Description

XEC has underperformed its Permian peers by ~15-30% over the past 6 months. Today, XEC trades at a significant discount to peers on both a multiple and NAV basis. A multitude of thematic issues (gas basis, oil gravity, STACK spacing) have driven recent underperformance despite XEC having a stronger than expected 1Q and increasing 2017 guidance. These thematic issues have the potential to negatively impact XEC’s returns and NAV. However, XEC is not alone in its exposure to these issues and the company has a few important contractual arrangements in place to protect it against a deterioration in the value its Delaware oil. At this price, XEC is now more than discounting the potential negative effects of these thematic risks. XEC is set to grow oil production materially faster than expected which will highlight the undervaluation of the stock. To the extent XEC provides disclosure around its oil marketing contract in the Delaware, fear around widening oil differentials are also likely to allieviate.

VALUATION:

XEC trades at ~8.0x 2018 EV/EBITDA a roughly 1-2x turn discount to Permian peers and in-line with diversified, low growth, lower quality E&Ps. XEC has generally traded in-line with CXO and EGN over the past several years given similar returns, growth, and balance sheet characteristics.

BUSINESS OVERVIEW:

XEC is a US E&P with a primary focus on the Delaware Basin and STACK/Cana-Woodford. Today the Delaware Basin represents 54% of total production and the STACK/Cana-Woodford represents the remaining 46%. Oil only represents 30% of total production given the STACK/Cana-Woodford is a gas-focused play. However, oil production should grow at a significantly faster rate than the corporate average over the next several years given XEC’s focus on the Delaware Basin, specifically the oilier parts of the Delaware Basin. From a capital allocation perspective, XEC will invest ~65% of total drilling capital in the Delaware Basin in 2017 and this % is likely to remain at a similar level in future years.

RISKS

• Oil Gravity: XEC’s Culberson county oil production (~1/3 of total Delaware Basin oil) has a higher API gravity (~55 degrees) than the typical WTI barrel (~45 degrees). There is a risk that high gravity oil begins to trade at a wide discount to WTI given the limited ability to blend it with lower gravity crudes as the Delaware Basin grows. However, XEC is protected against this potential basis widening given its contract with Plains All American which allows XEC to sell this higher gravity oil at a fixed $4/bbl discount to WTI.
• Gas Basis: 40% of XEC’s gas production is in the Delaware Basin. Given the significant expect growth in gas production in the Permian Basin over the next several years, the market is concerned that gas basis (Waha) may widen given the limited amount of gas takeaway pipelines in the Basin. That said, XEC’s Delaware Basin economics are primarily driven by the price of oil and midstream companies are eager to build pipelines to evacuate this gas from the Permian to downstream markets.
• Exploration: XEC has dedicated a small amount (<5%) of its capital budget to leasing around new exploration opportunities in the US. To the extent these new plays do not prove to be economic, XEC may not generate a return on this capital.

Catalyst

-          XEC shifted to drilling areas with a higher oil % in the Delaware in 2017 which should result in significant oil production growth throughout 2017/2018. The company exceeded oil production estimates in 1Q and this trend should carry through 2017/2018. I estimate that XEC’s oil production is likely to exceed current estimates by 20%+.

-          XEC is drilling some wells outside of its core Delaware acreage (Lea county) today which if successful could lead to an increase in NAV and potentially better capital efficiency.

-          XEC is focusing its STACK drilling in the oilier part of the play today. To the extent these results are equivalent to peers in the area, this would represent a  material improvement for XEC and potentially a more favorable view of its acreage in the STACK.

-          After the stock’s significant de-rating, XEC trades at the lowest per acre valuation in the Permian (~$20k/acre). Given continued need for more Permian acreage from larger peers coupled with an under-levered balance sheet, XEC could be an acquisition target.