Oil and Gas Investor Executive Q&A: Earthstone on the Rise

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[Editor's note: A version of this story appears in the February 2021 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

After his first year of college in the early 1980s studying pre-law, Robert J. Anderson decided he didn’t like that life path, so he unenrolled. He jumped from small job to small job in his hometown Denver, eventually picking up a Yellow Pages and looking up drilling contractors. He had heard about the oil and gas industry and was curious. He dialed the rotary phone until he came to Noble Inc., which back then still ran onshore rigs.

“Can you be in Williston tomorrow?” the man on the other end asked.

 Anderson began working as a rig floor “worm” during the bitter North Dakota winter where minus 40 is a real temperature. He worked on two deep wells commissioned by Chevron Corp. targeting Winnipegosis below the Bakken “long before the Bakken was discovered,” he said. “We would drill through the Bakken, and it was an annoyance.”

When he figured out being a rig hand wasn’t his calling, he enrolled at the University of Wyoming where he earned a petroleum engineering degree. Anderson graduated in 1986, when no oil and gas jobs were to be had, so he continued onward getting an MBA from the University of Denver. That foundation set the stage to becoming CEO of The Woodlands, Texas, based-Earthstone Energy Inc., a title he assumed in April last year.

“That experience helps you when you sit in this seat, because I appreciate what the guys in the field are doing.”

Earthstone is a small-cap, Permian focused producer with 34,000 net acres in the Midland Basin and an additional 14,500 net acres in the Eagle Ford Shale. Anderson was part of the management team at privately held Oak Valley Resources, formed with properties contributed from Encap Investments LP, which reversed merged into Earthstone in 2014 to gain access to the public markets. Anderson was elevated to president in 2018, and prior to that executive vice president of corporate development and engineering.

Before joining Oak Valley, Anderson was on the GeoResources team that exited to Halcón Resources in 2012 for $1 billion, the same team that later reformed as Oak Valley. GeoResources was also a reverse merger executed by Southern Bay Energy and which included Anderson.

Over the past six years Earthstone has utilized M&A of small operators to propel its scale building, including a 2017 acquisition of Bold Energy, another EnCap-backed company and which gave the capital provider a controlling interest in the stock. Earthstone in late 2018 abandoned a near-$1 billion acquisition of Sabalo Energy when WTI fell from $70 to $45 after signing the PSA.

In January, however, Earthstone closed the acquisition of Warburg Pincus-backed Independence Resource Management LLC (IRM), a fellow Permian producer, for $182 million in cash and equity. Earthstone picked up some 43,400 net acres across various counties in the Midland Basin and 8,780 boe/d, but the sweet spot is a 4,900-acre block straddling Midland and Ector counties rich in Spraberry and Wolfcamp targets complementing an existing position.

And riding an updraft of E&P stocks in the fourth quarter, Earthstone’s shares have more than doubled since October.

Oil and Gas Investor spoke with Anderson shortly after finalizing the deal.

Investor: What was your motivation for doing a deal at this time?

Anderson: Earthstone has a great platform, and we’ve got a good business strategy, but we’re small. And as a small, public company, it’s somewhat inefficient because you’ve got a certain amount of cost just to be public, and investors don’t really pay attention to small, public companies. Now we’re a bit unique in that we’re healthy, so investors give us a little more attention than they would somebody who’s highly levered.

The other point is that EnCap owned a little more than 60% of us prior to doing the IRM deal. Now they’re down to just under 50%. Our job is to get our equity into investors’ hands where it can be traded and that helps create share value because folks want it. With EnCap holding a big chunk of it that was never going to happen.

Also, this gives us one more area to go look to drill wells when the time’s right.

Investor: Why this particular company and assets?

Anderson: The assets were a good fit. It was a big, chunky, PDP [proved developed producing] asset with lots of cash flow, and we like that first and foremost because it’s easier to finance. In this case the bank market was receptive, and we increased the size of our revolver. We did it with bank debt and equity, which is our MO to keep our balance sheet simple and reasonably levered. And this deal will take us to a little over 1x leverage debt-to EBITDA, and that’s very comfortable for us.

Investor: Did you get any upside, and were you looking for upside?

