Description

QEP is a smid cap oil and gas producer with assets currently located in two key basins. They have 91,000 net acres in the Williston basin (North Dakota) and 49,000 net acres in the core of the Permian basin (Texas). Even after the stock move from recent weeks, at $4.07 there still plenty upside in the short-term (+42%).

Background/History

QEP originally spin-off from Questar Corporation in 2010. The stock traded in line with oil price and did very well for the first year (2010) then plummet in half at the end of 2011 as WTI was decreasing and likely combined with some Questar shareholders taking profits from the spin-off. The company decided to do a transition from a predominantly gas to an oil producer and it went on to acquire more oily properties. It acquired acreage in the Williston basin for $1.4 billion (at year end those assets were valued on the books at $2.8 billion based on reserves) and a year later bought their first acreage in the Permian for $950m. Those acquisitions were not received well by shareholders and as the stock never really did well and continued to trade sideways/downwards. Then JANA got involved with the name and reached an agreement with QEP to sell their midstream assets for $2.5 billion to Tesoro, which they did in Oct/2014 and some other midstream assets to other buyers. But unfortunately, the divestures happen all while the oil market was crashing in 2014. So QEP never got the credit for the sale in terms of the stock price. In the following years the company went on to acquire the other two acreage blocks in the Permian, which again were not perceived well by shareholders that at this point were only hoping companies would finally be free-cash-flow positive, which QEP never did until this recent quarter (3Q19).

Thesis:

The company doesn’t have the best track record in wall street. Just by looking at the all-time stock chart will illustrate it. Despite their troubled past and lack of shareholder communication, Today’s reality is they have great oil assets with tier 1 acreage in the core of the Permian, and have more than enough experience testing and operating unconventional wells and are amongst the lowest cost producers not just in the country but within the Permian itself, with netbacks close to $40/BOE. QEP is in a great position to generate very strong cash flows and being able to organically de-leverage their balance sheet at least by 2021. At the end of the day, investors skepticism with QEP’s ability to pay down their 2021 $398m Sr. Notes are overdone and are ignoring the fact the company has already secured most of the cash required to retire the notes by 2020YE.

The Q3 results placed QEP amongst the lowest cost operators in the Permian. Q3 Beat consensus on production (+13%) and capex (-17%) and generated $18m FCF while guiding $45m lower 2020 Capex than street estimated. In 2020 G&A will be 50% lower from 2018, all while the company is still increasing overall production ~6% annually. Insiders are buying shares (140k shares bought since Aug/2019, and no selling since 2016). The set up looks great and despite the move on the stock, which in our view was mostly due to the oil move, there is still another 42% and potential M&A ahead which also protects the downside.

We need to address some of the concerns that I often hear from sell side and other investors.

Sell side claims QEP have underperforming wells and bad acreage. –

The only underperforming are the ones in east of Williston. There is only way to find out the exact spacing between wells. It’s by testing over the years and it’s natural to get some bad results but those were back in 2016/2017. We looked at the data (go to DrillingInfo and you can check the data for yourself) and their wells are not underperforming at all. They perform just as any other producer with nearby acreage (e.g Pioneer, Diamond). We got the data from all QEP’s wells and created a blended type curve from their two formations (Spraberry and WCB), and each well will have a pre-tax NPV of ~$9m in this hypothetical model.

The claims that their acreage is bad, is another big misleading claim I heard and completely without merit, unless you are referring only to the Williston (by now they’ve produced most of the Williston acreage indeed). But we heard specifically that the Permian acreage is bad, however the same critics tells us that Pioneer and Diamond’s acreage were excellent. Well, if we look at their acreage map, they have a lot of adjacent acreage with QEP in Martin County, which by the way, is the 2nd largest productive county in Texas, second only to Midland (https://www.rrc.state.tx.us/media/55372/2019-09-monthly-production-county-oil.pdf).

Investors are overly concerned with Proved Reserves that will come in very low and break financial covenants –

This is another overdone concern. There is only one covenant that really matters and is under the bank credit facility as “Net funded debt” and the threshold is 1.5x and it uses PV-9 instead of PV-10.  It is basically the calculation of PV-9 divided by total net debt (For those familiar with PV-10, PV-9 is the same calculation but using 9% discount, so it should naturally be a higher value). This covenant limits the amount the company can borrow from the credit facility. You can simply divide the “PV-9” value by 1.5 and subtract net debt to arrive at how much they can still borrow under their facility. (e.g. 4,000 / 1.5 – 2,000 = ~$660m)

The company has had a dramatic decrease in their capital program before and reserves never came in lower.

