Earthstone Energy’s (ESTE) management had a good thing going. They would start a company, and then go bargain hunting to produce good results. Usually within five years that company was sold for an excellent profit. This sixth time around at replicating previous efforts has proved challenging. But now investors can get in at about 25% of the original cost of the institutions that backed the company as a startup.

Things began well enough as the current management took control of Earthstone through a reverse acquisition right around the time that oil prices began their big decline. But instead of oil prices rallying to previous highs in a cyclical recovery, the industry surprised pundits with a cost declining profit recovery instead. That led to repeating rounds of overproduction as ever declining costs led many industry players to produce those new wells with lower costs. The hope was that newer production would lift the company out of financial straits. Instead, ever lower costs kept a lid on oil price rallies as production relentlessly grew.

Now the market is finally accepting steadily declining costs while demanding companies profit from those declining costs now. The result is spending within cash flow rather than gambling on a bunch of new lower cost wells providing endless future profits. Ironically, this newfound discipline may finally provide a floor to oil and gas prices even though technology changes and operational improvements continue to sweep the industry.

Earthstone Energy is in a position to take advantage of this newfound market attitude because this management always believed that operating leverage would produce superior returns to financial leverage. The result is very low debt levels and a strong balance sheet that allows management many options going forward.

This debt averse management is very unlikely to reverse its attitude on debt fueled expansion in the future.

Source: Earthstone Energy December 5, 2019 Corporate Presentation

The key debt ratio shown above is very conservative. Yet in the past, this management has sold stock to completely eliminate debt from the balance sheet. Investors should probably expect a similar strategy in the future when the stock price recovers.

In the meantime, should an accretive deal present itself, then management would most likely pay for that deal with a combination of debt and equity to keep the deal accretive while the debt ratios remain low. As much as many shareholders scream about share dilution, the leveraged alternative has often proven far worse for long-term shareholders.

It should be instructive that I follow far more successful companies using the current strategy shown here than I do heavily leveraged companies. In fact, most companies that I follow at reader requests that are heavily leveraged are not with us anymore (or if they are, they reorganized while wiping out common shareholders). Financial leverage rarely if ever benefits long-term shareholders. Traders can take advantage of volatile stock price moves inherent with financially leveraged companies. But too many long-term shareholders that buy and hold find out that leveraged companies generally lose the total or most of the investment.

This management has produced excellent returns without using leverage.

Source: Earthstone Energy Inc., June 2016, Corporate Presentation

The current management of the company has worked together for literally decades in a few cases to create several oil and gas companies. What is disappointing this time around is that after about 5 years of doing things that worked before, investors have sizable losses from inception.

But the nice thing about an unleveraged balance sheet with a credit line far below the maximum amount suggested by banks is the ability for management to keep trying to get that decent return. Current investors can buy into a very experienced management team at a much lower price than the original investors. The chances of making an above average return are excellent from the current price. There is no reason for this management to sell the company at the current market valuation when there are a lot of distressed properties for sale.

This management typically has a very contrarian cyclical attitude. Therefore, shareholders should expect a lot of activity in a time period where prices are “below breakeven costs” according to Mr. Market. So many times expansion during a hostile industry environment provides very low costs for years to come. The comparison to companies in the Permian that paid up to $3 million for each drilling location is very easy. Even though there are likely to be write-offs in the current environment, the fact is that the managements of the companies writing off those millions and billions lost a lot of shareholder money the minute they decided to participate in the Permian buying frenzy. That will not be happening anytime soon with this management.

Source: Earthstone Energy Inc., June 2016, Corporate Presentation

One of the keys to making money is to not lose it before the production begins. Clearly, this management executes well on that front.

(Canadian Dollars Unless United States Companies)

Source: Peyto January 2020, Corporate Presentation

Many commodity industries source an independent firm that regularly gathers industry costs by firm and then sells anonymous costs to the industry participants so they can compare their costs to industry averages and accomplishments. This data, when it’s available, is often far more accurate than many broker reports or other industry related circulating documents because it comes from the companies themselves and is often verified somewhere.

Since you see company names above, someone researched public filings for this information as well. Still, it’s very instructive when industry insiders publish an industry opinion. Peyto, in particular has no reason to “slant” other industry participants. Now it may pick and choose comparisons to the advantage of management. But the numbers above are likely to be worth a lot of information.

The Canadian companies above are in Canadian dollars while the American companies are in American dollars. To compare costs in the Permian (above), you have to divide the numbers Earthstone shows by 6 (the conversion factor for oil barrels to gas MCF). What it shows is that Earthstone’s finding and development costs are far below typical industry leaders like Diamondback Energy (FANG). That typically makes for a lot of profitability when the oil and gas industry begins the next inevitable cyclical recovery.

A lot of time frequently gets spent on Tier 1 leases. It is almost as if any other leases are not worth considering for investment purposes. Instead, it should be the average (hopefully) accurately projected selling price less the accompanying costs. One of the things the Permian, especially Reeves County, is about to demonstrate is the costs to “get in on the action” were much too high. Therefore, a reasonable profit will not happen because those initial costs were too high despite the Tier 1 acreage. A company like Earthstone can make excellent profits with a less favorable production mix by keeping all the costs low. In fact, those low finding and development costs of Earthstone may at some point allow this company to favorably compete with established industry profit leaders like Diamondback Energy.

Source: Earthstone Energy Inc., June 2016, Corporate Presentation

The low finding and development costs of the company allow for a lower depreciation deduction from the cash margins shown above. Hence, the company can report profits at still lower oil and gas prices than is the case for many competitors in the industry.

Given the costs shown above by Earthstone, this company will be breaking even at the corporate level at far lower commodity prices than many of the industry competitors. Production is now ramping up as the development stage processes are completed. So that profitability and cash flow should become apparent to investors in the future. In the meantime, the stock price shows very little appreciation for that potential.

Source: Seeking Alpha Website February 29, 2020

As shown above, the market cap of this company is extremely low for a company with the currently bright prospects management has worked so hard to attain.

Source: Earthstone Energy Inc., June, 2016, Corporate Presentation

The company structure is a little more complicated because there are some shares that do not trade. But the bargain message still pertains. The stock price really has changed since the slide above was prepared (just not enough to change the general message).

This is a low cost operator trading at an undeserved low enterprise to EBITDA ratio. Once that price begins to rise in a rally, it is unlikely to visit the current pricing again. Management may or may not get the original investors decent profits over time. However, any investor getting in at the current price should profit from the next industry cyclical recovery plus any long-term growth. That return should be attractive under a great many industry forecasts.

A lot of investors like to crank out numbers and do extensive forecasts. Often the deciding factor is good management. Management is very hard if not impossible to value. But managements like this one with that past track record are hard to find. This kind of management is almost always a dominating asset that is well worth investment consideration by many types of investors.

I analyze oil and gas companies like Earthstone Energy and related companies in my service, Oil & Gas Value Research, where I look for undervalued names in the oil and gas space. I break down everything you need to know about these companies — the balance sheet, competitive position and development prospects. This article is an example of what I do. But for Oil & Gas Value Research members, they get it first and they get analysis on some companies that is not published on the free site. Interested? Sign up here for a free two-week trial.

Disclosure: I am/we are long ESTE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company’s filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

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2020-03-02