Callon Petroleum (NYSE:CPE), having declined by 58% in the last 12-months, has been a clear under-performer. The acquisition announcement of Carrizo Oil & Gas (NASDAQ:CRZO) has not changed my bearish long-term view on the stock. However, I do believe that there can be a possible trading bounceback in the near-term.
The focus of this article will be on the key concerns that make Callon Petroleum stock unattractive for long-term exposure even after a deep correction.
CPE’s Debt and Cash Flows
On a standalone basis, Callon Petroleum reported total debt of $1,330 million as of the first quarter of 2019 (1Q19). For the same period, Carrizo Oil & Gas reported debt of $1,715 million. For the combined entity, the total debt therefore stands at $3 billion.
Further, with LTM EBITDA of $1.2 billion, the leverage currently stands 2.5. With both companies generating negative free cash flow, it is likely that the total debt will continue to increase in the coming quarters.
Therefore, an increase in leverage is a concern for Callon Petroleum and CPE stock. My focus is on debt and debt servicing as the global economy has decelerated. Expansionary monetary policies can ensure that oil does not trend meaningfully lower. However, $50 to $60 oil is unlikely to be enough for Callon Petroleum to generate positive free cash flows.
The Permian Concerns for CPE Stock
Callon Petroleum indicated in the merger presentation that the company expects free cash flow to break even at $50 per barrel of oil. I am of the opinion that the estimates are optimistic.
Besides expected oil price weakness, the key reason is the company’s Permian assets. The Permian shale-well production has been falling off at a steep rate. It is clear from EIA data that production growth has been relatively muted in the Permian. In addition, legacy oil production change has trended steeply lower.
The implication is that shale producers need to invest more to maintain production. Therefore, capital expenditure can be higher than expected which implies a negative impact on free cash flows.
Infrastructure bottleneck at the Permian is another challenge that is likely to sustain through 2019 and potentially into 2020. It is worth noting that the company’s realized oil price for 1Q18 was $53.3 and declined to $42.18 for 1Q19. Once new pipelines are operational, realized price is likely to trend higher. That is still few quarters away.
The Positive Triggers for Callon Petroleum Stock
In April 2019, Callon Petroleum entered into an agreement for divestment of non-core asset in the Midland Basin for a consideration of $260 million. Post-acquisition of Carrizo Oil & Gas, the company will be looking at divest other non-core assets. This can be a potential source of cash that can be used to deleverage. However, I believe that the markets will wait for any such positive trigger before CPE stock trends higher.
Another obvious trigger for CPE stock trending higher will be upside in oil prices. The company’s production is weighted towards oil and higher realization would imply EBITDA margin expansion and free cash flow visibility. However, economic headwind is a near-term concern and it remains to be seen if expansionary policies trigger sharp upside in oil price.
It is also important to note that the PV10 for the combined entity is approximately $7 billion. Callon Petroleum and Carrizo Oil & Gas have a current combined market capitalization of nearly $2 billion. Even if total debt of $3 billion is considered, the company is undervalued considering the resource base valuation.
This valuation gap will fill only when Callon Petroleum demonstrates the ability to sustain production growth and turn free cash flow positive. Investors need to remain in the sidelines for these triggers to actualize before moving on CPE stock.
Concluding Words on CPE Stock
Before the acquisition, Callon Petroleum stock was a pure play in the resource-rich Permian Basin. CPE stock still trended lower on Permian-specific concerns that I outlined. With the acquisition of Carrizo Oil & Gas, the company is not more diversified in terms of asset base.
Callon Petroleum needs to demonstrate that the acquisition does bring in benefits in terms of size and scale. In addition, the company needs to focus on deleveraging and turning free cash flow positive.
Until then, Callon Petroleum stock is a good trading stock and I believe that current levels are attractive for medium-term exposure.
As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.
