RING ENERGY; REI-NYSE

COMPANY ANALYSIS

UPDATED — APRIL 10, 2017

Ring Energy has pretty much everything I’m looking for in a producer:

  1. A management team that’s built and sold a junior before
  2. Huge inventory (net 600+) wells with 12 month payout or less
  3. Tight share structure (less than 50M out)
  4. Net cash

Ring Energy Chairman Tim Rochford took his last venture–Arena Resources–from 13 cents per share in 2001 to $43 per share when it was acquired by Sandridge Energy less than 10 years later in 2010—a 34,396% return. CEO Kelly Hoffman sold his AOCO to LOMAC which eventually became part of Range Resources.

So they’ve done it before.  Now they are all back—before, friendly competitors each with a few decades of experience—but on the same team now—operating in the Permian Basin with Ring Energy.

The team’s pedigree is the main reason—up to now—that the stock has been able to trade at a HUGE premium to its peers. For Canadians, think how a Tier 1 CEO like Neil Roszell of Raging River or Dave Wilson of Kelt Exploration gets a similar premium when they start a new company.

But now, they have their first horizontal drill results out of their shallow San Andres play in NW Texas—and they’re amazing.  They averaged 660 boepd on a $2 million well that is giving them 90-140% IRRs and VERY fast paybacks—even at $40 oil.  Here at $50 paybacks are well under a year…on average.

They consider their San Andres land in the Permian’s Central Basin, not in the Permian’s eastern Midland or western Delaware Basins.  This is a conventional play that has gone horizontal—finally.  While it’s still early days, it’s clearly great news.

Combine that with net cash on their balance sheet and all of a sudden the premium here doesn’t look so huge—especially as they grow 80% year in 2017 and 2018.

I don’t know when oil prices will have The Next Big Run. But when it does, this is one I want to own—likely in A Big Way.

QUICK FACTS

Share Price:                                      $12.32

Basic Shares Outstanding:           48.4 million

Market Cap:                                     $596 million

Net Cash:                                          $55 million (after recent acreage purchase)

Enterprise Value (EV):                   $541 million

Current Production (Mar ’17):   3,618 boe/d (81% oil)

2018 EBITDA estimate:                 $96 million

2018 Enterprise Value / EBITDA:  5.46 times

http://www.ringenergy.com/

POSITIVES

– High IRRs should be allow them to grow big within or very close to cash flow

– Management team’s last venture in the Permian was a grand slam homerun

– Balance sheet = net cash

– Big growth ahead should be a major catalyst

– Latest acquisition gives them 600 net hztl drilling locations—over 10 yrs

NEGATIVES

Initial hztl well results VERY encouraging but still not fully proven

– One zone play (San Andres); others may come later

– Shallow carbonate play could have high decline rates on horizontal development (aka Swan Hills in AB)

– The best companies don’t always make the best stocks

BACKGROUND/PROPERTIES

 The Market doesn’t like small companies right now.  They don’t get respect from banks, service companies or investors.

Because of those challenges the only time I’m interested in looking at a junior is if there is a proven management team attached to it.  Look at what Chairman Tim Rochford accomplished at Arena:

That was a cool 34,396% total return.  By anyone’s measure that is an incredible return.  Management’s stated desire is do basically the same thing with Ring Energy by using the experience it gained the first time around.  CEO Kelly Hoffman has lived in nearby Midland Texas all his life—and built and sold a company before.

The two parts of the Permian that have everyone talking these days are the right and left flanks—the Midland and Delaware Basin respectively.  This is where the horizontal oil production growth is coming from for the oil and gas industry. Ring is in the middle. See map below.

Ring’s core assets are more focused on the Central Basin Platform—which is where they were at Arena.  You can see it in the map as the platform that separates the Midland and Delaware Basins.

In addition to the acreage it has in the Central Basin Platform, Ring has also entered the Delaware Basin and has some acreage in Kansas.

It’s important to note that Ring is a little different than the other Permian companies I have bought.  This is a shallow play, mainly focused on one zone—the San Andres.  It is not (yet) about stacked pay—which is what I usually talk about in the Permian.

It is amazing the new life that the Permian region has been given.  The Permian has had oil production for over 80 years.  A total of 30 billion barrels have been produced over that time.

Despite all of that time and that massive number of barrels produced the Permian still has a long way to go.  The Permian contains 22% of the remaining oil reserves in the entire United States.  There is a huge amount of oil still in the ground and that is why this old oil play has been given a new life.

Property #1 – The Company Maker—the San Andres zone in the Central Basin Platform (CBP)

Ring so far has assembled 63,000 net acres of land in Andrews and Gaines Counties in the Central Basin Platform.  This land is right on the Texas-New Mexico border and is only 10 miles north of where Arena Resources core production was located.

What is a little different about these assets is how they have been developed so far by Ring.  This has been a conventional development, which means old fashioned vertical wells and not horizontals—until now.

Ring built up its Permian acreage through a steady stream of bolt-on acquisitions of small leases acquired from different owners.  This is where management’s deep experience and relationships in this region has allowed them to be patient and persistent.

With the Market’s eyes on the Midland and then Delaware basins—Ring snuck right up the middle in the Central Basin Platform when no one was really looking, and assembled their land package.

Most of this land already contained legacy producing wells—about 270 total producers.  That provides a base of very low decline production that can generate cash flow to fund drilling.

Ring’s plan was to continue developing the land through a vertical 10 acre down-spacing program.  Down-spacing means that Ring would drill new wells in-between old producing wells to get at oil that would otherwise be left behind.  Think of an average city block being 2-3 acres.

The formation that Ring has targeted is the shallow San Andres.

The San Andres has long been developed using conventional wells (which was originally the Ring plan as well).  The thinking was that the “discontinuous” nature of the formation did not suit horizontal drilling.  “Discontinuous” just means the reservoir was in large but discreet pools or sheets—not quite as big as a blanket shale reservoir.

But again, here is where Kelly Hoffman’s operational team experience and patience paid off Big Time.

I had a great hour long chat with Hoffman in late April. He and his team started watching other operators go horizontal in the San Andres as long as five years ago.  Many of these companies were backed by Private Equity (PE), and had good budgets.  They went through the learning curve, showing the Market what didn’t work.

One example he gave me was that some operators from the Midland Basin came over and tried to use typical shale completion (fracking) practises on the more conventional (much more porous) San Andres.   That clearly didn’t work.

Hoffman says it’s more a mechanical play, and after watching other teams for a long time, their team felt comfortable enough to try it…and look at their results:

See how they are spending 8.6x the well cost to get 15.2x the reserves?  That’s what we call ACCRETIVE.

 

With 22 horizontal San Andreas wells coming this year analysts are calling for production growth from 2,400 boe/day in 2016 to 4,500 boe/day in 2017.   (I expect them to increase their 2017 program if well results and declines match expectations.)  With 600 net locations, they could drill a new well every week for 10 years—and likely do it within cash flow.  And there’s only 48.4M shares out.

 

The Permian horizontals that have made so much noise in recent years have been targeting deeper formations like the Wolfcamp.  Ring is targeting the much shalllower San Andres formation.

The discontinuous nature of the San Andreas means that the hydrocarbon bearing rock in the formation is not all found at the same depth.  The picture above helps make the point.  Think of potato chips in a bowl.  The odds are good, but not guaranteed.

 

Typically horizontal wells drill for long distances sideways through a shale formation that stretches for miles and miles—so consistent they’re often called a “blanket shale”.

 

Hit with one well, the Market expects you will hit the next 100 with 98-100% success.  And the Market then goes and prices in that future growth very quickly. See stock price jump HIGH!  That would be the Wolfcamp.

 

Competitors near Ring had been successful drilling horizontal wells into the San Andres.  Ring management has participated in a small interest in some of those horizontals and has also gathered insight from local service companies.

From all this information, Ring decided to go horizontal themselves.  The vertical drilling program was working fine, but horizontals should be better.

 

In its Q1 2017 ops update released in early April, the Market got to see how Ring is doing with that horizontal transition.  The Market liked what it saw.

 

Ring has completed 5 one-mile lateral horizontal San Andres wells on the Central Basin Platform.  The average initial production rate (15 to 30 day rates) of those wells was 660 boe/day with a range between 377 boe/day and 800 boe/day.

 

Based on those results the estimated rates of return on those production rates range from 70 percent at the low end to 500 percent for the best performing wells.  That is assuming $2 million per well cost and a $45 per barrel realized oil price.

 

Those are Big Time Numbers for a $2 MM well.  There is still uncertainy due to the fact that the production rates are from very young wells and we don’t know exactly how they will decline…but still very impressive.  The other factor Hoffman said in our interview was that because this area has been drilled like Swiss Cheese for decades, all the infrastructure like electricity, Salt Water Disposal (SWD) wells etc are already in place.

 

Contrast that to the very new Delaware Basin—where he intimates the very high IP rates being seen will need more infrastructure spending to get those hydrocarbons to market.

 

Now, look at this chart here where they show 13 month payouts at just $40 oil:

Hoffman says this chart was drawn assuming 55 barrels per lateral foot of recovery—and so far they are getting 59—7% more.  That would put their wells at well under a one year payout at $40 oil.   This chart doesn’t show their best wells; it shows what they believe will be a statistically relevant type curve across their inventory.

 

Ring has 63,000 net acres with 600 net hztl drilling locations—years of inventory. (Based on 6 wells/section;at 10 acre spacings would create more than that.)

 

Management has been very patient and was willing to sit on their hands until they were sure it was time to go.  Now they are hitting the gas pedal and showing what they have put together.

 

This Central Basin asset targeting the shallow San Andres formation is The Growth Engine of the company.

 

 

Property #2 – Delaware Basin

 

In addition to its land in the Central Basin Platform, last year Ring made a $75 million acquisition in the Delaware Basin.

 

OGIB readers will be very fond of the Delaware given our experience with Resolute Energy (REN-NYSE).  As mentioned earlier, this Basin is also part of the Permian—now the hottest part by far.

 

The 15,154 net acres that were acquired were from a private company.

In December 2015 Ring was getting 1,075 boe/day (67% oil) of production from this land from 78 different producing vertical wells.  Again, this is older, low decline production.  They only own rights from surface down to 6500 feet—so not the Wolfcamp.  However, they see several layers of payzones here in the shallows.

 

Ring thought this land was not been optimally managed previously.  They  upgraded the salt water disposal (SWD) handling capability on the land and increase production without drilling a single well.

 

Since acquiring the property last year Ring drilled only a single development well.  The company had virtually shut down all drilling (across the company) in 2016 waiting for oil prices to recover to a reasonable level.  They drilled one well in total in Q1 16.

 

The very low decline nature of the conventional producing wells that Ring has allows the company to not drill and still see production hold up pretty well.

 

The primary formation to developed in the Delaware Basin is called Cherry Canyon.  The plan is to develop these at a cost of roughly $650,000 per vertical well.

This is still a conventional vertical development.

In Q1 17, the Company drilled two new vertical wells, performed two recompletions on existing Cherry Canyon wells, drilled one new saltwater disposal well, and continued to upgrade and expand its gas and water handling systems.

The two new vertical wells were drilled deep enough to perform tests and gather information on the Brushy Canyon. Both wells are scheduled to be completed in the Cherry Canyon in Q2.

Clearly this one is well behind the Central Basin asset in terms of priority at this time.

KANSAS—PROPERTY #3

Ring has a third property which is located in Kansas.  The target there is the Mississippian where Ring joined Sandridge in a joint development agreement in 2014.

