Earthstone Energy Inc

F:BSC2

Earnings Call Transcript 2018-Q3

[Operator]

Ladies and gentlemen, good morning, and welcome to Earthstone Energy's Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. Joining us today from Earthstone are Frank Lodzinski, Chief Executive Officer; Robert Anderson, President; and Mark Lumpkin, Executive Vice President and Chief Financial Officer; and Scott Thelander, Director of Finance. Mr. Thelander, you may begin.

[Scott Thelander, Director-Finance]

Thank you and welcome to our conference call regarding our pending acquisition of Sabalo Energy. Before we get started, I would like to remind you that today's call may contain forward-looking statements within the meaning of Section 27A of the Securities Exchange Act of 1933 as amended, and Section 21E of the Securities and Exchange Act of 1934 as amended. For a complete description of this disclaimer, please refer to our press release that was issued on October 17, 2018.

Although, management believes, statements it has or will make are based on reasonable expectations, we can give no assurance that they will prove to be correct. These statements are subject to certain risks, uncertainties and assumptions as more fully described in our SEC filings. These documents can be found in the Investors section of our website, www.earthstoneenergy.com. Should one or more of these risks materialize or should underlying assumptions proved incorrect, actual results may vary materially.

The information recorded on this call speaks only as of today, October 18, 2018. Thus, any time-sensitive information may no longer be accurate at the time of any replay. A replay of today's call will be available via webcast by going to the Investors section of Earthstone's website, and also by telephone replay. You can find the information about how to access those in our press release. You can also find a presentation related to this acquisition on our website. We will likely refer to certain Pages in our prepared remarks and possibly in Q&A but will not review the presentation in detail.

I'll now turn the call over to Frank.

[Frank Lodzinski, Chief Executive Officer]

Okay, thanks, Scott. Welcome to everybody joining us on this call. Of course the big news today is the announcement of our pending transaction with Sabalo Energy, which includes a great asset, including about 21,000 contiguous net acres with a significant inventory of highly economic locations that can be developed with longer laterals. When combined with our existing acreage position, the acquisition provides us with significantly more scale and greater upside potential in the Midland Basin.

In addition, based on our demonstrated operational expertise, we positioned ourselves to realize a highly profitable growth profile and generate even higher returns. We're anxious to close this transaction and integrate it into our organization as soon as reasonably possible, and to further demonstrate our capabilities to the market. Just briefly, I'd like to put this major transaction into its proper context and review for our new listeners what our accomplishments are and our goals.

Some of you may recall that we initially entered the Midland Basin in 2016 through our nonoperated Lynden acquisition. We integrated that and advised the market that we would pursue a major operated transaction. We did exactly that when we acquired Bold in 2017. We integrated that promptly and advised the market that we would continue to enhance our acreage positions that we had at that time, our inventory of locations, while we continue to pursue additional transactions of significant size.

As you all can see from our recent press releases applicable to the southern Midland Basin, we have continued to block up our acreage positions there and build our inventory of longer locations and with Sabalo Energy we have secured another significant transaction. We will work hard to continue to deliver on all of our commitments. Again, for perhaps, some of the new people that I know – noticed that are on the line, please note that Earthstone is our fourth public company, and all of our prior entities have resulted in substantial returns for our shareholders.

We believe we consistently demonstrated proven leadership, technical and operational expertise and put up a track record of value creation for our shareholders over more than 25 years in multiple entities. Our operating team has been together for 15 to 30 years and has extensive experience running multiple multi-rig development programs across various basins, including having run 4 to 5 rigs in two totally different basins in our last public company.

So we feel pretty confident about our ability to execute efficiently in the Midland Basin. Aside from the team that's been together for 15 to 30 years, we continue to add talent and staffing over the past 1.5 years, as we've become a more significant operator in the Midland Basin. Our demonstrated operational capability gives us a lot of confidence too, as I said, to execute efficiently going forward. Before I turn the call over to Robert and Mark, I will leave you with another comment or two. Based on the detailed evaluation and our analysis by our technical personnel and advisers, we believe the acquisition of Sabalo is very compelling and puts us in an entirely new position.

Particularly because we feel a high degree of confidence in the lower Spraberry and Wolfcamp A, which are substantially derisked and support the purchase price. Just like our prior acquisitions, we believe the acreage, along with our prior acquisitions, has considerable potential upside in other benches, in this case, including the Middle Spraberry and the Wolfcamp B Post-closing, we'll continue to evaluate the benches across our combined acreage position and monitor the results of offset operators to capitalize on further upside for our shareholders. Our well results have proven just that in our operations in the southern Midland Basin, and we hope to achieve that in the northern Midland Basin. In short, what this transaction really does for us is provide us with scale and the ability to export our assets for the benefit of our shareholders.

I'll now turn over the call to Robert and Mark to provide an overview of the Sabalo assets, operations, demand and some general 2019 guidance then we'll open up the line for questions. Robert, you're next.

[Robert Anderson, President]

Alright thanks Frank. Good morning everyone on the line. First I’d like to tell you how excited we are about this very attractive acquisition. Not only does it further our strategic plans, but more importantly, as Frank mentioned, it takes Earthstone to the next level as a premium Permian Basin operator because simply put, this is a great asset. To reiterate, this is a highly contiguous acreage block in the heart of the northern Midland Basin and provides us with a deep inventory of high-return drilling locations that creates an exciting foundation for profitable growth.

