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Earthstone Energy has promise in the Permian

Why this producer – and its exceptional management team – holds the keys to unlocking a horizontal oil play

Jody Chudley is is a contributor to Agora Financial’s Outstanding Investments and Real Wealth Trader.

Aug 29, 2016

by Jody Chudley

The Play

Looking back, I find it strange that the best horizontal oil play in North America isn’t the one that was first developed. The Bakken got rolling in 2007 and accelerated once we got through the global financial crisis and oil prices rebounded. The Eagle Ford started having significant production in 2011. The Permian came last with the real increase starting in 2012. It was last, but isn’t least.

Over the last 18 months, the Permian has emerged as the most profitable place in North America to drill horizontally for oil. The share prices of Permian-focused players speak volumes. While much of the industry has fallen apart, Permian pure-plays have had no trouble going to market to raise cash at reasonable share prices. Asset sales in the region are still valuing Permian acreage as though oil is a commodity that we won’t forever have a supply imbalance of.

If this is truly the best horizontal oil play on the continent, then the companies that have several years’ worth of drilling locations in it should be the best producers to own over time.

Let’s have a look at one.

The Pick

Earthstone Energy (NYSE: BHI)

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I’ve decided this business of oil and gas production is a very difficult one to invest successfully in.

First, every company claims to have assets that provide economics in the top tier of the industry. That means that 90 per cent of these companies are exaggerating (my polite word for lying) or simply don’t know any better. Second, even if the company truly has some great acreage, there is no guarantee the management team can make the most of it: You can drill poor wells in a good play. Third, should you find a company that has both great acreage and the right operational expertise, things can still go wrong. There is always a chance that a company’s risk mismanagement of its balance sheet catches them on the wrong foot in a commodity price collapse. Getting all three things right isn’t easy, so how does one go about finding a combination of great assets, good operating ability and careful balance sheet management?

There are no guarantees, but I think the only way you can have some sort of confidence that you are doing this is by sticking with proven management teams.

Like the one at Earthstone Energy.

This team has built and sold five energy producers. You can get lucky once or twice, but five times seems like skill. And yes, they sold the companies for a profit (that is kind of important).

The Earthstone team just acquired Permian-focused Lynden Energy and now has a presence in the Eagle Ford, Bakken and Permian. Production and reserves are roughly 70 per cent weighted towards oil. Roughly 56 per cent of production is from the Eagle Ford, 25 per cent is from the Permian and the remainder is Bakken.

Lynden was a sleepy company sitting on a pretty good land position in the Permian. Getting these assets into the hands of Earthstone’s management group is likely good for both companies.

Perhaps more importantly, it gets Earthstone’s management a foot in the Permian door. Based on what the company said in its last conference call I would say we can expect more Permian acquisitions: “We will diversify our asset base and move into attractive acreage with significant horizontal potential in the Midland Basin,” said president and CEO Frank Lodzinski. “We intend to expand our presence in West Texas and pursue operated properties and acreage as our management team has done in each of our four prior public companies.”

Sounds good to me. This has to be a good time for a team that has proven it can create shareholder value through acquisitions to be doing exactly that.

The Postscript

Earthstone’s leadership group has bought nearly $1 million worth of Earthstone shares in the open market over the past six months. There is really only one reason to do that and it is to profit from the share price going higher.

The nice thing for investors here is that since this management group has built and sold five prior companies, you know there will be an exit point where they realize profits. That will be a catalyst to move the share price to a point where the company is fairly valued. Given management’s buying of shares I would expect that to be a share price that is higher than where it is today.

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