Gas in the Tank: Cimarex Energy

I've followed oil and gas producers for a long time, which has yielded three timeless, deceptively simple lessons. One: Asset intensive, cyclical businesses with huge operating leverage and fat debt loads are not an enduringly tasty recipe. Two: Given money, most management teams cannot resist the urge to drill a hole in the ground, build empires, or some combination of the two. Returns be damned. Three: complex financial transactions -- the likes of volumetric production payments or joint ventures -- can be the friend of shareholders and value accretive. But they're more often financial engineering.

And yet, investors, for some reason, are always willing to take the bait. In an industry dominated by flavor-of-the-week fashions, cowboy capital allocators, and debt-laden growth junkies, Cimarex Energy (NYSE: XEC  ) is a breath of fresh air. Management stresses capital allocation, return on invested capital, and a conservative, steady-as-she-goes approach. That recipe has consistently and quietly rewarded shareholders.

As markets fret over the fiscal cliff, elimination of tax breaks for E&P companies, and the state of the economy, Cimarex shares have languished. Foolishly minded investors can buy a returns-focused E&P whose transformation from a gas-focused player to oil and gas producer, ability to benefit from recovering natural gas prices and strong long-term demand prospects, and acquisition target potential remains wholly underappreciated by the market.

I see return potential of 40% to 50%, and I'm buying a position equal to 3% of my Real Money Portfolio's capital.

The business
Strategy managers and C-level executives take note: Growth in and of itself is not the endgame. Cimarex managers take this notion to heart. Where many oil and gas execs lock themselves in conference rooms near fiscal year-end, ply themselves full of coffee, set growth targets, and leave it to mid-level managers to engineer a path, Cimarex doesn't set production growth targets. Instead, it focuses on a single metric: return on invested capital. Earning strong economic returns is agenda one, and everything else follows.

The strategy has served shareholders well. From 2003 to present, returns on invested capital have averaged 15.3%, well above the firm's cost of capital. Production's more than tripled, and proved reserves have grown to 2 trillion cubic feet equivalent (tcfe). Understanding the industry's inevitable ebb and flow, management eschews complexities common to E&Ps, which often dilute shareholder returns -- joint venture partners and accordingly uncertain liabilities, equity issuances to fund drilling budgets, or huge debt counts. Cimarex's debt-to-capital currently sits at a modest 20%, and its share count has remained roughly static for six years running. Consistent with this mind-set, the company's drilling strategy targets projects according to perceived risk-reward, tilting toward those with the most favorable balance.

In its current incarnation, Cimarex's spends most of its drilling budget on its substantial acreage positions in the Permian Basin and Mid-Continent, the most attractive of which is the Cana-Woodford Shale. Each year, a smidge of its drilling budget is directed to its Gulf Coast assets, where high-risk, high-return prospects occasionally gush cash. The company owns close to 450,000 Permian acres and 120,000 Cana-Woodford acres.

Where recently flagging natural gas prices have turned gas-focused E&Ps into shrinking violets, these prospects contain sizable oil and natural gas liquids (or NGLs, whose pricing derives from oil, in the long run) reserves, offering excellent, relatively low-risk returns even in today's natural gas price environment. I estimate Cimarex's Permian acreage breaks even at oil prices below $40-$50, and its Mid-Continent prospects make money at around $3. These are cherry properties. Cimarex's acreage provides multiple years' worth of drilling inventory, and possibly much more (more on that later).

Historically a gas-focused E&P, Cimarex turned its focus to oily and liquids-rich prospects in recent years, as natural gas-focused prospects' economics flagged, a testament to its returns-focused approach. Many companies turned their eyes to the Permian and their oil brethren only recently, as horizontal drilling techniques and newfound oil potential awakened producers to their potential. They've chased returns, growth, and assets, paying sometimes absurd prices for acreage. Cimarex hasn't. Instead, the vast majority of its acreage is the product of its 2005 acquisition of Magnum Hunter, a transaction that looked awfully pricey at the time but now seems prescient -- it afforded Cimarex access to the Delaware Basin Bone Spring and emerging prospects in the Wolfcamp.

Cimarex's current production mix is about 51% natural gas, 31% oil, and 18% natural gas liquids, but in the third quarter its revenue was 65% oil, 20% natural gas, and 15% natural gas liquids. From 2008 to 2011, oil production at 18% compounded annual growth rate, and natural gas liquids grew from virtually nothing to the current rate.

Why buy?
Today, Cimarex shares come cheap as investors fret over the fiscal cliff and world economy, discount the potential in Cimarex's assets, and fail to give account to a probable recovery to natural gas prices and very attractive long-term fundamentals. They do that at their peril. And Cimarex's acquisition target charm is a nice kicker. Read on, Fool.

1. Potential in the Permian (and Mid-Continent): Investors might mistakenly think that the Permian is a single blot on the map. Describing the Permian as a single entity is kind of like calling Pittsburgh and St. Louis the same city because they're both in the Midwest. The reality is much more nuanced. Some areas of the Permian breakeven at $20 or $30 a barrel, and others lose even at $80 a barrel. Cimarex's acreage falls at the lower end of that range, but could trend even lower. Likewise, while the company estimates several years of drilling prospects, they could be much greater.

