- A 21% increase in revenues year-over-year
- Production increases over Q1 by 2%, at the high end of quarterly guidance
- 18% increase in EBITDAX
- Interest coverage of 2.7x
This week, Durig Capital takes a look at an oil and gas producer who has balanced its revenue streams between oil, natural gas and natural gas liquids (NGLs). Approach Resources has posted excellent results the past two quarters and has some unique advantages amongst oil and gas producers – significant, contiguous acreage, 100% owned infrastructure, improved well recovery and a balanced product portfolio. It’s most recent quarter continued the positive trend set in Q1.
A 21% increase in revenues year-over-year.
Production increases over Q1 by 2%, at the high end of quarterly guidance.
18% increase in EBITDAX.
Interest coverage of 2.7x.
Approach Resources not only increased production in Q2, the company also managed to bring down lease operating expenses by 8% over the previous quarter. Approach’s diversified revenue generation across oil and natural gas gives a level of insulation when one commodity experiences significant volatility. The company’s 2021 bonds are currently trading at a slight discount, giving them a yield-to-maturity of nearly 8.0%. These short 32-month bonds represent another outstanding addition to Durig Capital’s FX2 Managed Income Portfolio, the most recent performance of which is shown below.
Solid Second Quarter Results
Approach Resources charted its second consecutive quarter of revenue growth in its second quarter of 2018. First quarter revenues grew 9% over the prior year quarter. Second quarter revenues registered an increase of 21% over the second quarter of 2017. Other highlights for second quarter include:
EBITDAX of $15.3 million versus $13.0 million in Q2 2017, an increase of 18%.
Production increased 2% over Q1 2018, coming in at the high end of guidance.
Lease operating expenses (LOE) for Q2 decreased by 8% over Q1 LOE.
Approach’s multiple revenue sources (oil, natural gas and natural gas liquids, or NGLs) give the company a unique profile amongst its peers. In addition, the company has significant company owned infrastructure which ultimately translates to lower costs of production. These low production costs paired with commodity prices continuing upward is a fantastic combination to increase profitability.
About the Issuer
Approach Resources Inc. is an independent energy company focused on the exploration, development, production and acquisition of unconventional oil and gas reserves in the Midland Basin of the greater Permian Basin in West Texas. The company leases approximately 150,000 net acres as of June 30, 2018. The company’s long-term business strategy is to create value by growing reserves and production in a cost efficient manner and at attractive rates of return. Approach pursues that strategy by developing resource potential from the Wolfcamp shale oil formation and pursuing acquisitions that meet its strategic and financial objectives. At December 31, 2017, Approach Resources estimated proved reserves were 181.5 million barrels of oil equivalent (“MMBoe”), made up of 28% oil, 32% NGLs and 40% gas. The proved developed reserves represented 37% of total proved reserves at December 31, 2017. Nearly all of proved reserves are located in the Permian Basin in Crockett and Schleicher counties, Texas.
What Makes Approach Resources Unique
There are a few characteristics that make Approach Resources unique and could give them a competitive edge – room to run, 100% owned infrastructure and improving well recovery.
Room to Run: As of June 30, 2018, Approach Resources leased a total of 150,000 net acres in the Midland Basin. This large amount of acreage gives the company the ability for significant organic growth without any additional acquisitions. In fact, just in the company’s already leased acreage, Approach has identified approximately 1,350 drilling locations.
100% Owned Infrastructure:
Approach Resources believes its extensive, integrated field infrastructure system provides the company opportunity to achieve cost, operating and recovery efficiencies in the development of its drilling inventory. This company owned infrastructure is the key to its low LOE (lease operating expense) and impressive D&C (drilling and completion) cost structure.
(Source: Approach Resources, Q2 Earnings Presentation)
Improving Well Recovery: In the second quarter, Approach completed three wells, one in Pangea West, and two wells in Baker. The two Baker wells are performing above 700,000 BOE (barrel oil equivalent) type curve. In aggregate, the average cumulative production for the three wells outperformed both oil and well enhanced oil recovery for the 700,000 BOE type curve.