As you all know, it is in our DNA to grow organically through the drill bit, but also with acquisition such as this. After evaluating a large number of opportunities since our 2017 transaction, we believe this acquisition meets all our strategic, operational and financial criteria, including: number one, the superior reservoir and rock quality that the Earthstone team can further develop immediately; secondly, a large contiguous operated position that allows for efficient capital deployment; next, it had a meaningful PDP component that not only supports our current financing plans but puts combined production on track to produce 25,000 to 29,000 Boe a day in 2019; next, a very compelling valuation, supported by delineated, highly economic benches.

Also, stacked pay upside with the ability to utilize multi-well drilling to drive down development costs; and finally, an attractive midstream infrastructure, which provides flow assurance with access to local downstream markets, along with an integrated water infrastructure. In addition, this acquisition furthers our stated goal of building a leading Midland Basin profitable growth company that will provide significant returns to shareholders. Our goals include building an attractive Midland Basin portfolio with large contiguous acreage positions that enables long-lateral development with substantial oil production. Both this acquisition and our recent trade, check this box.

Secondly, focusing on being a premier low-cost Midland Basin operator. And again, over the last year or so, we've divested high-cost properties that have helped increase in this – helped us increase in this aspect of being a low-cost operator. And then finally, maintaining a reasonable capital structure, while aiming to reach free cash flow generation and long-term profitability. Further, we are clearly focused on increasing per-share value and trading liquidity and positioning the company as a possible acquisition target as we have done several times in the past. When combined with the strong cash flow profile of these assets, this transaction positions us to significantly accelerate our drilling program, increases our footprint in the Midland Basin by about 70% and includes substantial operated acreage with high working interest. This larger scale of operations combined with a much bigger base production, should drive a number of additional benefits as we secure additional dedicated services and focus on improving our operating efficiency.

This acreage is substantially the derisked by at least four benches across the majority of the position with a high oil content. The operated acreage portion has a high average working interest of 90%, while the total position is about 86% held by production. We expect to have the mass – vast majority of the acreage held by production in 2019 with only minimal obligation drilling beyond that.

So upon closing the transaction, which we expect to occur late this year or early in the first quarter of 2019 following a shareholder vote, we will have effectively doubled our acreage, drilling inventory, production and reserves, and we will be substantially increasing our growth trajectory. Earthstone will benefit from the strong growth momentum that Sabalo has created. Over the last 12 months, Sabalo's production has grown well over 300%, demonstrating the quality and repeatability of the asset base.

Additionally, Sabalo's net production in September was approximately 11,000 Boe a day, with 83% being oil. So on a combined basis, production is approximately 21,800 Boe a day, and our current oil percentage will increase from Earthstone standalone at about 63% to over 70%.

Upon closing, we will have an inventory of almost 1,000 Midland Basin gross operated drilling locations on over 50,000 net acres with approximately 40,000 of those acres operated. Sabalo's acreage is ideally situated for highly economic extended lateral development, and on a combined basis, our Midland Basin inventory will have average lateral lengths of nearly 9,000 feet, which should help drive improved well performance and operating efficiencies. Sabalo primarily focused its drilling capital on delineating the Lower Spraberry in Wolfcamp A formations on its acreage, which is almost entirely located in Howard County.

The posted presentation on our website contains slides showing detailed well performance for Sabalo as well as offset operators in these two formations, which, along with the producing assets, supported the valuation of this acquisition. The Wolfcamp A has the highest productivity of all benches in Howard County. And area operators have seen significant improvements in well performance, as they have transitioned to longer laterals, enhanced frac designs and improved landing zones. On our website, on Slide 12 of this recent presentation, you can see that the recently drilled wells have far outperformed the 1 million barrel equivalent, 10,000-foot type curve that we're using for the Wolfcamp A. Sabalo and offset operator activity has also delineated the Lower Spraberry resource across the entire position. We estimate that we will have over 300 gross operated locations suitable for extended laterals on the Sabalo acreage and close to 600 extended laterals locations on a combined basis, assuming 660-foot spacing.

Post-closing, our initial operating plan is to run three rigs in the Midland Basin, continuing the one rig on our existing acreage, while maintaining the two rigs currently operating on the Sabalo acreage, along with their dedicated frac crew. Again, we have an experienced operations team in place with a history of operating numerous rigs in multiple basins, and we are excited and look forward to taking over operations on the Sabalo acreage after closing. Through this transaction, we will be significantly accelerating our drilling program and the strong cash flow generation of these assets will greatly support our future growth.

As Mark will discuss further in a few moments, our preliminary 2019 capital program, which assumes closing of the Sabalo acquisition on January 1, anticipates running three rigs in the Midland Basin throughout the year resulting in a CapEx spend of $425 million to $500 million. The operating history of this management team has demonstrated our focus on prudently and efficiently managing service costs and lowering per unit costs, specifically, operational efficiency and cost improvements will occur as we transition to multi-well pad development, leading to more efficient rig and completion equipment utilization.

An integrated operated water disposal system consisting of company-owned disposal wells, 30 miles of saltwater gathering lines and access to third-party disposal, if needed, along with fresh water infrastructure for fracking and the initiation of a water recycling project will all lead to significant cost improvements. Another and very important characteristic of this acquisition is that Sabalo has multi-year midstream gathering agreements in place that provide flow assurance and supports long-term production growth.

