Cimarex's Stock Price Bakes In Unreasonably High Expectations

However, the stock now appears to have entered speculative territory. To justify Cimarex's current stock price, investors have to believe that one of two things will take place over the next few years: (1) oil prices will be much higher than they are now or (2) Cimarex will be able to replicate its long-lateral, high-proppant experiments across the vast majority of its Permian and midcontinent leasehold. Based on our macro work and our analysis of the company's well results to date, neither of these outcomes appears to be substantiated. Accordingly, we recommend investors avoid Cimarex at its current stock price.

How We Arrive at Our Contrarian Fair Value Estimate Our long-term oil and natural gas price assumptions are the single biggest driver of our cash-flow-based valuation of Cimarex. We believe oil and natural gas are likely to settle at $55 per barrel for West Texas Intermediate and $3 per thousand cubic feet (Henry Hub) as supply and demand in these markets equilibrate. For this assessment, we take these long-term price assumptions as givens, with our scenario analysis centered on the quality and depth of Cimarex's drilling inventory and the resulting impact on the company's fair value.

Estimating this inventory is far from straightforward, however, given the company's limited information disclosure. Unlike many of its peers, Cimarex does not generally provide identified drilling locations or type curve parameters for its assets, choosing instead to let analysts derive these figures from selectively disclosed data points (among them, 30-day peak initial production rates, acreage numbers, and well spacing pilot programs). What's more, the relatively small number of long-lateral, high-proppant wells Cimarex has drilled have been flowing for only a short time, which introduces uncertainty around their ultimate production profile and the applicability of these results to the rest of the company's acreage.

We use well-level data from Rystad Energy to form a more complete picture of the quality and depth of Cimarex's drilling inventory. Based on this information, we develop three scenarios--base, bull, and bear--across which we alter three key variables: (1) lateral length (which in turn affects our assumptions regarding IP rate, estimated ultimate recovery, and well cost), (2) wells per spacing unit (eight wells per 640 acres, for example), and (3) a leasehold risk factor (essentially trying to quantify how much of the company's acreage can be successfully drilled up). We apply the same price deck, per-unit operating costs, and discount rate to each of our scenarios and, depending on the scenario, adjust our rig count to balance operating cash flows with capital expenditures (keeping in line with Cimarex's historical approach).

Under our base case, we estimate Cimarex to be worth $89 per share, while in our bull and bear cases, we estimate the stock to be worth $139 and $63, respectively.

Across all scenarios, we expect Cimarex to deliver significant growth in production and earnings over the next several years, while living within cash flow and maintaining one of the lowest cost structures and best balance sheets in the upstream space. Through 2020, we project that Cimarex's net debt/EBITDA ratio will remain below 1 times, with a fully loaded break-even oil price of $35 or less per barrel. We expect Cimarex's longer-term returns on capital to average north of 12%, supporting our narrow economic moat rating.

Most of Cimarex's value resides in its Permian assets, despite the fact that this region has far fewer drilling locations than the company's midcontinent assets. This is largely due to the Permian's higher oil cuts and greater per-well resources. Depending on the scenario, the Permian accounts for between 65% and 90% of Cimarex's total asset value.

What Are So Many Smart Analysts and Investors Missing? Given Cimarex's wide analyst following, significant institutional ownership, a consensus price target of $140 per share, and the fact that the stock continues to trade at elevated levels, we're the first to recognize the contrarian nature of our $89 fair value estimate. The disparity between our view and that of the broader investment community probably boils down to one of two things: a difference in our long-term oil price assumptions and/or a difference in our assessment of how repeatable Cimarex's long-lateral, high-proppant well results are across its Permian and midcontinent leasehold.

Regarding the former, if we assume a long-term oil price of $65/bbl (WTI)--in line with analysts' 2020 consensus--and hold everything else constant in our model, we arrive at a fair value estimate of $126 per share, near where the stock is trading today. (At $65/bbl long-term oil, our bull and bear cases come in at $194 and $92, respectively.) Still, with most E&P stocks trading on the basis of a one- to two-year forward multiple of earnings and with analyst price targets rarely based on an estimate of intrinsic value, we think it's unlikely that a disparity in long-term price assumptions explains why our take on Cimarex differs so considerably from the Street.

Instead, we believe it's the latter factor--how repeatable are the company's well results?--and point to Cimarex's limited information disclosure as the primary basis for the Street's more bullish assessment of the stock. Based on our analysis of the far more comprehensive Rystad Energy data set, we believe the company's selective disclosure provides an incomplete picture of how consistent its results have been and how delineated the company's Permian and midcontinent acreage truly is. By extrapolating the handful of data points provided by the company--and without concurrently analyzing a more robust data set like Rystad--it's easy to see how analysts and investors could take an overly bullish (albeit unwarranted) stance on Cimarex's stock price. This bullish outlook is likely supported to some degree by management's strong record and more conservative approach, which we suspect leads investors to give the company the benefit of the doubt in the absence of information.

What Does the Smartest Money of All Say About Cimarex's Stock Price? It's always instructive to analyze insider buying and selling, as the directors and officers of a company arguably represent the smartest money of all. According to Securities and Exchange Commission filings, insiders have sold close to $40 million of Cimarex stock in open-market or privately negotiated transactions from 2015 to the present, during which the stock price ranged from $80 to $130 per share. The average selling price for insider transactions was $111 per share. There were almost no insider purchases during this period.

Moreover, it's telling that Cimarex issued close to 7 million shares of common stock at $109 per share in May 2015, with no specified use for the proceeds beyond increased drilling and completion activity and at a point when the company's net debt/EBITDA ratio was less than 1.0 times (that is, equity was probably issued to take advantage of a stock price that management considered either fairly valued or expensive).

While insider sales and equity raises don't tell the whole story, they do provide insight into how a management team--especially one like Cimarex's that is laser-focused on rate of return--perceives the intrinsic value of its stock.

What Will Drive Convergence of the Stock Price and Our Fair Value Estimate? Despite our belief that Cimarex is overvalued, we wouldn't recommend the name as a short candidate, given its strong balance sheet and the premium investors continue to place on low-cost, financially healthy E&Ps. Still, the burden of justifying its elevated stock price falls on the company's shoulders, achieved primarily by continuing to deliver consistently impressive well results across a much broader swath of its Permian and midcontinent acreage than it has to date. If these results fail to materialize--and we don't necessarily have reason to believe they will or won't, given the limited number of data points available for us to analyze--the stock is likely to correct.

With its highly competitive cost position, rock-solid balance sheet, and prudent management team, Cimarex is one of the better E&Ps we cover. At its current trading level, however, it's far from a compelling investment opportunity. As an alternative, we'd point investors toward