Description

This idea is for a pair trade: Long Halcon Resources (HK) and Short Jagged Peak (JAG) which are currently trading at $4.83 and $13.33, respectively. Borrow on JAG is available and the cost to borrow is currently -2%.  While I think HK is an attractive long given that it is trading materially cheaper than its peer group given the quality of its assets, I have some concerns about owning oil-focused E&P companies which will require decades of sustained demand for oil to truly justify their valuations.  As such, I think pairing HK, which trades very cheaply compared to its peer group, with JAG, which has very similar assets and trades, arguably, slightly expensively relative to the same peer group, is an attractive way to take advantage of what appears to be a substantial relative mis-pricing in the market.

Both HK and JAG are Permian oil and gas producers focused on the Western extent of the Delaware Basin.  Their acreage positions, size, and well results are quite similar; however, their valuations are substantially different with the major functional differences between the two being that (i) HK is more leveraged than JAG and (ii) JAG is 12 months ahead of Halcon in developing their assets.

Company Backgrounds:

Halcon was founded by Floyd Wilson in 2012 after he sold Petrohark to BHP for ~$15 billion.  Halcon became a relatively early mover in the Williston basin (Bakken) but was forced to restructure in 2016 after running up a ~$4 billion debt balance (~5-6x EBITDA) just prior to the oil crash.  After the restructuring Halcon began shifting its focus from the Bakken to the Permian and ultimately ended up selling their Bakken assets for $1.4 billion in the summer of 2017. Halcon’s restructuring which essentially wiped out the old equity holders appears to have affected the market’s perception of the company and Floyd Wilson (who had previously been considered amongst the best E&P executives); the market seems to be giving no consideration to the fact that what Floyd and Halcon got wrong was the direction of oil prices (a notoriously difficult market to forecast), not the assets or the operations.

Jagged Peak was formed in 2013 by the Private Equity firm Quantum Energy Partners (for, it appears, their fund V which was closed in 2009).  The company began acquiring acreage in the Permian basin in 2013 and began their drilling program late that year though the program didn’t pick up much steam until after the company went public in early 2017 - between 2013 and Q4 2016, the company only completed 16 wells.

Asset Overview:

Halcon owns ~60,000 net acres almost entirely located in Ward (~33k net acres) and Pecos (~27k net acres) counties of West Texas.  At present, Halcon is producing ~13,750 BoE/d (70% Oil). Halcon’s acreage breaks down into 3 areas: Monument Draw (22k acres), West Quito Draw (11k acres), and Hackberry Draw (27k acres).

Jagged Peak owns ~79,300 net acres similar located almost entirely in Ward (~35-40k acres) and Pecos (40-45k acres).  At present, JAG is producing ~34,500 BoE/d (77% Oil) JAG’s acreage also breaks down into 3 areas: Cochise (~13k acres), Whiskey River (~36k acres), and Big Tex (~30k acres).

The map below depicts the relative acreage positions with HK’s acreage in green and JAG’s in Maroon.

Note: The HK position in Western Ward (West Quito) is an approximation - the acreage map this is taken from is slightly stale.

Some notes on the various acreage positions: Halcon’s Monument Draw and JAG’s Cochise areas are adjacent to each other; JAG’s Big Tex position (~35-40% of total net acreage) is on the fringe of the Delaware basin and results to date as well as estimates of original oil in place indicate this area may be uneconomic.  Similarly, Halcon’s Hackberry Draw area (45% of total net acreage) has seen mixed results and some portions of this position may be uneconomic as well.

Drilling Result Comparison:

As mentioned, both operators have seen similar results as a function of the similarity in their acreage positions - though, if anything, Halcon’s results to date have been superior to those of JAG.  The chart below comes from a JAG presentation released on July 9th and it shows a combined type curve for all of JAG’s wells drilled in the Lower Wolfcamp A - the most economic area they are targeting.  The graphic indicates that, at 200 days, JAG’s wells are producing <700 BoE/d and at ~650 days around 350 BoE/d. JAG uses an internal type-curve (similar to the one their 3rd-party reserve auditors use) which projects ~1.2mm BoE of total production from these wells.

While Halcon’s wells aren’t perfectly comparable (HK’s wells are slightly longer and, according to recent disclosure, slightly cheaper), it is useful to note that Halcon’s Monument Draw wells are producing ~1,000 BoE/d at the 200 day mark having been above 1,000 BoE/d for the first 6 months (substantially better than what JAG has experienced):  In Monument Draw, Halcon’s type-curve calls for 1.9mm BoE of total production and Halcon’s results have outperformed this curve thus far. Oil & gas splits should be comparable for the two operators.

And wells from Halcon’s worst area (Hackberry Draw) drilled by the previous operator are producing in-line with Jagged Peak’s overall average at ~350 BoE/d at the 650 day mark:

In addition to this, DrillingInfo data shows HK’s results from Monument Draw as outperforming all peers in the area (including JAG):

And puts HK’s results in the middle of the pack (right near JAG) for their Hackberry Draw acreage:

And while JAG hasn’t provided any recent return metrics for their wells, modelling out well-level economics for the two producers indicates that returns from HK’s wells should be better than JAG’s driven by the higher production volumes as well as lower CapEx per lateral foot of drilling (driven, in large part, by the longer wells that HK drills).

As a final bit of context, the acreage positions for both producers have similar amounts of vertical exposure to the various zones of interest - between the top of the Avalon and the bottom of the Wolfcamp, HK and JAG both have ~3,500-4,000’ of exposure in Monument Draw, West Quito Draw, Cochise, and Whiskey River; both producers have ~2,500’ of exposure in Hackberry Draw and Big Tex.

Given the similarities in geography and geology, my expectation would be that results for the two producers should converge of time.

Because of these similarities, consensus estimates call for JAG to reach ~35,000 BoE/d of production by YE 2018 on cumulative drilling and completion CapEx since Q4 ‘16 (when production was ~6,400 BoE/d) of ~$1.2bln.  Consensus estimates call for HK to reach ~33,000 BoE/d of production by YE 2019 on cumulative drilling and completion CapEx since Q4 ‘17 (when production was ~6,300 BoE/d) of ~$1bln. While I think the HK D&C numbers may be a bit too low there is a fair bit of room to match JAG and much of JAG’s CapEx came during a period when E&P costs were considerably lower (i.e. pre-2018):

So, to recap, both companies have acreage in very similar areas; if anything, HK’s results have been superior to those of JAG so far; there is no discernible geologic reason to expect JAG’s acreage to generate significantly more value per acre than HK’s - they are targeting the same general areas of the same formations and have similar vertical exposures to these formations.

Valuation:

Despite the similarities between the two businesses, HK trades at a very significant discount to the implied valuation of JAG.  Taking JAG’s YE 2017 PV-10 and adjusting it for $70 Oil returns a value of ~$1,290m (happy to get into the methodology here in the comments if anyone is curious - it has proven fairly reliable over time) - substituting this into JAG’s balance sheet for various balance sheet items effectively captured by the PV-10 (DTL’s, asset retirement obligations, capitalized O&G property including unproved properties as I discuss them further below) returns an adjusted equity value of ~$900m which, compared to JAG’s current Market Cap of $2,656m leaves ~$1,960m of value ascribed to the unproved acreage.  Assuming, as a rough estimate, that ~75,000 of JAG’s ~80,000 net acres are NOT included in the PV-10 this provides an implied valuation per unproved acre of ~$26,000.

Doing the same exercise for HK generates a $70 Oil PV-10 of ~$560m, an adjusted equity value of ~$220m, and an implied value per acre of ~$9,600.

Comparing implied acreage valuations (using the methodology above) against measures of productivity for a number of Permian peers indicates that HK (not JAG) is the major stand-out here.

