Callon Petroleum Company (NYSE:CPE ) is an independent exploration and production company that is focused on the acquisition, exploration, and development of various assets in the oil plays of West and South Texas. Admittedly, this alone does not tell us very much, as this could be a description of pretty much any Permian drilling company. The energy sector in general has been one of the best-performing ones this year, although it has admittedly lost a bit of its shine in recent weeks as energy prices have retreated a bit.
Callon Petroleum has still delivered a reasonable return to its investors, though, as it is up 25.16% over the past twelve months. Despite this capital appreciation, though, Callon Petroleum appears to be remarkably undervalued at the current price, which may attract some investors to it. As is often the case with substantially undervalued companies, Callon Petroleum has some significant risks but is working hard to address them. Overall, the company might be worth considering, particularly given that the fundamentals point to energy prices remaining high or even increasing over the given year.
As stated in the introduction, Callon Petroleum Company is a relatively small exploration and production company that operates in various areas of West and South Texas:
This is a very popular region for energy companies. Indeed, the Permian Basin that stretches across the entire area has been the focal point of the American energy renaissance that has taken place over the past decade. This makes a lot of sense given the tremendous amount of hydrocarbon resources located in the area. Indeed, the basin is generally considered to be the second-largest source of crude oil in the world, with the Energy Information Administration estimating that it still contains proven reserves of five billion barrels of crude oil and nineteen trillion cubic feet of natural gas despite the fact that the basin has been producing since the 1920s. It is important to note that this is the number of resources that could be economically produced at 2018's energy prices. As prices today are considerably higher, it is conceivable that the basin's proved reserves are higher than this today.
The incredible mineral wealth of this region is reflected in Callon Petroleum's reserves. An energy company's reserves are often overlooked by investors, but they are critically important. This is because the production of crude oil and natural gas is by its very nature an extractive process. After all, the companies in this industry literally obtain the products that they sell by pulling them out of reservoirs in the ground. As these reservoirs only contain a finite quantity of resources, a company must continually discover or otherwise acquire new resources to replace those that are pulled out of the ground or it will eventually run out of products to sell. As a company's success at accomplishing this is by no means guaranteed, its reserves determine how long the company can continue to produce without having success at this task.
As of December 31, 2021 (the most recent date for which data is available), Callon Petroleum had total reserves of 484.6 million barrels of oil equivalents:
During the second quarter of 2022, Callon Petroleum produced an average of 100,700 barrels of oil equivalents per day. As such, the company currently has sufficient reserves to produce for just over 13 years at its current rate without discovering any new sources of resources. This is better than many of the majors and positions the company quite well going forward.
One thing that we notice above is that Callon Petroleum is that it is heavily focused on the production of crude oil. Indeed, about 63% of its production and 82% of its revenue come from crude oil. Callon Petroleum consistently emphasizes this as a region to invest in the company, and indeed ten years ago it would have been. The fundamentals for natural gas back then were quite poor and the price was so low that it was pointless to attempt to bring the compound to the market.
However, this has been changing. Over the past twelve months, natural gas at Henry Hub is up 61.30% while West Texas Intermediate crude oil is only up 20.55%. As we will see in just a bit, too, the demand for natural gas will likely increase much more than that for crude oil. Thus, I do not see Callon Petroleum's focus on crude oil to be nearly as much of an advantage as the company's management does. With that said, though, the price of both compounds is likely to increase, which should help Callon Petroleum's earnings.
One thing that we have been seeing some other Permian Basin producers doing is increasing their production. This is in direct response to the surging oil prices that we have been seeing over the past year or two. Callon Petroleum is not an exception to this as the company intends to drill between 38 and 42 wells during the third quarter, which will increase the company's production to an average of 102,000 to 105,000 barrels of oil equivalents per day. Callon Petroleum also expects this to be its average over the course of 2022 as well, which implies that the company will increase its production further in the fourth quarter in order to offset its weaker average in the second quarter.