(Source: Approach Resources, Q2 Earnings Presentation)
Balanced Production Portfolio: In its latest quarterly results, it is clear that Approach Resources is not just an oil producer. In fact, its production is nearly evenly split between oil, NGL (natural gas liquids), and natural gas. For the three months ending June 30, 2018, Approach’s production was broken down as follows – 26% oil, 36% NGLs, and 38% natural gas. This means that the company is not overly exposed to the volatility in any one commodity.
Trends in Oil and Gas
After years of oversupply driving down the prices of oil and gas, it appears possible that there could be a supply crunch looming in the near future. Despite the increasing oil production in the United States, the International Energy Agency (IEA) has been speaking of the possibility of a supply crunch since 2016. Global demand continues to grow, while investments by oil companies in many major projects have been deferred during the extended downturn. Thus, there is less potential supply available. Even as prices and activity levels have been on the increase recently, there are still challenges ahead for the sector. First, there is an ongoing decline in new discoveries. It’s getting more and more difficult to find large discoveries of oil as most prospective areas have already been explored. Second, exploration funding has been slow to recover since it fell with oil’s price collapse in 2014-16. Globally, exploration spending fell by 60% between 2014 and 2017. Third, in existing oil fields, production is declining and accelerating by about 4% per year. A fourth challenge is deferred maintenance. Most companies have delayed non-critical spending in recent years in order to keep costs down. Now as infrastructure continues to age and is in need of maintenance, companies will need to devote time and resources to ensure its continued viability.
Interest Coverage and Liquidity
Interest coverage is of paramount importance because it indicates the company’s ability to service its existing debt. For its most recent quarter (three months ending June 30, 2018), Approach Resources had operating income (without the effects of non-cash depletion, depreciation and amortization) of $16.6 million and interest expense of $6.2 million for an interest coverage ratio of 2.7x.
In terms of liquidity, as of June 30, 2018, Approach Resources had $27.2 million in total liquidity including cash on hand and available borrowings under its credit facility.
The risk for bondholders is whether Approach Resources can continue to add consecutive quarters of growth. The company has had an excellent first half of 2018. It has kept costs low, while using its well drilling and completion techniques to increase well production. It has a balanced revenue profile, with revenues from not only oil, but also natural gas and natural gas liquids. It has significant net acreage to develop- possible growth without acquisition. In light of these factors, the nearly 8.0% yield-to-maturity on these short 32-month bonds does appear to outweigh the risks identified.
Approach’s revenues are from the sale of oil, natural gas, and natural gas liquids. Commodity prices are volatile and affect the price the company receives for its products. A substantial drop in commodity prices could adversely affect Approach Resources profitability.
In general, bond prices rise when interest rates fall and vice versa. This effect tends to be more pronounced for lower couponed, longer-term debt instruments. Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss. Higher yielding bonds typically have lower credit ratings, if any, and therefore involve higher degrees of risk and may not be suitable for all investors.
Summary and Conclusion
Approach Resources is a unique oil and gas producer, with revenues split between oil, natural gas and NGLs. The company has had a solid first half of 2018, with the expectation that this will continue for the balance of this year and into 2019. The company has done a fantastic job of keeping costs low while increasing production. If the supply crunch does happen as predicted by the IEA, prices will likely increase and this would likely increase revenues and profitability for oil and gas producers like Approach Resources. Therefore, the company’s 2021 bonds make an ideal addition to Durig Capital’s FX2 Managed Income Portfolio, the most recent performance of which is shown above.
Issuer: Approach Resources Inc.
Ratings: Caa3/ NR
Yield to Maturity: ~7.9%
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Disclosure: Durig Capital and certain clients may hold positions in Approach Resources’ June 2021 bonds.
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