Description

Situation overview  

If we learned one thing from the shale debacle it was that the only thing that matters is production growth, right?  Right?  Or wait was it capital discipline?  I can’t remember but it doesn’t matter because PrimeEnergy Resources Corporation offers both.  This company isn’t covered by Wall Street, is nearly 50% owned by its CEO, has no debt, consistently repurchases stock, doesn’t grant options, and has grown book value per share by 27x over the past 20 years.

PNRG was late to the horizontal drilling game and currently has in front of it a significant opportunity to (i) put attractive acreage to work with two- and three-mile horizontal wells and (ii) transition its mostly conventional production base to more attractive well economics.  This opportunity is also why the stock is cheap.  The market is overemphasizing the risk associated with funding the incremental production (or it’s just a microcap and nobody knows/cares).  PNRG offers 50-80% upside over the next few years followed by continued compounding (and likely repurchases).  If the drilling doesn’t work out, we still have an existing production base to run off.  Chuck Drimal, CEO since 1987, is likely to steer the ship in the right direction, reducing risks related to all of the various things that can go wrong with an oil and gas producer.

Company and industry overview

PrimeEnergy Resources Corporation (Nasdaq: PNRG) was organized in March 1973 and primarily develops and produces oil and gas properties.  This isn’t a complicated story.  Net acreage in the Permian and Scoop/Stack.  As of December 31, 2022, the company operated ~630 active wells and owned non-operating interests and royalties in ~800 additional wells.  PNRG’s general focus is to develop what it describes as its “extensive” oil and gas reserves through horizontal drilling.  These reserves include 9,969 net acres (16,940 gross) in the Permian of which nearly all is located in the attractive Reagan, Upton, Martin, and Midland counties, and 4,113 net acres in the Scoop/Stack.  PNRG boosts its risk-adjusted returns on capital by partnering for development with companies such as Apache, Ovintiv, Hibernia, and Double Eagle.  The company’s existing production base (498 net wells at year-end) is largely vertical wells, resulting in production costs and per-well production rates that are much less attractive than other Permian players.

The company also provides well servicing site-preparation and construction services, but for Q123 this business represented only 3% of PNRG’s cash gross profit.  In addition, PNRG holds a 12.5% overriding royalty interest in over 30,000 acres in WV (property has not yet been developed), a 60-mile offshore pipeline on the shallow shelf of Texas (also not currently in use but supposedly available to be put into use in the future), and a 33.3% interest in a 138k sq ft retail shopping center on ten acres in Prattville, AL ($500k of working capital, no debt).  As stated below, these assets may have value in the future but aren’t needle movers currently.

While competent management and cash allocation is a high point of the PrimeEnergy story, it must be said that the board compensates management very well for their expertise.  In 2022 CEO Charles Drimal earned ~$4.5mm (in cash!) and CFO Beverly Cummings earned $2.3mm (also in cash) on consolidated net income of ~$49mm.  Not too shabby!  The sting is lessened a bit by their equity holdings.  At current prices Beverly’s PNRG holdings are worth $7mm and Drimal’s holdings are worth ~$115mm against a total market cap of ~$250mm.  The company doesn’t pay dividends, but annual weighted average diluted share count has declined ~19% in the last ten years, and ~38% in the last 20 years.  Though they’re highly paid, at least this pay is in exchange for working for shareholders.

The company has no debt outstanding, ~$16mm of AROs, ~$14mm of balance sheet cash, and ~2.6mm diluted shares for a market cap of ~$247mm and an enterprise value of ~$249mm.  TTM revenue was ~$122mm with EBITDA of ~$57mm though that was obviously weighted toward the first half of the TTM period given oil price movements.  Q123 annualized revenue is ~$90mm with EBITDA of ~$34mm.  Average daily total production for Q123 was ~3,900 boe.

How we got here

So there are many reasons why PNRG is a bit of an odd duck, but the biggest one is the dissonance between their strong and stable financial results (in the last 21 years, as a microcap E&P company they’ve only had three negative net income years, somewhat predictably in 2009, 2015, and 2020, with cash flow excluding development positive every single year, and cash flow net of all exploration and development costs positive thirteen of the past fifteen years, AND a nearly 40% decline in the share count since 2002) and their…well…not great production metrics.  While PNRG is much smaller than other Permian producers such as ESTE, CPE, and SM, and much much smaller than APA, FANG, and PXD, and thus higher production costs might be expected, PNRG’s costs are still out of whack at $15 to $25 per barrel while others are around $10-$15.  Similarly, PNRG’s production per net well is extremely low relative to other Permian players.  Why? Well, the good news is that PNRG didn’t participate in a lot of the shale stupidity over the last decade or two, and the bad news is that PNRG didn’t participate in a lot of the shale stupidity over the last decade or two.  By that I mean that the company has been very late to the horizontal drilling game and has not spent every nickel it could to boost production above all else.  For example, PNRG started its West Texas horizontal drilling program in 2015 and by the end of 2016 had drilled and completed eight horizontal wells, relative to a total net wells figure of 959.  This is understandable for a small, capital disciplined player who doesn’t have hundreds of millions of other people’s money to overinvest in the shiny new thing.  However, the industry was already well-invested in horizontal drilling by this point and was moving from one-mile horizontals to two-mile horizontals.