It should be fairly obvious how a production increase will cause the company's revenues and profits to increase. After all, a higher level of production means that the company has more products to sell and earn money from so all else being equal, it will make more cash flow and profit. However, all else is rarely equal in the energy industry and this production increase is fairly meager. As such, a slight decline in energy prices, such as might accompany a recession, could more than wipe out the benefits from the production increase. Fortunately, Callon Petroleum has a way to protect itself against this. As with many other energy companies, Callon Petroleum uses hedges such as forward and futures contracts, to essentially lock in a selling price for its resources. Here are all the current hedges that the company has:
There are both advantages and disadvantages to this. The advantages are that these hedges aid the company in keeping its financials relatively stable no matter what crude oil prices do as well as aiding its financial planning. After all, it is much easier to plan the company's finances when management knows exactly what price it will receive for some of its production. The disadvantage is that when energy prices increase quickly, as they did over the past year, then the company ends up locking in a price that is much less than the market price. We can see this above as Callon Petroleum's hedges have locked in prices ranging from $61.09 to $65.34 per barrel of crude oil. As of the time of writing, West Texas Intermediate is trading for $86.23 per barrel. While it may certainly be disappointing that the company is receiving less than market price for its products, it, fortunately, does not have all of its production hedged so it is still benefiting from today's high prices, just not as much as it would without the hedges. With that said though, the presence of the hedges is still beneficial considering that oil prices can go down and up.
As we have just seen, Callon Petroleum focuses primarily on the production of crude oil. I was also somewhat critical of this practice given that the fundamentals of natural gas are much better than the fundamentals of crude oil. With that said though, crude oil demand is still expected to increase going forward, just not as much as natural gas. According to the International Energy Agency, the global demand for crude oil will increase by 7% over the next twenty years:
Pembina Pipeline/Data from IEA 2021 World Energy Outlook
Pembina Pipeline/Data from IEA 2021 World Energy Outlook
The growing crude oil demand may be somewhat surprising considering that many of us live in nations in which the governments are actively trying to reduce crude oil consumption. However, it is a very different story in emerging markets. These nations are expected to see tremendous economic growth over the projection period, which will have the effect of listing the citizens of these nations out of poverty and putting them firmly in the middle class. These newly middle-class people will naturally begin to desire a lifestyle that is much closer to that of their counterparts in the developed world than it is today. This will require increased consumption of energy, including energy that is derived from crude oil. As the populations of these nations are significantly larger than the populations of the world's developed nations, the increasing demand for crude oil from these nations will more than offset the stagnant-to-declining demand in the world's developed nations.
It is, however, unlikely that production will grow sufficiently to satisfy this projected demand growth. This is because of a few factors. The first, and most notable of which, is that the traditional energy industry has been significantly underinvesting in production and midstream capacity ever since the bear market of 2015. This is one of the biggest reasons why the offshore drilling industry never recovered from that event. In fact, Moodys recently stated that the industry must immediately increase upstream spending by $542 billion in order to avoid a supply shock.
It is highly unlikely that energy companies in aggregate will increase spending to this degree. First of all, they are under tremendous pressure from politicians and environmental activists to improve the sustainability of their operations. In addition, the energy sector has been one of the worst performers in the market over the past decade and investors have been demanding improved performance. Thus, we will likely have a situation in which the demand for both natural gas and crude oil will increase by more than the supply of these compounds. According to the laws of economics, this results in rising prices. Naturally, rising prices for both products will benefit Callon Petroleum as it does produce both crude oil and natural gas despite being weighted heavily toward crude oil. This should likewise benefit investors in the company.
As stated earlier in the introduction, Callon Petroleum is not without risks. Perhaps the most significant of these risks is the company's debt load. The reason that a high debt load is concerning is that debt is a much riskier way to finance a company than equity because debt must be repaid at maturity. This is usually accomplished by a company issuing new debt to repay its maturing debt, which can cause its interest expenses to increase depending on conditions in the market.