Anderson: We always look for inventory that either is better than what we have or can least fit into an allocation of capital in a program. And so this comes with inventory. We see 4,900 net acres with 70-plus horizontal locations in the Spanish Pearl area, which is at the Midland-Ector county line, very similar to what we have in our own assets in Midland County.

Investor: There was also a large acreage package in the southern Midland Basin.

Anderson: It’s definitely PDP, but it does have upside; there’s been some horizontal drilling in the Wolfcamp as well as other horizons. We’ll tear it apart, look at it, get the help of IRM during this transition to understand it, and then figure out if it’s got some upside that maybe just needs a higher oil price, or maybe some exploration opportunities. We’ll sit on it for a little while and figure out how it folds in, but that was not a focus of the acquisition.

Investor: What were the acquisition metrics on that?

Anderson: IRM third-quarter production was about 8,700 barrels of oil equivalent per day. The $183 million purchase price gets you roughly to 20,000, 22,000 per boe flowing, and we were $10 million valuation above PDP value at strip pricing. So, we paid for a little bit of upside. We did it at a reasonable valuation on a flowing metric compared to historical deals.

Given where the market is today and what valuations are, we thought it was fair and win-win for both sides because they got equity. Since we’ve been talking about the deal that equity has gone up more than twice in value to when we got to closing, so that’s a pretty good run. We think that’s the upside and the allure to doing something with Earthstone: We have a piece of paper that is somewhat liquid and has the ability to grow in value quite a bit. We’re both pretty pleased with the outcome.

Investor: Do you see the A&D market as ripe for opportunistic deals at the present?

Anderson: I think it’s always ripe for opportunistic deals as long as the volatility with prices isn’t going nuts. That’s why deals in the first six or eight months of 2020 couldn’t happen because of that volatility. But toward the end of the year, we saw a lot of deals and mergers of equals—including us—because of less volatility in prices. I think there are still more opportunities out there that will happen this year.

Investor: Are you looking to add in the Eagle Ford also?

Anderson: We have looked at Eagle Ford for deals, and we’ll continue to look there for deals. The Midland Basin is our primary focus, and we’ll continue to hopefully grow there, but we’ve got a small footprint in the Eagle Ford and for the time being our plan is to keep our Eagle Ford and keep looking because there are deals out there. We’re seeing some deal flow of marketed processes.

“We’ve always looked to fight another day, and if you can’t be in a position where you can get up tomorrow and fight, then you’re doing something wrong in your organization.”

Investor: What is your outlook for consolidation in the Permian?

Anderson: I think there will continue to be consolidation. There are too many companies and so much fixed G&A that the margins aren’t good enough, so sooner or later you have to consolidate and operate with a lot less. Companies individually have operated throughout 2020 with a lot less because they were forced to but, as an industry, to become further investable whether publicly or privately, we need to have some of those fixed costs removed from the system.

Investor: By necessity then?

Anderson: By necessity. We’ve exploded with the number of companies. If you look at the late ’90s, we had a lot of private and public independent companies, but we lost some of those names through consolidation because people thought that oil prices were never going to recover. Then with the recovery in oil prices and access to capital over the last 10 or 15 years, the proliferation of companies was tremendous. I think we’ve reached that point now where it’s saturated and it will come back down.

Investor: What makes Earthstone an aggregator?

Anderson: We’ve got a great platform and great people. We have a tried-and-true track record of creating shareholder value, and we want to continue to do so. We’ve got a good balance sheet. We’ve got great supporters in EnCap and now Warburg, two big, private equity sponsors that recognize we’ve created value and we can continue to grow. Ultimately, we’ve got public investors who like what we’re doing, and the proof is in what happened over the last few weeks with our stock price and our volume. We’re just not done. We’ve got more capacity.

SIDE BAR:

THE LODZINSKI CONNECTION

It’s hard to tell Robert Anderson’s story without mentioning Frank Lodzinski, Earthstone’s executive chairman. Lodzinski has been a build-and sell-specialist since the 1980s and was the driving force behind the Southern Bay to GeoResources to Halcón exit. Anderson mentored under Lodzinski as a part of his executive team for 17 years before taking over the CEO role.

