Newfield Exploration (NFX) is a large cap independent American-domiciled E&P.  NFX’s historical focus has been gas-weighted production in the Mid-Continent (Woodford shale in Oklahoma and Texas panhandle: 47% of proved reserves) but it has diversified into oilier plays.  In the United States its areas of operation in addition to Mid-Continent are the Rocky Mountains (Uinta basin in Utah and southwest Wyoming, North Dakota Bakken, and Alberta Bakken in northern Montana: 37% of proved reserves), the Onshore Gulf Coast (Eagle Ford and Maverick fields: 7% of proved reserves), the deepwater Gulf of Mexico (2% of proved reserves).  In February, NFX disclosed that it had acquired a large acreage holding in the Cana Woodford, in an oily window of the Woodford play in Oklahoma.  NFX is also the operating partner for a JV with Hess in the northeastern Marcellus, in the dry gas window.  In addition to its U.S. operations, NFX has international exposure to oilfields offshore of Malaysia, Thailand, the Philippines, and China.  Of these, the Malaysian fields are currently producing and account for 7% of NFX’s proved reserves.

NFX is currently transitioning itself from a historical natural gas focus to an oil focus, and during the past several years has disposed of certain properties, acquired other properties, and re-oriented its capital expenditure to achieve this transition, a process which the company estimates will last through 2013, at least.  During 2012, the company’s operating results have disappointed the market, culminating with its 4^th quarter reporting in February, when it guided that production and reserve growth would be flat in 2012, with increases in the oily Uinta and North Dakota Bakken areas, and declines elsewhere.  The stock has traded down from the $65-70 range last summer to $36 today, following the 4th quarter call.  The stock has not been this low since the first half of 2009, when it troughed to $20.

The most likely positive catalysts for 2012 are positive exploration results from the Woodford Cana that could be forthcoming in the 3^rd or 4^th quarter of this year, or a disposition of nonstrategic Gulf of Mexico assets at an attractive valuation. The most likely negative catalysts are weak or mixed exploration results from the Woodford Cana, or a new acquisition on the order of $100 million or above.  While we do not think that NFX is actively looking for new assets or acreage at this time, the company has been acquisitive historically, and CEO Lee Boothby remarked on the 4^th quarter call that NFX would continue to add acreage if available “at attractive prices and it fits with our overall strategy”.  We think that the market would prefer to see NFX concentrate on developing its current portfolio of assets, and would react negatively to a major acquisition, particularly if it is for acreage outside of the company’s most prospective core area in the Uinta Basin.  We expect that the company will mostly stay within organic cash flows during 2012 and 2013, and it has ample liquidity of over $1 billion on its bank lines to fund any capital expenditure shortfalls even if it does not sell any assets.

We think that NFX common stock is cheap on the basis of asset coverage and fairly cheap on the basis of projected operating cash flows during 2012 and thereafter.  At $36 per share, we estimate that NFX is trading at about 60% of risked net asset valuation (NAV) that is 2:1 weighted to oil and liquids over natural gas, and at 5.1 times 2012 EBITDA.  We think that NFX will “grow into” an 80% NAV valuation and 6.0 times EBITDA valuation as it executes successfully its operating transition from natural gas to oil. 

¦  NFX Description

The bulk of NFX’s operations and 93% of proved reserves are in the United States.  The company also has working interests in oilfields offshore of Malaysia, Thailand, and China.  Of these, the Malaysian fields are currently producing, including new developments brought on-line since January, and account for 7% of proved reserves.

Mid-Continent

NFX’s historical core area of operations is the Mid-Continent, particularly the Woodford-Arkoma areas of Oklahoma and the Texas panhandle.  During 2012, the company will realize significant natural gas production from its legacy Woodford shale wells, but is planning no active development of these at current natural gas prices.  NFX has substantial natural gas hedges in place for 2012 and 2013.  The Mid-Continent also contains NFX’s recently announced “stealth play”: 125,000 acres in the Woodford Cana area acquired during 2011 that will absorb $300 million of capital expenditure with up to 7 operated rigs during 2012 in an accelerated exploration program, with results expected to be announced around mid-year.

The Mid-Continent accounts for 47% of proved reserves and 50% of probable reserves at year-end 2011.

Rocky Mountains

NFX’s most attractive U.S. assets are in several holdings in the Uinta Basin of Utah and southwest Wyoming, and in the North Dakota Bakken.  Together with acreage in the Alberta Bakken which is not a focus of current expenditure, these areas comprise NFX’s Rocky Mountains holdings.  In 2012, NFX plans to dedicate nearly half of its capital budget, or $700-800 million to the Uinta and North Dakota Bakken, where production is heavily oil- and liquids-weighted.