A second reason that high debt is concerning is that a company must make regular payments on its debt in order to remain solvent. Thus, a decline in cash flow could threaten a company's financial solvency if it has too much debt. This is especially a big concern in the energy industry as the volatile nature of commodity prices can cause cash flows to fluctuate much more than in many other sectors.
One metric that we can use to evaluate a company's financial structure is the net debt-to-equity ratio. This ratio essentially tells us the degree to which a company is financing its operations with debt as opposed to wholly-owned funds. It also tells us how well the company's equity will cover its debt obligations in the event of a bankruptcy or liquidation event, which is arguably more important. As of June 30, 2022, Callon Petroleum had a net debt of $2.5102 billion compared to $2.2593 billion in shareholders' equity. This gives the company a net debt-to-equity ratio of 1.11. Here is how that compares to some of the company's peers:
As we can clearly see, Callon Petroleum is substantially more levered than its peers. This is a warning sign to investors that the company may be using too much leverage in its financial structure. However, there are other warning signs too.
Another metric that is frequently used to judge the leverage of upstream companies is the leverage ratio, which is also known as the net debt-to-EBITDAX ratio. In short, this ratio tells us how long (in years) it would take the company to completely pay off its debt if it were to devote all of its pre-tax cash flow to that task. At the end of the second quarter 2022, Callon Petroleum had a leverage ratio of 1.67x based on its trailing twelve-month EBITDAX. This is substantially higher than the 1.0x or lower ratios that many of its peers have and could likewise indicate that Callon Petroleum will struggle more than many other energy companies should some event cause its cash flows to decline.
One possible cause of a cash flow decline would be falling energy prices, as has been happening over the past few months. Fortunately, it appears management is well aware of this problem and has been taking steps to reduce the company's leverage. At the end of the third quarter of 2021, Callon Petroleum had an incredibly high leverage ratio of 3.46x, which has been rapidly falling ever since:
The company expects to achieve a 1.00x to 1.25x ratio by the end of the year, even given the recent falling prices. This would still not be nearly as good as some of the firm's best-financed peers but it is reasonable. We will want to keep an eye on management's success at achieving this given that crude oil prices are not nearly as strong as they were four months ago.
It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. One metric that we can use to value an energy company like Callon Petroleum is the forward price-to-earnings ratio. This ratio essentially tells an investor how much they are paying today for each dollar of earnings the company can be expected to generate over the next year.
According to Zacks Investment Research, Callon Petroleum currently has a forward price-to-earnings ratio of 2.68. This is a remarkably low ratio in any market, but it is especially so in today's market in which most companies have forward price-to-earnings ratios well into the double digits. However, as I have pointed out in various previous articles, pretty much everything in the traditional energy space is incredibly undervalued today. As such, it would make sense for us to compare Callon Petroleum against its peers in order to determine which company has the most attractive relative valuation:
(all data courtesy of Zacks Investment Research)
As we can clearly see, all of these companies have very attractive ratios given the general conditions in the market today. However, Callon Petroleum is by far the most attractive of any of them. This is probably due to the company having a somewhat higher risk due to its debt. However, the fact that the company is working to address this problem and the fact that the valuation is so much more attractive than its peers could mean that the company is worth taking a chance on.
In conclusion, Callon Petroleum is a little-known independent operator that could have a lot to offer an investor. Admittedly, I am not particularly attracted to it because of its focus on crude oil, but the valuation is hard to ignore. The fundamentals for crude oil are not as bad as some believe, either, which improves its prospects a bit. The biggest concern here is the company's incredibly high debt load relative to its peers but it is working to address this, and if it does, any investor buying today should be very happy with the results.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Additional disclosure: I am long various energy-focused mutual funds that may hold any company mentioned in this article. I exercise no control over the investments held by these funds.