Earthstone Energy Inc

F:BSC2

Earnings Call Transcript 2021-Q3

[Operator]

Greetings, and welcome to the Earthstone Energy's Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

Joining us today from Earthstone are Robert Anderson, President and Chief Executive Officer; Mark Lumpkin, Executive Vice President and Chief Financial Officer; Steve Collins, Executive Vice President of Operations; and Scott Thelander, Vice President of Finance. Thank you, Mr. Thelander. You may now begin.

[Scott Thelander, executive]

Thank you, and welcome to our third quarter conference call. Before we get started, I would like to remind you that today's call will contain forward-looking statements within the meaning of federal securities laws. Although management believes these statements are based on reasonable expectations, they can give no assurance that they will prove to be correct. These statements are subject to certain risks, uncertainties and assumptions as described in our third quarter 2021 earnings release and in our filings with the SEC. 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 prove incorrect, actual results may vary materially.

The conference call also includes references to certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable measure under GAAP are contained in our earnings announcement released yesterday.

Today's call will begin with comments from Robert Anderson, our CEO, followed by remarks from Steve Collins, our Executive Vice President of Operations; and Mark Lumpkin, our CFO; and then we'll have some closing comments from Robert. I'll now turn the call over to Robert.

[Robert Anderson, executive]

Thanks, Scott, and good morning, everyone. I know it's a busy morning, so we appreciate those of you who can join us for this quarterly conference call. Our outstanding third quarter results demonstrate the effectiveness of both our strategy and our execution.

Throughout the year, we have substantially increased our scale through attractively priced acquisitions that have resulted in an approximate doubling of daily production volumes, which should be close to 30,000 barrels of oil equivalent or BOE per day by year-end, while we continue to drive down our per BOE cash operating and overhead costs. Our LOE plus cash G&A was under $7.50 in the third -- per BOE in the third quarter, compared to last year when we averaged about $8.50 per BOE.

We continued to generate substantial cash flow -- free cash flow in the quarter despite the capital cost of having added a second rig in early August, which will have no associated production or cash flow benefit until early next year. Year-to-date, we've generated almost $80 million in free cash flow and over $150 million in free cash flow over the past 6 quarters.

Although we have increased our capital spending with the addition of the second rig, we expect to generate free cash flow in the fourth quarter, which will be used for debt reduction. And Mark will give us a little bit more color on that as we proceed through the call.

This week, we closed on our fourth acquisition of the year, which was the previously announced Foreland acquisition, a bolt-on Midland Basin asset located near our Tracker acquisition that we closed in July. Not only did we purchase it at only 1.7x estimated adjusted EBITDAX, but with the assets near our existing Earthstone operations, we expect to realize some incremental operating synergies and drive down operating costs further. We are really pleased that we have successfully continued to close on accretive and well-priced acquisitions of low operating cost, high margin producing assets.

Throughout the year, we have significantly increased production, cash flows, inventory and our acreage profile with minimal impact on our debt to EBITDAX ratio. Additionally, these acquisitions have used equity as a meaningful component of total consideration to the sellers. So by taking shares, these new investors are validating our strategy and confidence in our team's execution.

Exiting this year, like I mentioned, we'll have approximately double daily production versus last year. We should have a similar level of leverage as measured by debt to EBITDAX while only increasing our share count by about 34%. So we have significantly increased production per share over the past year. And with the rising commodity price environment and our continued reduction in per unit costs, we are delivering what we believe are exceptionally strong increases in per share value.

Our ability to get highly accretive deals done using a mix of cash and equity has allowed us to maintain the strength of our balance sheet so that we can continue to be active in the M&A market. We are exiting the year as a significantly larger company and believe our added size and scale now positions us to look at larger acquisition targets that add production, cash flow and drilling inventory.

But as is our history, we intend to remain very disciplined and continue to apply strict technical and financial reviews to any deal we consider. Discipline is key to our operating execution as well. Thoughtful integration and careful execution are incredibly important to us, as Steve will cover later. So we will closely monitor our pace, make sure we fully understand newly acquired assets and promptly apply any learnings that we may gain throughout the process. We believe our 2-rig program is a good fit for our current asset base and plan to continue operating at this pace in 2022.