If we recall in 2016 10-K the company capital program was $713m for FY18 and $781m for FY19. When the 2017 10-K came out, the capital program has decreased 34% (to $468m FY18 capex) and 9% (to $710m FY19 capex). Conversely, the PUD reserves were 51% higher, or more accurately they were flat once adjust by subtracting the 70mmboe from PUDs that were added by the “Robinson acreage acquisition” that year. So in other words, we’ve seen a strong decrease in capital program of over $300m but it didn’t affect the reserves at all. I’m not saying this time there won’t be a decrease. It will, but won’t be as catastrophic as some critics point.

As reported in the FY18 10-K, QEP capital programs for 2020 and 2021 were $882m and $1b respectively. If we take sell side estimates for 2020 and 2021 of ~$600m capex for each year, it’s a decreased of $707m (or -32% and -41% decline). One way to quantify how much the new capex program should affect the new PUDs, see below:

We are using actual performance of their wells, according to data from DrillingInfo from all QEP wells in the Permian, which equates to 270k barrels per well for the first 5 years of production. So we quickly estimate that $700m less in drilling spending will reduce PUDs by ~27 million barrels. Continuing, we need now to make some adjustments to account divestures, 2019 production and estimate conversion from PUD to PDP from the 2019 drilling program.

In estimating the transfer of PUDs to PDP, we assume FY2019 will have 50% lower # of rigs (as the recent quarters of 2019 are showing) so we can decrease by 50% what the 2018 transferred of PUD to PDP was (51mmboe was transferred in FY18) and so we move from PUD to PDP 25mmboe. The new final revised total proved reserves for 2019E comes down to 415mmboe (211 PUD + 204 PDP). This would equate to a -51% decrease in PUDs and -11% decrease in PDP and is our most conservative number because we are not giving any credit for drilling efficiency and longer avg lateral length. We know that the company provided SEC PV-10 at 18YE on the amount of $5 billion pre-tax, but the covenant uses PV-9 and our calculation outputs $3.3 billion for 2019E, which gives a “net funded debt” coverage of 1.66x, still leaving some room for error in my estimation for the 1.5x threshold.

What does that mean for their liquidity?

(3.3 / 1.5 – 1.98 = 0.215) in other words, the company has at least $215m of additional liquidity under their credit facility. In addition to their estimated cash balance for 2020 ($350m; explained below) means they will have $565m of usable cash by the end of 2020.

Finally, The concerns around debt payment are overdone

There is $1.5 billion debt maturing by 2023 of which $398m notes are maturing by March/2021.

QEP has $92m in cash, $112m in tax refunds ($75m in 4Q19 and $37m in FY20), will generate ~$150m in FCF (~75% 2020 production already hedged at $58) and will do $50m FCF in 4Q19. Adding all up and subtracting the $52m notes they’ve recently retired, we get $350m of cash balance at 2020YE. With 237 million shares outstanding, that’s a $1.48 increase per share just from debt repayment, that has been pretty much guaranteed at this point. With the recent move in WTI, they could start hedging Q1 2021 production at $55, another positive for FCF beyond 2020.

If that’s not enough cash on hand, there is also the join-venture from their water business which the company believe they can receive ~$120m sometime in 2020. Management said during earnings call that if this was a standalone business, it would be generating $50m in EBITDA. RTLR (“Rattler Midstream”) is a publicly traded water business and trades at 8x forward EBITDA. This would make QEP water business valued at ~$400m, if they sell 1/3 of the business it makes the $120m very achievable. Another way to look at this is by valuing based on water disposal capacity. QEP have 245mb/d, and based on the article below of WPX exploring a sale or JV of their water business valued at ~$600m which has 200mb/d water disposal, would indicate QEP water could be worth north of $600m.

https://www.forbes.com/sites/joecornell/2019/06/24/wpx-energy-to-explore-options-for-its-permian-water-business/#48549ba0d7aa

Downside protection by M&A

The next 4 years there will be a wave of M&A activity. This article from Barron’s explains it well (https://www.barrons.com/articles/oil-and-gas-mergers-2020-permian-basin-shale-takeover-targets-51578001734 )

