CRGY - Earthstone Energy: Smooth Sailing

2023-05-18 14:46:53 ET

Summary

• The OPEC production cutback enhances the operational optimization of the acquisitions process by providing more cash flow.
• Occidental Petroleum Corporation had the exact opposite experience by running into covid challenges right after the acquisition.
• The buyers' market enabled the company to rapidly expand operations while paying close to zero for undrilled locations.
• Location costs are rarely revealed to shareholders in breakeven calculations.
• Earthstone Energy's strategy is confirmed by larger entities like John Goff and KKR through Crescent Energy pursuing a similar strategy.

Earthstone Energy, Inc. ( ESTE ) management is a company with a goal of building and selling the company. As I have noted many times before , this is the sixth attempt for management to build and sell a company. Nothing helps that goal like an OPEC production cutback announcement. Any company that has just merged or acquired loves high prices because there is more cash flow for the assimilation process. This gets the operational optimization process off to a fast start, which can raise the profitability of the merger by a few percentage points.

Timing is everything in this business. Occidental Petroleum Corporation ( OXY ) had easily the most publicized battle to purchase Anadarko and then ran smack into the covid challenges. The covid situation obviously caused potential sales prices to fall and made deleveraging the balance sheet far more challenging. All one had to do is watch how fast the balance sheet improved in the past year or so to see what a difference a more robust commodity price market made for the company. Even Warren Buffett noticed that.

For a smaller company like Earthstone Energy, the logistics of acquisition optimization are reduced. That is true even with the shopping spree this company went through.

The company easily expanded its presence in some of the more lucrative areas of the industry. This likely was made possible because the company began with a smaller core area, had a decent stock price, and was looking for bargains rather than "perfect acreage."

One of the things that likely enabled these bargains was the announcement that the Biden administration has issued more permits than the Trump administration at this point. It was known that Biden found a lot of positions that were empty for years (with the work piling up on empty desks). So that permit difference is only likely to widen now that positions are filled.

But those empty positions caused routine things like permits to pile up rather than be processed. Earthstone Energy management was able to purchase at least some operations on federal land because sellers likely wanted out after that experience. Most managements at this point have asked for and received permits for several years in advance "just in case" something like that ever happens again. But in the meantime, management got a bargain, and they can drill "to their heart's content."

This points to the fact that this management is always on the lookout for an edge. Maybe management did not get "prime locations." But they did buy acreage at a price that assures an above-average return for the money invested. This is what shareholders pay many managements to do (but it rarely happens in practice).

Rarely does any management ever show the well location cost as part of the breakeven calculation when shareholders are presented with that breakeven calculation. Yet, acreage does cost money and that cost needs to be recovered on the way to reporting quarterly profits. Management can often bypass this cost because land does not depreciate. If management needs to, excess costs can be written off as part of the "clear the decks" housecleaning during the next cyclical downturn. Then it can be blamed on hostile industry conditions or poor commodity prices (and not management overpayment of an acquisition).

This makes it hard for shareholders to understand what is going on. Generally, high land costs reduce the return on equity or return on capital invested or something likewise indirect. There are plenty of other costs that show up in the cost section of the income statement so that investors know when those costs got out of hand just by reviewing the income statement. Location costs are the exception.

Here, management is telling you that undeveloped location costs are so low as to not be material in the well breakeven calculation. That is a huge advantage over competitors that paid as much as $66K an acre for prime locations in the Permian. If wells are spaced 100 acres apart, a competitor would have to recover roughly $6.6 million per well drilled of acreage cost compared to nearly zero for Earthstone. So, management is talking about a very material profitability advantage that lasts until all the wells at that location are drilled.

One of the things that helps to confirm the strategy of a small company like Earthstone is confirmation of basically the same strategy by a well-known partnership. John Goff and KKR combined to form Crescent Energy Company ( CRGY ) which has a similar strategy. Like Earthstone Energy, Crescent Energy management has long maintained there are a lot of sellers and not a lot of buyers.

I chose to keep the slide from an older presentation because it covers thoroughly the investment criteria.

Both managements aim to take advantage of the situation as long as a buyers' market is the key condition. Both managements will likely sell the company when market conditions switch to a sellers' market. People ask me all the time "when do you sell and what is your price target?" Most investors like these will sell into a sellers' market, and they will wait for that sellers' market. I will wait for them to sell. They may not necessarily get the top price. But it is likely to be a very good price.

There is always a risk that waiting misses the highest price. But a seller has the advantage of selling during favorable conditions when there are likely to be multiple bids for the company by waiting for that sellers' market to develop. In cyclical industries, it seems to happen periodically.

All one has to do is look at all the car companies that recently went public to get an idea of what a sellers' market would look like in this industry. When professionals decide to sell at least part of the company as was indicated by all those companies going public, then you know that professional insiders have decided they are getting value for their backers by selling part of the company. At that point, you really do not need to know much more except that it is probably time to form an exit strategy because the next step is almost always over-production and a cyclical downturn.

Clearly, oil and gas is nothing close to that step. The only oil and gas issue that went public (and under brutal conditions at that) was HighPeak Energy, Inc. ( HPK ) which I previously covered in another article . Interestingly, a company that goes public like that all by itself will likely beat the new issue odds by a considerable margin. Ironically, demand for such a likely quality issue was relatively low despite the likely odds of success.

Therefore, I am going to hold my shares of Earthstone Energy, Inc. For me, ESTE stock is likely a strong buy at this point because most insiders are buying or getting into the industry. I will set an ESTE price target when I see something that has happened with the automotive industry happen with oil and gas. Until then, like Earthstone Energy, Inc. management, I will wait for a favorable seller's market to develop. It is the old "buy low and sell high" adage that is so incredibly hard for most investors to execute.

For further details see: