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David Messler

David Messler

Mr. Messler is an oilfield veteran, recently retired from a major service company. During his thirty-eight year career he worked on six-continents in field and…

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Commodities And Consolidation: Earthstone’s Bold Asset Swap Strategy

  • Amid falling commodity prices, companies like Earthstone Energy are high-grading their portfolios through asset disposal or acquisition, with Earthstone making a $1.5 billion cash deal for Novo Oil and Gas Holdings' Delaware basin acreage.
  • The Novo acquisition is expected to boost Earthstone's production by 33% without increasing capital expenditures, bringing significant free cash flow, while also providing efficiency benefits due to increased scale in operating legacy properties.
  • The primary risk for Earthstone is the continuous deployment of its roll-up acquisition strategy, though the company's solid reserves base and the financial cushion provided by a PV-10 of reserves exceeding enterprise value by a 2:1 factor offers some protection.
Oil

When commodity prices fall off as they have the last eight months, companies begin to high-grade their portfolios or seek a way to lower costs. In the high-grading exercise, they are either wanting to dispose of assets that will not compete for capital in the environment they see for the next few years or want to acquire assets that help round out their acreage portfolio with the same mindset. Sometimes they are selling with one hand and buying with the other. 

“Horse-trading,” or high-grading, is as old as the oilfield. There is lot of horse trading going on these days in the Permian basin with Chevron (NYSE: CVX), announcing the desire to sell some of its Permian properties. In what became a very busy day, TRP Energy, largely owned by a Private Equity firm, Greenbelt Capital Partners, announced that it was looking to monetize its Permian assets in the Midland basin, and seeking $1.5 bn to cash out. And, that’s just this week.

In the case of lowering costs, there is nothing like a merger, particularly if it’s a stock swap that leaves the surviving company relatively free of debt and able to compete in a declining market. We have seen a lot of that in the last couple of years. Some, like ExxonMobil’s (NYSE:XOM) rumored merger with Pioneer Natural Resources (NYSE:PXD) remained stuck the rumor stage with no official announcement forthcoming from the companies. This in spite of the compelling arguments for the merger I put forward in an OilPrice article at the height of the tempest. Not every rumor comes to fruition obviously, but that doesn’t mean the wheels of M&A aren’t churning just down the road. 

Part of the rationale involves the recognition that the number of participants in a fragmented play needs to be reduced in a “Roll-up” strategy. This brings the benefits of scale to the acquirer, which then utilize these assets more efficiently. A recent wrinkle in the general interest in M&A activity is the entry of non-operating companies providing capital to consummate a deal, while taking a working interest.

Energy analyst and consulting firm RBN Energy summarized the rationale in a recent blog post.

“Today, oilfield service costs have risen, increasing production costs, and as DUC inventories are depleted, producers must invest more to rebuild their inventory. Therefore, scale matters, and location matters. If a company can negotiate better terms with a service provider or midstream company because they can utilize assets for longer due to more production, reserves, or inventory — whether it’s using a rig crew or shipping a molecule — this will incentivize more production as the marginal cost of production per unit will be lower. The drive to consolidate acreage in the premium shale plays will no doubt lead to significant future solicitations to the non-op companies to participate in transactions with small or mid-size operators.

The latest example of this merger mania is Earthstone Energy’s, (NYSE:ESTE) $1.5 bn all-cash deal ($1.0 bn net after a $500 mm working interest buy-in to Northern Oil and Gas, (NYSE:NOG) for 33-1/3% of the deal), for privately held Novo Oil and Gas Holdings, Delaware basin acreage. If you are reading this article you probably know that the Delaware is the hottest play on the planet now due to its stacked reservoir horizons in the Wolfcamp A, B, C, and D, as well as the Upper and Lower Bone Spring that make multi-laterals and Super-fracs economic. The Permian basin is the only shale liquids play where monthly output is still rising. The Delaware sub-basin is a big part of the reason.

Company filings

This most recent buy caps a torrid streak of M&A activity since 2020 by Earthstone, participating in 7 transactions totaling $2.5 bn. It’s taken a toll on the balance sheet, but during that time production has risen from ~15K BOEPD to ~100K BOEPD. With the 1/3 non-op NOG participation in Earthstone’s deal for Novo, the balance rises above its 1.0 D:E target in 2023, but the company forecasts bringing back into line in 2024.

