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Morningstar | Laredo Prioritizing Capital Efficiency With Low-Density Development Plan

Laredo Petroleum's third-quarter financial results were as expected, with adjusted EBITDA and adjusted earnings per share coming in at $161 million and $0.27, respectively (consensus estimates were $159 million and $0.28). Production was 71 thousand barrels of oil equivalent per day in the third quarter, consistent with prior guidance and 18% higher year over year. However, while management ratcheted up full-year growth guidance to 17% from 15%, it now expects only 7.5% year-on-year oil growth (down from 10% previously).

The deterioration in mix was driven by unexpectedly high second-year oil declines. To mitigate this, management is switching to low-density development with four to eight wells per spacing unit. This should improve well performance over time and enhance capital efficiency. The downside is that with wider spacing, the firm’s inventory contains only 1,600 undrilled locations--less than half of what we were previously modeling. Even so, that’s still more than 20 years of potential runway at the current pace. Thus, the negative impact on our valuation is modest. We have lowered our fair value estimate to $7 per share from $8. Even so, Laredo is currently trading below our fair value estimate, given that the stock has slipped 35% since the end of September, dwarfing the losses of most peer firms as well as the broader market.

Overall, our thesis is unchanged: We still think other operators are better positioned to deliver returns to shareholders over time. Since the downturn, Laredo has done an admirable job boosting efficiency while keeping costs down (on average, drilling days per 10,000’ was down 25% year on year and lease operating expense has been under $4/boe for nine straight quarters). Also, the company continues to benefit from contiguous acreage that lends itself to very long laterals offering superior economics, all else equal. But the location of the firm’s acreage on the eastern fringe of the Midland Basin results in much weaker oil cuts than what other operators are enjoying in the core of the play, and the decision to switch to low-density drilling suggests that the acreage quality differential could be even steeper than we thought. A weaker oil mix results in lower prices, narrower margins, and higher operating leverage, which makes the firm more vulnerable to commodity price fluctuations.