportunistic hedging that will save it from this difficult period, TALO is a strong speculative buy. Its price to TTM CFO is only 1.5X and TTM EV/EBITDA is only 2.1X.
Earthstone Energy is an independent producer in the Midland Basin of West Texas and the Eagle Ford in south Texas. The company aims to capitalize on the maturation of the Permian basin and has minimized its risk exposure.
Earthstone currently produces 15.7K per day with total proven reserves of 94 MMBOE. About half its Q2-Q4 2020 production is hedged at an extremely strong price of $57 per barrel. Most impressive is its all-in cash costs per barrel of only $13.5, which is extremely low. Even if its realized costs are higher, Earthstone is a very high-profit margin company and can survive in this environment. See recent investor presentation for this information.
Despite this, the company is very cheap with a TTM “EV/EBITDA” of only 5X. Even more, astonishing is its TTM “P/CF” of 1X. See below:
The company’s income will likely be lower this year. However, its margins are strong as is its current hedge book; its long-term COVID impact will likely be minimal. The balance sheet is not alarming and the company has over $100M in available revolver borrowings. It had temporarily cut production this month due to low prices and aimed to cut expenses materially. Still, its margins and hedges are strong, so a rapid recovery is likely.
Bonanza Creek is an independent producer focused on the Niobrara Oil shale patch in Colorado. In its recent quarterly report, the company had 122MM BOE in proven reserves and produced about 25K barrels per day.
Similar to the other two, the company has stellar margins and is benefiting from its hedges. It currently has a $10 total cash cost per BOE which is the lowest of the three companies. Additionally, approximately all of its remaining 2020 production is hedged with an average floor of $40. This is not as great a floor as the other two, but unlike those, it has a larger hedge position and will likely maintain strong margins.
Most impressive is BCEI’s near-complete absence of debt. It has some debt, but a nearly equal amount of cash, so its enterprise value and market capitalization are nearly equal. See below:
As you can see, the company is trading close to its TTM CFO and EBITDA. Again, 2020 will likely see income decline, but not by too much given its hedges and naturally strong margins. In my opinion, BCEI is another stellar, deep-value opportunity.
The Bottom Line
Overall, there seems to be a clear disconnect between the true quality and value among energy producers and investor/media sentiment. Most investors are fearful to invest in these companies due to their awful performance over the past few years. This is likely exacerbated by the news stories surrounding high-profile bankruptcies.
However, when we look at smaller independent producers, there seems to be greater quality at lower prices. Put simply, investors and analysts seem to have forgotten about these firms and have left them substantially undervalued. Many are well-hedged, have greater margins, and are far more nimble than their more expensive larger counterparts.
These three companies are not as cheap as they were a month ago, but they all have extremely low valuations. Indeed, they seem to make bank stocks in 2009 look expensive.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ESTE, TALO, BCEI over 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.