The acreage is located near the Big Spring Refinery and Sabalo has a 7-year oil gathering agreement with its owner Delick that contains an optional 3-year extension, essentially solidifying 10 years of flow assurance. Oil on the Sabalo acreage is gathered and transported by Delek via a recently constructed trunk line, removing any need for tracking of oil, while at a very attractive transportation cost. Sabalo also has a 12-year agreement with WTG to gather, transport and process its natural gas. Neither of these agreements contain minimum volume commitments, which is very important to us.

So in summary, we're excited to have access to decade's worth of high-quality drilling locations on a combined Midland Basin acreage position. We presently have the expertise in-house to effectively execute our plan to generate attractive returns and create substantial shareholder value from this outstanding asset.

Now I'll turn it over to Mark to discuss the financing plans and pro forma guidance for 2019.

[Mark Lumpkin]

Thank you, Robert. Well, as you've read, we've entered into a definitive agreement to acquire all the assets of Sabalo Energy, including assets held by a financial participant, which includes producing assets and undeveloped acreage for a total consideration of approximately $950 million, subject to purchase price adjustments and to customary closing conditions. We currently expect the transaction to close later in the fourth quarter of this year or sometime in the first quarter of 2019 and the effective date of the transaction is May 1, 2018.

The purchase price includes approximately $650 million of cash and $300 million of common stock consideration going to Sabalo at a price of approximately $9.20 per share which equates to about 32.3 million shares of Earthstone Energy Class B common shares and the corresponding Earthstone Energy Holdings’ membership units that go along with Class B shares. We intend to fund the cash purchase price with approximately $500 million of new senior notes and the net proceeds from a fully committed $225 million preferred equity issuance from investment funds managed by EIG Global Energy Partners and also, an upsized fully committed revolving credit facility with a minimum borrowing base at closing of $475 million.

The financing is backstopped by fully committed $500 million unsecured bridge, which gives us certainty of funding of the acquisition. As you all know, we’re very cautious in terms of incurring significant levels of leverage, and we do aim to operate with leverage below 2x EBITDAX. On a pro forma basis as of June 30, 2018, our financing plan results in leverage on a debt to second quarter annualized EBITDAX of approximately 2.5x. We anticipate our operating plan will result in consistent deleveraging and expect to be below 2x leverage in 2019.

Further, in considering Sabalo’s significant production in cash flow, we expect our combined operating plan to have an outspend in 2019, that’s fairly similar to our standalone Earthstone plan, if we were to add a second rig later this year or early next year. During 2019, we do expect to make considerable progress towards generating free cash flow at some point in 2020. Also, due to the increased borrowing base at closing, we expect that our pro forma June 30, 2018 liquidity is approximately $470 million. So in other words, we’ve got a financing plan that results in a reasonable capital structure with ample liquidity and one that supports our development plans and delivers immediate growth, and ultimately, from the standpoint of liquidity versus level of outspend, it really eliminates any need for any additional financing for the foreseeable future.

Moving forward to next year’s expectations and operational guidance, we’ve set our preliminary 2019 capital budget in a range of $425 million to $500 million, as Robert mentioned. And this assumes that we close the Sabalo transaction on January 1, 2019. And this assumes a three-rig program for all of 2019, which is one rig on our operated acreage in the Midland Basin and two rigs on the existing Sabalo assets, which is consistent with what both we and they have been running in 2018.

And we also would expect, on the Earthstone side, a similar program in the Eagle Ford in terms of a CapEx spend there. Well, as Robert mentioned, on this basis, we’re estimating 2019 production to be somewhere between 25,000 and 29,000 per day, with oil content of something in the range of 70%-plus. In terms of Earthstone on a stand-alone basis, we also put out on deck some early estimates on EBITDAX in production for the third quarter, and on an adjusted EBITDAX basis, we’re expecting to be somewhere around $30 million to $31 million, and on a production standpoint, for the third quarter, we’re expecting to be somewhere between 10,550 and 10,750 BOE per day. These amounts are, of course, preliminary and subject to change but should give you an indication of how we think the third quarter will shake out.

With our continued focus on controlling cost and with added scale in the contiguous nature of both assets on a combined basis, we do really expect to realize benefits of the efficiency going forward, both as it relates to CapEx and to OpEx. Let me close just by saying that this transaction with the deep inventory of high-return drilling locations really provides an exciting foundation for growth with a visible path to free cash flow, and certainly be larger asset base and contiguous acreage position. And we expect to see a boost in results and lower our cost through extended lateral development and just a greater operational economies of scale we should be able to realize.

So with that, I’ll turn it over to Frank to wrap this up before we head into Q&A.

[Frank Lodzinski, Chief Executive Officer]

Thanks, Mark. So we can see on the screen here that we have a lot of participants and that our audience for this call includes most of our analysts, several of which we have spoken to already last night and this morning. Many of our shareholders, thankfully, it looks like new interested parties, and of course, our dedicated employees.

So to our analysts, shareholders, potential investors, I just like to say that we are absolutely focused on integrating this transaction post closing on a very timely and efficient basis. We’ve been able to demonstrate that in the past with each of our acquisitions, both in this company and in predecessor public company. Further, we’re absolutely committed to building shareholder value on a per share basis.

