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State Of Flow Part II: Magnolia Oil & Gas Corp.'s Big Bet On Cash Flow Creation


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By Pescadero Energy Partners :

Introduction

I uncovered the dragon letter while doing research on Steve Chazen for this piece on his new outfit- Magnolia Oil & Gas Corp ( MGY ). I wanted to know what made this man tick (and went down a crazy search engine rabbit hole in doing so).

I finally found it on page 4 of the Google Chrome search engine. "Large dragon, thick paper, exceptional colour and centring with intact perforations all around..." Estimated value, Hong Kong Dollar $3,800,000-5,000,000. *Shuffles over to www.themoneyconverter.com. 1 USD = 7.7998 HKD.

So, this weird dragon envelope from 19th century China is worth north of half a mill?

Source

I had no clue what I was looking at other than the name scrolled at the very bottom of the picture of an outrageously expensive Chinese envelope: The Steve Chazen Collection.

I harbored a quiet admiration for Mr. Chazen during his tenure as CEO of Occidental Petroleum. While his peers and predecessors were chasing IOC projects created by the spoils of the American war machine, Mr. Chazen was satisfied with poking around in the backyard. His vision for Oxy ultimately led to their present-day success as a Permian powerhouse- even if it was perhaps unintentional.

Like Mark Papa, Chazen is forfeiting his golden years to run a shale business at a time when the industry is facing intense scrutiny for lack of profitability. Surely, he scored a sweet retirement package from Oxy after exceeding the mandatory retirement age of 68. Why not just buy a Labradoodle and a mansion in suburban Houston?

What I have learned is that Chazen is a quirky individual. Spending big bucks bidding on ancient Tibetan envelopes and letters from the Battle of Medina. Retirement must have been boring.

Chazen watched his peers, Mark Papa (former EOG CEO) and Jim Hackett (former Anadarko CEO), take turns playing the blank check game- quietly surveying the market's perception. Centennial Resource Development ( CDEV ), at least initially, got an upvote. Alta Mesa Resources ( AMR ), an unequivocal downvote.

Chazen read the market tea leaves like an ancient Shanghai parcel and decided to buy mature Eagle Ford Assets from Enervest's South Texas Division. The Karnes trough Eagle Ford is among the lowest breakeven rock in shale.

With field-level infrastructure in place, proximity to Gulf Coast markets, a mature cash flow profile and upside in the re-emerging Austin Chalk play, Chazen ticked all the boxes on what he describes as "…a free cash flow focused business, this means generating free cash flow is part of our core philosophy. We've generated free cash flow since our inception last year and plan to generate free cash flow this year and going forward. We are not striving to get there, we're already there, and the free cash flow we generate creates options for us, either to supplement the existing business or to return it to shareholders." Source: Q1 2019 C/C

Upon consummation of the deal between Enervest and the PE firm behind the "blank check", TPG Pace Energy; Magnolia Oil & Gas Corp. was born. The net acreage acquired in the Karnes trough (approx. 16,000 net acres) was questionably small given the $2.66 Billion price tag.

However, the deal also came with a massive and intriguing science project. 400,000 plus net acres of mostly "HBP" leasehold in the Giddings field.

The clean balance sheet, legacy cash flow, minimal lease requirements, and short-cycle payout times for new locations have put Chazen's company in rare air for shale drillers. Chazen defines the plan going forward, "60% of our annual cash flow for capital towards growing organically…We view the remaining 40% of the cash flow as undesignated."

Will Chazen's model be enough to satisfy the market's capricious view on self-sustainable LTO companies?

Let's look at the technical aspects of MGY's operation to get a better understanding.

The metrics used for DCA/DCF are disclosed in footnotes at the bottom of each section (Karnes & Giddings)

Karnes County Eagleford and Austin Chalk Outlook

When the Sugerkane field name designation popped back up on the radar in Karnes County circa 2016, I paid attention. At first, I thought, oh no, here comes the chalk again... turning billionaires back into millionaires.

I have been forced to eat my words. Applying the EF completion paradigm to higher porosity rock when it occurs in thick and charged intervals has proven to be a true winner and has given the Central Eagle Ford a powerful stacked pay one-two punch to rival that of the Delaware or Midland Basins.

MGY has a mixed bag of acreage in the Karnes trough. In order to visualize field-wide decline rates and economics, we are incorporating the EF and AC wells into a combined type curve to pattern the economics.

I start by assimilating the type curve for all EF completions in the past 3 years.

MGY Karnes EF Position and Type Curve

Source: DI Analytics, Author's Creation

I do the same for the chalk, again noting that this considers all wells drilled. No high-grading techniques applied to the type curve.

