by Eugene Robin, CFA | Research Analyst
Approach Resources, Incorporated (Ticker: AREX) is an independent oil and gas exploration company located in west Texas. As a spin-out from energy private equity firm Yorktown Partners, Approach situated itself on land that was, at the time, a natural gas play on what was known as the Ozona Uplift formation. The average purchase price for each of their acres from 2004 through 2009 was roughly $300 per acre. In parallel to the company’s acreage acquisition, several other larger E&P independents moved into acres north of their foothold to explore a new shale discovery named the Wolfberry/Spraberry field situated on the Permian shale reservoir. Eventually it was realized that the entire Permian was a strategically important “oily” shale play with an average of 60 percent oil content in addition to the 20 to 30 percent natural gas liquid (NGL) production expected from a typical well.
Even though it was located on the marginal edge of the Midland Basin on the Permian, Approach was successful in initially proving out their acreage via a vertical well drilling program into the “Canyon/Ellenberger” formation. These vertical Canyon wells show after-tax internal rate of return (IRR) of 12 to 14 percent based on $3-gas and $80-oil assumptions. Interestingly, the wells on their own were enough to create over $300 million in net asset value (NAV) for the company, which in early 2010 was only around $220 million in market cap. In response to the new “fracking” sensation Approach began to prove out their acreage for both vertical and horizontal fracked wells in early 2010, naming the horizontal program the “Wolfcamp” and the vertical “Wolffork.” The released type-curve for the Wolfcamp horizontal indicated poor initial production (IP) rates and estimated ultimate recovery (EUR) relative to those of their peers in the area, EOG Resources, Incorporated (Ticker: EOG) and El Paso Corporation (Ticker: EP). Initial results supported the expected curves and as a result, the stock floundered and declined as people wrote off the horizontal play as a flawed attempt on flawed acreage.
While this was happening, Approach was also proving out their vertical Wolffork wells and releasing type-curves that indicated a 35 to 40 percent IRR at $3-gas and $80-oil based on pilot wells at an estimated cost of $1.2 million per well with a 20 percent risk factor baked in. Unfortunately for Approach, the market was more concerned with the perceived failure of their horizontal wells to notice that these verticals could provide $1 to 1.5 billion in NAV to a company that was trading at a $400 million market cap in mid-2011. This was part of our value-based attraction to the stock, with the horizontal drilling regarded as more of a free option for the company. The 2011 third quarter call on November 3rd showed the market that the company’s three most recent wells came in at IP rates and EURs that matched or were only marginally lower than those put in by EOG and El Paso. With this result we modeled that Approach’s horizontal play could produce IRRs of 25 percent at $3-gas and $80-oil and account for an additional $1.4 billion in NAV based on a 20 percent risk factor.
What makes Approach’s acreage unique is both the duality of their fields and the layered pay zones that can be exploited. The acreage has three tiers of pay zone that can be identified as the Wolfcamp A, B and C zones with each zone supporting vertical and horizontal fracking. This creates a situation where, if horizontal wells do not work, vertical wells can still be applied to the shale rock. The way the math works is that for each horizontal well not drilled, the company can drill four vertical wells and save $1 million in capital expenditure while getting better uplift in terms of barrel of oil equivalent (BOE) production per day. Of course if the horizontals come in at the recent higher production levels then the uplift potential for the horizontal wells is much greater than the combined four verticals. To add further proof to Approach’s drilling campaign, the cost to acquire an acre of land within the Permian has skyrocketed since the early days when the company initially built its position. While Approach’s average cost per acre has now settled at $900, land within a 10 mile radius of their acreage has gone from $4,500 to $5,300 per acre at recent University of Texas auctions. Even more dramatically, if one were to look at the multiples paid for acquisitions within the Permian, the range is much wider and comes in at an astonishing average of $12,000 per acre (Approach has 142,000 net acres). Using either measure, the $900 per acre paid by Approach is undoubtedly one of the lowest land acquisition costs in the area. Our valuation takes into account several different ways of looking at Approach Resource’s value, running from multiples on proved BOE reserves to discounted cash flow NAV estimates, with these different metrics giving us values ranging from $35 to $70 per share. The target value is an average of these different readings and points to a value in the mid $40’s.
We started buying the stock at $24. It is a 2.5% position in our small cap portfolios.
—
This report is published for information purposes only. You should not consider the information a recommendation to buy or sell any particular security, and this should not be considered as investment advice of any kind. The report is based on data obtained from sources believed to be reliable, but is not guaranteed as being accurate and does not purport to be a complete summary of the data. Partners, employees, or their family members may have a position in securities mentioned herein.
Past performance is not a guarantee or indicator of future results. The opinions expressed herein are those of Cove Street Capital and are subject to change without notice. Consider the investment objectives, risks, and expenses before investing. These securities may not be in an account’s portfolio by the time this report has been received, or may have been repurchased for an account’s portfolio. These securities do not represent an entire account’s portfolio and may represent only a small percentage. You should not assume that any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in this report. Recommendations made for the past year are available upon request.
CSC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. Additional information about CSC can be found in our Form ADV Part 2a.