He quips, “My change to CEO was effective April 1 of 2020, a really good time, right?”

Anderson first joined Lodzinski and his core team in 2004 at AROC Inc., a Gulf Coast, Permian and Midcontinent private producer as vice president for A&D and engineering. AROC was a predecessor to Lodzinski’s Southern Bay Energy, a platform that took over publicly held GeoResources. Anderson was executive vice president and COO over GeoResource’s Bakken assets.

Following GeoResources’ sale to Halcon Resources, Anderson rejoined the Lodzinski team at Oak Valley in 2013, and the rest is history. Lodzinski stepped out of the day-to-day operations early in 2020, handing Earthstone’s controls to Anderson.

“He’s been a lot more than just a boss or a partner. He’s taught me an incredible amount about being in this business. I spent a year or so as president, and maybe I’ve been groomed for this for a long time, so he finally got [me] to the point where I knew enough and he could turn the keys over.”

Anderson noted a number of Earthstone employees and investors preceded even his arrival on the team.

“Some of these guys have been with Frank for over 20 years, in the office and in the field.” The culture, he said, gives everyone autonomy to do their job, with a voice at the table. “It’s a team sport and everybody has to pull their weight. And everybody gets some kind of reward out of it.”

Investors, too, have stayed on board for the long haul. Besides EnCap Investments, which is on its third placement with the Earthstone management, other individual and institutional investors have placed their faith in the team for up to 30 years, he said.

“We’ve created a culture for creating value with those guys and they’re still
with the stock.”

Anderson said he feels a duty to continue Lodzinski’s core beliefs. “I have the duty to make sure we keep a financially sound company, to continue to grow shareholder value and grow the culture among our employees like we’ve had for the last 17 years when I came the first time, which is work hard.”

Investor: Why did you cancel the Sabalo acquisition in 2018?

Anderson: Prices cratered. We signed the deal in October at $74 oil, and by December oil prices got very low. The amount of debt we were using and the leverage would have been just too great. You could make a case to go back and renegotiate, but we had raised a debt facility that was pretty big, we had equity going to the seller, we had some convertible preferred, and Sabalo had a drillco that was a tag-along, which also would have had to have been renegotiated. It just would have taken a lot of surgery to extract all the pieces and put them all back together again.

Also, Sabalo is an EnCap company. We had already offered as much equity as the sellers wanted to take and any more would make EnCap greater than a 75% to 80% owner [of Earthstone]. That would have made sense to probably go private at that point, but that didn’t mesh up with their goals.

Investor: Do you still consider it a good decision?

Anderson: If we had a perfect crystal ball and knew by the middle of 2019 oil prices recovered, maybe we should have kept on going. But the leverage was just too great. Had we had everything hedged and closed much quicker, it probably would’ve worked. When you didn’t have as much hedged as you needed to and oil prices fell as far as they did as quickly as they did, it was a good decision to walk away.

Investor: How important is scale in the eyes of Wall Street investors?

Anderson: I think small companies need scale to attract new investors. Does that mean we don’t have good investors today? No, absolutely not. We’ve got great investors. We’ve got investors who’ve been around for quite some time owning our stock, and some of them were investors in GeoResources who made a significant return on that investment. But to get the long-only investors who do invest in oil and gas—and there may not be very many of them left—to attract them we need to be bigger.

And we also need to have more trading volume because these investors can chip away and can buy shares, but if they need to get out in a hurry for some reason, it’s hard to do it when your volume is so small. And that’s what we’ve recognized over the years.

“We are not trying to build the next empire. We are trying to create shareholder value, and we think the way to do it outside of putting a for sale sign out is just keep operating appropriately and—sooner or later—you will get noticed.”

When we had GeoResources, for instance, we had the same problem when we first got started, and we did three different equity deals along the way to get our volume up. Ultimately some big, long-only money managers noticed the scale, noticed the trading volume, and invested.

Scale is important but has nothing to do with the fundamentals of our business about being able to minimize LOE or maximize margins. You can do that at any size. But to get Wall Street interested, we’ve got to have scale.

Investor: What does that look like? What kind of scale do you need to attract more Wall Street interest?

