Description

I am presenting WPX as a long idea, taking advantage of the typical spin-off dynamics we are all familiar with. This “new” company, and new equity, began regular trading on 1/3/12, after being spun off its parent company, Williams Cos (WMB). After the original plan of IPOing a portion of the company was shelved in favor of a 100% spin-off, WPX came to market with little fanfare – no underwriters had IPO fees incentivizing them to host a typically promotional roadshow, and the company started unofficial trading in the when-issued market on 12/12/11, closing that day at its LTD high of $19.25. Having to be discovered in a traditionally slow end of year period, without much institutional support, and against the tailwind of WMB holders likely to be net sellers rather than buyers since the beginning of the year, the WPX opportunity being offered in the market is unique. This exploration and production (E&P) company is now one of the cheapest of its kind, with a number of levers for growth, a conservative balance sheet, and arguably a free international option (Apco, see below) which one part of the market – those selling WPX - assume is worth very little, even though another part of the market – those buying Apco stock – believe is worth over $1.6bn to WPX.

As the company is released from the constriction of a pipelines/infrastructure-focused parent company, it will be free to develop its assets and exploit the opportunities inherent in its portfolio. Over time, the market should correct the valuation discrepancy*.

(* Of course, no matter how cheap an E&P trades, it is still driven by future oil and gas prices. One can choose to hedge out that risk via, e.g. shorting a basket of E&Ps, but regardless of one’s approach to risk management, one must be aware that “margin of safety” for a commodity company is often defined in relative terms.)

WPX is an E&P operator with three core areas onshore US, and an international operation with a focus on Argentina. It is the largest operator in the Piceance, with new (and growing) positions in the Bakken and the Marcellus.

Price: 16.67

Shares Out: 199mm

Market Cap: $3,317mm

Net Debt: $950mm

Enterprise Value: $4,267m

Piceance: Once considered a top-notch “resource” play (like the Barnett and later, Marcellus), this is the core of WPX dating back to the WMB acquisition of Barrett Resources in 2001. WPX is the top natural gas producer in Colorado, and the development of this asset is generally considered low-risk and predictable (as most resource plays are defined). The negative aspect of the Piceance is that it is mostly natural gas, but the decline in the commodity price has been offset to an extent by the strength in crude and resultant strength in NGL (natural gas liquids) prices, which have provided a margin uplift (Piceance reserves are “wet” gas as opposed to “dry” gas, which do not contain material NGLs). WPX’s scale in this region provides well cost advantages (they suggest 20+%). Over time, there may be upside in this play from horizontal drilling in the deeper Niobrara pay zone.

Bakken: WPX holds 3P reserves of 185mmBOE (1,110Bcfe), all acquired in one transaction in 2010. The company has added 2 rigs (to get to 5) and intends to add another rig in each of 2012 and 2013. This oil play is a key asset for the company to diversify away from natural gas and is still in its early stages of exploitation. WPX’s assets are in the core, in the southern part of Mountrail County, where the understanding of the reservoirs is fairly advanced.

Marcellus: Another resource play early in its exploitation history, the Marcellus is one of the fastest-growing gas basins in the US. WPX plans to add 2 rigs to its current 4 operating units, in 2012, which should help improve its cost/return profile. This basin is considered to have attractive rates of return even below $4 natural gas (where it is today), and the largest acreage position WPX holds is in the dry gas “sweet spot” of Susquehanna County.

Apco: WPX’s international exposure is held through Apco Oil and Gas (ticker: APAGF), of which they own 60%. Apco is a controlled company (i.e. sharing the same management team as WPX), and is active in the prospective Neuquen Basin in Central Argentina, as well as the Austral, San Jorge, and Acambuco basins in the country, in addition to assets in Colombia. Apco is self-financing, and generally does not have operating interests in its wells (meaning it is typically a JV equity partner with a non-operating interest). Without going into a long-winded discussion of the potential of Argentina, I would point to this presentation by Argentinean operator YPF, which lays out the potentially massive resource play currently being delineated:

YPF link: https://imagenes.repsol.com/es_en/TGB_tcm11-614890.pdf

The upside prize in Argentina is a similar shale oil and gas development potential as the US has just experienced. As one analyst stated in a report on small cap BOE.cn:

“The Vaca Muerta compares extremely favorably to international plays with greater thickness, porosity, and higher OGIP and EURs than elsewhere. With the Argentina government supporting higher prices up to ~$7 / mmcf for unconventional shale and tight gas plays, the economic conditions to prove-up and develop unconventional resources has now become much more favorable in-country.” – Caismir Capital, 10/3/11

WPX owns 20.3mm shares, or $1.615bn of value, in APAGF. The shares trade on average ~$2mm/day.