This first graph shows net estimated ultimate recovery (with gas included on a price equivalency basis) per $ of drilling and completion capital for various Permian peers - something I use as a measure of capital efficiency - against their implied value per unproved acre:

The second graph shows net estimated ultimate recovery (again with gas on a price equivalency basis) per lateral foot for the same peer group - something I use as a measure of acreage quality - against their implied value per unproved acre:

If HK were to trade up to JAG’s current implied valuation the stock would appreciate by ~125%.

If JAG were to trade down to HK’s current valuation JAG would fall by ~40-45%.  The differences - more than a double vs. less than a halving - are a function of the leverage at HK.

Obviously, returns for the pair trade would be ~½ of these amounts (depending on how it is structured) so ~20-60%.

I would note that this relationship (HK being cheaper than JAG) holds at any oil price down to ~$40-45 at which point HK’s equity would be worthless (assuming no option value for the acreage) and JAG’s equity would have a tiny bit of remaining value (but would be down ~90%).  Similarly, as oil prices rise, the relative discount for HK expands. Using different discount rates to estimate the PV-10 doesn’t have a significant impact on the conclusions here.

Beyond these valuation criteria, JAG is more expensive on more traditional valuation metrics (keep in mind that HK is ~12 months behind in development - they should have the ability to compound their profitability for longer than JAG so comparing HK’s 2020 profitability #’s to JAG’s 2019 #’s might be more accurate):

HK:

P/B - .66

2019 P/E - 19x

2020 P/E - 6x

2019 EV/EBITDA - 6.2x (with much higher growth in 2019 - 5x Q4 2019 annualized EBITDA)

JAG:

P/B - 2.55

2019 P/E - 15x

2020 P/E - 9x

2019 EV/EBITDA 6.3x (5.6x Q4 2019 annualized EBITDA)

Some thoughts on why the opportunity exists:

As I’ve mentioned above, HK had to restructure their debts because they were caught wrong-footed during the 2014 downturn.  I’ve noticed a pattern in the markets where post-emergence E&P equities trade much more cheaply than peers who didn’t have to restructure despite the fact that the restructurings were a function of their capital structures rather than a repudiation of their asset bases.  Over time I suspect that awareness of HK and the quality of its asset base should alleviate these issues; while the market appears to have soured on Floyd Wilson for the moment, his track record is very strong.

There are concerns that HK is over-levered even now and that recent Permian basin oil discounts are going to strain their liquidity.  Like the company, I believe these concerns are misplaced given the anticipated expansion in the company’s reserve-based revolver and my expectation that discounts (which are also impacting JAG) will be transitory; Halcon has spent the past few years developing a high quality field services business to handle, among other things, its water needs.  Because HK has non-op working interest partners in its wells, this business has to charge a commercial rate and, at that commercial rate, is expected to do $40m of EBITDA in ‘19 and $65m in ‘20. Halcon has floated the idea of selling all (or, preferably, half) of their field services business and Floyd recently stated he “wouldn’t do a deal for $400m” and later indicated that something in the $450-500m range was more reasonable which seems about right given the growth trajectory of this business and the multiples that assets of this type tend to trade for.

Risks:

The big risk here for the pair trade (besides some unforeseen geologic anomaly or operations hiccup) is that both companies see themselves as acquisition targets (and have been open in discussing as much) for some of the Permian basin consolidators (FANG, CXO, etc.).  That said, recent commentary and deal activity indicates that the days of acreage-only transactions are behind us. At present, companies are interested in acquiring others for stock on an accretive EV/EBITDA basis as well as a price per acre basis (netting out production at a fairly arbitrary $30-35k/BoE/d).  Given these considerations there is a risk that, because HK is ~12 months behind JAG, JAG gets acquired at a premium in an accretive deal and, before HK can reach the same point, the window for these types of deals closes (though presumably this would mean that the market had soured on the consolidators which is what a JAG short would have rolled into in this scenario).

Catalyst

Continued execution of HK's development plans should illustrate the gap in valuation between these companies.

A potential sale of HK's field services business could alleviate market concerns about leverage.

YE 2018 PV-10 #'s (which one could expect sometime in late February or early March) should help illustrate the valuation disparity.