Production Growth With a Caveat

What copper and gold company sees oil and gas production doubling in five years? Freeport-McMoRan Copper & Gold (NYSE: FCX  ) , and almost all of their oil and gas assets are in North America.

High hopes
Freeport makes 75% of its EBITDA from its mining operations and 25% from oil and gas. Freeport has several big projects going on right now, from California to Texas to the Gulf of Mexico.

In North America Freeport has 688 million barrels of oil equivalent in reserves, a sizable amount. 77% of Freeport's reserves is oil, 19% natural gas, and 4% NGL. This will provide 11.5 years of production at double its current production rate, which is what it's forecasting to produce.

Currently Freeport is producing ~163,000 barrels of oil equivalent per day, so if it doubles its production it will be producing ~326,000 boe/d by 2018. The caveat with this is that in 2013 oil accounted for 77% of its oil and gas production, but in 2018 oil will only account for 58% of production, and in 2020 that will go even lower to 54%.

If you factor that in, from 2013 to 2018 oil production will only grow from 125,500 barrels per day to 189,100 bpd, and not double. This means Freeport's cash flow will still grow, but significantly less than what it is leading some investors to believe.

This makes little sense considering most of Freeport's reserves are oil, which points toward Freeport not making the most of its liquid-rich reserves in the Eagle Ford and California.

Natural gas prices are currently unprofitable for most producers and carry much smaller margins than oil, which hurts free cash flow and hampers efforts to invest back in the business.

While investors should be happy that production is forecasted to double in five years, they should be wary of the production mix. Want a company that understands how to produce a very profitable production mix? Just look at Continental Resources (NYSE: CLR  ) .

Mostly oil
Continental's production mix is 71% oil and allows it to maximize the returns off each well it drills, with cash margins of 73%, up from 69% in 2009. This has allowed Continental to invest more back into the business and push up production from 37,324 boe/d to 128,655 boe/d over that same time period.

The growth doesn't stop there as it plans on increasing its capital expenditure budget from $3.6 billion in 2013 to $4.05 billion in 2014. This will allow Continental to ramp up production and meet its guidance to triple production by 2017. Continental is already beating its guidance to triple production and plans on completing 22% more wells in 2014 than in 2013. In order to do so Continental is increasing its rig count to 43 from 35.

Continental is guiding for well completion costs to be at or below $8 million for its Bakken wells by the end of 2013, which is a major improvement over the 2012 cost of $9.5 million. The lower the well completion cost the more wells Continental can bring online.

Production is expected to grow by 38-40% this year and by 26-32% next year. This, combined with high liquid production mix, will significantly increase Continental's free cash flow and allow it to bring more wells online.

Another way Continental is going to increase its cash flow is through downspacing. Right now Continental has 9,976 drilling locations but through downspacing Continental could increase that to 19,353. Downspacing will also increase Continental's reserves. This will increase its growth runway significantly and allow it to meet or exceed its guidance of tripling production.

Continental isn't the only company banking on oil, Denbury Resources (NYSE: DNR  ) has an even higher oil production mix than Continental.

It's over 90!
94% of Denbury's 74,052 boe/d production is oil, which results in very high levels of free cash flow. Denbury expects its free cash flow to double by 2016 as it exploits its oil-rich plays.

Denbury has ~1.1 billion barrels of potentially recoverable oil equivalent, but it has the chance to significantly increase that. Two of its plays have the potential to yield between 4.7 to 9.7 billion barrels of recoverable oil in the region due to increased recovery rates from CO2 injections.

Denbury's strategy used to be that it would buy mature fields, pump them with CO2, and then extract oil from those wells. Up until 2008 that was Denbury's focus, but now it has diversified into several other plays.

In 2008 Denbury started producing from the Tinsley play and since then it has moved into four other plays as well. Diversifying away from mature wells has enabled Denbury to see some strong production growth, which was up 16% quarter over quarter. Denbury is currently seeing record production.

Final thoughts
While production growth is good, investors have to make sure that the company is utilizing its reserves in the most profitable manner. If you have oil in North America but you plan on pumping out natural gas while it's at record low prices, you have to wonder if you should change your focus.   

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