MGY Karnes AC Position and Type Curve

Source: DI Analytics, Author's Creation

From here, I can build out the long-term EUR and resultant economic profile.

As with the CDEV profile, we are using $60 oil, $2.50 gas as our benchmark. However, we are factoring in a $5 premium to WTI to account for the higher middle distillate content of MGY's predominate oil quality (roughly 40-degree API) and proximity to desirable markets. For gas, we have a smaller NGL cut but lower shrinkage and processing fees than newer fields. You can note the large discrepancy between the Karnes acreage and that of Giddings in the footnotes. We are assuming a PV10 and our BOE conversion works out to about 15.9:1.

MGY Karnes DCA Liquids

Source: DI Analytics, Author's Creation

MGY Karnes DCA Gas

Source: DI Analytics, Author's Creation

Karnes EF + AC Economics

Source: DI Analytics, Author's Creation

The combined type curve profiles well for the economics of the Karnes acreage. If we take the payout number and back-out all completions for the past 17 months we can create a vintage profile of MGY's well history to better visualize the PDP cash flow stream.

The chart is based on 20:1 BOE conversion:

Karnes Vintage Cash Flow Profile for Paid Out Wells

Source: DI Analytics, Author's Creation

Going back to the 2011 vintage, the paid-out well count sits at 55. MGY also participates as a non-operating partner in many wells so I am not attempting to put a figure to their per day BOE number for Karnes.

Looking at the graph above, it is easy to understand just how skinny the back-end cash flow profile is for any shale well. It will take a high paid-out well count to boost daily cash flow to levels which unlock true value in this company.

Giddings 2.0 Austin Chalk Outlook

I covered some of the history of the Giddings field here:

MGY appears to be positioned well in Giddings 2.0. Their leasehold dominates the liquids combo fairway of Washington County. The chart below depicts MGY's position relative to their peers in this play; Wildhorse Resources (now CHK) and Geosouthern Operating. What jumps out to me is that MGY has far and away, the best oil cut.

MGY Giddings Position and Type Curve

Source: DI Analytics, Author's Creation

MGY's best Giddings wells will produce oil EUR's that match or exceed that of the Karnes trough. However, they have a tremendously high gas/NGL component. This only helps the economics but will dilute MGY's company-wide oil cut as the field gets developed. Apparently, this matters to most analysts I follow although it really shouldn't.

While still in delineation mode, we have enough well control to build out the EUR model of the Giddings 2.0 Austin Chalk.

MGY Giddings Chalk DCA Liquids

Source: DI Analytics, Author's Creation

MGY Giddings Chalk DCA Gas

Source: DI Analytics, Author's Creation

Giddings 2.0 is mostly a condensate/NGL/gas play.

As such I deduct about $10 from the WTI benchmark and add some extra shrinkage and processing to the gas economics. I use a PV10 equation and our BOE number works out to about 13.2:1.

MGY Giddings Chalk Economics

Source: DI Analytics, Author's Creation

The economic profile of the Giddings Chalk wells is pretty remarkable. A Giddings Chalk well takes longer to pay-out than a Karnes well but the long-term cash flow creation is much higher. So is the PV10 value.

Much of this is due to the Chalk being deep and over-pressured in this area. This creates a shallower decline and better cash profile over the life of the well.

The Giddings Chalk is also very thick. I thought I might illustrate a cool feature of MGY's well planning that I found using Drillinginfo's subsurface mapping tool. What we see below is the Washington County Neva 1 and Neva 2 wellbores operated by MGY. Note that Neva 2 was completed directly below the Neva 1.

Neva 1 and 2

Source: DI Analytics, Author's Creation

The Neva 1 was completed "open hole" with an acid treatment in 2003 (the old paradigm for chalk wells). The well has produced a cumulative 93,000 bbl of oil and 1.66 BCF since completion.

The Neva 2 was completed in September of 2017 using a massive slickwater frac job and nearly 13,000,000 lbs of proppant (modern completion technique). The Neva 2 has produced a cumulative 179,000 bbl of oil and 3.3 BCF in 19 months while also giving a boost in production to the old #1 wellbore.

This underscores the size of this resource. It may require development at multiple intervals to effectively drain. Good news for MGY!

I have my doubts about how much of the 400,000 acres of Giddings leasehold is perspective for the wells described above. However, I would be remiss not to point out that the legacy chalk wells still contribute a fair amount of cash flow. This oil comes from shallower, up-dip parts of the field and probably receives a premium to WTI. Pulling in all active wellbores operated by MGY -I get roughly 2,900 bbl of oil per day and 50,000 MCF. per day.