To get a sense, consider the company's progress in the Mid-Continent: By drilling multiple wells from a single rig (called pad drilling), the company's reduced its well cost from $8.5 million a year ago to $7 million to $7.5 million and taken drilling times down. By drilling wells at closer intervals (down-spacing, in industry speak), it's also increased the reserve potential in the Mid-Continent, which the company estimates at 3.5 tcfe, two and a half times its current reserves. As it expands its downspacing, pad drilling efforts and continues to tweak at efficiencies, results in the Mid-Continent should continue to improve.

The same applies to the Permian. Exploration of the Permian is still in its early days. As management refines its efforts, starts pad drilling, and reduces well spacing, costs should come down, and estimates of recoverable resource should increase -- tactics successfully employed by Permian veteran Apache (NYSE: APA  ) . Already attractive economics should improve. Because the Permian contains what industry folk called stacked pay -- multiple resource basins sitting on top of each other -- heretofore unknown oil and gas may lie in wait.

As this happens, Cimarex's evolution from a natural gas to an oil and gas company should continue, costs will decline, and oil production will represent an increasing proportion of revenue and production.

2. Natural gas prices and demand: Natural gas prices, and producers, have a problem. They're low. So low that for a few months this spring and summer, natural gas-focused producers couldn't make money, as bloated inventories, a warm winter, and overzealous drilling pushed prices to 10-year lows. But there's hope. Long term, it's completely unsustainable. Economics should rule the day. Prices should approximate the marginal cost of production and then some (the cost of pulling the last bit from the ground), currently about $5 per million cubic feet (mcf). Otherwise, producers have no incentive to drill. Recently, there's been light on the horizon. Prices have recovered from lows, gas-focused rigs are 50% lower year over year, inventories are declining, and producers are swearing off drilling it until prices turn higher.

The long-term demand picture is similarly bright. Relative to oil and coal, natural gas is cleaner and more abundant. For industrial and petrochemical producers, it's way cheaper than oil on an energy equivalency basis. At prices between $3.50 and $4/mcf, natural gas is more economical than coal for power producers. Recent indications of increasing demand for gas-fired turbines (for power plants) could make the shift more permanent, and the ever-present risk of laws limiting carbon emissions may dramatically improve the near- and long-term consumption picture. If shale reserves begin to approximate industry estimates, a meaningful export market, as large as 20% of current domestic production, could develop over the next five to seven years.

Taken together, these factors point to higher natural gas prices. For Cimarex, where 51% of current production is natural gas, that will be an absolute boon.

3. The economy, fiscal cliff, and taxes: The so-called fiscal cliff has raised many concerns. Some are legitimate, others more nuanced, and many completely nonsensical. The reportedly negative impact of removing tax breaks -- most notably, the intangible drilling cost deduction -- for oil and gas companies falls into the latter camp. A recent Woods Mackenzie study posits that removing IDC breaks and Series 199 (intended to level the playing field for industrial producers) would render 38% of currently producing fields uneconomic. What's that mean? Ironically enough, higher oil and natural gas prices. Producers won't drill unless they receive a return on capital invested. So, while shares of E&Ps might initially suffer, their long-term prospects remain largely unchanged. Consumers, unfortunately, will bear the cost.

The cloud hanging over the global economy -- China's soft (or hard) landing, Eurozone, and the fiscal cliff and America's unsustainable finances -- hasn't helped matters. I won't mince words. The near-term prospects are not particularly bright, but a little context brings clarity. During the credit crisis, worldwide oil consumption declined less than 5%. Though oil prices plummeted to near $30 a barrel, they recovered to near $80 within a year. Taking a very long view, oil and natural gas prices follow the same rules. Marginal cost economics rule, and for oil, that's about $85 a barrel.

That's a long way of saying that, in the long run, none of this matters, and they might not even matter in the near term, either.

4. Acquisition target? Large integrated oil companies, whose growth prospects are flagging, have shown a remarkable zeal for mid-sized independent oil and gas companies with sizable shale inventories. Cimarex sports a low debt load, relatively few partners, and is bite-sized but large-enough to "move the needle." In short, it represents an ideal candidate for an ExxonMobil (NYSE: XOM  ) , Royal Dutch Shell (NYSE: RDS-A  ) , or Chevron (NYSE: CVX  ) . If the shares languish long enough, I wouldn't be surprised to see it remedied this way.

Valuation
In valuing Cimarex, I expect oil prices to average $85 across the long term and increase at a rate approximating inflation. Across the next three years, I also expect natural gas prices to approach the marginal cost of production, recovering to $5/mcf on increasing demand, a more rational supply picture, and colder winters. I expect production growth to average 4%, as the company methodically invests in its Permian and Cana-Woodford prospects. As a matter of conservatism, I expect only marginal improvements to Cimarex's well-level economics, and some improvement as general and administrative expenses scale on growing production. On this basis, I peg Cimarex shares' worth at $82.

Risks
The risks to an investment in Cimarex are fairly straightforward. Though its balance sheet is solid, and it faces no near-term debt maturities, a prolonged decline to oil or natural gas prices would sting and shares would decline. For reasons above, I don't think that's particularly likely.

Likewise, Cimarex will need to reinvest its money in new prospects at some point. Though management's proven capable stewards of capital, they could screw up. In that vein, the risk that Cimarex's drilling inventory, some of which are still early in development, fail to return according to management's (or the market's) expectations. It's also possible that, while economics would indicate otherwise, higher tax rates might crimp margins without an according increase to oil and gas prices.

The bottom line
Cimarex represents a best-of-breed operator with a sizable inventory of oil and gas properties, a shareholder-oriented management team, and numerous sources of upside potential at a cut-rate price. That's why I'm buying today.


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