Callon Petroleum Company (NYSE:CPE) Q4 2022 Earnings Call Transcript

Callon Petroleum Company (NYSE:CPE) Q4 2022 Earnings Call Transcript February 23, 2023

Operator: Ladies and gentlemen, thank you for standing by, and welcome to the Callon Petroleum Fourth Quarter and Full Year 2022 Earnings Conference Call. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Kevin Smith, Director of Investor Relations. Please go ahead, sir.

Kevin Smith: Thank you, Regina. Good morning, and thank you for taking the time to join our conference call. With me on today’s call are Joe Gatto, President and Chief Executive Officer; Dr. Jeff Balmer, SVP and Chief Operating Officer; and Kevin Haggard, SVP and Chief Financial Officer. During our prepared remarks, we may reference our fourth quarter and full year earnings press release, our 2023 outlook news release and our supplemental slides, all of which are available on our website at www.callon.com. Today’s call will include forward-looking statements that refer to estimates and plans. Actual results could differ materially due to risk factors noted in our presentation and in our periodic SEC filings. We will also refer to some non-GAAP financial measures, which we believe help to facilitate comparisons across periods and with our peers.

For any non-GAAP measures we reference, we provide a reconciliation to the nearest corresponding GAAP measure. You may find these reconciliations in the appendix to the earnings presentation slides and in our earnings press release, both of which are available on our website. Following our prepared remarks, we will open the call for Q&A. I would now like to turn the call over to Joe Gatto. Joe?

Joe Gatto: Thank you, Kevin. Good morning, and welcome, everyone. We have a lot of good news to share with you and are excited about our plans to unlock the tremendous value we see in Callon today. By now, I trust you’ve had a chance to review our 2 press releases issued last night, one detailing our Q4 results and the other, our 2023 outlook. These are accompanied by other supplemental disclosure slides on our website. We will reference a few of these slides in today’s call, but I encourage you to review the entire package to provide background for questions. As demonstrated in our fourth quarter and full year 2022 results, we had a strong finish to the year on the production front despite periods of adverse weather conditions, and we’re right on the mark with our capital spending forecast.

Looking forward, our 2023 business plan is designed to capture capital efficiencies through larger scale projects, and we expect to deliver solid returns and help offset industry-wide inflation, ultimately creating value for our shareholders through reinvestment in our high-quality inventory. We are eager to address your questions, so we plan to keep the prepared remarks relatively brief today. The call today will be divided into 3 buckets. First, I will outline our key objectives for 2023. We are confident that our 2023 development plan will drive significant free cash flow, clearly demonstrate improved efficiencies through continued application of our life-of-field co-development model and enable us to further reduce debt balances. Next, we will move to a brief summary of our fourth quarter and full year 2022 financial and operational highlights.

And lastly, I’ll discuss our capital allocation framework and some important updates on our path to returns of capital. Let’s get started. Our top priorities in 2023 are pretty simple: invest in our premier assets to generate free cash flow and pay down debt. To the last point, our track record of strengthening the balance sheet has been outstanding. Since the first quarter of 2021, we’ve improved our leverage ratio by more than 3 turns or over 70%. Overall, we anticipate investing approximately $1 billion this year with more than 80% of our D&C activity allocated to high-return Permian Basin projects, which are expected to generate average IRRs of approximately 70% and average pay-outs of less than 2 years. Callon has a premier asset base with an inventory of over 1,500 risk locations and core zones, representing over 10 years of locations that are economic at $60 per barrel or lower, and that’s assuming current service costs.

We are fortunate to be positioned with the quality asset base we possess today, which is the result of many years of important decisions related to building our team and the development strategy we have employed on our multi-zone asset base over time. Our Life of Field co-development model has been a key tenet of Callon’s operations going back several years as we built our position in the Midland Basin, and that loss be carried with us into the Delaware Basin upon our initial entry in 2017. While co-development is not unique to Callon, we are part of a select group that has adhered to the strategy over time. This is a critical point. The power of the model comes from the cumulative impact of consistent application over time, ultimately creating an inventory with more consistent quality into the future and maximizing the NPV of the resource base.

Focusing on one element of our development model, we will continue to increase the average number of wells targeted within our projects this year, co-developing multiple zones to mitigate risks associated with parent-child well interactions and balancing today’s well productivity with tomorrow’s value proposition. In addition to the subsurface optimization, there are also economies of scale that translate into D&C savings. In 2023, our average project size will increase by over 20%. Importantly, as our development program has achieved critical mass and we’ve established a solid ongoing DUC inventory, we can increase the use of simultaneous operations to reduce our cycle times. We estimate that our simultaneous D&C activities will reduce cycle times by approximately 20%, which significantly improves capital efficiency, even as larger project sizes are used.

