Oil prices have declined steeply since the second half of 2014, and oil and gas stocks have witnessed major corrections. It is said that in every challenge, there is an opportunity. The crash in the energy sector presents some excellent value-buying opportunity for long-term investors. The value-buying opportunity includes large companies as well as emerging stocks in the sector. This investment case looks at an emerging stock in the oil and gas sector that holds immense promise for the long-term.
RSP Permian (RSPP, Financial) is an independent oil and natural gas company that operates in the Permian Basin of West Texas, engaged in the acquisition, exploration, development and production of unconventional oil and associated liquids-rich natural gas reserves. This investment case will discuss the reasons that make the stock interesting from a 12-24 month investment horizon.
Company overview
RSP Permian, an independent oil and natural gas company, has a market capitalization of $2.8 billion. Majority of the company’s acreage is located on large, contiguous acreage blocks in the core of the northern Midland Basin, a subbasin of the Permian Basin, primarily in the adjacent counties of Midland, Martin, Andrews, Ector and Glasscock.
For the year ended December 2014, RSP Permian had 106.4mmboe of proved reserves and the company holds 225,000 net effective horizontal acres and 63,000 net surface acres. The company’s acreage has 2,400 horizontal and 1,700 vertical drilling locations.
RSP Permian got listed in the stock exchanges in January 2014, and the company’s production has surged from 7,837boepd in 4Q13 to 24,000boepd in 3Q15. The company’s growth strategy is organic as well as inorganic growth, and the company has been successful in its strategy as indicated by robust production growth in the last few years.
It is also important to mention here that the company’s proved reserves have doubled from 53.9mmboe in FY13 to 106.4mmboe in FY14. Strong reserves growth and robust production growth are an indication of management quality, and the strong management quality will be evident in several other factors that will be discussed in the article.
Key upside triggers
This section of the investment case will address the factors that have the potential to make RSP Permian a stock to watch out for in the coming years. The stock has the potential to surge in the next two to three years even with a gradual increase in oil prices. This section will back my view.
Massive production and reserves growth potential
I mentioned that the company’s proved reserves have doubled from FY13 to FY14 and that the company’s production growth has been robust in the last few years. While the growth has been organic as well as inorganic, even if the current resources are considered, RSP Permian has 2,400 horizontal and 1,700 vertical drilling locations in an acreage that holds massive potential. The company’s current drilling locations translate into reserve life of more than 18 years. The point is that as these horizontal and vertical drilling locations are exploited, RSP Permian will witness strong growth in proved reserves and production. In other words, even if the company witnessed no inorganic growth, the proved reserves and production would still continue to surge.
Aggressive inorganic growth strategy
As challenging times continue for the oil and gas industry, RSP Permian has chalked out an aggressive inorganic growth strategy. I believe this is a good decision as the company can acquire some quality Permian assets at an attractive price.
To put things into perspective, since August, RSP Permian has announced its intention to acquire approximately 10,700 net acres for a consideration of $450 million. In October, the company announced LOI for acquisition of 4,100 net acres in the Midland Basin for a consideration of $137 million.
With the company going aggressive on the acquisition front, I expect positive revision in production estimates for FY16 as well as robust increase in proved reserves or probable reserves. This will translate into upside for the stock in the medium term. From an acquisition funding perspective, it is important to mention that RSP Permian completed an equity offering of 8.74 million shares in October, resulting in net proceeds of $218 million.
Further, the company’s revolving credit facility was increased from $500 million to $600 million. RSP Permian currently has $138 million in cash and $600 million in credit facility, taking the total liquidity to $738 million that will be used for capital investments and acquisition.
Another important point to note from a funding perspective is that Standard & Poor's 500 upgraded the company’s unsecured notes to "B" from "B-," underscoring the point that the company’s balance sheet health remains robust even after an aggressive growth strategy.
Low-cost structure and robust cash margin
RSP Permian has among the best cash margin structure in the industry, and this will translate into robust EBITDA margin once oil prices recover. As of 3Q14, RSP Permian had cost of $15.09 per barrel of oil equivalent with a cash margin of 78%. At that point, the company’s realized oil price (excluding hedges) was $86.88.