The company has 16,673 net acres here and shot extensive 3D seismic in the fourth quarter of 2014.   As of today development of this asset is on hold.  At higher oil prices it would be more interesting.

FINANCES

Ring’s initial 2017 budget plan for $70 million in spending that will be split as follows:

– 22 CBP (Central Basin Platform) horizontal wells

– 6 CBP vertical wells

– upgrading its existing infrastructure in the CBP

– 8 Delaware Basin verticals

– Workovers on 12 producing Delaware Basin verticals

– upgrading Delaware Basin infrastructure

It will be the Central Basin Platform horizontal wells that are going to move the needle for this company.  The land is cheap at $500/acre and wells are cheap at $2 million.

So this team can keep a clean balance sheet full of cash.  They did just spend $16.6 million buying another 30,000 acres of San Andres, though.  Hoffman told me they would finance a major land deal with debt with if they thought it was the right thing to do.  He is also not afraid to issue new equity for that—which, considering they trade  well above NAV, they should.

At the end of December 2016 Ring had $71 million and no debt—covering that latest M&A deal, and the $30 million outspend this year, without considering incoming cash flows.

After having hunkered down for 2016 by choice (drilled one well in Q1) and waited for oil prices to rebound before drilling the company is now ready to get going.

With 22 horizontal San Andreas wells coming this year analysts are calling for production growth from 2,400 boe/day in 2016 to 4,500 boe/day in 2017.

My calculator tells me that is an 88% increase. Hoffman told me they expected to complete those wells by the end of September, and they could drill more.

To achieve this will require outspending cash flow by about $30 million.  That would still leave the company with $25 million of net cash at the end of the year.

As yet, the company does not have any hedges in place, though Hoffman said they would consider hedging if oil gets back up to $55.

VALUATION

On the surface, the stock looks crazy expensive—even for me (I like expensive stocks…they tend to stay expensive).  But before we talk too much about valuation let’s put a couple of things on the table.

One is that this company has net cash.  The Market pays for the “optionality” that brings.  Between cash flow, net cash and debt, this proven team could potentially go spend $200 million on an asset they really love.

Two—this company is growing by 80% this year.  And again next year.

With all that in mind I won’t split hairs over exactly what EV/EBITDA multiple Ring has. On 2017 projected cash flow (using strip pricing) they’re trading about 12x.

On 2018 cash flow the projected multiple (again using strip pricing) is under 6 times.

You see what is happening here?

I would call it very rapid and sustainable growth.  When you find a company that can do that at $50 WTI……well, I get very interested.

WHAT THE ANALYSTS SAY

FIRM                                      TARGET PRICE

Canaccord Genuity            $18.00

Ladenberg Thalman           $17.00

Northland Securities         $22.00

SunTrust Rob Humph        $22.00

Wunderlich                          $18.00

STOCK CHART

CONCLUSION

I’m not an oil bull—yet.  The E&P stocks I have been buying in the last year are companies that can absolutely grow within cash flow at $45-$50 oil.  This would include more defensive stocks—like the royalty stocks (VNOM-NYSE; FRU-TSX), and the energy retailers like Crius (KWH.UN-TSX; CRIUF-PINK).  The ONLY real E&P I’ve owned this last year was Resolute.

Now, Ring Energy may or may not have the potential to be a Resolute.  I think it’s really important to see what kind of declines these wells show over time.  A Canadian experience going horizontal in dolomites did not go well—the Swan Hills play.  Investors may remember juniors like Arcan, which went to $6 and then off the board, or Second Wave, or Pinecrest…all had good runs on good IP rates…but then quickly turned into disasters.  Investors lost their collective shirts.

Generally, shallow wells have less pressure behind them and decline more quickly than deeper ones.

But there’s enough “good smoke” here with the initial high IRRs to deduce that there could be A Big Fire here—and A Big Run in the stock if management manages their growth and the asset properly.

Expect me to start a position here very soon if the price of oil shows real signs of staying above $50/barrel.

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