Mariner: Smooth Sailing Ahead
We view Mariner Energy (ME; $23) as an attractive oil and gas exploration and production company, with expanding acreage positions in the Gulf of Mexico and West Texas expected to drive double-digit production, reserve, earnings, and cash-flow growth over the next several years. We believe Mariner has a quality asset base and a sizable inventory of prospects, including high-impact deepwater projects and underexploited assets in the conventional shelf of the Gulf of Mexico, which are complemented by steady West Texas Permian Basin assets.
With strong production growth and high oil and gas prices, Mariner, by our analysis, will have plenty of cash flow from its asset base to fund its exploration and development program, which consists of high-impact deepwater projects in the Gulf of Mexico. We also expect Mariner to continue to replace its reserves at competitive finding and development costs.
Including the effects of property acquisitions, we expect the company to increase production by 25% in 2007 and 38% in 2008. Coupled with a consistent hedging policy that mitigates the downside risk of oil and gas prices and our view that there are several upcoming catalysts for the shares over the next several quarters, we view the shares as undervalued. We have assigned the stock Standard & Poor's highest investment recommendation of 5-STARS, or strong buy.
Houston-based Mariner is an independent oil and gas exploration, development, and production company with principal operations in the Gulf of Mexico and the Permian Basin in West Texas. In the Gulf of Mexico, areas of operation include the deepwater and the shelf area.
Reserves: As of Dec. 31, 2006, Mariner's estimated proved reserves of 716 Bcfe (billions of cubic feet equivalent, a unit of measure used to equate natural gas and oil volumes), of which approximately 60% consisted of natural gas and 40% oil, condensate, and natural gas liquids, compared to 338 Bcfe at Dec. 31, 2005, or a 112% increase. The company's acquisition of Forest Oil in 2006 added 298 Bcfe of proved reserves. Excluding the effects of the acquisition, Mariner estimates a three-year reserve replacement rate of 280%, ahead of peers, at a three-year finding and development cost of $1.70 per MMcfe (millions of cubic feet equivalent), a very attractive level, in our opinion. We estimate Mariner's reserve life to be 8.9 years, in line with Gulf of Mexico peers.
Strategy: Until 2005, Mariner grew reserves primarily through the drill bit—by identifying and developing high-impact shelf, deep shelf, and deepwater projects in the Gulf of Mexico. In 2005, Mariner added significant proved reserves through onshore acquisitions in West Texas. As part of its growth strategy, Mariner will seek to continue to acquire producing assets that have the potential to provide acceptable rates of return and further reserve additions. Mariner manages its risk profile by targeting a balanced exposure to development, exploitation, and exploration opportunities.
The company intends to continue to develop and expand its West Texas asset base, which we believe contributes stable cash flows and long-lived reserves to its portfolio as a counterbalance to its high-impact, high-production Gulf of Mexico assets. Furthermore, it seeks to diversify risk in drilling projects by entering into arrangements with industry partners. Mariner intends to continue sharing costs of offshore activities by selling interests in projects.
Mariner expects to continue its strategy of growth through the drill bit. It plans to achieve growth by generating prospects internally and by selectively participating in prospects generated by other operators. The company believes the Gulf of Mexico is an area that offers substantial growth opportunities, as evidenced by its acquisition of Forest Oil's Gulf of Mexico operations.
Exploration and Production: In the first half of 2007, Mariner's production totaled 46.7 Bcfe, compared to 31.7 Bcfe in the first half of 2006, up 47%. In the second half, we are anticipating a 13% increase in total production from the first half of the year. For full-year 2007, we expect production of 99.2 Bcfe, a 25% increase from 2006 levels, mainly on acquisitions, development, and improved recovery of deepwater assets. With the continued development of these projects, we project a 38% increase in 2008 production. We see improvements at High Island and Mississippi Canyon adding 70 to 100 MMcfe per day in the second half of 2007. In 2008, the Bass Lite and NW Nansen deepwater projects should add 50 to 75 MMcfe per day in the first half of the year.