A few months ago, I would have said a 2-rig operated program for 2022 would run us about $250 million without nonoperated activity. However, with the recent and expected cost increases, we are still working on this estimate, but our 2022 capital program will be impacted by current cost pressures, and we would expect it going up 10% to 15% from here. Our team has been doing a great job working to offset some of the cost inflation with operational efficiencies. But with the significance of what we are seeing, inflation will not be completely offset.

Now I'd like to turn the call over to Steve Collins to provide an update on operations.

[Steven Collins, executive]

Thanks, Robert. Good morning, everyone. During the third quarter, one of the rigs in our 2-rig program completed drilling on a 4-well pad in Western Reagan County on our West Hartgrove unit, where we have 87% working interest. That rig also completed drilling on a 3-well Hamman pad in Upton County, where we have a 75% working interest. And it is now drilling on a 6-well pad in Upton County, where we have 100% working interest.

Our second rig was deployed mid-quarter and is operating smoothly. It is currently drilling on a 5-well pad in Upton County, where we have 100% working interest. We expect to complete drilling there in the next couple of weeks and then move the rig back to Midland County to commence drilling on a 4-well pad.

As we highlighted in our earnings release, we completed 3 wells in Midland County at the end of the second quarter. And today, the 3 combined are producing around 1,500 BOE per day with 80% oil. Towards the end of the quarter, we turned to sales 4 short lateral wells on the Pearl Jam pad in Midland County, which continue to clean up. This is the first set of wells drilled and completed on the IRM acreage acquired early this year. We are eager to evaluate the well performance and our operational approach and apply what we learn to the future development of the IRM acreage in 2022.

During the fourth quarter, we anticipate bringing on the 4 West Hartgrove wells in Reagan County and the 3 Hamman wells in Upton County. These recent completions are all with short laterals which have taken up a large portion of our 2021 plan. We look forward to bringing on a string of longer lateral wells in 2022 with average lateral length closer to 9,000 feet. Our operations team has done a good job working with vendors to find ways to minimize cost increases while maintaining best practices. For example, we've been working with our pipe supplier on assembling casing and tubing inventory in bulk to help offset recent spike in spot casing prices. This will be evident as we continue to run 2 rigs in 2022 without interruption.

Let me wrap it up with a couple of quick comments on the integration of operations on our recent acquisitions. We took over operations on the tracker assets a couple of months ago, and it's been a very smooth transition with no hiccups. Although this is a low-cost asset, we are starting to see the potential for cost reduction under our management. As we take operations over at Foreland, we are similarly well prepared for the transition and are eager to integrate those assets. Having an established operations based nearby will be really advantageous for a smooth transition, and we look forward to continue to driving down cost on what is now a sizable asset base in that part of the Midland Basin.

With that, I'll turn it over to Mark.

[Mark Lumpkin, executive]

Thank you, Steve, and good morning, everybody. Today, I'm going to try to streamline my comments a bit and not repeat all the standard GAAP results for the quarter, which, as you know, are available in our earnings release and in our 10-Q. And instead, I'm just going to focus on some key highlights.

So let me start with a few big-picture comments related to the balance sheet. During the quarter, our borrowing base on our revolving credit facility was increased from $550 million to $650 million as a part of our regularly scheduled redetermination. With borrowings of $278 million at quarter end, we had over $370 million of undrawn capacity at quarter end. Based on debt at quarter end and the $65 million of EBITDAX for the quarter, our debt to third quarter annualized EBITDAX was 1.1x.

As you know, subsequent to quarter end, we funded the approximately $39 million of cash consideration in the Foreland acquisition, which we closed on earlier this week. And that still leaves us with over 50% availability on the revolver. So our liquidity remains very strong.

Looking to our year-end, and as Robert alluded to, we're tracking ahead on our targeted leverage reduction, which even with the incremental debt from Foreland in the fourth quarter really hits a goal and does better than the goal we are expecting to achieve. And we now expect to be well under that stated 1.25x debt to EBITDAX target at year-end and are hoping to be closer to 1x leverage at year-end.

And really, as you look into 2022, we continue to expect the deleveraging to accelerate with absolute debt levels going down as we use free cash flow to pay down debt. But at the same time, EBITDAX rising as we have more production and less burdensome hedges.

