EUR 850.00 For Business Accounts Only

Morningstar | LPI Updated Star Rating from 24 May 2019

After a closer look at Laredo Petroleum's first-quarter operating and financial results, we are raising our fair value estimate to $6 per share, which reflects a 100% premium to the last closing price.

We believe this stock is one of the most compelling opportunities in the upstream oil and gas segment. Only a year ago, it was trading above $10, before Laredo announced a midstream dispute with Shell that left it vulnerable to Permian Basin basis differentials right before a major pipeline capacity shortage took hold in the region (the first-quarter news release hints at a favorable settlement of the resulting litigation). However, the subsequent failure of the firm’s downspacing initiative was a bigger driver. This compromised well performance, leading to weaker initial production rates and unexpectedly high oil declines.

We were spooked too, eventually cutting our fair value estimate to $2.50 per share, $0.30 below the early 2019 bottom. In hindsight, though, that looks like a severe overreaction. The firm has now completed the last of its downspaced wells, paving the way for a resurgence in well productivity during 2019 now that it has reverted to 4-8 wells per drilling spacing unit in each reservoir layer. The incremental performance under this configuration was established in 2016-17, with about 75 wells averaging over 100 barrels of oil equivalent per day per thousand lateral feet in the first 90 days of production. Though wider spacing means fewer potential drilling opportunities, the firm still has around 1,600 locations to work through, translating to more than 20 years of runway at the current pace. Laredo has also made considerable progress cutting costs since the change in strategy was announced and has shaved off over $1.50 per barrel in operating expenses. Given the firm’s relatively high operating leverage, this improvement is highly accretive to our valuation.

The unfavorable location of Laredo’s acreage on the eastern fringe of the Permian Basin will always prevent it from earning the same returns as its peers in the more profitable core of the basin. Laredo is also growing at a more modest clip than most Permian operators. So it certainly deserves to trade at a discount. However, at just 3.2 times consensus EBITDA in 2020, that discount is overdone, in our view. For reference, the other Permian pure plays we cover are trading at about 6 times 2020 EBITDA on average, while our current fair value estimate for Laredo shares--double the market price--translates to a multiple of only 4.3 times.