Anderson: You’ve got to be in the billions [market cap]. Is that $1 billion or $5 billion? I don’t know the answer. I think there’s continually going to be investors who will play in the smaller-cap-scale companies and as you get bigger, you just get bigger investors. And that is what we’re striving for.

Today we’re at $500- or $600 million. We have 78 million shares outstanding as of this deal and we’re trading at close to $6. In November we were under $3.

Investor: Can a small-cap company compete for public investor capital in today’s marketplace, or are they just off the radar for now?

Anderson: You can’t get back on the radar if you don’t put up good metrics, if you don’t have a good balance sheet. I’m not going to say 1x leverage is the answer. Maybe you can get away with 2x leverage, but you’ve got to have liquidity, lower leverage and be able to operate with the highest margins possible. And then you will get exposure to the public investor who is willing to play because the growth potential in a small-cap stock is obviously much higher than with a major or larger independent, for instance.

Right now we’ve all had the luxury of growing since last March or April when our stocks were beaten up badly. But at the normal status quo, a $50 environment, the little guy growing probably has the potential for an outsized return.

Investor: My perception is that they’re only going for the largest caps now.

Anderson: In a very volatile, rough time, they’re looking for security, right? If you’re going to stay invested in the oil and gas space, you’re going to go to the big guys for security. But as long as the small guy is operating and putting up good metrics, I think the investor will come back to us.

Investor: You position Earthstone as a growth company but, from your perspective, how does the investment community view growth vs. returns for a company your size?

Anderson: For small companies, return of capital is limited. Smaller companies get traded on some kind of cash flow or EBITDAX multiple, so if you’re not spending capital and growing your EBITDAX, then your valuation is probably going down from a public company standpoint.

Now, if you can’t spend capital because you’re overlevered, and you’re paying the banks every month, then you’re in a difficult cycle. We are different in that we’re not overlevered. We can run a one-rig program and still have free cash flow to continue to pay down debt. And so we’re sitting in the best of both worlds where we have options to spending capital and growing.

Investor: Are you generating free cash flow presently?

Anderson: Yes, but we didn’t spend any capital to speak of in 2020 because we stopped our drilling program in May. We completed some wells at the very end of the year, so we spent $70 million and analysts have us generating $140 million of EBITDAX.

Investor: When did you pivot to free cash flow positive?

Anderson: We were an outspender in 2019, but we were rotating to spending either a little bit plus or minus our cash flow in 2020 prior to March and the world shutting down. We can run a one-rig program now and have a little bit of both growth and free cash flow—and pay down debt. For a small company that’s a great position to be in. And if we don’t want to pay down debt, if we want to go and buy more assets, we have the luxury to do that. If we can find the right assets.

Investor: Is that a new directive for Earthstone, or will you go back to debt-induced growth once prices justify it?

Anderson: It’s going to depend a little bit on what the investing community wants us to do, right? And we have that flexibility where we can turn it on or turn it off. We could run two or three rigs—well, probably not three. We can run two rigs quite easily and outspend cash flow, but only by maybe 10%. There’d be debt growth, but production growth would be pretty significant.

We’re only going to do that if we get rewarded by the investors to have an outsized EBITDAX growth. If we’re not going to get rewarded by the investors, then we can still have EBITDAX growth within a one-rig and cash flow program.

Investor: Can you grow organically?

Anderson: Just through the drill bit? You bet. And that’s our plan. Acquisitions are somewhat serendipitous or, you know, just being in the right place at the right time with the right capital structure. We always continue to look for those opportunities because of gaining scale and wanting to be bigger in the public markets, but we always look at can we grow organically with a drill bit. And we can.

Investor: But can you grow organically at the pace you want, or is M&A a better option at this time?

Anderson: M&A is like big, giant stair steps, whereas organic drillbit growth is slow and steady. You’ve heard that when oil’s low, you can look for it on Wall Street much cheaper than you can drilling wells? We want to make sure we have that flexibility to do both. We’re compelled to continue doing consolidation for good, financially disciplined, technically disciplined acquisitions. And we’re going to continue to do that. We will look for opportunities that make sense.

Investor: Your track record is building public E&Ps and then selling. Is your goal, therefore, to be a larger scale, investable public E&P, or is it to achieve a certain critical mass where you become a target for another company?