On the exploration front, Mariner has drilled 14 of 19 successful wells year-to-date and has another 6 to 9 scheduled for 2007. Although Mariner drilled only 22 development wells (with 100% success) in West Texas in the second quarter, vs. 33 in the first quarter, management noted that it is now running six rigs in the area, up from five. We expect a four-well program at Eugene Island 342 to commence in the second half of the year. Mariner sees nice upside associated with this property. Vermillion 380, another a four-well project, should also be getting under way shortly.
Hedging Policies: In an effort to reduce the effects of the volatility of crude oil and natural gas prices on Mariner's operations, management has elected to hedge oil and gas production through the use of fixed swaps and costless collars.
For the remainder of 2007, we estimate Mariner has hedged 65% of its crude oil production and 45% of natural gas production. We estimate Mariner has hedged 25% of 2008 total estimated crude oil production and 20% of estimated 2008 natural gas production.
Based on data from analytical firm Global Insight, our current price estimates are $68.68 per barrel in 2007 and $74.25 in 2008 for crude oil, and $7 per thousand cubic feet (Mcf) and $8.11 per Mcf for natural gas. Given our production and oil and gas price estimates, we anticipate increases in earnings before interest, taxes, depreciation, and amortization (EBITDA) of 31% and 41% and earnings-per-share (EPS) growth of 11% and 36% for 2007 and 2008, respectively.
Exploration and Development Budget: Mariner's exploration and development capital expenditures for 2006 were $518.5 million. In addition, the company invested $70.9 million in acquisitions other than the Forest Oil transaction during the year and incurred $56.5 million in hurricane repairs. Mariner's capital expenditure budget for 2007 is $658 million, excluding an estimated $19 million related to the 2005 hurricanes. About a third of the budget will be dedicated to exploration activities; the remainder will go to development, including $157 million allocated to the Bass Lite and NW Nansen deepwater projects. Geographically, the budget will be allocated 45% to shelf, 43% to deepwater, and 12% to West Texas projects. We believe the company will be able to fund its budget using operating cash flow.
Mariner's shares are up about 16% year to date compared to a 24% rise in the S&P Oil & Gas Exploration & Production Index (as of Sept. 28). We attribute the relative underperformance to the company's disappointing deepwater drilling results last quarter. However, we believe the underperformance has been too pronounced given Mariner's strong drilling track record and several impact projects coming on line to potentially provide major production increases.
The shares were recently trading at 9.6 times our 2008 EPS estimate and at a 3.7X enterprise value-to-projected 2008 EBITDA, both discounts to peers. We view the stock as a compelling value at current levels, with the company exhibiting strong production, reserve, earnings, and cash-flow growth.
We expect Mariner's EPS to achieve a three-year compound annual growth rate of 18%, ahead of peer exploration and production companies in our universe. (Our 2007 and 2008 EPS estimates are $1.75 and $2.38.) However, Mariner's stock recently traded at a 33% price-earnings discount and at a 35% enterprise value-to-EBITDA discount to its exploration and production peers in our universe. We view the discount as unwarranted given Mariner's quality asset base and sizable inventory of prospects, including high-impact deepwater projects, underexploited assets in the conventional shelf of the Gulf of Mexico, and steady West Texas Permian Basin assets.
We base our 12-month target price of $29 on a blend of our relative analyses, all below average peer valuations, but premiums to current levels. We also blend our discounted-cash-flow model, which assumes a weighted average cost of capital of 18.7% and a terminal growth rate of 3% and indicates an intrinsic value of $30.
Our view of Mariner's corporate governance is generally favorable. The board of directors has only one inside director, Chief Executive Scott Josey and no affiliated outsiders. In addition, the compensation and executive committees consist solely of independent outside directors. Some other positives: The performance of the board is reviewed regularly, and officers and directors have a vested interest in Mariner, owning a combined 1.4% of the outstanding stock.
However, an area of concern for us is that the chairman and CEO roles are filled by the same person, which we believe presents a potential conflict of interest. In general, we believe a nonaffiliated chairman better serves the interest of shareholders.
Risks to our recommendation and target price include declines in production volumes and crude oil and natural gas prices. Other risks include changes to economic, industrial, or operating conditions, including difficulty in replacing reserves and heightened geopolitical risk.