Even After Rally, RSP Permian's Still Attractive

For 2018, we anticipate around 40% year-on-year production growth, 10% higher than preliminary guidance. The West Texas Intermediate benchmark has risen well above management’s base case of $50 a barrel, making it more likely than not that the company will add a completion crew and a horizontal rig this year as planned.

With commodities at their current levels, we wouldn’t rule out further acceleration, though our new fair value estimate and production growth forecast do not depend on it. Either way, we anticipate no trouble living within cash flows for the foreseeable future, and by midyear, RSP’s slightly elevated leverage should be in line with the peer average.

Our updated estimates incorporate our bearish views on crude prices. This year, we expect U.S. shale growth to surprise to the upside, especially if producers get carried away with current prices and ramp up their operations. Waning compliance with OPEC production cuts could further limit how much fundamentals can improve. That sets up the market for a difficult second half, which could spill into 2019 as well. Meanwhile, we expect further improvements in efficiency and productivity from shale producers, offsetting cost inflation and preventing break-evens from climbing above our midcycle forecast of $55/bbl (WTI). Thanks to its very low-cost acreage, RSP Permian can still thrive in this environment, though. And if we’re wrong and oil prices continue beating our estimates, there could be even more upside for the stock.

Low Break-Even Costs RSP Permian is a lean, efficient Permian Basin oil producer. The location of its acreage, overwhelmingly in core areas with very strong well performance trends, is a huge advantage--it minimizes unit costs and enables the company to generate best-in-class margins. In 2016, it reported finding and development costs of $6 per barrel of oil equivalent and operating expenses of $11/boe, which translates to a WTI break-even of less than $30 per barrel, one of the lowest in our coverage. As such, the company can tolerate prolonged commodity price dips, if necessary.

Since the downturn, the entire industry has focused on efficiency and productivity. RSP was an early adopter of innovations like high-intensity completions and is still ahead of the pack. It recently completed a high-resolution 3-D seismic survey of its acreage in the Delaware Basin, which will help with reservoir characterization and landing zone optimization. It also expects to benefit this year from switching to local sand suppliers, using its own water handling system in the Delaware Basin, and shifting further to multiwell pads. These improvements should take the sting out of higher service costs and enable the company to maintain its competitive edge.

Commodity Price Uncertainty Prevents Moat RSP Permian is one of the lowest-cost producers in the upstream oil and gas segment. Its acreage in the Permian Basin is optimally located, with consistently high initial flow rates and projected well recoveries. Operations are lean and efficient, with minimal overhead, and the company has been well ahead of the pack with recent innovations, including faster drilling and optimized completions. It has enough drilling locations in its inventory to support several decades of drilling. However, the uncertainty associated with long-term commodity price forecasts prevents us from awarding a narrow economic moat rating.

RSP’s moat rating is based on the quality of the assets currently held. Future acquisitions and divestitures could materially affect the attractiveness of the portfolio, and although such transactions are possible, none have been announced that are not already included in our analysis. There are no other factors in play that would alter RSP’s competitive advantage right now.

Leverage Not a Concern As with most exploration and production companies, a deteriorating outlook for oil and natural gas prices would pressure RSP's profitability, reduce cash flows, and drive up financial leverage. Other risks to keep an eye on include regulatory headwinds (most notably environmental concerns) and uncertainty regarding future federal tax policy.

RSP’s financial leverage is temporarily elevated following the 2017 acquisition of Silver Hill Energy Partners for $2.4 billion. But because it is increasing production very rapidly while living within cash flows, net debt/EBITDA should be back under 2 times by mid-2018. In the meantime, RSP has ample liquidity in place and can quickly dial back its activity in a weaker commodity environment to keep cash flows aligned with spending.

The company can generate cash-flow-neutral growth under a wide range of commodity scenarios, but if it does get into a tight spot, there’s $600 million available on its revolving credit facility. No debt is due until 2022.