Now for our employees and our existing shareholders so forth, particularly the employees, no offense to our shareholders, but, guys, I thank you very much for the efforts that you put into this to take this across the finish line. Get ready for integrating this asset because it’s coming. So we want to do so very effectively.

And with that, operator, we’ll take any and all questions.

[Operator]

Thank you. [Operator Instructions] Our first question comes from the line of Neal Dingmann from SunTrust. You are now live.

[Neal Dingmann, SunTrust]

Good morning, guys. Nice asset, nice price, Frank. Looks like a great deal.

[Frank Lodzinski, Chief Executive Officer]

Thank you.

[Neal Dingmann, SunTrust]

Frank, my first question, just – you talked a little bit about the budget that you placed out there. Could you talk a little bit about – I know, not going into too many details yet on the 2019 program, but really, I think looks like to me initially, if everything sort of stays true around where pricing is now, then payout spend would be pretty minimal out there for the first year based on that three rigs. Could you talk about sort of what level of outspent you would be kind of comfortable or how – when you and Robert and Mark talk about it, how you see? Is it more that three rigs based on just sort of what you’re comfortable outspending or how you kind of came up with that plan?

[Frank Lodzinski, Chief Executive Officer]

Hold on a second, I’ve got to ask Mark a question. We’ve only – Neal, I only calculate this 15 times a day but I got to go to the expert here. So what are we kind of thinking about, if we have, say, a $450 million capital budget?

[Mark Lumpkin]

Yes. I mean, I would say, like just from a modeling standpoint – and we certainly recognize that this is a lot to, kind of, see overnight and work into model with not a ton of information. From a modeling standpoint, I think the way that I would think about it is, take your Earthstone standalone model, I know, the analysts by and large are assuming.

[Frank Lodzinski, Chief Executive Officer]

That’s a great starting.

[Mark Lumpkin]

So don’t add the second rig. Figure out what Earthstone looks like. And then, take our guidance around production and EBITDAX and kind of fill the gap with Sabalo. And you’ll get to an outspend that’s not incredibly dissimilar from Earthstone standalone, adding a second rig, and you can probably look at your number and consensus numbers in terms of what our 2019 outspend would be on that basis. You’ll certainly hear there’s a lot of moving parts, and we will be picking up operations of the rig until – or the two rigs that Sabalo is running until sometime either late this year or early next year.

[Frank Lodzinski, Chief Executive Officer]

So you basically talked over the course of our normal dealings with folks – you guys have generally talked about how they are forecasting things and so forth. And to reaffirm the models that folks are running then had us adding a second rig on the southern acreage, the outspend, for, what, 2019 will be, we’re estimating that on a combined basis, it will be a similar outspend.

[Neal Dingmann, SunTrust]

Okay.

[Frank Lodzinski, Chief Executive Officer]

And that we get to. Yes. And that we get to free cash flow sometime in 2020.

[Neal Dingmann, SunTrust]

Got it. Okay. And then just lastly for Robert.

[Frank Lodzinski, Chief Executive Officer]

Let me add one other thing. Lock that in, and given the growth trajectory of these assets and given the fact that our guidance is – well, guidance, our estimate is 25,000to 29,000, we’re going to hedge a significant amount of those combined production forward so that we’re not – so that we’re alleviating that risk from the equation.

[Neal Dingmann, SunTrust]

Okay. Okay. Yes, I think all that will keep leverage very minimal, seems like to me. But – and then lastly, Robert, you talked about – between the slides and the prepared remarks, the infrastructure, I guess, my question is sort of in light of SM was talking about on an update of theirs, about being impacted by third-party processing. Could you just talk a little bit more about that particular third-party gas processing and just, again, as you ramp, maybe just talk a little bit more, again, about between gas oil, water, gas processing, how you feel, sort of, from a growth perspective in the new area?

[Robert Anderson, President]

Sabalo’s done a great job of getting themselves set up to be able to grow production and have the Midstream and water infrastructure keep up with it. The takeaway capacity on the oil, as I said, it’s all piped to Delek, but the contract allows for some barrels to be taken back at some point in the future to two different other marketing outlets. So even if the pricing doesn’t look so good at the refinery base, it has somewhere else to go. And so that’s not an issue. The barrels will leave the tank batteries without any problems. The gas is going to WTG. WTG has several plans, and they’re all integrated. The pipeline system out there is very integrated, and so whether it goes to the nearest plant or a little further away, there’s no issues other than when you bring on a new well, you may not have all the tie-ins necessary so you may have to flare for a short period of time. But up till now, there’s been no problems in terms of the gas and having any plant issues. And then lastly, on the water infrastructure, I mean, it’s got its own facility, own saltwater disposal, deep wells, lots of capacity there. And then, in the few instances where the lines don’t go all the way to the outer reaches of the acreage position, they’ve got third-party access so that no barrels have to be trucked, and there’s plenty of capacity with third-party commercial disposal. So it’s a very well-managed situation in terms to – in terms of handling the growth that we’re forecasting over the next year.

[Neal Dingmann, SunTrust]

Very good. Thanks for the details guys. And nice job.

[Operator]

Thank you. Our next question comes from the line from John Aschenbeck from Seaport Global. Your line is now open.

