Crimson Exploration Looks Undervalued, But Mind The Well Economics

By Stephen D. Simpson, CFA | January 22, 2013 AAA

Energy is a cyclical market that seems to inspire despair in the worst of times and frenzied elation in the best - and that's true for both investors and companies alike. When an area gets hot, many companies scramble in and pay almost whatever it takes to establish acreage, but the economics don't always support this. I think this is worth remembering in the case of Crimson Exploration (Nasdaq:CXPO) - while the company's shift toward liquids is logical and the its Texas acreage may well be undervalued, the ultimate profitability of these operations gives some reason for pause.

SEE: A Guide To Investing In Oil Markets

Crimson's Assets Look Respectable or Better
Crimson Exploration is a small, early-stage energy company, but one with producing assets in familiar Texas energy fields in the southeast and south of the state. In particular, much of the attention on Crimson is going to center around its operations in the Woodbine and Eagle Ford areas - areas where the company hopes to generate higher liquids production over the next year to exploit the higher value of oil and liquids production today.

So far, the company's early efforts in both liquids plays have been encouraging, with solid initial test rates. Moreover, both of these areas have been popular lately, with major producers such as Anadarko (NYSE:APC), EOG Resources (NYSE:EOG) and ConocoPhillips (NYSE:COP) taking positions and many others having bought acreage or companies that arrived earlier.

All told, Crimson has about 32,800 net acres in the Woodbine (Madison and Grimes counties) and another 8,625 net acres in Eagle Ford (Dimmit, Karnes and Zavala counties), as well as other acreage in Colorado and Texas. While about 81% of the company's reserves are gas, the company has been showing solid finding and development costs, and the company has the aforementioned strategy in place to drive greater liquids production in the near term.

SEE: ETFs Provide Easy Access To Energy Commodities

What About the Economics?
Figuring the value of what Crimson Exploration owns in the ground is no easy task. It's common to value companies like Crimson on a net acreage basis, but that creates some problems. Recent deals from Penn Virginia (NYSE:PVA) and Sun Resources in the Eagle Ford and Woodbine plays worked out to about $2,500 per net acre, but then Marathon Oil (NYSE:MRO) paid almost $53,000 per acre in another deal back in October. Clearly, the old real estate cliche "location, location, location" has its place.

What concerns me about these deals and Crimson's valuation is the still-uncertain economics of operating in these areas. These areas require expensive horizontal wells (and fracking), with well costs running from $5 million or $6 million (each) to as much as $10 million in some cases. At the same time, a paper from the Society of Petroleum Engineers has discussed average estimated ultimate recoveries of about 207,000 barrels of oil equivalent from wells in the Eagle Ford, with a range from the low tens of thousands to upwards of 400,000 barrels based on the county.

So let's do a little quick math. Say oil stays at an average price of $95 for the life of the wells - that works out to an average revenue potential of about $20 million per well. With small and mid-cap energy companies averaging about 50 to 65% cash margins on production, that doesn't leave a lot of wiggle room. More to the point, if oil prices drop or production/drilling costs rise significantly, this doesn't look like such a great opportunity.

A few other points are worth making. First, I think the fact that production and development costs being what they are (and there's not a lot of leeway) is going to keep oil prices pretty high for the foreseeable future - there just isn't enough cheap oil coming online anywhere in the world to make me think that prices can go substantially lower absent real demand destruction. Second, estimates of ultimate recovery are notoriously difficult to make, and it's still early days for the Eagle Ford. So, while I intend no disrespect to the engineer(s) who researched and wrote that report, it wouldn't be unprecedented for the ultimate numbers to be higher than forecast - particularly as service companies like Schlumberger (NYSE:SLB) continue to develop new ways to improve recovery.

SEE: A Primer On Offshore Drilling

The Bottom Line
With Karnes and Dimmit counties close to the Eagle Ford averages, I'm not too worried about the relative value of Crimson Exploration's holdings. And while I do think the economics of shale drilling/development aren't talked about enough, I'm generally optimistic about the returns to be had in the Eagle Ford.

Looking at Crimson Exploration, the company seems too cheap relative to its peers. Small-cap energy stocks as a group are trading at about five times 2013 estimated EBITDAX, but not Crimson. Give Crimson just a 4.5 times multiple to this year's sell-side EBITDAX estimates and fair value looks to be around $5. While this is a risky stock only suitable for aggressive investors, the relative valuation makes it a worthwhile stock to research further for those investors who believe oil prices will stay high.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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