Laredo Petroleum (LPI) will report a drop in production in the second half of 2020 but its output will begin to recover from 2021 after the company increases drilling activity. The Tulsa, Oklahoma-based company’s production will climb back to pre-crisis levels in 2021. The production growth will be accompanied by earnings growth. I also expect the company to generate free cash flows from the second half of this year and in 2021. Laredo Petroleum has held up well during the downturn and its outlook is now looking better.
Image courtesy of Pixabay
Cutting Drilling Activity
Laredo Petroleum, like its peers, reported a large drop in earnings and cash flows in its second-quarter results. The company slashed capital expenses and reduced drilling activity in the second quarter in response to the weakness in oil prices. Laredo Petroleum worked with an average of 2.4 drilling rigs, 0.3 completion crews, and completed just five wells in Q2-2020. By comparison, the company operated 4 drilling rigs, 1.7 completion crews, and completed 28 wells in the first quarter. Laredo Petroleum produced a total of 94,117 boe per day in the second quarter, including oil production of 31,241 bpd, and forecast a drop in production in the coming quarters with declining activity.
Image: Author. Data: Midpoint of the company’s guidance from Q2-2020 investor presentation.
Laredo Petroleum’s adjusted net income fell from $55.5 million a year earlier to $28.4 million in Q2-2020. Its cash flow from operations, ahead of changes in working capital, dropped by 68% to $54.8 million and it ended the three months with a cash flow deficit (or negative free cash flows) of $23.5 million. The weakness in earnings and cash flows came after the company realized oil prices of just $24.66 per barrel, down from $57.76 a year earlier.
But since the second quarter, oil prices have improved substantially. The US oil spot price has hovered near low-$40s since early-June, substantially higher than the Q2-2020 average of a little less than $28 per barrel. The commodity was at $43.27 per barrel at the time of this writing. This increase in prices has prompted many shale oil producers, including companies such as Continental Resources (CLR) and EOG Resources (EOG), to slightly increase drilling and completion activity. Many companies are taking a cautious approach and remain reluctant to deploy new rigs and will focus on working through their inventory of drilled but uncompleted wells. Laredo Petroleum is also exercising caution but the company has said that the prices have now risen to a point where it can start increasing completion work towards the end of the year.
Laredo Petroleum has made the sensible decision to focus on working in Howard County which is its highest-return oil-rich acreage. Laredo Petroleum will operate a completion crew here which will work on a major project in the fourth quarter. The company doesn’t plan on completing any wells in the third quarter but will bring 15 wells online in the fourth quarter, with one completion crew likely working on a full-time basis in the final three months of the year. That’s going to give the company solid momentum heading into 2021 when its production will start to recover.
In other words, although Laredo Petroleum’s production will likely decline in the second half of the year as compared to H1-2020, it will begin to climb from early-2021. If oil prices stay strong and the company continued to get support from low service costs, then it will likely add another rig in early-2021. That’s going to mark normalization of activity since the company will be working with two rigs and one completion crew.
Image: Laredo Petroleum Q2-2020 Investor Presentation [link provided earlier]
I believe Laredo Petroleum’s production will likely continue to gradually climb throughout 2021, allowing the company to achieve its target of ending the year with oil production of 27,000 bpd to 29,000 bpd. That’s up from 26,200 bpd to 26,800 bpd forecasted for 2020 and in-line with 2019 production of 28,400 bpd. That’s going to mark Laredo Petroleum’s full recovery, in terms of output. Due to the gradual increase in output throughout 2021, I expect Laredo Petroleum to end 2021 with meaningfully higher volumes than 79,000 boepd (21,000 bpd oil) projected for Q4-2020. The company will, therefore, likely enter 2022 on a firm footing with growing production.
Besides getting its production back on track, I think Laredo Petroleum looks all set to grow earnings as well. In the short term, the earnings growth will be driven by the improvement in oil prices. The company reported an adjusted profit of $2.43 per share while operating in a sub-$30 per barrel oil price environment. At $40 oil, it will report substantially higher profits, although the positive impact of higher prices will get partly offset by declining production. But in 2021, as the company ramps up activity and production recovers, the increase in volumes will also become a key factor that might help push earnings higher.