From an EBITDAX standpoint, our EBITDAX of $65 million was a 21% increase quarter-over-quarter and that came in a little bit higher than we expected, driven not just by the strength of commodity prices but also by lower than forecasted LOE and our ability to control G&A costs. We added $18 million of free cash flow in the quarter, which brings us close to $80 million of free cash flow for the year, and we expect to continue generating free cash flow, which we will apply to debt reduction.

From a production standpoint, we're right around our expectations of 20,836 barrels of equivalent of oil per day, and that was comprised of 44% oil, 29% natural gas and 27% natural gas liquids. With the closing of the Foreland acquisition this week, we have increased our production guidance for the balance of the year to a range of 28,500 to 29,500 BOE per day, and we expect to be exiting around 30,000 BOE per day, as Robert mentioned, due to bringing on new wells throughout the quarter.

Further on the guidance, we reduced our cash G&A guidance for the year with the third quarter having come in better than forecasted. And on the LOE, we also came in really well with LOE per BOE in the third quarter of $5.46 being below the low end of our guidance, which was a range of $5.75 to $6 per BOE.

With closing of Foreland this week, I know it will take a little bit of time to apply our low-cost operating approach to those assets. We did not lower the per barrel equivalent LOE guidance for the remainder of the year, but we're certainly aiming to be on the lower end of our fourth quarter guidance.

From a capital expenditure standpoint, we have not changed our guidance for the year. But as Robert mentioned, we are seeing some upward pressure in service costs plus we have a little bit of incremental nonoperated capital announced later in the fourth quarter. So while we're not increasing our range of $130 million to $140 million of CapEx, we do expect to be at or around the high end of the range.

As you know, we have benefited in a limited way this year from the run-up in commodity prices with our oil and natural gas production being pretty significantly hedged. We do expect to be relatively less hedged in 2022, and we've also been utilizing some colors into our hedging strategy, which gives us downside protection but more exposure to upside on commodity prices as well.

With that, I'll turn it back over to Robert for closing comments.

[Robert Anderson, executive]

Thanks, Mark. Well, 2021 has certainly been a unique year for all of us and very much so for the oil and gas industry with unexpected challenges and continued commodity price volatility, but we've been able to identify and seize some excellent opportunities to strengthen Earthstone. We utilized our strong balance sheet, along with equity consideration to continue our consolidation efforts and closed over $430 million of accretive deals that added over $500 million of PDP value alone, not including any upside.

These transactions, along with our drilling program, have us doubling production in 12 months and allowed us to take a very significant step forward in adding size and scale while maintaining balance sheet strength. This is consistent with our message and strategy we have been discussing with you over the past several years.

As we look to 2022, driving shareholder value remains our primary objective when assessing potential deals. And despite the acquisition market incorporating higher commodity prices, we will continue to pursue opportunities that complement our asset base and further improve our operational performance.

As a larger company now, we are better positioned to participate in this challenging M&A environment. However, we will not sacrifice our strong cost structure and our clean balance sheet to get a deal done.

Now with that, operator, we're glad to take a few questions.

[Operator]

[Operator Instructions] Our first question is coming from Jeffrey Campbell of Alliance Global Partners.

[Jeffrey Campbell, analyst]

Congratulations on the Foreland acquisition. Wanted to ask a few questions there. Does the low decline aspect of the assets imply that these are larger, older long-tail wells?

[Robert Anderson, executive]

A little bit so, Jeff. Not dramatically. They had some new wells that were completed this year, but the majority of their production has been on for quite some time. So yes.

[Jeffrey Campbell, analyst]

Okay. So you had any relevant color to the high-margin aspect of the assets. I think this is interesting for investors because the assets are not that [ oily ].

[Robert Anderson, executive]

Yes. Again, it's a low decline, really good near term -- that we've seen near term in prices with NGLs. And natural gas have helped and not a [ Waha ] differential that is way blown out. And then low-cost operations, but not as low cost as the tracker assets, and we haven't built all the upside in that we could, but I know Steve and our guys will be able to drive down some LOE there. So we even think the margins will improve on a stand-alone basis compared to what we had in our internal model.

[Jeffrey Campbell, analyst]

And that was sort of my last question with regard to Foreland. Just any specifics on what sort of synergies you see that will add value? Just interested there since it's already an up and running asset, what are you guys able to come in and do the [ not cost on ]?

