LPI: Midland Basin Pure Play Prints Free Cash
LPI: Midland Basin Pure Play Prints Free Cash
Price $52.05 Growth Holding December 22, 2022
- Low valuation should expand.
- Estimated Fair Value of $150 per share at a 5.0x PE.
- Free cash being used to delever and derisk the balance sheet.
- The roll off of lower priced hedges will boost earnings.
- Growing production.
- SPR (Strategic Petroleum Reserve) depletion cessation and a recovery in Chinese demand will in our opinion drive oil prices higher into 2023.
- High free cash being returned to shareholders with stock repurchase.
Investment Thesis
Laredo Petroleum (LPI) is an oil and gas exploration company focused on a pure-play position within the Midland Basin West Texas. Across 163,000 acres, LPI produces 73 mboe/d (thousands of barrels of oil equivalent per day).
Presently LPI has several low strike price hedges in place for LNG and natural gas production which caused price realization to below spot in 2022. As these continue to roll off into FY23, we expect price realization to improve. FY23’s capital expenditures are expected to stay near the $600 million level.
With Chinese demand for petroleum bouncing back significantly and the SPR ceasing its 1 million bbl/d release, we expect much stronger energy prices in FY23 (in the $100/bbl area). In addition, while LPI does not presently pay a dividend, they are delevering and returning cash to shareholders through buybacks.
Estimated Fair Value
Estimated Fair Value = E23 EPS times P/E
EFV = $30 X 5.0x = $150 per share
Our P/E calculation is at the low end of the typical 5.0x – 10.0x range at which exploration and production companies typically sell.
Mix and Operations
LPI produced 73 mboe/d, with a 47% oil mix. Unit sales volumes are up 4% year over year. However, the mix has changed significantly over the last year. Oil sales volume is up 22.5%, while natural gas is down 16% and NGLs are steady year over year.
Within 3Q22, LPI completed 11 wells, incurring $140 million in capital expenditures. 4Q22 is expected to be near the same level. Full year 2023 capital expenditures are expected to be around $600 million but with fewer completions than FY22.
Lease operating expenses (LOE) are at $6.50/boe, which is roughly average for the basin. Therefore, based on their financial statements, we estimate their fully loaded breakeven price is $22.77/boe.
Current development plans are focused on north Howard County which has consistently had high-output wells. While this area is a low-cost production area, there are numerous players, and LPI could face some diversification risk due to “frac hits.” Frac hits are a product of the ever-increasing horizontal drilling length (LPI hitting 12,000ft in 3Q22). These frac hits are when a new well actively utilizing hydraulic fracturing leaks into an existing producing well. This causes a halt in production for both wells while repairs are done.
LPI still has low strike price hedges on the books, especially in natural gas. As those roll off, we expect to see higher cash flow generation. The average sales price for oil was 103% of the West Texas Intermediate (WTI) price, while NGLs and natural gas were only at 25% and 47% of their spot price respectively. We expect the NGL and natural gas numbers to go north of 80% realization in FY23 as the older hedges roll off the balance sheet.
Financial Performance
Drilling and completion costs for 4Q22 are expected to be around $140 million, with 13 completions averaging 12,000 feet in lateral length. As a cost saving measure, LPI owns and operates a sand mine that is used to backfill wells. This is estimated to save $400,000 per well in startup costs.
At current commodity prices, FCF (Free Cash Flow) is expected to remain elevate in 2023 at $900 million.
LPI has consistently moved forward the sub 1.0x debt-to-EBITDA debt target, expected to hit it sometime in 1H23. 4Q22 debt-to-EBITDA is expected to be 1.2x. So far in 2022, LPI has retired $285 million in debt out of a reduction target of $700 million by end of FY23.
LPI has repurchased $37 million in shares since initiated in Q2Q22. The opportunistic program is authorized up to $200 million. This is 2.6% of outstanding shares. Depending on commodity prices and free cash generation for FY23, LPI reserves the ability to adjust the mix of debt retirement and stock buybacks.
Consensus Estimated EPS for 4Q22 is $4.09, slightly lower than 3Q22. However, as the low-strike price hedges roll off and interest expense decreases, earnings are expected to move up sharply with E23 EPS at $31, up from $23 for E22.
Market Dynamics
The price of oil and gas has dropped year to date and has more than retraced its spike around the Russian invasion of Ukraine. We expect the WTI (West Texas Intermediate) price to move back above $100 in FY23. Our number is above the $93 mark that the EIA expects. Our $100 assumption is driven on Russian oil sanctions creating inefficiencies that will increase the price of oil globally. In addition, the SPR (Strategic Petroleum Reserve) depletion is ending, and Chinese demand is coming back online as strict COVID shutdown policies are eased. Both of these additional factors will put significant upward pressure on oil prices as inventories are low and global demand increasing.
Risk
Despite our $100 price expectation for WTI, a severe recession will soften demand. The margin of safety on LPI is solid given their low breakeven costs.
LPI has a strong pool of assets in the very high margin Midland Basin; however, the Midland Basin is a hot development zone. As a result, LPI faces concentration risk, and as previously discussed, Frac-hits have become more common. In this example from an LPI Howard County rig, there was a frac-hit that caused a shut down in production while a repair was underway.
| Laredo Petroleum (LPI) | E2022 | E2023 | E2024 |
|---|---|---|---|
| Price-to-Sales | 0.5 | 0.6 | 0.6 |
| Price-to-Earnings | 2.3 | 1.7 | 1.6 |
Competitive Comparisons
| Estimated Next 12 Months | Dividend Yield | EV-to-EBITDA | Price-to-Sales | Price-to-Earnings |
|---|---|---|---|---|
| Laredo Petroleum (LPI) | 0.00% | 2.2 | 0.4 | 2.3 |
| Ranger Oil (ROCC) | 0.80% | 2.4 | 0.8 | 3.8 |
| Talos Energy (TALO) | 0.00% | 2.7 | 1 | 5.7 |
| Peyto E&P (PEYUF) | 4.30% | 4.1 | 1.7 | 6.2 |
| Gulfport Energy (GPOR) | 0.00% | 2.8 | 0.7 | 4 |
| Earthstone Energy (ESTE) | 0.00% | 2.9 | 0.8 | 2.9 |