So does this mean the company doesn’t know what it’s doing?  Not necessarily.  Weak wells can be good investments if the price is right!  Another look at PNRG’s financials confirms this.  The company has generated an average roe of almost 16% over the past 20 years.  If we want to get cute with the numbers, excluding the very weak year that was 2009 results in an average roe of 21.7%.  Was this performance all in the company’s earlier days? No! Five-year average roe is over 10% and ten-year average is 14.5%.  In terms of actually delivering value to shareholders, the growth in book value per diluted share has also been strong.  PNRG’s diluted book value per share five-year CAGR is 10% (and that number is low because of the 2017 to 2021 environment.  The six-year CAGR is 18%), ten-year is 16.7%, and 20-year is 18%.  The company’s shareholders are getting paid to go along for this ride!

The reason all this is important is that it sets up the current situation - a company whose managerial skill lowers the volatility of cash flows (and overall downside risk) and whose financial skill delivers strong returns on capital, is in the process of transitioning its well base to a much higher productivity horizontal program (in what we assume will remain a capital efficient manner).  PNRG may also be benefitting from having observed the consequences of the loose capital behavior of the past decade in shale drilling.

Where we are now

So what are we actually buying today?  PNRG stated that it began its West Texas horizontal drilling program in 2015 and its Oklahoma horizontal drilling program in 2012.  The company has participated in ~27 net wells since 2015 and ~80 net wells since 2012.  PNRG’s current well base of 498 net wells supports the narrative that the company is partially exposed to horizontal drilling economics but has a long way to go (as does the fact that the company’s production per well has increased since 2015).  Fortunately PNRG also has a ton of runway in terms of wells coming online.  Let’s take a look at that runway.  Across projects that are in progress (25 wells, 7.1 net), projects for which PNRG has received indications of interest from partners (24 wells, 8 net), other near-term anticipated projects (24 wells, 7.4 net), and projects farther out expected for 2025 and 2026 (27 wells, estimate ~8 net) we get a total of 100 wells, or 30.3 net wells.  Normally this wouldn’t seem like enough to move the needle, however the company’s current well productivity is so low that in fact these new wells will have a significant impact on overall production.  Under 9 boe per day per net well!  I have checked this number a few times to make sure it could be right.  Permian wells come online at initial production rates of 800 barrels per day or more and can decline to around 100 bpd in the first two years.  Rather than engage in some false precision and try to predict decline rates, let’s just use the fact that Callon Petroleum has average net well productivity of ~70 boe / day / well, and Pioneer has ~80 boe / day / well.

If we assume that PNRG’s new net wells add on average 85 boe / day each (8.1 net wells come online in the remainder of 2023, 14.4 in 2024, 5.6 in 2025, and 2.3 in 2026), it does make a meaningful difference in the production base.  Specifically, overall production increases by over 30% (and average well productivity across the fleet is STILL only just over eleven boe / day / net well).  While I don’t include it in my valuation, PNRG states that in addition to these 30.3 net wells, the company believes that its Permian acreage can support the drilling of an additional 160 horizontal wells and its Oklahoma acreage can support another 46 horizontal wells.  This is the crux of why the stock is cheap.  There is a lot of additional potential cash flow that is not being valued given this upcoming inflection point (I’ll note that the company’s description of these additional well opportunities is very disorganized and confusing, repeats the same information in multiple different ways, and took me a long time to get laid out properly), and the related development costs will need to be funded.  As I discuss below, some amount of PNRG’s acreage may be best sold in order to fund the development of this well project.  Given the non-promotional nature of this management team (no quarterly conference calls and the shortest quarterly earnings announcements that I’ve ever read), I think the comments around additional wells are likely fair to take at face value.