[Robert Anderson, executive]

There's probably some low-hanging fruit that we can talk about in the first quarter after we get it processed. But we're not going to use as many people in the field as they had. We've got good supervision across our asset base with folks already. And then we see a couple of operational things that we just do differently than they do, and we'll work with some vendors and hopefully drive some costs down. Anything else, Steve, that cover?

[Steven Collins, executive]

No, we already have supervision in the area, and we already have an operations base. So we just expand on it a little bit instead of creating something from scratch.

[Jeffrey Campbell, analyst]

Got it. I wanted to ask a broader question about Irion. [ Foreland ] follows the Tracker acquisition. That was also in the Irion, and it's -- Tracker seems to be competitive within the -- first on portfolio. So I was just wondering, is there anything in particular about Irion that you like? Or is it just sort of happenstance that these attractive acquisitions came to you one after the other?

[Robert Anderson, executive]

We do like the area because it's low cost. It is a little bit gassier. There is some good drilling opportunities that will capitalize on in 2022. But they were attractive and priced right and sellers that were willing to take equity. And so everything kind of lined up. The Foreland guys actually contacted us and said, "Hey, I saw you did the Tracker deal and -- is there some opportunity for us to join in," and that's kind of the way it happened. So we hope that there's more of that coming as we continue to execute.

[Jeffrey Campbell, analyst]

Yes. That's a nice way to make an acquisition. My last question regarding what you said earlier a couple of times today, you said that Earthstone is now in a position where it can take on larger acquisitions. We don't want to assume anything here. What do you see as the most important variables that support this assertion that you can take on a different kind of deal if you want to?

[Robert Anderson, executive]

Well, we're always going to manage each acquisition independently and review it maybe to death, as some of our guys would say, from a technical standpoint and then financially and make sure that it fits. I mean we've got some levers to pull with a pretty clean balance sheet. But at the same time, we're not going to manage to a leverage number that gets us in trouble at $80 oil when maybe it goes to 60 or 50 or 40 at some point in the future, right? So each deal is somewhat probably unique and has to stand on its own, but we can go look at deals that have larger cash flow components, but also some inventory and as long as they fit in the scope of where we're looking, which we've been pretty open about where we're looking. Midland Basin is first and then the Eagle Ford and the Delaware or 2 other areas that have very good competitive opportunities for us to consider. That's kind of how it works, Jeff.

[Operator]

Our next question is coming from Neal Dingmann of Truist Securities.

[Neal Dingmann, analyst]

Maybe Robert, I'll just ask my 2 questions now. But you mentioned, obviously, shareholder return being top of [ Azure ]. You guys have suggested maybe using this to scale still just wondering if you still think that's the best use, if you and Mark might comment on shareholder return. And then just secondly, on just the 2 rigs. I think one is [ enough], but maybe just idea of where do you plan on continuing to run those?

[Robert Anderson, executive]

Okay. Good questions, Neal. I think we're still a little bit young to be able to develop sustainable distribution type model, whatever that might be. I think we need some additional scale, and we see that there are still a lot of opportunities out there to consolidate. And I think we're better suited to do that than just sit here and run 2 rigs and distribute cash flows, free cash flows after we get down to a certain debt level.

We'll just continue to run 2 rigs. I think it's the right pace for the asset base we have today, and we'll delever to a certain point and then free cash flow will be considered as we have it in order to buy other opportunities and continue to scale up, size up our business. So hopefully, that answers your questions.

Operator, we'll go to next question.

[Operator]

I'll move on to the next question. Our next question is coming from Scott Hanold of RBC Capital Markets.

[Scott Hanold, analyst]

Yes. Robert, back to some of the commentary on consolidation. It still seems a very high focus for you all. And you did make some, I think, a comment at the end of your opening statements that the market is getting a bit more challenging or it's a more challenging market. Can you give us some color around that? And what you had to think -- what you think you have to do to be competitive?

[Robert Anderson, executive]

Yes. Good question, Scott. I mean in every environment, A&D or M&A is always challenging. When prices are where they are, it makes it a little bit harder because sellers -- there might be a different kind or a bigger bid-ask spread. Sellers are looking at $80 oil and want to get paid for it. And we're a little bit nervous about where it is. We love the cash flows, but do we want to go buying assets at the top of the market, maybe. Maybe it's going to $100, I don't know. But that creates a little bit of issue between the buyer and seller a lot of times.