Anderson: I don’t think those are diametrically opposed. I think you can run your business so that either one of those might happen. It takes the right capital market and chemistry to be bought. We’re going to continue to run the business and grow it, and if the chemistry and the market is right, then somebody will come along and talk to us at some point. That’s no secret. Everybody knows the track record.

“We’re compelled to continue doing consolidation for good, financially disciplined, technically disciplined acquisitions. And we’re going to continue to do that.”

We always have a “for sale” sign out. We are not trying to build the next empire. We are trying to create shareholder value, and we think the way to do it outside of putting a “for sale” sign out is just keep operating appropriately and sooner or later you will get noticed.

Investor: To what level are you aiming to pay down debt?

Anderson: The question is what level is low enough? A half a turn of leverage? There’s no reason to be zero. Using leverage at a 2% or 4% interest rate seems like a good idea to me if you’re making 40% or 50% rates of return wells and you can do that consistently. So yes, there is a point where we say we don’t need to pay down debt anymore. And if we’re big enough, maybe that’s okay. We pick up a second rig or we go buy some assets.

You do want leverage to be in a range low enough that you can survive these dips that we’re going to continue to have. We’ve seen them throughout our entire careers. That’s why we never want our debt to get to a point where it’s 2x and all of a sudden it becomes 3.5x when oil prices go down. You’ve got to be disciplined about using debt. We’ve spent a lot of time focusing on making sure that in a down price environment it doesn’t sink us.

Investor: When do you plan to add back any rigs?

Anderson: We don’t want to get that cart before the horse. We want to make sure that we’ve got all our land and inventory ready to go, which we’ve spent the last year working on because we weren’t drilling. We’re looking at how do we incorporate the IRM acreage to allocate capital. Within the first half of the year, we’ll have a rig running, and I hope it’s sooner than that.

Investor: When you do to put a rig back into play, where will it go?

Anderson: To the highest return projects that we have. So Midland County, Upton County and then the Midland County IRM assets. We’ll rotate between those three project areas.

Investor: Do you intend to add a second rig any time this year?

Anderson: We have a plan that shows a second rig and to see what that looks like. We’re going to walk before we run. We’ll get that first rig up and running, work out the kinks and get our team focused on that. And then we’ll take a look at where the market is and oil prices and different options and see if it makes sense to run a second rig.

SIDE BAR:

UPSIDE IN A DOWN YEAR

Responding like most E&Ps in 2020, Earthstone laid down its one rig and shut in about 70% of operated production in response to the oil price collapse early in the year. The forced pause resulting from the COVID-19-induced global supply glut had its benefits: capex for the year dropped by more than half, from $160 million in 2019 to an estimated $70 million for 2020. And as production was brought back online after a brief one-month hiatus, the company posted positive free cash flow for the first time—some $70 million projected by analysts. A basket of $60/bbl average hedges put in place in 2018 didn’t hurt either.

“2020 was a very difficult year for a lot of people, but it was pretty good for Earthstone,” said CEO Robert Anderson. “I’m really pleased with what we accomplished in 2020.”

Prior to the unforeseen events of the year, the company was already posturing to cash-flow neutral entering 2020 by dropping from two rigs to one to appease investor sentiment on volume growth and debt levels.

The suspension of Earthstone’s drilling program in May left 11 uncompleted wells in waiting, all in its core area in Upton County, of which six were completed and brought online in the fourth quarter. Those results will be made public in the company’s fourth-quarter report, but the production boost was enough to put total year 2020 production output in the growth category year-over-year, Anderson said. The remaining five wells will be completed in first-quarter 2021 before mobilizing a rig.

With the Permian’s stacked-pay opportunities, Earthstone tries to keep its drill-and-complete program simple by targeting one formation at a time with a top-down approach rather than developing all the zones in a defined cube at once. However, it will co-develop formations if it believes the reservoir will suffer damage if not developed simultaneously, which is what it did on the two Upton County pads now being completed.

“We felt strongly that they needed to be developed all at the same time or we were going to have issues trying to come back to one of those zones in the future. We drilled two Wolfcamp As, and the rest were Bs. We did drill one C there because there’s been some good C development offsetting us.”