PNRG’s greatest opportunity, this significant capacity for additional wells, is also its greatest risk (outside of a protracted catastrophic decline in oil prices of course).  This is a lot of capital to come up with in the next few years.  PNRG states in its 10-k that the entirety of this drilling will require about $400 million of capital.  However it has already spent about $62 million of this amount and my estimates of their drilling costs (based on some per-well costs that they give in their filings) imply that the amount remaining is just over $300 million to be spent between H223 and H126.  This is a lot of capital but it’s doable.  They’ve invested over $770mm of capital in property acquisitions and development costs (plus another $26mm in exploration costs) over the last twenty years, and for a large portion of this time period, PNRG was a smaller company.  Also as a reminder this company has navigated industry ebbs and flows since 1973.  As I mention in the risks section, these development agreements could, in a very weak scenario, require an equity raise.  However I believe that Chuck Drimal’s large equity holding and lack of potential future options grants provides some assurance that it would be done in the least painful way possible.

When I model this out using today’s oil and gas prices of about $83 per barrel of WTI and Henry Hub of $2.58 per mmbtu, the company generates about $35mm of cash this year and ~$60mm in 2024 and 2025 (reminder this is understated since I’m bringing the wells on at 85 boe/day which ignores a large amount of production that’s likely to occur in the first two years).  This leaves about $40mm of funding that will need to be covered this year and another $95mm in 2024.  After that there is enough internally generated cash flow to cover all development and go back to returning cash to shareholders.

So how do we cover this funding gap?  First, and easiest given that PNRG has no debt, I expect the company to raise some debt.  PNRG’s credit facility currently has $60mm of availability, and I note that the company has had as much as ~$136mm in debt outstanding with a lower operating income than they generate today so there may be additional debt available beyond the current credit facility.

Secondly, there are likely some assets available that the company can sell.  Over the last twenty years, PNRG has averaged $10mm per year in asset sales and has averaged $8.5mm in gain on sale of assets(!).  This implies that these assets were held on the books at 15% of market value.  If another ~7% of the asset base is similarly marked, that’s all the funding they’ll need.  While I’d of course rather see the asset base remain intact, it makes sense to sell in order to fund these near-term highly productive wells.

Obviously, this path becomes more difficult if/as oil prices decline.  At $60/barrel of go-forward oil prices, the total funding gap increases from $135 to $190, requiring (using the same numbers as above) sales of ~12% of the asset base if only $60mm of debt can be raised.  At $40/barrel the required funding increases to $247mm (implies selling 16.5% of asset base) and we don’t see return of capital until 2027.

To be clear, this isn’t a project that I’d trust to just anyone, and management acknowledges that they’ll need to be managing cash flow carefully, but this team has delivered results over decades and decades, and I think on the other side we’ll be looking at a much larger, more profitable production base.

Valuation and expected outcomes

So how do we value an oil and gas producer in 2023? Do we look at EV / daily production?  What if production vs. reserves is particularly high or low?  EV / acreage? Well what kind of acreage is it and what pureplay comps are available?  EV / reserves?  What if reserves are over/understated vs total resources?  EV / cash flow?  DCF? PV-10?  Well what are oil prices going to be over the next several years?  Do we use current pricing because we can’t forecast oil prices and differentials aren’t going to change?  Do we use the strip because we believe in other peoples’ ability to forecast oil?  It was so much simpler just a few years ago when Permian resources and profits were infinite and the only thing that mattered was production growth.

Although it has basically become a meme at this point to value a Permian producer on production levels (and rightfully so!) it remains true that in general a producer that is producing 30% more and returning capital to shareholders is worth more than a producer that is producing 30% less and returning capital to shareholders.  That is fundamentally what we’re looking at with PNRG.  I’m happy to live through a couple years of cash burn because (i) I believe in this management team’s ability to manage through the cycle, (ii) unlike in many situations, CEO Chuck Drimal is truly working with his own (and his friends’) money, and (iii) PNRG is undertaking the transition to horizontal drilling at a time when they have been able to learn from many years of giant mistakes that have already been made by other shale companies.

PNRG is trading today at ~$57k / boe / day, which is a premium to the smaller names in the compset, but a discount to the better loved names PXD and FANG.  This makes sense to me.  If we use today’s production multiple and roll it forward to pro forma production for the incremental wells, we come out with a stock price of ~$127 or about a 35% increase.  This is okay but it’s not that interesting, and given that we’re looking a few years out, doesn’t compensate for the risk involved.  While I’m not going to pound the table that PNRG should trade like PXD or FANG anytime soon, it’s true that the company’s pro forma production will be higher quality and more profitable than its current production, so this valuation is likely somewhat understated.

