A Pure Play on the Return of the Permian Basin

The Permian Basin is coming back alive thanks to horizontal drilling. There are several big players and a few big pure plays on the shale. Here is one of today's more reasonably priced options.

May 19, 2014 at 10:13AM

By now you might know that the Permian Basin in West Texas is, perhaps, the most promising new shale play in the country. Initial estimates by Pioneer Natural Resources (NYSE:PXD) rank the Permian Basin as the second biggest oilfield in the world when probable shale oil reserves are included. The best part? The drilling of this shale oil is just getting started.

In general, horizontal appraisal and exploration didn't get started on a large scale until the latter half of 2012. Those who missed out on the Bakken and Eagle Ford might get a chance to participate in the horizontal shale formations of West Texas. 

One way to do so is Concho Resources (NYSE:CXO). Concho is a pure play on the Permian Basin. The company was founded in 2004 by Tim Leach. Concho was the last of three companies founded by Leach and certain others, and it was specifically designed to explore for shale oil.

But with a massive 600,000 net acre interest in some of the best spots in the Permian, I believe that Concho could end up being worth a lot more -- perhaps several times more than what the company is worth today. Consider this: With 500 million barrels equivalent of proved reserves, the market is essentially valuing those reserves at a reasonable $26 per barrel. 

However, the company estimates a potential of 3 billion barrels in total reserves. If this potential were to be realized, the market would now be valuing each barrel equivalent at just $4.33. It is not unreasonable to think that Concho's stock price may double or even triple in such a scenario. 

Cxo

Source: Investor Relations

The 2 x 3 plan
The source above is what management calls the "2 by 3 plan." In other words, this is a plan to double production in three years while staying oil-focused. To achieve this growth, Concho is employing a massive 33 rigs throughout the Delaware and Midland basins, and 29 of those rigs are horizontal. In just the first quarter of this year, Concho drilled 127 gross wells. And there's much more work to be done: Management estimates a total of 22,000 drilling locations. No, that's not a typo. 

Cxo Completion Day

Source: Concho Resources

Declining well costs
Of course, management's plan is not to merely drill for drilling's sake. In addition to rising production, the completion cost for a standard well is declining. In just the last six months, well costs on a typical frack job have gone from $5.6 million to just $5 million. And, as you can see, the time it takes to complete a horizontal well is falling.

Conservative finances
No discussion about a company can be complete without looking at its finances. Like most exploration and development companies, Concho does have substantial debt. However, management's explicit goal is to keep total debt at no more than 2 times earnings before interest, taxes, depreciation, and amortization expenses.

In addition, and perhaps more importantly, Concho pays for most of its drilling expenditures from cash flow, thereby keeping its funding gap modest and under control. For example, over the past 12 months, $1.6 billion out of the company's $2 billion in capital expenditures was paid for by operating cash flow. 

Adam Levigne Permian Basin

Overhead view of Permian Basin oilfield. Photo by Adam Levine

Bottom line
Right now Concho is trading at a reasonable price when compared to its Permian shale-drilling peers. Shares of Concho trade at about 3.7 times book value; closest peer Pioneer Resources sits at 4.4 times, and geographically diversified shale driller EOG Resources sits at 3.5 times. If the Permian indeed ends up being the world's second largest oilfield, you'll be glad you bought Concho here.

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Casey Hoerth has no position in any stocks mentioned. The Motley Fool owns shares of EOG Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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