ESTE - Permian Resources: Oil & Gas Has Gotta Be Cheap When This Happens

2023-08-23 11:11:43 ET

Summary

• Permian Resources and Earthstone Energy are taking advantage of cheap oil and gas prices to acquire acreage and build a profitable combined company.
• Premiums are beginning to be included in offers, indicating a return to historical premium offers in the industry. Cracks are appearing in the "cheap" part.
• The lack of speculative money in the industry is allowing for a more rational oil and gas cycle, and insiders are capitalizing on cheap offerings.
• Shoppers acquiring shoppers means that the industry is still historically very cheap.
• Permian Resources management and backers have a lot of experience building and selling companies.

When the shoppers start acquiring the shoppers, then oil & gas has got to be dirt cheap. Both Permian Resources (PR) and Earthstone Energy (ESTE) have been grabbing bargains at levels I never thought would be possible. Yet those bargains persist. Now the two are combining force s into what should be a shopping juggernaut that we may not see again in our lifetimes. The idea that each could be acquiring a lot of acreage while keeping debt ratios very low, and then combining forces on top of that to still have low debt ratios, gives investors an idea just how cheap oil & gas remains. The equity valuations and enterprise valuations likewise remain dirt cheap as well.

The chances of this situation lasting throughout the industry are not great. Already, premiums are beginning to sneak into offers. Long-time investors may remember that after the 2015-2020 period, Mr. Market was strict about no offer premiums (it really began during that period, though). This offer appears to have a small premium for Earthstone Energy shareholders. As these deals continue and the benefits keep becoming apparent, the market will likely return to historical premium offers as that disastrous five-year period fades into a distant (forgettable) memory.

The demand for no premium really goes with the demand for return of capital and no growth because a lot of speculative money (that should have known far better) "lost its shirt" on deals that never should have happened in the first place. That was because there were a lot of investors that did not realize that the "go-go days" of the early 2000s which featured rapid unconventional growth and lots of profits were at an end. Naturally, the blame for those losses was pointed everywhere but the "man in the mirror".

It now looks like a return to a rational oil & gas cycle is finally "front and center" as the speculative money is nowhere to be found. Hopefully, it stays that way for a while too. In the meantime, insiders like these managements are fully taking advantage of the cheap offerings to build a very profitable combined company.

Discipline

The experience of building and selling companies is important. Also important is the lack of debt used to make these transactions. The carnage that began in 2015 wiped out all those entities expecting high oil prices "forever". It always happens in the industry. It is just that this pastime it happened "later" and therefore lulled a few people that should have known better "to sleep" with the result they got very careless in their deals.

Permian Resources' management shows no signs of making mistakes that were fatal to a lot of predecessor competitors. One of the things both competitors realize is that the market will not tolerate a big offering premium, no matter how justified it is from a business standpoint. Therefore, to get around that issue, managements of both realize a series of small premiums through stock deals will likely get you to the same spot. It is a little more work. But the end result appears to be worth the effort.

Then There Is Politics

The oil and gas industry got caught in the political crosshairs, with valuations suffering. In particular, permits were not getting processed on a timely basis because of all the administrative vacancies in the past administration. This led to Earthstone (and many other) managements stating that during the current administration, they now had years of permits with more on the way. They said it repeatedly, too. Mr. Market, once burned, puts that part of the business in the doghouse usually for years.

Mr. Market just will not let go of a problem that no longer exists. This is shown in the valuations above. The fact is that permitting, and a lot of administrative procedures are now historically "in bounds". But as shown by the relative valuations above, Mr. Market is firmly stuck in the past.

Also complicating matters is the fact that both companies have gone shopping quite a bit. But Earthstone, even considering that is so much cheaper than Permian Resources, that management could offer a premium and still have an accretive transaction.

Lost in the whole discussion though is the elephant in the room. With the ability to now secure any permits and the government stating that leases, approved projects, and contracts would be honored, at some point the market will realize that projects, permits, and anything government are now processing at a greater rate than was the case before. That means business can return to normal, and valuations over time should likewise return to normal. All Permian Resources will have to do is just wait out the time period necessary for values to head back to historical levels.

Sponsors

Usually, these smaller companies have some experience behind them. This one is no exception.

This management plans to return about 50% of available cash flow (as calculated) to shareholders. Therefore, if that valuation does not fix itself rather quickly, these shares are likely to provide a generous return to shareholder through a combination of appreciation from share repurchases and a potential dividend.

The acreage is some of the best acreage in various parts of the Permian. The well paybacks are relatively fast, even considering the helpful commodity price levels. That usually means that cash flow will build at a quick pace.

The relatively low debt levels calculated post-merger means that debt does not have to be paid lower (but could be). That means management can concentrate upon building value for shareholders.

Note that the considerable backing shown above continues a trend of entities with considerable industry experience "getting in" rather than selling out. There was a secondary offering. But that offering was a relatively small part of the institutional (backers) holdings shown above. It is still very cheap to grow by buying production. In fact, it is still very cheap to buy whole companies.

That means that most holders should consider hanging on until a lot of these managements sell the company and exit. What you are waiting for is something like what happened with cars just a little while back with all those companies going public. It is probably a few years away. Oil and gas can be very volatile and low visibility. But most of the time, insiders will let you know when it is time to pare your holdings.

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