Description

Magnolia Oil & Gas allows you to travel back in time to March when oil was at $60, buy oil exposure, and re-play the rally to the current low-70s. That's free money. On top of that, it's still super cheap, generates more FCF yield than virtually any energy E&P out there, is run by a savvy and prudent capital allocator, and carries minimal execution/geological risk. There is no catch. This is the most compelling energy opportunity we have found in the last 5 years, and one of the very few that posts financial metrics and capital allocation parameters comparable to conventional industrial companies (high FCF generation, low leverage, high all-in ROIC).

Magnolia (NYSE: TPGE, or TPG Pace Energy) is an energy SPAC spearheaded by Steve Chazen, formerly the CEO and CFO of Occidental Petroleum (OXY). On July 31st, TPGE will close its combination with Magnolia Oil & Gas, an Enervest investment, and TPGE's trading symbol will shift to MGY. The deal's timing was a home run: it was announced in Mid-March with oil in the low $60s, and at that point TPGE units bounced to $10.20. As we all know, over the next 4 months oil prices staged a strong rally to today's low-$70s (WTI). Over that time, TPGE has crept up only to $11.47, which pales in comparison to even low-beta largecap energy names like EOG or COP which have rallied 25-30% in the same period. Even XOM has performed better than TPGE. Meanwhile, smallcaps with comparable assets to TPGE's, like SM or CRZO, have rallied 50-90% (admitedly they are more levered). In short, we believe as the Magnolia deal is consummated and the story reaches the larger public over the next couple of months, there is a 20-30% catch-up move in the near-term before we even get into the company's fundamentals.

Magnolia's assets are all located in East Texas in the Eagle Ford shale, with 14k net acres in Karnes County and 345k in the Giddings field. This was already a great asset in March when the deal was announced: oil cuts are high (62% of production, and 78% including NGLs), EBIT margins are phenomenal (41% at $65 oil), and payback on new wells are very short (X months). Since March, the darling of US shales, the Permian basin, has ran into takeaway bottlenecks as midstream capacity is insufficient to support planned oil production growth through YE19. Thus, Permian oil is currently realizing prices $15/bbl below WTI benchmarks. Meanwhile, Magnolia's location in the Eagle Ford, with plenty of takeaway capacity and proximity to Houston and refining centers allows it to realize near LLS prices, which are trading at a $2/bbl premium to WTI. In other words, over the next few months, TPGE will earn $15-17 more per barrel of oil than unhedged Permian players. Besides the obvious financial advantages of this, this angle to the story is incredibly beneficial to TPGE, given the scarcity value of quality non-Permian smidcap E&Ps. Many Eagle Ford small caps have recently expanded into the Permian (SM, CRZO), diluting their "non-Permian" allure. Other small caps outside the Permian include Bakken producers such as WLL and OAS, which are highly levered, and then even OAS or QEP (Bakken names) have also recently entered the Permian through sizeable acquisitions. Magnolia's scarcity value as a non-Permian quality operator will make it an obvious go-to name for investors looking to avoid Permian exposure.

In the interest of getting the idea out asap, I don't want to spend too much time decscribing the Eagle Ford asset, but it's safe to say it's among the most tested and reliable in the unconventional lower 48. Karnes County, which accounts for 78% of total production, is arguably the best county in the entire Eagle Ford. MGY’s leasehold is adjacent to EOG’s position. EOG is the gold standard in the industry and has been drilling horizontal wells all over Karnes County for over a decade. EOG is in fact TPGE's largest non-operated partner in the area (TPGE has interests in many wells/acres where EOG is the operator). My point is, Karnes doesn’t require delineation or carry exploration risk. This asset is well understood, and can be reliably modeled into the future. MGY is operating an average 1.5 rigs in Karnes County in 2008 and plans to take it to 2.0 in 2019.

As for the Giddings Field, this is a more prospective and gassier (30% oil) asset in the far Northeast of the EF, where efficiencies are rapidly improving and there’s opportunity for NAV upside. MGY’s closest comp here is WRD (Wildhorse Resources). We conservatively assume only 15% of MGY’s drilling locations in Giddings are economic, which results in a NAV of $5.50/share for Giddings alone (out of a total $17.50 base case for MGY). If MGY can demonstrate attractive positions beyond our 15%, there could be upside into the $10-13/share in our opinion.

Magnolia also stands out in that despite its smallcap status, it's not a start-up asset that needs to spend billions to grow into expectations; it's already got a respectable production base that throws off huge FCF. CEO Chazen wants to keep things this way: he understands that energy investors have had enough of unbridled drilling plans and perpetual CF deficits at other E&Ps. He will stick to his original plan for 4 drilling rigs in 2019 in spite of much higher oil prices, and will just let FCF build, all while growing production in the low-mid teens. This is unheard of in most smallcap E&Ps, and in particular in SPACs such as AMR or CDEV which are outspending CF massively in order to grow production from near zero. If you're not familiar with Chazen, it's worth looking at his track record at OXY, where he remained disciplined in not issuing equity, avoided excessive leverage, and focused on FCF and maintaining/growing the divvy, even through the 2014-16 downturn. Once again, this really stands out in the world of profligate spenders that energy has always been. Chazen owns about 2% of TPGE.

Chazen plans to re-invest FCF into M&A over the next couple of years, as he thinks there is an opportunity to block up his leasehold in the Eagle Ford through relatively small acquisitions. He claims there's $400mm worth of deals in the very near-term, where TPGE would only have to pay around 4x CF. While this sounds too good to be true, Chazen is adamant that there just isn't much competition for bolt-on deals like the ones he's pursuing. Some of these deals might involve modest need for equity, but we're confident Chazen is savvy, disciplined, and "gets" accretion.

Valuation looks extremely compelling whatever metric one looks at: we see the stock trading at a 13%+ FCF yield in 2019, and at 3.6x our 2019 EBITDA estimate of $790mm (including 2018 FCF). 3.6x EBITDA is 2-3 turns below where any reasonable peer is currently trading. We assume strip commodity prices. In terms of NAV, our conservative base case is $17.50/shr, but could reach the mid $20s if MGY is successful in the Giddings field.

Catalyst

Finally, a word on the set-up for the next 2-3 months, which we believe is rich in catalysts for the stock:

·         TPGE’s initial guidance when it announced the Magnolia deal earlier this year assumed lower oil prices, as oil was in the high $50s-low $60s back then. The base case $515mm EBITDA guidance assumed $58/bbl oil, and its bull case of $65/bbl implied $581mm. Both of those numbers are obviously stale by virtue of the move up on oil prices – MGY will update this guidance with 2Q earnings in the next few weeks. Note that in terms of FCF sensitivity, each $1/bbl move in oil prices roughly translates into $10mm extra FCF to MGY.

·         There is substantial upside to TPGE’s initial production guidance, as 1Q results (after the initial FY guidance was issued) came significantly above expectations (1Q 45.5kboepd essentially already in line with FY production guidance of 16.6mmboe). It is very likely that FY18 production guidance will also be raised with the 2Q18 report.

·         Sell-side initiation reports will roll in in the next few weeks and we expect them to be uniformly bullish.