On the cost savings front, our scale program has been instrumental in limiting the inflationary increase in our D&C cost per foot to roughly 10% year-over-year. I ask you to now take a look at Slide 10. This is a powerful chart that really captures the prospective impact of our life of field focus and the implications for sustainable free cash flow generation. Over the next 5 years, we expect that our annual capital efficiency metrics as measured by total capital invested divided by total average daily production will be consistent and directionally improve on average under the development scenarios captured. This dynamic is underpinned by a couple of key drivers. In terms of wedge production from new drilling activity, which is the production that is incremental to establish base production, we expect to benefit from the relatively consistent return profiles of new co-development projects as discussed earlier, improved project cycle times from the ongoing use of simultaneous operations and optimization of project sizes over time and leveraging of past facilities investments as we return to previously developed areas.

In addition, capital efficiency will benefit from the maturing of our corporate PDP decline profile over time. Clearly, this type of analysis represents a point-in-time outlook with several underlying assumptions and resulting outputs, but I want to make sure there’s one key takeaway. The capital efficiency profile embedded in our current inventory provides differentiated flexibility for meaningful capital allocation to what we envision as the 3 key drivers of shareholder value going forward. Disciplined investment in high-return inventory, ongoing debt reduction and an impactful return of capital program. Let me switch gears and cover our fourth quarter and full year 2022 financial and operating results. For the fourth quarter, total production averaged 106,000 barrels of oil equivalent per day and oil sales averaged just over 66,000 barrels per day.

Both were in line with expectations despite weather impacts we experienced from winter storms around year-end. For the year, our 2022 production increased by about 9% over 2021. We generated $412 million in adjusted EBITDA and posted adjusted net income per diluted share of $3.36 during the fourth quarter. Our results were driven by strong well performance and the continued strength of both oil and natural gas realizations. We realized 102% of NYMEX WTI during the fourth quarter, owing to our close proximity to premium Gulf Coast markets and contracts tied to waterborne and international pricing. Of particular importance, 2022 marked the third consecutive year that we posted improvements in EBITDA margins. Our work to control costs through supply chain efficiencies, LOE reductions from the Primexx acquisition and strong price realizations has helped us enhance margins and mitigate industry-wide inflation.

Overall, our cash operating costs during the fourth quarter were in line with expectations with LOE per BOE down 2% sequentially and cash G&A in line with the previous quarter. Proved reserves at year-end were approximately 480 million BOE, of which 57% were oil and 85% weighted to the Permian, with an associated PV-10 value of $10.5 billion. During 2022, we added 68 million BOE from extensions and discoveries, which represented 180% of 2022 production. As a result, our proved developed reserve volumes grew by 7% over 2022 to approximately 295 million BOE, with an associated PV-10 value of $7.1 billion. Said another way, the PV10 value of just our proved developed reserves represents over $75 per share in equity value after deducting debt balances.

We get a lot of questions from shareholders regarding our capital return strategy. Our answer has been consistent. Let’s make sure that we have addressed the balance sheet first and not declare victory too soon. We made tremendous progress on this front, which was recognized in credit rating upgrades from all 3 agencies in 2022. We reduced our debt by $462 million last year and by more than $715 million since the start of the first quarter of 2021. In sum, the balance sheet is very close to being in a position for us to implement a return of capital program. But before I address this further, let’s take a step back and start with a few points on the broader allocation of the cash flow generated from operations. Callon has a deep and robust inventory development projects and an outlook for improving capital efficiencies as evidenced by the stats around our 2023 capital program.

Reinvestment in our assets is the cornerstone of our strategy and disciplined capital allocation into an asset base with consistent return profile that provides confidence in our ability to generate sustainable free cash flow. Given the high returns and quick payouts on our portfolio of investments, we expect to generate a significant amount of free cash flow for allocation to an expanded set of shareholder value initiatives. Based on the assumptions detailed in the presentation, we expect to generate more than $2.75 billion of free cash flow over the next 5 years under our baseline development scenarios. As a frame of reference, this amount of free cash flow represents approximately 125% of our equity market cap and over 60% of our total enterprise value today.