[John Aschenbeck, Seaport Global]

Good morning, Frank, Robert and Mark and congrats on the deal.

[Robert Anderson, President]

Thank you.

[John Aschenbeck, Seaport Global]

So for my first one. I was hoping you could share your thoughts on how you see your development plan for the Sabalo asset unfolding, and how you balance a development program with delineation, specifically in regard to determining your proper spacing assumptions and also understanding the Wolfcamp B and the Middle Spraberry. So since the asset is significantly HBP, it seems like you could essentially begin a manufacturing-style development program pretty quickly. But I also understand, you probably want to get a better understanding of spacing and the potential of other zones and test those different concepts to better inform your development process. So just any thoughts you could share with us on that front would be greatly appreciated.

[Robert Anderson, President]

John, on the first part, we’ll just say that we’re very comfortable at the 660-foot spacing across any particular bench at this moment. We are seeing some operators do some line racking and go into 330s in both the Wolfcamp A and the Lower Spraberry as you move west in the county. And we’re seeing it elsewhere in the basin. So our view is, early on, we’re going to codevelop the Lower Spraberry and the Wolfcamp A. And the way these units are set up, they are 0.5 mile wide in general. And so that’s four wells per bench, eight wells on a total mile wide. And so most units have a Lower Spraberry or Wolfcamp A already, so it makes sense to go in there and develop at least a couple of wells if not six wells and finish out drilling of those two benches. And then come back later as both the Wolfcamp B and the Middle Spraberry. And then on top of that the [indiscernible] mill, which is slowly coming into its own right in the County, get a little bit more data. Sabalo has recently drilled a Middle Spraberry well, well, it’s nowhere near being completed yet, it’s in line but we’ll see how that turns out. We’re pretty excited about the – and have high hopes and expectations for the Middle Spraberry.

[John Aschenbeck, Seaport Global]

Okay. Great color. Appreciate that Robert. And my next one, a high-level question just in regard to portfolio management. I was curious how you see the Eagle Ford fitting into the portfolio following this transaction. And similarly, how you view your non-op acreage acquired from London [ph].

[Frank Lodzinski, Chief Executive Officer]

Well, if you look – I guess, it’s been about two weeks ago, John. Within the last couple of weeks, what we announced acreage trade acquisition where we traded some op for non-op – no, just the opposite non-op for op. And you almost have to visualize where we’re going with this thing. The Sabalo acreage is terrific in that, it is contiguous and has all the attributes. You’ll see that down in Reagan County. We essentially blocked up by about 14,000 acres with this trade. We will – we hope to look out a year from now, and in the existing acreage that we have, have less of it, non-operated and more of it blocked up. So from a picture standpoint, if you will, to the market, we're clearly demonstrating that we have the ability to efficiently develop blocky acreage. That's the whole plan. So we'll continue to acquire acreage through trade in the southern Midland Basin. Well, look – heck, we may sell some acreage in the southern Midland Basin if it makes sense. We'll churn it to make the picture look really good to our operational folks from an exploitation standpoint that should lead to shareholder value. So it's a work in progress. So all I can say is, see what we've been able to do with some of these acreage trades over the last year, which are not easy, are slow and so forth. But there is a mentality out there in the Midland Basin that people will kind of work with each other. So our goal is, block up acreage, move more and more towards 10,000-foot laterals, how we just recently drilled a 12,500-foot lateral, and keep on doing that. And so we just keep working on that every day. And I didn't answer you on the Eagle Ford. The Eagle Ford is a great little asset, okay? We would have to, of course, speak with our joint owners about this. There is some activity going on in the area with folks drilling extended laterals offset to what our position is, we're watching that. We have developed, and we will develop, continue to develop, as Mark mentioned, the little bit of holdings that we have down in southern Gonzales County. But candidly, it could be a divestiture candidate at some point, and we just haven't made that determination right now.

[John Aschenbeck, Seaport Global]

Okay, perfect. That’s it from me. Congrats again.

[Robert Anderson, President]

Thank you.

[Operator]

Thank you. Our next question comes from the line of Jeff Grampp from Northland Capital Markets. You’re now live.

[Jeff Grampp, Northland Capital Markets]

Hey guys. Congrats on the deal.

[Robert Anderson, President]

Thank you.

[Jeff Grampp, Northland Capital Markets]

Was wondering maybe, Robert for you, if you can maybe discuss the prospectivity of the various branches, kind of, across the footprint, and maybe if there were any areas that you guys maybe risked a little bit more for underwriting the acquisition or if you view, kind of, across the footprint that these zones are mostly derisked?

[Robert Anderson, President]

Well, my answer is, there's mostly derisked. Sabalo's done a good job of drilling North South East and West in the Wolfcamp A and the Lower Spraberry or participating with other operators. And if you go to, I think, it's Slide 11 on our deck, you'll see that there's plenty of well results that we highlight in at least the Wolfcamp A and B and the Lower Spraberry. Middle Spraberry, we've got lots of log data, we've got a few wells out to the west. They look really good, and like I said, Sabalo has recently drilled one, we'll see – get it completed here towards the end of the year and see how that performs. So that A and the Lower Spraberry carried the day on the valuation, and if you look at our reserve report that we highlighted out there even our total proved value is much more than the acquisition price. So that also is a pretty nice half that we've got there in terms of the valuation. And then the Middle Spraberry, which has no proved reserves and very limited proved reserves in the Wolfcamp B, just add to it.

