An Interesting Pure Play in the Permian Basin

It might sound counterintuitive to buy a company after it encounters multiple operational issues, but in some situations the quality of assets and management team warrant such a move. In the case of Laredo Petroleum Holdings (NYSE: LPI  ) , the company has fantastic acreage in the suddenly hot Permian Basin. Note that Pioneer Natural Resources (NYSE: PXD  ) has suggested the Permian Basin contains more than 50 billion barrels of oil equivalent, making it the largest domestic oil field. Laredo also has an executive team that has developed and successfully sold multiple exploration companies in the past.  

While the Permian Basin is hot now, Laredo has been unsuccessful at exploiting the potential thus far. In the latest quarter, multiple operational issues limited production gains to only 17% in the Permian. The production issues had already lowered fourth-quarter numbers, and now the company has released further problems in early December. Laredo's struggles appear similar to Carizzo Oil & Gas (NASDAQ: CRZO  ) (NASDAQ: CRZO  ) , which had numerous stumbles in the Eagle Ford Shale on the way to huge stock gains this year.

Production issues
Most recently, Laredo revealed that severe winter weather had materially affected operations enough to lower guidance for the forth quarter. As of Dec. 4, the company had more than 50% of wells shut in due to facility constraints caused by widespread power outages, reduced access to production and drilling facilities, and curtailed trucking services. The company experienced several operating events during the third quarter that reduced production volumes. The events included mechanical issues at one well, casing integrity issues, and a fire that destroyed a truck station.

Carrizo reached $42.50 back in summer 2011 and proceeded to watch the stock drop back to $20 on numerous occasions. The company's stock only recently managed to climb above those 2011 levels after nearly two years of pain for investors. Carrizo has seen earnings surge this year on the back of nearly 34% revenue growth. The company is targeting 40% oil production growth in 2014.

Permian geology
Laredo owns approximately 141,000 acres in the Permian and is a now a pure play after selling the Anadarko Basin properties for $438 million. The company drilled and completed the first stacked lateral test of vertical spacing with three horizontal wells drilled on the same pad into the Upper, Middle, and Lower Wolfcamp zones. Current estimates suggest Laredo has roughly 2,000 feet of net pay counting those different zones and the Cline. When you add the additional zones of the Spraberry (Upper and Lower) above the Wolfcamp and the Strawn, Atoka, Barnett, and Woodford below the Cline zone, the company estimates an average of 4,000 feet of play.

In addition to the potential of vertical spacing, Laredo is increasing its drilling rigs by 50% at the end of the year. The company added a fifth horizontal rig at the end of September and expects to add the sixth horizontal rig before the end of the year. These two initiatives should lead to substantial growth opportunities if the company can overcome operational issues.

All of the news isn't good, though. Pad drilling efficiencies do create some issues. Laredo estimates that a new four-well stacked pad drilling rig delays initial production up to 123 days versus an individual well. At the end of the program, though, the four-well stacked pad program increases the time to drill four wells by at least 40 days.

Permian potential
Pioneer Natural Resources alone estimates it has more than 8 billion barrels of oil equivalent from vertical and horizontal drilling on more than 35,000 drilling locations. The company had 27 rigs operating in the region, of which 15 were drilling vertical wells and 12 were drilling horizontal wells. A total of 420 wells will be drilled in 2013, with a surprising predominance of 300 being vertical.

In total, Pioneer has 7,000 operating wells and 640,000 net acres in the Permian; this provides investors in Laredo with an area expert to follow. In addition, Pioneer is quickly shifting drilling activity from vertical drilling to more capital-efficient horizontal wells similar to those of Laredo.

Bottom line
The good news continues to be that the big exploration firms like Pioneer back up that claims of an exceptional resource in the Permian Basin. If Laredo can solve all the operational issues it has encountered during the past few quarters, it could help lead to faster growth in 2014. The adding of two additional rigs should lead to substantial production growth in 2014 as well. Carrizo Oil & Gas provides a prime example of what happens when an exploration firm turns the corner from development to sustained production growth. After its hiccup at the end of 2013, Laredo could be on the cusp of fast growth in a very promising basin.

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