The investment case for Earthstone Energy

The investments for Earthstone is underpinned by a solid P-10 reserves base that exceeds their Enterprise Value-EV by a factor of 2. This is unusually strong and speaks to the skill of management in putting past deals together that they are not burdened with excessive debt. It also is bolstered by the ~1,020 PUD drill sites spread across the key producing counties of the Permian basin, once the Novo deal closes. This will allow for steady increases in production with the company’s 5-rig drilling program.

The production that Novo brings will catapult Earthstone’s daily output by 33% at year end, when the transaction closes, while lowering the percent oil and liquids by (4) and (2) percent, respectively. The company doesn’t plan any changes to its drilling program or capex, so the Law of Large numbers kicks in and the reinvestment rate-a measure of the return on capital expressed as a percent, declines by 15%. This will prove to be a substantial driver of free cash in 2024.

The Novo transaction also brings scale enabling Earthstone to more efficiently operate legacy properties in the Delaware and Midland basins. Earthstone has been using this roll-up strategy as shown in the slide below, completing seven separate transactions in the Permian basin since 2020.

CEO of Earthstone, Robert J. Anderson summarized the Novo deal thusly-

“With significant production volumes from the Novo Acquisition, we expect Earthstone’s near-term production levels to surpass 135,000 barrels of oil equivalent per day (“Boepd”). Further, we anticipate Free Cash Flow to increase significantly compared to standalone Earthstone as we have added substantial producing assets but are not increasing capital expenditures. The addition of approximately 200 high-quality, low breakeven locations deepens our drilling inventory and with our flat rig count, extends our inventory life significantly to over a decade. We believe the benefits of continued consolidation are very compelling, and we strongly believe this is a value-creating transaction for Earthstone.” 

Details of the transaction include

The Novo deal brings into the fold another 38K BOEPD from 114 producers. The assets of the transaction include 21 DUCs that can help maintain production without additional drilling costs. The incremental cost for DUC is just sand, water, and pumping time and helps efficiency when working in a particular area. ESTE estimates that the Novo properties come with a ~$40 breakeven and extend the company’s drilling inventory to 13 years at the present rate of development.

Earthstone will add an estimated 73.9 mm BOE of PD reserves and 37.2 mm BOE of PUD reserves as a result of this transaction. The net reserves addition are $912 mm for the PD reserves and PUD reserves bring another PV-10 of $260 mm, or a PV-10 of $1,172 mm net to the company.

With an effective date of 1 May 2023 and using the NY Strip of May 24th, ESTE estimates that the Novo deal will be cash flow accretive in 2023. The Novo assets should put between $360-380 mm EBITDAX on the income statement, with unlevered free cash flow of $290-310 mm on a TFM-twelve forward month basis.

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Funding will be accomplished from cash on hand and borrowings under the Company’s senior secured revolving credit facility. In conjunction with the Novo Acquisition, Earthstone has secured $250 million of incremental commitments from existing lenders. This increases elected commitments under Earthstone’s Credit Facility from the current $1.4 billion to $1.65 billion and provides for ~$1.2 billion in undrawn commitments at closing based on $452 million debt outstanding as of March 31, 2023. 

Risks

The primary risk for Earthstone is the continued deployment of its acquisition Roll-up strategy. It’s worked well the past few years but that’s no guarantee that it will continue in that vein. ESTE does have the advantage of having a “Big Daddy” with its finger in a number of pies and in a position to funnel deals to the company.

Your takeaway

The Novo deal at a net $1.0 bn implies a Next Twelve Month-NTM, multiple to EBITDAX of 2.7X, and a 30% cash flow yield. The company is trading now at an EV/EBITDA basis of 2.8X, a top value metric, and P/FB basis of $22K per barrel. Also, a peer-leading metric. With the PV-10 of reserves exceeding the EV by a 2:1 factor, there is a lot of cushion for investors at current share prices.

Investors looking at a vehicle that will deliver rapid growth may consider ESTE at present prices.

By David Messler for Oilprice.com

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