Ring Energy Stock: Goodbye Hedges (NYSE:REI)

(Note: This article appeared in the newsletter on May 10, 2022, and has been updated as needed with current information.)

And hello cash flow! The second quarter pricing for all oil and gas companies, including Ring Energy (NYSE:REI), was even better than the first quarter. So, that means earnings and cash flow will jump in the second quarter when compared to the first quarter.

Management had a plan that was rudely interrupted first by the OPEC pricing war and then by the coronavirus demand destruction. Despite the fact that the debt acquired to purchase the Northwest properties was originally seen as conservative by many, the unplanned challenges of fiscal year 2020 changed that overnight. Now some more unplanned events have come to the aid of the company’s deleveraging goals. The good news for shareholders is that the market will notice the unexpected debt progress sooner rather than later.

Probably the largest progress by far is the growth in cash flow before the changes in operating assets and liabilities. Accounts Receivable alone soaked up a fair amount of cash generated in the first quarter because commodity prices rose. Therefore, the amount of receivables from customers also rose along with the prices.

That accounts receivable growth should diminish in the second quarter. But the ability to generate some very good cash flow should remain. That will increase the ability of the company to retire some debt as the year proceeds.

Management has wisely pursued growth as well as debt repayment. The company had an original plan to use debt to get to a proper level of production as the company left the development or lease acquisition stage. But 2020 abruptly stopped the transition. That left management with insufficient cash flow compared to the debt, with an asset story that was now meaningless to lenders. Now conditions are allowing a gradual return to the original plan.

Management announced a continuing rig program that should allow for production growth. Production growth will allow for a far superior cash flow stream, even if commodity prices drop significantly from current levels. Most wells drilled in the current environment pay back within months. It is, therefore, very easy to justify drilling wells while keeping an eye out for any hint of pricing weakness. That payback can easily be protected with some hedging should the need arise.

In the meantime, management has announced the end of the hedging program. Evidently, that is not completely the case as management added some hedges with considerably better pricing. Right now, there is more production exposed to commodity prices than has been the case for some time.

Consistent hedging is generally looked at by the market as a zero-sum game. Therefore, hedging programs are generally not valued at all by the market. This managing is changing to an opportunistic hedging. That can be a lot riskier because management does not hedge unless they think they need to. Many times, that plan of operation does not work. Therefore, the appearance of the latest hedges is a welcome sight. It appears management is willing to bear some additional risk. But management is not going “all the way” to opportunistic hedging.

Current prices have the debt ratios well within allowable territory. This management, through production increases and repaying debt, has a goal to have reasonable ratios at considerably lower prices. This is a company that probably needs a year of the current prices to really get itself back on track. Two years would be even better.

Right now, the ability to repay debt is extremely important to the lending market. So that will have priority. The good news is the current prices also allow for that full time rig as well. So, management did not have to choose between growth and debt repayment. As growth proceeds and cash flow meets management’s objectives, there should be a relaxation of the lender attitude towards debt repayments.

Most likely, the asset story of the value of the leases is back in operating order in the current environment. So, the loan should be protected as well as it was when it was first made. That consideration alone may allow the company at some point to entertain more debt to get that production to the minimum optimal amount that is cost-effective.

Management is likely to repay about $40 million of debt in the current fiscal year while growing production roughly 15%. Cash flow before changes in operating accounts should remain at least $35 million in each of the quarters. As long as prices do not head back in the $40 range for oil, this company should recover nicely enough to be able to put the challenges of the past few years aside.

Any money obtained from the sales process underway of some noncore leases would rapidly accelerate debt repayment. In the current environment, the banks may allow a second rig, as was originally planned, to operate. That would allow a much faster monetization of anticipated profits from the Northwest properties.

The reason that may happen is that the annualized first quarter cash flow is in the $140 million range. The properties to be sold have some older production that is likely more expensive to produce than the company average. Therefore, the reduction in cash flow may not be quite as significant as some investors expect. It could easily be replaced by operating a second rig for a little while without using all the sales proceeds. Newer production tends to be a lot more profitable than older production.

The outlook at Ring Energy is very good for the first time in a few years. There are going to be a lot more shares outstanding than was the case before the coronavirus demand destruction. But there are also a lot of profit opportunities here.

So far, the recovery has been somewhat muted by the debt issues and the increase in shares outstanding. The growth in production and cash flow should go a long way towards resolving debt ratio issues that plague some companies. Steady progress in repaying the debt will have a similar effect.

The stock price will respond to steady progress. This is a very conservative management that ran into an unfortunate future occurrence that no one saw coming. They are not the only ones either, as a lot of development stage and companies converting to operating stage were caught in the consequences of fiscal year 2020 challenges. Here, the debt levels combined with the very profitable wells will allow management to “drill its way out” of the whole situation. Not many managements have that option. Now let us see what the future holds.