Sometimes, the market indiscriminately throws the good, the bad, and the ugly out the door. The oil and gas industry seems to be undergoing such a period at the current time. Bargain prices are becoming bigger bargains to the dismay of many investors. That appears to increase the selling to the point where prices are so cheap compared to asset values and cash flows. Yet the usual signs of a bottom that include consolidating acquisitions and dispositions are not yet apparent. Yet, for many investors, good companies purchased at bargain levels often treat investors well even if they have scary declines from those bargain levels to even lower bargain levels.
Price Action
Ring Energy (REI) is one of those stocks that has been a bargain for some time at considerably higher levels. Yet the price has now become extremely cheap.
Source: Seeking Alpha Website August 17, 2019
Ring Energy roughly doubled the production reported from the previous year in the second quarter. In both the press release and the conference call, management mentioned the acquisitions in the previous fiscal year (with the last one completed this Spring) that enabled these positive comparisons. As a group, they were highly accretive from the initial acquisition date. Yet the stock price appears to point to a complete disaster.
Mr. Market is in a do not care mode. But Mr. Market has gone through this attitude as part of the industry cycle many times before. Quality will matter at some point. This is one of the higher quality oil and gas companies in the business.
The Difference
This company has a lot of conventional opportunities. Those opportunities are found in an area that is known for unconventional opportunities. Therefore, the relatively cheap wells that are combined with lower conventional decline rates do not matter to Mr. Market at all right now.
Source: Ring Energy Second Quarter 2019, Conference Call Slides
The wells are relatively shallow, and the expensive fracking process is clearly not required. Therefore, the relatively lower decline rate of these wells not only leads to a fast payback but also tends to have sky-high profit rates.
The declining depreciation rates over time is a testament to the advantage of this area. The latest acquisition of Northwest Shelf leases appears to offer management the chance to increase the oil production percentage while maintaining very low total expenses. This company could be in a position to report both growth and profits under far more hostile industry conditions.
Reported Results
The company issued shares as part of the acquisition and used debt as well. Not many can do that and still report growth in the quarter immediately following the latest acquisition.
Source: Ring Energy Second Quarter 2019, Earnings Press Release
It is rare for companies to report a 100% increase in per share earnings at the same time they report significantly increased shares outstanding. Yet this management reported a giant quarterly comparison. Even adjusting for nonrecurring items still allowed for large positive comparisons.
More importantly, the stock now trades at less than $2 per share. So, the price earnings ratio of this solidly profitable company is now a little over two despite the large production growth as long as earnings remain at the current level for the next two quarters.
Management warned that growth would slow while they assimilated the acquisition by catching up on deferred maintenance. This management is going to a one rig program while doing a lot of workovers and reworks to optimize production costs and make sure the infrastructure can support more growth. It is extremely reasonable that 100% production growth would result in some temporarily slower future production growth until operations are in optimal shape.
Even though this company is in a position to reported giant earnings comparisons for the rest of the fiscal year, Mr. Market could care less.
Finances
The company uncharacteristically reported about $361 million of long-term debt in addition to negative working capital of about $30 million or so. Normally, this company does have negative working capital. But management has usually striven to keep the company debt free.
Therefore, shareholders can probably expect some sales. The Brushy Canyon leases no longer compete well for capital budget money. Therefore, these leases could be sold. They also have a very desirable saltwater disposal system that could make them a little more valuable than many leases for sale in the area.
Source: Ring Energy Second Quarter 2019, Earnings Press Release
The market may be concerned about the debt level, combined with the lack of cash flow growth at the six-month interval. However, acquisition costs have largely dominated the cash flow statement up until now. The unfavorable change in Accounts Receivable and Prepaid expenses and retainers kept the cash flow from growing to $50 million at the six-month period. Yet the cash generation ability remains after the acquisition items fade.
Plus, once management is ready to grow again, the low cost wells shown above ensure that management can easily grow production at far less cost than many unconventional operators. The quick payback period ensures a cash flow build even at a lower level of activity.
Management did note the market preference for free cash flow. Therefore, management has a goal to accomplish all objectives while attaining cash flow neutrality. Officially, the cost will be single-digit production growth until all optimizations can be completed. On the other hand, the market demanded free cash flow should begin in the next fiscal year. Any lease sales could speed the process up considerably.
Risks
Obviously, the market is scared of a recession or depression. The current trade war talk has investors absolutely terrified. Yet it is in on one's interest for either side of the dispute to wreck the economies. Until the market recognizes posturing when it sees it, expect this stock to remain cheap until there is a trading agreement in place and the threat of recession fades.
A future acquisition could backfire.
Oil prices could remain abnormally low for the foreseeable future.
Key managers could leave the company or pass away.
Conclusion
The stock is priced for disaster. Clearly, the stock is worth more than this.
Source: Ring Energy Second Quarter 2019, Conference Call Slides
The long-term rapid growth of the company should be expected to continue (notwithstanding the guidance for low growth next fiscal year). Management has a history of adding value to the company through purchases and acquisitions. Investors should assume a reasonable rate of success in the future.
Source: Ring Energy Second Quarter 2019, Conference Call Slides
Most importantly, the reserves behind each share are at least 5 times the current share price. It may take a quarter or two for the cash flow to confirm the value of the reserves behind each share. But this low cost producer will have a much easier time growing production than many unconventional producers with broken business models, high debt, and high production costs.
The opportunities are conventional. That makes this company materially different from the unconventional or "shale" crowd. Eventually, the market will realize the difference and probably provide a handsome return along the way.
Cash flow should top at least $40 million a quarter in short order once operations become optimized. An oil price rally could make that figure conservative. As long as oil prices remain in the range they currently trade in, this stock could easily more than double over the next 12 months. These common shares represent one of the better market bargains available.