[Jeff Grampp, Northland Capital Markets]

Okay, great. That’s really helpful. And then to the extent, you can maybe comment on this one, I was just kind of curious maybe, get a little color on the 2019 production numbers that you guys put out. Can you maybe discuss some of the variables that could get you to the high end versus the low end of the range. Is that just, kind of, generic, I guess, kind of, timing variability or determinations on pad size, cycle time that sort of thing? I'm just kind of curious on what could get you to one end versus the other, if anything.

[Robert Anderson, President]

Well, mostly, it has to do with timing, right? And our pad sizes generally in the southern Midland Basin are two to three, and in a couple of instances, we're looking at some four-well pads or maybe five, and we're still trying to plan that. So putting out those numbers, we put our best foot forward, but we've got a lot of planning to do both with ourselves and on the Sabalo assets, trying to figure out exactly what the plan is for 2019. The majority of the Sabalo pads in the short term will be two-well pads but there could be, in a couple of instances, four wells, so it is a matter of timing. The good news is, they've got a frac crew dedicated, and between three rigs, you really need a frac crew and then a portion of another frac crew every now and then when you get kind of a backlog, and if we can keep what we've been doing in the southern Midland Basin with the frac crew we're using down there intermittently it will help get us to the high end of that guidance.

[Jeff Grampp, Northland Capital Markets]

Okay, great. That’s really helpful color. I’ll let someone that will hop on.

[Robert Anderson, President]

Thanks, Jeff.

[Operator]

Our next question comes from the line of Brad Heffern from RBC Capital Markets. You’re now live.

[Brad Heffern, RBC Capital Markets]

Hey. Good morning everyone. I guess since Sabalo is running a couple of rigs right now, can you give any clues as to what the turning line schedule looks for the rest of the year? And any thoughts on where the production could be versus the 11,200 number by the time the deal closes.

[Robert Anderson, President]

Well, they’re running a one frac crew so – and they've got an inventory of six or seven wells right now that are waiting on completion or are in process, and they've got some multi-well pads that they're working on to – drilling wise right now. So we could see another six or seven wells online by the end of the year. They've recently just brought on two wells, so all total, that would make eight, I guess. And again, some of these wells take a little longer to clean up and reach that peak rate than we're used to seeing in other areas. And that's quite typical though of the Wolfcamp A as you move south, they're in the Lower Spraberry up in this area. So at this point, we'll hold off on giving any exit numbers until we get a little further down the road, and then maybe we can provide some exit numbers to you on both us and Sabalo.

[Brad Heffern, RBC Capital Markets]

Okay. Thanks for that. I guess just thinking about the scale of the organization in general. Do you guys need to go and hire a bunch of people to run the new asset? Or are there people coming over from Sabalo?

[Frank Lodzinski, Chief Executive Officer]

No, I – the Sabalo folks have been nice enough. They're going to help us through a transition period of three months. There probably won't be any folks coming over simply because of our expanding operations in the southern Midland Basin. We have been hiring folks, as I mentioned during my prepared comments, both in the office and, most importantly, in the field because as most of you know, we've always had a dedicated company operation staff in the field with pumpers and production superintendents and so on because that's where it all starts. So what we've done in terms of staffing over the last six or eight months – your G&A is not a linear variable, it's a step variable. So right at this instant, we're a little bit ahead of the curve on just our existing assets, we'll continue that and start building that. You can probably factor in another $3 million worth of G&A, maybe as much as $4 million. But that's kind of where we're at.

[Brad Heffern, RBC Capital Markets]

Okay, got it. And then finally, on the infrastructure front, obviously, it sounds like the asset has a lot of great infrastructure in place. But how do you think about infrastructure spend over time? Is there anything significant at a 2-rig level. And then if you chose to add rigs later on, is there any, sort of, meaningful infrastructure left?

[Robert Anderson, President]

There always is, Brad. You always want to make sure you're well ahead of the water needs, and we are with third-party, both on ourselves and the Sabalo assets. But I can see in both places where we're going to want to spend $5 million to $10 million on – in each area related to infrastructure, and we're trying to figure that out on – definitely on our own assets, but on the Sabalo assets, maybe adding one more deep saltwater disposal well to the system. So that's going to be something that will refine our capital plan for 2019 as we move forward.

[Frank Lodzinski, Chief Executive Officer]

I think Mark or Robert mentioned that right now, we're kind of in the range of $425 million to $500 million. We know that that's a wide range. It does have some infrastructure built into that simply because you need that to handle incremental production. We're just going to have to refine those numbers as we get closer to closing.

[Brad Heffern, RBC Capital Markets]

Okay. I appreciate it.

[Operator]

Our next question comes from the line of Ron Mills from Johnson Rice & Company.

[Ron Mills, Johnson Rice & Company]

Just to piggyback on one of one of Jeff's earlier questions, Robert. When you talk about in the presentation the Lower Spraberry and the Wolfcamp A or B or basically completely delineated. If you looked at the Middle Spraberry and the Wolfcamp B, what would – how would you describe those? You seem to suggest that you think they're mostly delineated as well. What would it take to achieve "completely delineated" description?