NFX is Utah’s largest oil and natural gas operator with production of 22 mboepd from three sub-areas of the Uinta Basin: Green River, Wasatch, and Uteland Butte.  In the last few months, the company announced two off-take agreements with Utah refiners for up to 38 mbpd of oil production beginning in 2013 and 2014.  The company expects to fill this capacity limit from production growth by 2015.

In the North Dakota Bakken, cost inflation led NFX to defer 17 long-lateral well completions scheduled for 2011 to 2012. Subsequently, the company sold 23,000 acres in Williams County, including 300 flowing boepd and 8 of the uncompleted wells, for $276 million.  This transaction will close in the first quarter of 2012.  In January 2012, NFX resumed activity in the Bakken with a reduced number of rigs relative to 2011, and expects to increase production by 35% during 2012.  NFX has downsized its Bakken commitment and production guidance since 2011, but both remain significant during 2012.

The Rocky Mountains account for 37% proved reserves and 41% of probable reserves at year-end 2011.

On-Shore Gulf Coast

These assets consist of active, though limited, exploration and development programs in the Maverick Basin and the Eagle Ford shale, all in Texas.  NFX plans a single rig program for 2012.

Gulf of Mexico

Newfield has working interests in roughly a dozen deepwater developments of the coast of Louisiana.  The most recent Pyrenees development began production in February.  The deepwater Gulf has been an area of declining interest to NFX since the drilling moratorium in 2010, and concurrently with 4^th quarter reporting in February the company announced that these assets are nonstrategic and available for sale or other disposition.  NFX is not committing capital to the Gulf of Mexico in 2012.

The Gulf of Mexico accounts for 7% of proved reserves at year-end 2011.

Marcellus

NFX is the 50% operating partner in a JV with Hess Energy in the deep, dry gas portion of the Marcellus in northeastern Pennsylvania, Wayne County.  To date the JV has drilled but not completed a handful of exploration wells, and has no capital allocation for 2012.

International

NFX’s international oil production comes from several offshore Malaysian fields, including two new offshore developments, East Piatu and Puteri, which began production at the end of 2011.  The company expects production from Malaysia to increase by 25% in 2012 over 2011.  Also in 2012, NFX will invest $100 million to develop the Pearl River Mouth Basin, offshore China, with first production targeted by early 2014.

¦  Valuation

We value NFX both on the basis of risked NAV and as a multiple of estimated 2012 EBITDA.  At $36 per share, we think that NFX common stock is cheap at approximately 60% of our risked NAV, and fairly cheap at 5.1 times 2012 EBITDA.  Details of these valuations are in the following tables; our EBITDA and free cash flow estimates appear in the income statement at the end of this report.

Why is NFX so cheap?  NFX stock has declined from the $65-70 range last summer to $36 per share today.  We think that the breakdown in the stock is due to three factors.

First, NFX is a large cap independent whose portfolio constitutes a grab bag of disparate geographical assets.  In the eyes of the market, it is excessively diversified and lacks a cohesive geographical focus, especially in currently attractive oily assets.  Collectively, its most attractive Uinta and North Dakota assets will account for only 20% of 2012 production.  As a result, NFX is subject to a “sum of the parts” discount relative to its NAV.

Second, NFX is a historically gas-weighted producer who is transitioning to oil, and is involved in a “shrink and grow” process, selling nonstrategic or excess assets while simultaneously acquiring acreage in new target areas.  NFX’s recent history of asset dispositions includes various transactions totaling $400 million in 2011, a sale of excess Bakken acreage for $276 million earlier this year, and Gulf of Mexico assets deemed nonstrategic and currently planned for disposition.  Meanwhile, the company has just announced the accumulation of a 125,000 new acres in the Cana Woodford, which will absorb a major share of planned capital expenditure in 2012.  The process of transition with accompanying re-orientation and turnover of NFX’s asset base poses execution challenges, and leads the market to discount growth projections ahead of their realization more severely than competitors with a more linear asset development story.

Third, the market reacted strongly to NFX’s guidance on the 4^th quarter of flat production and reserve growth in 2012, and limited growth in 2013, as the oil to gas transition proceeds.  In general, E&P’s trade in higher proportion to NAV when reserves are growing, not staying flat (or shrinking).  We think that this concern is overstated in the case of NFX, since production and reserve growth is focused on oily plays, particularly Uinta and the Bakken, while declines in legacy gassy fields, like the legacy Woodford shale, are the natural consequence of their active development being discontinued.  Physical roduction and reserve metrics are based on volumetric equivalents of oil and gas, whereas the oil increase is several times more valuable than the gas decrease at current prices.

We think that as NFX successfully executes its transition from natural gas to oil, and as its resource base stabilizes around its new core properties, then the stock will appreciate into the mid-high $40’s, which implies roughly a 75%-80% ratio to risked NAV, and an EBITDA multiple of 6x to 6.5x.