Let’s look at a few other valuations.  The company owns a few oddball assets that may have value in the future (12.5% royalty interest in 30k undeveloped acres in WV, a third interest in a shopping center in AL, and a currently-idle 60-mile pipeline on the shallow shelf of TX) but aren’t needle movers today so I’m not including them.  If we ignore development costs and only value current production at current prices, PNRG offers a relatively attractive 15% yield on forward cash flow.  By contrast, pro forma cash flow for the current drilling projects offers a 26% yield on today’s stock price (with the expectation that, as usual, some portion of that will go toward continued buybacks).  If we instead take today’s 15% yield and apply it to PNRG’s pro forma production, we get a share price of ~$163, or a ~73% premium to today’s price.  That is attractive!

It is worth pointing out that PNRG’s cash flow as a % of EBITDA is higher than most of the comps, meaning that the company is less likely to appear attractive on a relative basis when looking at EBITDA multiples.  For example, PNRG is currently trading at 3.5x to 4x pro forma EBITDA of ~$75mm, which is inline to slightly higher than the comps.  While higher cash flow to EBITDA ratio is one reason this doesn’t concern me, I again believe this management team will manage its debt load appropriately, allowing us to be comfortable focusing more on cash flow-based valuations.

If we assume that, following this major set of development projects, PNRG spends $30mm per year on further development, we get ongoing cash flow of ~$32 million that is growing at a modest rate.  The comps trade mostly around 12x price to net-of-development cash flow with ESTE at 7x and CPE at 14x.  While 7x net-of-development cash flow would represent a 10% price decline for PNRG, it doesn’t seem likely to me that the company would trade at a significant discount to the group.  At 12x cash flow and 14x cash flow, we get stock prices of ~$146 (+54%) and ~$170 (+80%), respectively.

While we already saw that lower oil prices will increase the funding needed to complete PNRG’s current slate of projects (likely resulting in some asset sales) but will not necessarily turn the operation unprofitable, let’s look at another kind of downside case.  What happens if the drilling project is somehow a total failure and we’re left with just the existing production base runoff?  If we discount the resulting cash flows at 10%, we get a stock price of ~$74 or a ~22% decline.  This is a case that I’m happy to live with, especially given all the NPV-positive drilling that this skilled management team has access to, and my trust (apologies for the ad nauseam) in Chuck not to blow up his own fortune with large, misguided development projects.

Though I’ve only mentioned it briefly, we should also keep in mind the further years of compounding available to the company via its additional resources (200+ wells) beyond the drilling projects we’re currently valuing.  This also seems like a good setup for a potential sale of the company.  While I believe the company is not looking to sell, they are also not against selling at the right price.

Key risks

Oil prices is the obvious one here.  The company is currently unhedged (but says they’ll hedge if a lending agreement requires them to).  I’ll note again that this company has, since its founding in 1973 (and since Chuck Drimal became the President and CEO in 1987), made it through all of the tough environments the industry has seen.

A second meaningful risk is the large amount of capital that will be needed to fund the drilling program as currently planned.  This risk is exacerbated by the fact that under some of its development agreements, PNRG may not be in control of when a certain well or wells get(s) drilled.  Usage of the company’s credit facility is likely ($60mm borrowing base currently).  If production drops significantly or oil prices are too low to generate sufficient cash flow, then PNRG could be at risk of defaulting on its development agreements and/or may need to raise equity capital, which could be difficult to accomplish on attractive terms.  I’m again looking to the company’s long operational history as a somewhat mitigant of running into serious trouble.

Thirdly, the company doesn’t report anything beyond its proved reserves.  While its proved reserves do represent a decade of production at the current rate (inline with other Permian producers), additional reserves will eventually need to be purchased or proven.  While this also gets at the larger question of “is the Permian running out of oil?” I do take comfort in Chuck Drimal’s giant stock position and his desire to do right by shareholders (he appears to be very close to the other large shareholders who, beyond his 47% holding, represent another ~40% of the company).  In addition, the small size of the company means they might be able to squeeze out some meaningful reserve increases where larger companies cannot.  Given the company’s un-promotional nature, perhaps there are additional resources available that won’t appear publicly until they’re proven.

Finally customer concentration: in 2022 Apache purchased 55% of PNRG’s oil and 58% of PNRG’s gas, while Plains purchased 16% of PNRG’s oil and Targa purchased 11% of PNRG’s gas.  These are relatively high numbers but I’m less concerned about this risk with an E&P company than I would be with a less commodity-like company.

Disclaimer

We make no claims or guarantees about the accuracy, completeness or adequacy of the contents of this report and expressly disclaim liability for errors and omissions in the document.  We have no obligation to update this document and may change our position at any time without posting an update.  The views expressed here are merely the opinion of the author and is presented herein without warranty of any kind - whether express or implied. Readers should do their own due diligence.

Catalyst

New horizontal wells result in improved productivity and higher cash flow and returns on capital

Cash flow from new wells leads to further stock repurchases

Possible sale of the company if the right buyer approaches PNRG