Legacy Giddings Cumulative and Daily Production

Source: DI Analytics, Author's Creation

I would imagine the lease operating expense is formidable for these old wells but the cash flow generation should fund a steady and methodical approach to developing Giddings 2.0.

Conclusion

MGY looked, at first, to be declared a winner. A wicked sell-off in oil and gas prices beginning in 4th quarter 2018 and declining sentiment in shale's investment prospects have colluded to beat the stock price down to around $11.

There is a lot to like about MGY's operation. Continued access to capital markets is one of the biggest threats facing shale drillers. A company that can live within cash flow and develop its assets at a slower pace holds a major advantage if 1.) interest rates were to ever go up 2.) appetite for new equity issuance disappears 3.) lender's tamper down leverage requirements on revolving credit lines.

Chazen has taken a step in the right direction with MGY. Considering the size of the company, he must now execute his plan with flawless precision. The Karnes acreage is not homogeneous. There is certainly disparate reservoir quality in the EF and the AC across the leasehold. The truly high rate-of-return locations are running thin. Most remaining locations are in-fill drills. This impacts a company like MGY more than most.

The parent well is often the most productive especially if normalized to a certain completion generation. However, the parent well is never profitable. This is because the first well eats the entire expense component from the initial exploration expense down to the corporate level SG&A. Child wells, particularly when spaced tightly, may only achieve EURs between 75% and 90% of the parent. If we are talking about organic leasehold, a driller would prefer to drill a good well that holds a unit and then amortize the remaining cost over the life of the unit. Even if the in-fill wells are not as productive.

For MGY, the cost described above were sunk from the time of purchase. While most would be happy to trade cash flow for high start-up costs, it is unlikely that MGY's remaining locations are of the same quality that I may be modeling this data off.

The reality is that MGY either has less locations than they let on or less quality locations that should not attract capital. So far, Chazen has delivered on his promise of using cash flow to grow and they have bolted-on some nice pieces since the inception. For a company this size, it is incumbent upon management to replenish high NPV locations.

That may be easier said than done. The market price for Tier 1 rock is set- no matter if it is in the Permian, the EF, or any other play.

Squeezing distressed non-operators may be one way for MGY to grow. They should avoid the temptation to overpay via a large acquisition. They should also avoid replacing top tier locations with fringe acreage. It appears from some recent lease data that they have added some non-contiguous acreage in Gonzales County, Texas which is nowhere near the quality of their Karnes Rock.

While they have a ton of optionality with their Giddings acreage, they will need to be meticulous and cautious about how they understand and develop the field. In the same conference call, Chazen eludes to the difficulty of utilizing modern completion techniques in a naturally fractured field.

So far, MGY has posted a wide range of results in Giddings 2.0. The definitive commercial fairway looks small and may only encompass a tiny percentage of their actual leasehold.

There may be some upside to the up-dip, legacy field. Chazen's time at OXY would have bestowed upon him a treasure trove of secondary recovery knowledge. Maybe he has plans to squeeze as much cash flow from that acreage as possible.

The leases will not last forever. However favorable for drillers and onerous for landowners that old leases may be, once a well no longer pays "in commercial quantities" the lease may have to be forfeited. With 400,000 net acres and only 2,900 bbl p/d of oil production, that point may come sooner than later.

Back to the Q1 conference call, MGY guides to a future dividend. Mr. Chazen says, "My wife has always liked dividends."

That's great Steve. I like dividends too. I would ubiquitously prefer them to share buybacks except maybe in this case.

MGY suffers from the same capital structure problem as CDEV . The share count is strangling the stock to death. The days of 20X PE's for shale drillers are over. Reducing the share count would go a long way to creating shareholder value especially in a market which seems to be compressing the multiple for LTO drillers into single digits.

As of today (6/25/2019) the forward multiple still looks too high for my tastes. If the stock falls below $10 per share I am a buyer.

If you need an invest-able idea, one of the commentators on the previous article (link below) mentioned something that I think makes a lot of sense. While the equity component in companies like CDEV and MGY might not be well-liked by the stock market, the bond market points to a more sanguine outlook for these companies.

Both companies have some senior, UNSECURED notes with attractive coupons. I think future equity performance for any LTO brand is a crap shoot. I have no going concerns about the solvency of a company like MGY.

You can read Pt. 1 here :

See also Intercept And Ocaliva In PBC: The Clinical Plan For Bezafibrate on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.





This article appears in: Investing , Stocks
Referenced Symbols: MGY , AMR , CDEV , OXY



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