[Robert Anderson, President]

I'd say around, Ron, that the Wolfcamp B has a lot – is a lot farther along than the Middle Spraberry. And that is because you've got operators who have drilled both to the north and in a couple of instances, Sabalo's owner – working interest owner in those wells. And then, you've got wells out to the east. There's an old Apache well, horizontal well, short lateral, but on a short-lateral basis looks really good in the Wolfcamp B. And then there's a Sundown well operated by SM that is a good B well. And then you don't have to worry about going south or west because as you look in both of those directions, you see the B being drilled by other operators. Maybe a little bit off of the acreage position but definitely producing.

So what we really need is some additional Middle Spraberry maybe out to the east, it'd be nice if some of the operators out there would drill a test well in the Middle Spraberry. But like I said, Sabalo has drilled their own well, and we'll get it completed, hopefully, by the end of the year and have some results. We've got good looking rock quality based on logs so it's not like we're sitting out here drilling a horizontal well in the Middle Spraberry without seeing a log. But good, strong log indications compared to the western part of Howard County, where we've seen production. So I think the analog is setting us up nicely.

[Ron Mills, Johnson Rice & Company]

Okay. And from my brief history of the transaction standpoint, maybe this is for Frank. Can you give us a little bit background on the history of this transaction, was it a fully marketed deal? Was it a deal that was marketed previously that had been pulled? Clearly, you have a long-standing relationship with EnCap. So I'm just curious more about how this came about. Was it more of a process or more of a negotiation?

[Frank Lodzinski, Chief Executive Officer]

Well, I think it was a combination of both, Ron. As you know, when we file our proxy, there'll be 15 pages of ad nauseam background to the transaction. But let's just say, for a goodly portion of this year, this has turned into a negotiated transaction, and we are happy with – we are very happy with the job that the Sabalo people have done out there, and with the fact that they and EnCap have worked with us on this transaction. So we've been working on this since early in the year. And that's all I'm going to say for right now, there'll be more about that in the proxy.

We keep a regular – just – we keep a regular momentum going with all the investment bankers out there. We call folks individually with – we talk to all the private equity guys, and thankfully, this one worked for us.

[Ronald Eugene Mills]

Great. And then, last one for me. You talk about some – or you mentioned recent improvements in some productivity as they have changed their completion design, maybe lateral targeting, Robert, from the work you've been able to do on it so far, how do you think Sabalo did as operators? What other kind of refinements and enhancements do you think you can do to even show improved results relative to the recent wells versus the type curve? Thanks.

[Robert Anderson, President]

Yes, there's maybe some a little difference in the way we pump the frac jobs, for instance. Whether we're using 12 clusters or 8 clusters, the amount of propane or the amount of fluid. Other than that, on that side of it, like I said, there'll be some minor tweaks that we think have some benefit, and we're doing that in the southern Midland Basin and we see a little bit of improvement over old wells by having more clusters, more holes in the pipe, that kind of thing, better frac initiation.

Landing zone is probably the biggest one that everybody out there in that portion of the world is still working on and trying to figure out, okay, do I have two landing zones? And where is the best one, and target it first. And that's an ongoing discussion and it kind of moves around across the acreage position whether you're right on the A, B kind of line, when you land these wells or a little bit higher in the A or what have you. So it's something that we're going to develop up a plan going forward with Sabalo, as we continue to work towards closing.

[Ronald Eugene Mills]

Great thank you.

[Operator]

Thank you. Our next question comes from the line of Joe Allman from Baird.

[Joe Allman, Baird]

Just a couple of quick ones. With SM to your east, how does your acreage differ geologically from SM's?

[Robert Anderson, President]

Say that again, Joe?

[Joe Allman, Baird]

Yes, the question is, you've got SM pretty close to your east, but the question is, how does your acreage differ geologically from SM's acreage, if at all?

[Robert Anderson, President]

I'd say it doesn't, materially. I mean, you see some – in certain benches, you might see a little bit of a carbonate debris flow in there. It may impact a little bit of where you might land. But when you look at the SM results out to east, and especially the Southeast where Sabalo has a working interest on SM wells, the results are really good and forecast and translate into the Sabalo acreage.

[Joe Allman, Baird]

Okay, that's really helpful. And then to the question on the free cash flow. I know your goal or your targets, they have some free cash flow in – at some point in 2020. Is the plan after that to generate free cash flow? And how does that relate to the activity levels? So is the plan as of right now, to just basically keep that activity level flat and just continue to generate free cash flow going forward beyond 2020?

[Mark Lumpkin]

You know, Joe, I don't want to be smart-alecky in answering this, but it all depends on what the market conditions are and what the source of financing, and what the stock price is. You – and here's the smart aleck part, you tell me what the market's going to look like in 2020, and we'll give you a definitive answer. But for the past year, the market has been – has moved from growth – or whatever the timing is, I'm not – the market's moved from growth and a tolerance for outspend to an intolerance for outspend even if that means a slower pace of growth. So we are targeting our operations to comply with the market in the way it is perceived right now. And if the market changes, we can always ramp up accordingly.

I just don't know how to answer that any differently. We are not – there's a couple of rules here that we are not going to violate: one, we are going to get our leverage down below two times. We're never going to be a highly leveraged company. And for a couple of the folks that are on the line, that spoke to me last night, we're taking a little bit different tact in this acquisition, but there's 11,000 barrels a day, and it justifies the financing when you hedge it forward. So we're pretty excited about this.

