Pioneer Natural Resources (IL/A): Initial success from exploration portfolio, though capital discipline a concern - Goldman Sachs - May 10, 2006
We have confidence that Pioneer Natural Resources can generate production growth from its legacy onshore fields such as Spraberry and Raton, and the company has made advances in its exploratory plays in Texas and the Rockies. With operating costs and DD&A rates higher than expected, Pioneer must simultaneously grow production and add reserves without an erosion of capital discipline, and we remain concerned that Pioneer?s growth is coming at lower returns than peers. We continue to believe that Pioneer Natural Resources deserves to trade at a discount to peers based on proved reserves, though that discount can narrow with greater confidence in profitable unbooked resource potential, and a discounted cash flow analysis of the company?s resource yields a $60 traditional peak value. We continue to rate Pioneer IL/A.
PRODUCTION AHEAD OF GUIDANCE, NOT UNNOTICED BY MANAGEMENT
Pioneer's 1Q 2006 production from continuing operations was 110,000 BOE/d when adding back volumetric production payments (95,000 BOE/d after VPPs), up 5,000 BOE/d versus 4Q 2005. Already, the company is on track to beat its guidance for an exit rate of 95,000-100,000 BOE/d after VPPs. Tie-in of successful exploration wells at the Edwards Trend could provide additional upside from the normally-expected growth from Spraberry, the Raton Basin and the Horseshoe Canyon coal-bed methane play in Canada. Given management's track record of missing production estimates in the past, beating guidance would be notable, especially considering a consensus bearish Street view on the stock. Because of this recent track record, we believe management was a bit too aggressive in focusing the Street on the positive production results and the potential for upside this early on in the year. While management in our view was completely correct in its assessment of production upside and potential, greater conservatism could ultimately give management greater optionality in case of some exogenous production hiccup during the remainder of the year. Additionally, given Street concern regarding capital discipline, the company will likely need to raise production guidance if it increases capital spending (we have increased our estimates for both) at midyear.
KEY COMPANY-SPECIFIC CATALYSTS
(1) Further drilling in Edwards Trend and other exploration/emerging areas. Pioneer has seen consistently positive initial results from the Edwards Trend exploration play in South Texas. In the Sinor area, Pioneer drilled four successful wells in the Sinor prospect with rates between 2.5-3.2 MMcfe/d. On the conference call, management indicated that there could be 300 Bcfe of recoverable resource, which if true is not factored into Pioneer shares in our view. Away from the legacy Pawnee field, Pioneer saw success at the Stingray prospect. Wells from both potential fields are expected to come online during late 2Q 2006. Overall, Pioneer plans to drill 35-40 horizontal wells in the Edwards Trend in 2006, one third of which will target new fields. We believe near-term upside can come from success in its exploration wells, but sanctioning a development program would be key to fundamentally changing Pioneer's profile in this area. Results from the company's Rockies exploration plays - Lay Creek, Columbine Springs and Castlegate - are expected towards yearend. In our $60 traditional peak value, we have attributed a 15% success rate on Pioneer's overall onshore US exploratory portfolio, representing net probable resource of 314 Bcfe and corresponding to $2.17 per share of value.
Pioneer could also see upside from successful development of the Oooguruk oil field in Alaska and the South Coast Gas project in South Africa, although we do not expect this credit to be afforded until closer to production startup (late 2007 for both projects)
(2) Accelerated development in the Spraberry field. In the Spraberry field in West Texas, Pioneer is ahead of its plan to drill 350 wells this year and increase the rig count to 18 from 10 by yearend 2006. We believe near-term upside can occur through accelerated development, especially considering that the bulk of Spraberry production is oil and natural gas liquids. Management indicated that additional drilling could be both on proved undeveloped locations as well as probable locations, increasing the potential for reserve additions from Spraberry in 2006. Longer-term upside may stem from deeper potential in the Wolfcamp formation, opportunistic acreage expansion and acquisitions, infill drilling to 20-acres, and additional recovery from waterflood projects. In its recent analyst meeting, Pioneer indicated it believes there are 100 MMBOE in unbooked reserves at Spraberry. In our view, instilling confidence in proving up these reserves could provide long-term visibility and a more likely chance of greater than 100% reserve replacement rates in the future.
(3) Beating production guidance at the Raton Basin. The Street and Pioneer have been disappointed with the results coming out of the Raton Basin since the acquisition of Evergreen Resources in 2004 - we now assume a 6%-7% growth rate, in line with company expectations and down from initial expectations of 15%-20%. Now that Pioneer has realigned expectations to a lower base, if it manages to beat this target under a controlled-cost environment, its cash flow multiple and erstwhile below-average returns could expand. Pioneer plans to drill 330 wells this year and, like Spraberry, has indicated that drilling is ahead of schedule.
VALUATION
Pioneer currently trades at 5.0x 2007 EV/debt-adjusted cash flow versus 5.6x for its mid-cap E&P peers. We believe management is placed in a tough position to allocate capital: on one hand, management plans to accelerate development in its legacy assets, while on the other hand, it is undergoing an active leasing program to increase longer-term probable and possible reserves. We believe Pioneer can trade closer to the peer group average if it is able to exhibit a healthy balance of the two: growing production from legacy fields without either concern over a lack of unbooked resource potential or an erosion in capital discipline. We continue to expect lower returns at Pioneer than at peers (13.5% cash return on cash invested in 2007 versus 18.5% for other mid-cap E&Ps), in part because of VPPs and in part because of negative free cash flow. With success, we see 52% upside to a $60 traditional peak value.
ADJUSTED EPS LOWER THAN OUR ESTIMATE ON EXPLORATION EXPENSE AND COSTS
Pioneer reported adjusted 1Q 2006 EPS of $0.57 on both continued and discontinued operations, lower than our estimate of $0.93 and higher than the First Call consensus estimate of $0.48. Pioneer's total production, including VPPs, of 1.05 Bcfe/d was slightly lower than our estimate of 1.07 Bcfe/d. U.S. realized oil prices were $59.97 per bbl, higher than our estimate of $46.11 per bbl, although natural gas prices of $6.04 per Mcf were lower than our estimate of $7.72 per Mcf. Total costs on continuing operations (excluding assets sold in Gulf of Mexico and Argentina) were $4.42 per Mcf versus our estimate of 3.89 per Mcf. Also, exploration expense was $125 million, higher than our estimate of $85 million. Net debt-to-tangible capital is 30% versus 52% last quarter. Operating cash flow was $196 million versus our estimate of $376 million.
UPDATED ESTIMATES
We are updating our 2Q, 3Q, 4Q and full-year 2006-2007 EPS estimates on higher costs, higher production, and minor other company adjustments. Our new estimates are $0.54 ($0.66 previously), $0.74 ($0.83 previously), $0.93 ($0.94 previously), $2.19 ($3.36 previously), and $4.30 ($4.83 previously) respectively. We are also updating our 2008-2010 (normalized) EPS estimates to $1.41 ($1.58 previously), $1.74 ($2.04 previously), and $2.09 ($2.41 previously) respectively.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Brian Singer, Arjun Murti |