For 3Q15, the company’s cash cost has declined to $10.5 per barrel of oil equivalent with a cash margin of 71%. While the cash margin has declined by 700 basis points, it has been largely due to 3Q15 realized oil prices being $44.84 per barrel. When oil prices trend higher, the scenario will be completely different and RSP Permian will be generating strong EBITDA.
Continued decline in the cost structure is also indicative of an excellent management. In particular, the cash G&A cost has declined from $3.19 per BOE in 3Q14 to $1.92 per BOE in 3Q15, indicating successful cost-cutting measures amid decline in oil prices.
In addition to the positive related to declining cash cost that will trigger stock upside when oil starts trending higher, RSP Permian also has the lowest F&D cost in the Permian. According to the company, the total F&D cost per barrel of oil equivalent for FY14 was $13.88 as compared to Permian peer average of $23.28.
Strong growth plans for 2016
For the next 12 to 15 months, RSP Permian’s stock upside will be driven by the following factors – First, inorganic growth coupled with robust reserves and production growth; second, robust drilling program for 2016 will translate into strong EBITDA and attractive valuations on an EV/EBITDA basis.
At an average oil price of $60 per barrel, RSP Permian plans capital expenditure of $350 million to $400 million. The capital expenditure will translate into 57 to 62 horizontal well completions. The important points to note are as follows:
Even at $40 or $50 per barrel, RSP Permian expects double-digit growth in production, and this is a key stock upside trigger for 2016. The company’s robust production growth trajectory will continue.
For 2016, the company is targeting 57 to 62 horizontal well completions in the highest return operating areas (similar to 2015). In 2015, the company has beaten estimates on production, and I expect RSP Permian to outperform even in 2016, resulting in stock upside.
Long-term story
While RSP Permian has several factors that can trigger stock upside in the near term, the company’s long-term outlook is bright with nearly 25 years of high-quality drilling inventory.
It is important to note that Pioneer Natural Resources (PXD, Financial) has key assets in Permian in West Texas. With RSP Permian also having key assets in Permian (West Texas), the company is a potential Pioneer Natural Resources in the making. This is considering a thre- to five-year investment horizon.
My conviction for the long term also comes from the fact that RSP Permian had a reserve replacement ratio (organic) of 1,140% for FY14, and the overall reserve replacement ratio was 1,406%. RSP Permian will continue to boost production and continue to increase its asset reserve life, which currently stands at 18 years, if the reserve replacement remains robust (very likely).
Another reason for considering RSP Permian an excellent long-term story is the company’s financials, and that will be addressed in the next section. The key point here is that a quality management has been able to sustain robust growth along with maintaining strong fundamentals.
Financial analysis
The company’s financial analysis supports the entire argument that RSP Permian is an excellent stock for the long-term. To grow at a robust pace, high financial flexibility is critical and RSP Permian has that flexibility.
To put things into perspective, RSP Permian’s annualized EBITDAX (based on 3Q15 EBITDAX) comes to $313 million, and this implies that the company is currently trading at net debt to EBITDAX of 1.8. Therefore, the leverage is not high, and this is especially true for a company that has been growing at a robust pace. Further, with total liquidity of $738 million as of September, RSP Permian is well positioned to finance 2016 capital expenditure along with the acquisitions that have been lined up for the foreseeable future. In other words, the company is fully funded for FY16, and this includes bandwidth to increase production and quality acreage.
RSP Permian has also issued equity shares in October, and I expect further equity dilution if attractive acquisition opportunities emerge. However, investors should not be concerned about any further equity dilution as it would only enhance growth.
Conclusion
Considering the points discussed, RSP Permian has ingredients to make it big in the long term, and I recommend exposure to the stock at current levels. It is important to note here that RSP Permian stock has trended higher by 7.2% in YTD15.
In my view, this is an excellent performance considering the challenging industry conditions. With broad industry conditions likely to improve gradually, I expect RSP Permian to deliver stellar results and stellar returns.
Disclosure: No Positions