We could do another acquisition. We could build more scale. We could bring net cash flow forward to the benefit of shareholders. We'll just have to assess that on an ongoing basis as we always have, Joe. And I know that's kind of mealy-mouthed but that's the answer.

[Joe Allman, Baird]

Frank, just a follow-up. In terms of the economics, did the economics assume keeping the activity level flat? Or was there some assumption about it at some point wrapping it up and accelerating cash flow to justify?

[Frank Lodzinski, Chief Executive Officer]

I think on our economics, I'll have to refer to Rob, but I think in our economics and our modeling, we basically – two sets of economics. One – I shouldn't say two sets of economics, but you know you have to always comply with the SEC 5-year rule, right? So put that aside, I think our economics – what did you guys do in the modeling? Is it three rigs constantly? Or did we move up to a fourth sometime going forward?

[Robert Anderson, President]

Yes, look. I mean, Joe, everything we're doing right now is based on running one rig on our assets and two rigs on Sabalo assets. Sure we've run a bunch of different scenarios, whether it's adding rigs or changing the timing or increasing the cost or changing the price tags, we've run a ton of scenarios. But everything we're doing right now is absolutely based on running three rigs on a combined basis. And to Frank's point, we work for the shareholders, whether that's an individual or institutions or EnCap, and we have skin in the game too. We're going to do what we think is in the best interest of the shareholder. And two years ago, I think we would have thought it was grow as fast as you can, that's definitely a different

[Frank Lodzinski, Chief Executive Officer]

Mindset today.

[Robert Anderson, President]

Yes, different mindset today, and in two years, it may or may not be the same. But yes, I mean, our valuation and what we're paying, it looks good from a lot of different scenarios in terms of assumptions on whether it's three rigs or adding rigs or others.

[Joe Allman, Baird]

Okay, all very helpful thanks guys.

[Frank Lodzinski, Chief Executive Officer]

So operator, this is going to be our – is this David?

[Operator]

Yes, David will be the questioner.

[Frank Lodzinski, Chief Executive Officer]

Okay.

[Operator]

David Beard [Coker Palmer] yours line alive.

[David Beard, Coker Palmer]

All right. Good morning, gentlemen thanks for sitting me in, and congratulations on the acquisition. Just – we've kind of circled around your assumptions to get to free cash flow positive in 2020. So I assume that's running three rigs, and now what oil price are you guys using to get there?

[Mark Lumpkin]

I mean, we've run on the strip. I mean, I think probably our most recent deck is after we've taken a little bit of a dip down here in the past, kind of, 0.5 weeks. Yes, we've already put a decent bit of hedges on in 2019 and, to some degree, in 2020. It doesn't look different, if you're assuming a $30 oil price versus a $65? Yes, absolutely. But certainly, based on the strip, it some movement around it. The 2020 frame is pretty reasonable. And really, I mean, there's some scenarios from a just timing standpoint and price standpoint where it might even be late 2019, that's not how we're thinking of a base model, what guide you to that. But 2020 is a very reasonable goal and target based on what the strip looks like with some variance.

[Frank Lodzinski, Chief Executive Officer]

What do you run for dips next year?

[Robert Anderson, President]

Our dips – like, I mean, in our model, we're assuming kind of minus $8 in the Midland Basin. Obviously, the dips have tightened quite a bit versus that.

[Frank Lodzinski, Chief Executive Officer]

So it might look better.

[Robert Anderson, President]

Yes. No, I mean, just this week, we've put on some dips in the Midland Basin at minus $5.50 for 2019 and minus $0.10 for 2020. I mean our assumptions are definitely more conservative than that. And the hedges we do have on the basis are obviously embedded in our model. But there's some definite variance around price where price goes down $2, it doesn't change our outlook on hitting free cash flow in 2020.

[Brad Heffern, RBC Capital Markets]

Now understood. And then a little more detailed question about the geology. As you move west to east across there, when I just looked at Slide 11 and looked at the western side wells and average about 125 a foot and eastern wells about 112. It's a 10% degradation. Are we talking too small of a sample size? Or is there some variance as you move east?

[Robert Anderson, President]

Well, David, if you look at – on Slide 12, the Wolfcamp A, and on Slide 13, the Lower Spraberry, you look at where our type curve is and you could say, perhaps, that we're sandbagging a little bit because the performance of the wells, on average, is probably higher than that type curve. So we looked at a big data set of wells all across the position, north, south, east, and west. Tightly spaced wells and more single wells and incorporated that all into our economics and our type curves. So we're kind of smoothing out the data for some of the variability that will occur as you move east to west and north to south.

[Brad Heffern, RBC Capital Markets]

Great thanks, appreciated.

[Frank Lodzinski, Chief Executive Officer]

So look, we have to wrap up this call so that we can get – actually so we can get on the phone with the lawyers to accelerate the proxy and get everything closed as quickly as possible. We thank you all for joining the call. If any investors, shareholders, analysts have any call – have any lingering questions, feel free to call Mark or any of us. And thank you very much.

[Operator]

Thank you, ladies and gentlemen, this does conclude our teleconference for today. You may now disconnect.