The Northwest Shelf acquisition is proving to be a fantastic bargain for Ring Energy (REI). Costs were already low for an industry where breakeven costs are a moving target. Now the company just announced some of the lowest costs in the Permian Basin. The ironic part is that much of this acreage is not considered "Tier 1" by the "know-it-all" crowd. But management has figured out how to make some decent money without the best acreage in the Permian.
Profits First
Source: Ring Energy Third-Quarter 2019 Earnings Press Release
One of the signs of a good acquisition is an immediate profit increase. As shown above, this acquisition led to a large profit increase. Confirmation of that profit was located on the cash flow statement where cash flow also increased despite the usual acquisition costs and operational optimizations needed before the real profits roll in. The deferred maintenance is not all that unusual when a property is marketed for sale. Management appears to have adequate compensation for that deferred maintenance.
Emphasize Profit Margins and Operating Margins
Going forward, there will probably be more operators finding ways to make decent profits on less desirable acreage. The oil industry has a long history of expanding the definition of desirable acreage. That history appears set to continue for the foreseeable future.
Source: Ring Energy October 2019 Production Update Press Release
The central basin acreage already boasted returns that were the envy of the industry. But the North Shelf has slightly higher flow rates and a greater percentage of oil production for drilling costs that appear to be about 44% more than the company's Central Basin Platform. The combination of improved results with slightly higher costs allows this company to break even below WTI $30 on new wells drilled and break even as a company at WTI $35. That is a boast that few competitors can make.
Right now, management has elected to have some extremely high administrative costs. But those costs have produced gems like the latest acquisition. Management has already built the supporting administration for a far larger company. Therefore administrative costs will decline in the future as the company grows. Actual well costs per barrel are among the lowest in the industry. Very seldom in the unconventional industry does one observe depreciation rates as low as shown above.
Then management dropped another great bombshell. Production actually increased 4% over the previous quarter even though management concentrated upon realigning the costs of production in the new acquisition. Once the Northwest Shelf is firmly repositioned with lower production costs, the re-emphasis on expanding production could have some explosive consequences. This is turning out to be one very profitable company.
Production already had nearly doubled from the acquisition. Such a large relative acquisition to the company size normally warrants a break in growth while the company digests the acquisition. Any growth on top of the acquisition is therefore "icing on the cake" and definitely not expected.
Source: Ring Energy October 2019 Corporate Update
The recent acquisition raised the reserves. But there is always doubt about reserve reports until the cash flow to back up those reserves appears on the cash flow statement. The operations update recently issued by management would tend to support more cash flow before year-end than the market was expecting. That is good news for the asset values shown above. It lends credence to the value advertised by management.
Some of the cash flow worries will quickly fade when production beats expectations and costs decline. As long as oil and gas trade in current ranges, this company should be able to announce favorable earnings comparisons for the foreseeable future. Only a sustained oil price crash would put a crimp in the bright future of this company.
Source: Ring Energy October 2019 Corporate Update
Cash flow took a significant jump despite the fact that management really owned the Northwest Shelf only most of the quarter before management could make any operating improvements. This property was a bargain because it has deferred maintenance. That made the property less valuable to many buyers that did not want to deal with extra problems.
Source: Ring Energy Third-Quarter 2019 Earnings Press Release
The cash flow progress slowed as the reworks and other operation optimization measures began in earnest. However, the main culprit was the payment of some older invoices as shown by the nearly $15K unfavorable change in assets and liabilities. That is far larger than the roughly $3K unfavorable change the year before.
It is not that unusual after an acquisition for a lot of bills to be paid (and of course for the credit line to get used). What is unusual here is the immediate jump in profits that signals some very good cash flow comparisons in the future.
But the potential profitability of new wells was ignored by Mr. Market. Even though debt is now slightly under $400 million. The continuing production improvements will bring key debt ratios into some very tolerable ranges until some non-core acreage is sold. That non-core acreage could be the Delaware Basin acreage which would be very saleable as it is partially in (and the rest near) Reeves County. The profitability of that acreage is not questionable. It is just that management is doing far better with other acreage. So many operators wish that they had these kinds of problems.
That Permian acreage is very marketable and very desirable. Therefore the strategy to sell that acreage to bring down debt is very reasonable even in the current hostile industry climate. Besides, many times concentrating on one area as this management appears to be doing leads to administrative efficiencies.
In The Future
This conventional producer is frequently overshadowed by the more visible unconventional industry. The cheaper wells of a conventional producer allow for far greater profitability when the opportunity presents itself.
Source: Ring Energy October 2019 Corporate Update
The key is that management issued some shares and borrowed for the rest of the latest acquisitions. The result is accretive acquisitions from the minute management closed on the acquisitions. That means the reserves per share grew quite a bit and production doubled while shares outstanding grew by quite a bit less.
The potential of the new leases is shown by the announcement of a 4% growth in production even though management went back to a one-rig program while repositioning the production costs of the acquisition.
This stock trades at an enterprise value of less than 5 times anticipated cash flow for the (and probably about 4 times the fourth quarter cash flow annualized). However, the profitability of the wells drilled will allow a quick cash flow build. The profitability combined with the initial rate decline implies that most of the cash used to drill and complete wells quickly returns to company coffers. As long as oil prices remain in the current range, this operator is poised to take advantage of weakening service pricing by drilling more wells in the future.
The assets behind the stock price shown in the slide above appear to be very realistic. Therefore this stock has a bright future ahead. The company will report tremendous growth figures for at least the next three quarters. By then the Northwest shelf costs and operations should be optimized. That would allow management to go back to a two-rig drilling program to produce some very fast production growth.
Source: Ring Energy October 2019 Corporate Update
Optimal production costs are a moving target as the well ages. Different sized pumps become desirable. Sometimes more water is produced (per barrel of production) as wells age. A lot of things change which require constant attention to keep costs low. Obviously the Northwest Shelf "was frozen" while the property was marketed. That led to a steady increase in deferred maintenance.
Management intends to grow slowly until operations are optimized. After that growth will depend upon the hedging program as well as the oil price outlook.
Debt repayment or cash flow increase will be the priorities until the balance sheet ratios are again conservative. In the meantime, there are a lot of very valuable and marketable assets backing up the debt until the balance sheet again returns to its former conservative self.
Current pricing is extremely cheap for the management results so far. Short of an economic disaster, this stock should be trading for a whole lot more over the next few years. Asset stories often need a catalyst in order to avoid being a value trap. Here the very profitable wells and increasing cash flow provide that catalyst.
All the investor needs to do is be patient. The stock is actually pretty safe for many types of investors at current levels because of the marketable assets and the reserves behind each share. Timing the comeback is a lot harder. But well-run companies like this tend to treat investors very well over the long term.