Here, laterals average 8,500 ft in length spaced 880 ft to 1,000 ft apart. Completions are pumped at 2,500 lb of proppant and 50 bbl of water/ft on 160-ft stage spacing. “We don’t want to extend our fracs out too wide,” he said.

Earthstone also uses artificial intelligence technologies in its operations to lower costs. MWD tools are now accompanied by AI sensors that, using algorithms, make projections on where to turn the bit to stay in horizon. Completions are monitored in real time to determine the effectiveness of the hydraulic fracture. “Are we fracking it the right way?” he asked. “Are we rubble-izing the rock or creating a pipeline to the next well over?”

In March, Earthstone completed three wells in southeastern Reagan County in the southern Midland Basin, a carryover from the 2019 drilling program and an area that gets overlooked, Anderson believes. Two Lower Wolfcamp B wells flowed 1,617 bbl/d (85% oil) on an average 27-day peak rate before being temporarily shut in due to the COVID-19 outbreak. A Wolfcamp B Upper well averaged 1,483 bbl/d over those 27 days. With fewer land restrictions here, laterals average 10,000 feet.

“That’s an area that flies under the radar screen,” he said. “It’s an area that most people think is really gassy and has low rates. Over time those wells ended up being about 50% or 60% oil, so we know that the oil declines off and the gas increases, but we’re pretty pleased with the outcome there. Wells over 50 barrels a foot EUR are not uncommon in that part of the world. They’re pretty nice oil wells.”

Investor: What’s your plan for the Eagle Ford assets? Will they receive any capex in the near future?

Anderson: Everything that we could drill under a $50, $55 price environment we’ve drilled and everything else needs higher prices. I think over time maybe technology will help fix that as we change our frac designs.

Investor: In the past, your start-up model was to buy producing assets essentially to cover G&A, then to reverse merge into a small public company. Is that strategy still viable today for somebody else considering it?

Anderson: You haven’t seen that in a while. It’s getting harder now with the investing population being less. Coming out as a small, public company is pretty difficult today.

Then you have to have some ability to grow, and that by itself is constantly a challenge. Now, as consolidation happens and bigger companies start selling off assets, which I think will happen, I think you’re going to find assets getting put into the market because they’re not going to get any attention from the bigger guys. Maybe that creates the opportunity again for a small company to go out and acquire them.

Investor: Are you suggesting that it would be better to stay private in the current environment because the public markets aren’t there for growth opportunities?

Anderson: Absolutely.

Investor: What advice would you give to next-generation management teams to guide them through volatile events like we’ve seen in the past year?

Anderson: Having lived through these environments like the past year, and really since the end of 2014 when oil prices crashed, makes you better manager and makes you recognize that if you get out over your skis, you’re going to end up taking a tumble. Having good folks around you in all the different disciplines will help you succeed.

And watch the way you finance and structure deals. A debt leverage ratio at one oil price is a totally different leverage ratio when your EBITDAX drops in half because oil prices dropped in half. If you can’t pay down debt fast enough to avoid those kinds of issues, then that deal probably isn’t right for you. A combination of debt and equity are really important.

Then, you need a little luck. For several months we’ve seen the tide rise and we’ve all felt a lot better than we did last March and April. We’ve always looked to fight another day, and if you can’t be in a position where you can get up tomorrow and fight, then you’re doing something wrong in your organization.

Investor: Why should an investor consider Earthstone at this time? What sets you apart?

Anderson: For one, we’ve got a track record of returning value to shareholders. Two, we get up every day and we work hard on all the operating metrics, trying to make sure we have the highest margins possible and protecting for downside risk, meaning keeping leverage as low as we can. We continue to focus on hedging to protect some of that downside—not to make a call on where oil prices are, but to protect for 2020-like events.

And last, we’re going to continue to be one of the survivors in this business. Many companies have had a rough go of it, and we actually feel that we’re set apart from that in that we haven’t had survival issues. Our issue in ’20 was, how are we going to thrive through that environment? And I think what you saw at the end of the year with the IRM deal is an example of how we thrived, and we’ll continue to look for opportunities to do that.

I’m looking forward to 2021.