Moreover, I believe Laredo Petroleum’s cost-cutting efforts have put it in a good position to expand margins. By lowering its cost structure, Laredo Petroleum also looks better prepared today than it did at the start of 2020 to handle weak oil prices.
Following the headcount and payroll cuts, Laredo Petroleum pushed its unit G&A charges down by 23% from the first quarter to $1.02 per boe in Q2-2020. The expenses are also below the peer average of $1.90 per boe. Laredo Petroleum was also able to bring its lease operating expenses down by 14.3% from the first quarter to $2.40 per boe in the second quarter. The unit LOE will likely climb in the future as the company shifts its operations to the Howard County acreage. But Laredo Petroleum expects to maintain the LOE below $3 per boe in 2021. Therefore, even with the uptick in expenses, Laredo Petroleum will likely remain one of the lowest-cost operators whose LOE will be substantially below the peer average of $4.46 per boe.
Cash Flow Outlook
As indicated earlier, Laredo Petroleum burned cash flows in the second quarter but its outlook is looking better. The company’s cash outflows as capital expenditures will decline, considering the company expects to spend an average of $55 million per quarter in H2-2020, down from $155 million and $78 million spent in Q1-2020 and Q2-2020 respectively. I expect the company to generate strong levels of cash flows, thanks to the support from crude oil hedges, which, with decreasing capital expenses, will push the company to free cash flows in the second half of the year.
Laredo Petroleum will also receive support from its crude oil hedges, which bolsters the company’s ability to generate free cash flows and provides downside protection. Laredo Petroleum has covered a vast majority of oil production for the upcoming quarters with hedges at great prices. For the remainder of this year, the company has hedged 3.6 million barrels of oil using swaps at a weighted-average price of $59.50 WTI per barrel and 1.2 million barrels of oil using swaps at a weighted-average price of $63.07 Brent per barrel. For the next year, Laredo Petroleum has hedged 70% of oil output using swaps, puts, and two-way collars at a weighted-average floor price of $51.11 Brent per barrel.
I think Laredo Petroleum might generate free cash flows in 2021 as well. That’s because oil prices could end up averaging in the mid-$40s a barrel range in 2021, as indicated by the current futures. That’s also in-line with the US Energy Information Administration’s forecast of an average 2021 price of $45.53 per barrel. This increase in prices will give a boost to the company’s cash flow from operations. Nearly 65% of the company’s output for 2021 has direct exposure to increasing oil prices, since these barrels have either been hedged using puts or are un-hedged. The company’s capital expenses, on the other hand, are projected to decline slightly by 2% from 2020 to $337.5 million in 2021, as per the mid-point of the company’s guidance. I think this combination of mid-$40s a barrel prices, hedge coverage, and low CapEx puts the company in a good position to generate free cash flows in 2021 as well.
Laredo Petroleum stock has fallen by 19% in the last three months. But I think it can bounce back on the production recovery, earnings growth, and free cash flows. The company’s shares are trading at just 2.75x in terms of EV/EBITDA (fwd) multiple, substantially below the sector median of 7.7x, as per data from Seeking Alpha. I think Laredo Petroleum is a good play on oil prices and investors should consider buying the stock.
Before loading up on Laredo Petroleum stock, investors should consider some risks as well. In my opinion, Laredo Petroleum is a high-beta play and might not appeal to defensive investors. The company doesn’t have a strong balance sheet and its financial health has deteriorated in the recent past. The company carries a lofty debt-to-equity ratio of more than 300%. Its liquidity, which mostly consists of funds available under the revolving credit facility, has shrunk considerably to $402 million at the end of Q2-2020 from $723 million at the end of Q1-2020 after its borrowing base got reduced to $725 million from $950 million in April.
I don’t think the company is facing a liquidity crisis or a serious bankruptcy risk, considering it seems to be on track to generate free cash flows in the future which will help rebuild liquidity and it doesn’t have any near-term debt maturities. But the large debt load can still weigh on the company’s performance. If, for instance, oil prices unexpectedly decline and the company starts burning cash flows, just like it did in the second quarter, then that might increase liquidity and debt-related concerns. Any weakness in oil prices will likely push all E&P stocks lower but, in my opinion, Laredo Petroleum, due to its weak balance sheet, could get hit particularly hard.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.