Financial Overview

Management has provided the following guidance for 2012:

Adjusted segment profit (EBIT): $100-500

DD&A: 1,100-1,300

EBITDA: $1,200-1,800

Capex: $1,200-1,800

Production: 1,300-1,490 MMcfe/d

Comparables

To illustrate how cheap WPX is relative to peers – particularly on cash flow and reserves - it is helpful to compare them to a few large, gas-focused operators (UPL, QEP, ECA), as well as to a “cheap” but more-balanced E&P in PXD:

Another way to consider valuation is as a modified sum-of-parts; specifically, the company’s multiples look even lower when subtracting out the recent prices paid for the Bakken and Marcellus assets, as well as the public stake held in Apco. The key rationale for considering this approach is that the Bakken/Marcellus assets currently constitute only ~5% of the company’s reserves, partly due to the timing of the deals (2H 2010, with the majority closed on 12/21/10). Bakken production, through Q3 ‘11, tripled from the start of the year (6,400 Boe/d from 1,700 at YE2010), so one would reasonably expect to see a step-up in the YE2011 reserves. Apco is similar at ~6% of YE2010 reserves.

WPX EV: $4,267

Bakken: $949mm

Marcellus: $599mm + $164mm (disclosed) = $763mm

Apco: $79.58 x 20.301mm shares = $1,615mm

Adjusted EV: $940mm

WPX Reserves: 4,473 Bcfe

                Less: 513 Bcfe

WPX Adjusted Reserves: 3,960 Bcfe

Adjusted EV/MMcfe: $0.24

The only caveat is that the prices paid to enter those two plays, while not egregious, were certainly above average on a per acre basis (though each transaction is different in terms of geological attractiveness, infrastructure access, etc). Furthermore, there is no guarantee that the company did not simply over-pay and the actual reserve additions will not disappoint.

This all being said, one might argue that even without adjusting for these assets, WPX is trading too cheaply on cash flow and reserve multiples. To the extent that Apco’s valuation is justified, and the other reserves and cash flow are today “fairly” valued at the bottom of the peer group, there would appear to be upside of 41% to $23.47:

If you went further and speculated that Apco’s valuation was justified AND WPX should trade in line with peer UPL ($1.46/MMcfe), WPX shares would be worth $34.

Even if Apco is ultimately worth zero, there still appears to be upside in WPX – there is no apparent reason why it should trade with the kind of discount it has today versus peers.

Risks

• As a commodity energy producer, WPX is subject to prevailing oil and gas prices, as well as price differentials (regional discrepancies due to local supply/demand, takeaway capacity, varying degrees of output quality, etc). WPX has lower unit profitability than a number of peers who are more oil-focused (vs gas), and thus has a lower margin to absorb weakness in prices, leading to a risk of production declines if prices were to fall significantly from here.
• The vast majority of WPX’s reserves will be produced using hydraulic fracturing (per the company: “Our net acreage position in the basins in which hydraulic fracturing is utilized total approximately 550,000 acres and represents approximately 94% of our domestic proved undeveloped oil and gas reserves”). Obviously, any state or federal restrictions on fracking, which are continually debated in certain regions, would be detrimental to the company’s production and thus cash flow. While nothing appears imminent, this is a highly-charged debate and it has already yielded a number of surprises.
• While not necessarily “small” players in their new regions, WPX is new to both the Bakken and the Marcellus. This entails two issues: one, they are still learning about the reservoirs and the optimal production techniques (though this is less worrying as both are sufficiently advanced at this point to not represent critical risk). The second risk, however, can be more problematic in the short term, and that is getting priority access to equipment and services – see NFX’s Q3 reduction in production guidance for the year, based on as number of issues but primarily due to Williston Basin (Bakken) service tightness and resultant cost increases. Without scale in these rapidly expanding producing basins, WPX may suffer from service providers allocating resources elsewhere.
• M&A is unlikely, per the company (“would have to be incredibly compelling”, CEO interview on 1/3/12), but always possible.
• The realization of value in Apco, if that was to occur, may suffer from a tax consequence.
• As a new management team (vis-à-vis public markets experience), there may be growing pains, especially in terms of communicating with investors and analysts.

Catalyst