As we think and look at deals, what I think makes us attractive as a buyer in a situation where equity can be used is we've had a good -- really good response by investors in the market when we have announced deals and used our equity and each seller has seen some value accretion to selling to us versus doing an all-cash deal at the same kind of price. So I think that helps as well when we look out there at the competitive landscape and how we have an advantage.

[Scott Hanold, analyst]

And when you think about this kind of transactions you want to do going forward, I mean, it seems like over the last year or so, it's been a bit of a mix of some transactions that can add really core acreage with inventory scale and then some that look more opportunistic. And the bottom line, you can get them below, get them at PV-20 or whatever, just a real cheap price.

And as you go forward, it seems like there's more of an appetite to maybe do more in the inventory -- core inventory side versus just the low-cost deals? Or do you see that as still a little bit of a balance in a mix?

[Robert Anderson, executive]

I think if we could have a good mix of those 2, it would be okay, but there's definitely opportunities out there to look at deals that have inventory. And then there's some chunky assets out there in the market or will be coming to the market that are more cash flow PDP weighted, and we'll take a look at either of those 2. It just depends on the kind of consideration that we can use whether one of those is more attractive than another. I mean if it's a 100% cash deal that has a lot of inventory and not much cash flow, and it's big. That probably doesn't make the most amount of sense for us versus one where we can use our equity in some form. So it's definitely a balancing act.

[Scott Hanold, analyst]

Got it. And then lastly, with those 2 rigs you're running through next year, what could -- in terms of like color on working interest and kind of the location you'll be targeting, what can you give us?

[Robert Anderson, executive]

Yes, sure. I don't think it's going to be a whole lot different than this year in terms of -- we'll have wells that we drill that are somewhere between 70% and 100% working interest. I don't know exactly, off the top of my head, the balance, but definitely, Mark and Scott can help you out there a little bit. And I don't know what the average is, but we're getting longer laterals next year.

So our efficiency will improve on a per foot basis or however you want to think about it. But then again, longer laterals, a little more cost. So we're definitely baking that into our thought process of our budgeting that we're going through now. We'll continue to focus in Upton and Midland County. We'll do a little bit of drilling on the tracker assets that we acquired in July, so over in Irion County. And then we'll have a pad or 2 sprinkled in there that will be in Reagan County. So it's a good diverse set of assets across our footprint.

[Operator]

[Operator Instructions] Our next question is coming from John White of ROTH Capital Partners.

[John White, analyst]

Congratulations on another nice quarter. You talked a little bit about [ oilfield ] service inflation in your opening remarks. Is it too early to put some ballpark percentages on that looking to 2022?

[Robert Anderson, executive]

Well, I kind of gave you a little bit of a preview of what we're thinking, maybe it's 10% to 15%. But it is a little bit early yet as we still are trying to figure out exactly lateral lengths and pipe use that we're going to have and what's going to happen with frac services and things like that. I mean we're seeing, like everybody else, labor, diesel, other casing, anything steel-related costs are increasing. Hopefully, that's not as great going forward as it has been this year.

[John White, analyst]

Okay. Yes, we're hearing about pipe cost increases from a couple of other companies too. On your Hamman 45 pad, did you complete a well in the Jo Mill?

[Robert Anderson, executive]

We did. Good memory.

[John White, analyst]

Okay. How did it go?

[Robert Anderson, executive]

It might be the highest oil producer on that 3-well pad, is that right, [ Mark ]?

[Mark Lumpkin, executive]

[ Rocky ], it's doing great now. It's cleaning up. We do it everyday.

[John White, analyst]

Wow, that's a little surprising given the history of the Lower Spraberry and the Wolfcamp B. But I'm glad to hear it, and congratulations. You got a lot more Jo Mill locations there?

[Robert Anderson, executive]

We have a few, yes. We might expand our inventory in that area because of that.

[Operator]

Thank you. At this time, I'd like to turn the floor back over to Mr. Anderson for closing comments.

[Robert Anderson, executive]

Thanks, everybody. We appreciate your attendance, and we look forward to talking to you soon.

[Operator]

Ladies and gentlemen, thank you for your participation and interest in Earthstone Energy. You may disconnect your lines or log off the webcast at this time, and have a wonderful day.