This Mid-Cap Producer Is Worth Owning for Permian Acreage
Rosetta Resources (NASDAQ: ROSE) is a fast-growing independent exploration and production company in the US, mostly in South Texas. Rosetta has 64,650 net acres in the Eagle Ford and has most recently acquired over 53,000 net acres in the Permian Basin.
Rosetta's expertise is horizontal shale drilling. Like many Eagle Ford players, Rosetta is rapidly growing its production. The company's recent Permian acquisition is transformational because it will give Rosetta a more oil-focused production profile as well as upside from shale oil potential. This article looks at Rosetta as a whole, but will focus on this important acquisition.
Growth in the Eagle Ford
Of Rosetta's 64,000+ Eagle Ford acres, 83% is entirely untouched. Between 2012 and 2013 Rosetta's production is estimated to grow by over 37%, the vast majority of which will come from the Eagle Ford. At $91 per barrel of West Texas Intermediate oil, the company's average Eagle Ford well should have a 70%-80% Internal Rate of Return, which is the discount rate needed for the future value of a well's cash flow to be zero. At 70%, we can see these wells are pretty profitable.
But the company's production mix is not, at this time, as optimal as Eagle Ford leaders such as EOG Resources . Today, the most profitable of the Eagle Ford producers are all very "oily." Rosetta concentrated on wet and dry gas. So while EOG, Sanchez and Carrizo (NASDAQ: CRZO) are almost entirely oil, Rosetta's production is only 25% oil. Dry gas makes up for 38% of production and the remaining 37% is Natural Gas Liquids.
Rosetta is still quite profitable in the Eagle Ford with relatively low well costs. The Eagle Ford is special, however, only because of its oil. Oil well economics in the Eagle Ford are among the best of all shale plays. That's less so for gas, where the Barnett and Marcellus generally have a lower cost-base. While Rosetta is working to increase its relative oil production, it won't likely be able to catch up with the other three in the Eagle Ford.
Turning a new leaf in the Permian
Much of Rosetta's 53,000 acre Permian acquisition was in the "Delaware Basin" portion in Reeves County. Most of the acreage is oily, too. Just what Rosetta needed.
The acquisition was from Comstock Resources for $768 million, or about a fourth of the company's market cap. With a break even of seven years at current production, it may seem like management paid too much. But consider the upside potential.
EOG has also invested heavily in the Delaware Basin on the bet it will yield shale oil. That Rosetta set up shop in the same place is no coincidence. EOG is a huge company with two other shale plays to contend to, but Rosetta only needs to focus on the Permian and Eagle Ford. In fact, Rosetta's Permian position now accounts for nearly half of the company's total acreage. If the Permian yields large amounts of shale oil, Rosetta Resources will be the more levered play.
Debt and capital response
Data by Morningstar Financials
Rosetta's debt has been steadily increasing. And after this acquisition, we really shouldn't expect that trend to reverse. This year Rosetta will still spend nearly 70% of its $800-$900 million capital budget on the Eagle Ford. About 20% of the budget will go to the Permian. We can expect Permian spending to continue increasing.
All of Rosetta's debt is in the form of fixed rate bonds. Weighted average cost of debt sits at about 6.8%. I believe that the capital markets will appreciate Rosetta's newly diversified asset base, and will respond by offering lower rates in the future, all things being equal. None of the company's debt comes due until 2018. By then the company should have much stronger cash flow numbers.
From a P/E standpoint, valuing an oil and gas company is difficult because of the cyclicality of earnings. Book value is often used as a substitute. At 2.3 times book Rosetta is fairly valued, especially compared to Carrizo's 2.3 and Sanchez's 1.5, both of which are also mid-cap names.
We can see here that the market has rewarded both Sanchez and Carrizo because of their more oily production growth. Rosetta still lags behind. But if it successfully harnesses the upside of its new permian acreage, Rosetta could be a "comeback play."
While Rosetta today is an Eagle Ford name, its best hope for high-return profit now lies in the Delaware Basin. In acquiring Delaware Basin acreage, Rosetta is following in EOG's wake. Successful shale drilling in the Permian could allow Rosetta to join Sanchez and Carrizo as premier, mid-cap oil growth names in Texas.
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