There have been a few speculative bids for QEP. Elliot is the obvious choice as it already offered $8.75/share. The interesting thing is that Elliot’s 3rd biggest portfolio position and his biggest in Energy is HESS (with a $1 billion stake) and another $257m in Marathon. So in total, Elliot has currently 15% of his portfolio in the companies with very significant presence in the Williston. Exxon would be 2nd in our view, as they have direct adjacent acreage in both basins and their most recent operated wells in Williston have been moving east towards QEP largest acreage block.  The “red splashes” on the picture below are Exxon operated wells since 2018. They are clearly moving east and have very recent completions in the wells circled that are just west of QEPs largest block of acreage.

And as we can see in the picture below, HESS and Exxon are the most active operators

There is real speculation that Exxon would acquired Pioneer which they’ve been cleaning their books for a while now. If Exxon does acquire Pioneer, let’s say at a $180 per share it would be $30 billion transaction. Adding another ~$3B for QEP does make a lot of sense because as Exxon has direct adjacent with QEP in both basins. Interestingly, the new QEP CEO that started in Jan/2019 (“Timothy J. Cut”) worked over 20 years for Exxon Mobil.

Exxon also stated on their Q2 2019 call that they think the best way to produce is to drill from multiple horizontal benches simultaneously.

“I also discussed at that time that we are working on plans that we'll develop and drill multiple horizontal benches at one time. Our feeling -- there is communication between these horizontal benches. And if you go in and drill one bench now and expect to come back years later and drill the other benches, we do see or we do believe there's communication between the benches and it should dissipate. And our belief is that drilling of multiple benches simultaneously in the approach that I laid out appears to be the right way to go.” -Neil Chapman, Exxon SVP

Obviously, we are not betting our chips on M&A speculation, but we think that given the M&A outlook on the market, plus thinking from the operator’s chair, it makes total sense to acquire QEP. The question becomes weather QEP wants to be sold and for what price. We think it adds a nice layer of downside protection.

VALUATION

QEP already trades below peers at 3.6x 2020 when the Peers trade at 4.5x-5x. One can argue is due to their high leverage (2.87x as of Last Q), however with debt payment as I’ve described previously, leverage will come down considerably to 2x or lower and currently QEP is one of the few companies yielding strong FCF this year (~15%). Being conservative and keeping low multiple of 3.5x, we estimate 2020 EBITDA of $866, so $3b TEV. With a cash balance of $350m to pay debt will imply a market cap of $1.38 billion or $5.81/share, and net debt of $1.65b (1.9x leverage). Plus, if they do get $120m from water JV, that’s another $0.50/share. In total, assuming multiples don’t get further compressed, I see no way of the stock not being worth at least $5.81 (42% upside) which we view as a conservative price given the certainty in their cash position.

Or if an acquisition scenario (our bull case)

Most M&A deals are based on a flowing price per barrel plus acreage price. We analyzed all the deals with nearby acreage in the Permian and Williston from mid 2018 to Today. The avg from the Permian deals were $47k per acre and $40k per flowing barrel and there was only 1 deal in Williston in 2019 (“flywheel energy”) that was $45k/flowing and $3k/acre according to DrillingInfo. After adjusting for the current WTI, net acres would be $43k and flowing at $37k. It would give $10/share for Permian (after subtracting debt). The question is how much is Williston worth? They got a $1.7 billion offer last year but the deal fell through as oil pull back. It’s not worth that much now, but would it be worth $1 billion? I mean even at 0, does it matter? We get $10 per share based on relative transactions. I don’t think QEP wants to sell for $10, but things may change.

Risks:

Like any producer, the biggest risk is oil prices. If Iran sanctions are lifted it would be 2 million barrels added to the supply which is enough to crash the market. This won’t happen as oil at $40 is another 1-2% unemployment rate at the heart of Republican territory. That’s why these wars in the middle east won’t end in our lifetime. On the other side, China-US deal will likely make China a buyer again, and that will be a massive demand and oil could go back to $65-$70.

A lower oil will put pressure on 2021 hedges and Williston would be FCF negative (below $55) and that could drag even further overall QEP FCF. This could jeopardize future proved reserves estimates if capex program comes lower and at that point, then the availability to draw from the revolver could be a material issue.

Catalyst

- Future quarterly results

- Debt payment