The next logical question is how will we deploy this free cash flow? We expect to achieve our key $2 billion debt milestone later this year, which is now our only gating financial metric to achieve before adding a return of capital program. So this element will now squarely be part of our broader capital allocation framework. And as to the form of this program, based on our equity value today and our desire to retain financial flexibility, we believe the highest return proposition for execution of a capital return framework for shareholders as a stock repurchase program. In addition to capturing the value arbitrage between our public market valuation and our internal view of intrinsic value, share repurchases will enhance production growth per share beyond our organic potential and also increased per share exposure to our strong inventory position.

And to front run the question, we will be detailing elements of this program as we get closer to formal initiation. I want to make one last point here and refer you to Page 8 of the materials and the check list on the left-hand side of the page. Just to be clear, even when we reach $1 billion in debt and commenced capital return initiatives, debt reduction will continue to be a key priority for our free cash flow deployment with an eye towards achieving less than $1.5 billion of gross debt and a leverage ratio of less than 1x. Before taking your questions, I’ll summarize what we believe are the key ingredients for Callon to warrant a premium valuation. A deep and high-quality inventory that contributes to an improving capital efficiency profile over the next 5 years of development, our life-of-field co-development model that has been consistently followed over the past several years differentiates our longer-term asset value proposition.

A solid plan to obtain our $2 billion debt milestone and commenced the return of capital to shareholders later this year that will complement further debt reduction and the successful integration of ESG initiatives and targets across the business, which tied to compensation to incentivize right behaviors. Overall, we are confident that the execution of our plan will close a significant valuation gap we see in our equity today. This concludes our prepared remarks, and we are now happy to take your questions. Operator, we’ll turn it back to you.

Q&A Session

Operator: Our first question will come from the line of Neal Dingmann with Truist Securities.

Neal Dingmann: First, my first question is on the operating plan, really, Joe, for you or the guys. Just wondered how sensitive is this plan would you consider to the energy tape? Or maybe asked another way, what would it take to add or drop 1 or 2 of those current, I think, 7 rigs you have?

Joe Gatto: Neal, I think we’re pretty well dialed in on this program with a large-scale program. There’s a lot of planning that goes into that. And we’re we got to stay very well advanced of our plan. So we’ll see how the commodity shapes up. Obviously, alongside that, we got to see how service costs react because it’s not about any one headline price. I’d say that as we look at the landscape here, we look at our program and how we’re setting up for next year that we see optionality for additional activity into 2024 would probably be where we stand today, but 2023 is pretty locked in. On the flip side of that, if we see things pull back into the low 60s, probably time to revisit our plans moving forward. But for right now, we think this is a resilient plan. Obviously, with the return profiles that we’ve shown for 2023, there’s a lot of economics to go around and weather the ups and downs.

Neal Dingmann: And then just lastly, could you talk about — I know you’re getting much closer to sort of hitting those optimal leverage debt levels. Could you talk about — would you get — do you have to wait until you actually get there? Or maybe just talk about the time line, if you could.

Kevin Smith: We’ve been asked this question before our answer remains the same. When we hit those debt targets, we’ll be ready to go with an announcement.

Operator: Your next question will come from the line of Phillips Johnston with Capital One.

Phillips Johnston: Joe, on the third quarter call, you guys highlighted a 28% improvement in the Midland Basin well productivity just in terms of the 22 vintage wells relative to the average for the prior 3 years. Just wondering if you have an update on how the productivity is trending now.

Joe Gatto: I think we’re similarly in line with that, just because we didn’t have a huge body of work there in terms of extended performance. We didn’t provide an update here, but you can expect that as we move forward to keep supplementing that. Jeff, is there anything you want? The Midland Basin continues to be a very strong opportunity area, extremely good capital efficiency metrics across the board.

Phillips Johnston: And then on the LOE guidance, it looks like it’s ticking up a little bit, kind of $8 to $8.50 range from sort of the high 7s or so for ’22. Just wondering what the drivers might be there.

Joe Gatto: The primary ones are just some modest inflationary costs that we’re seeing. We’re hoping to obviously trim that back. One area that I would point out as a strong success is the significant improvement in the Delaware Basin South or over the Primexx acquisition occurred. Those have come down quite a bit despite the fact that inflation has continued through, of course, through 2022 and the beginning of 2023. But that’s the primary headwind is still a little bit of inflationary pressure that we hopefully again, anticipate nibbling away at that.

Operator: Your next question will come from the line of Paul Diamond with Citi.

Paul Diamond: I was wondering if you guys could just kind of walk-through kind of the rationale of shifting the kind of those gating targets more towards the asset debt leverage and kind of a kind of a wage leverage ratio. Is that more of a comment on your perceived disconnect in the equity value, which is why you’re focusing on the share you may focus on a share buyback? Kind of just walk through the thought process there.

Kevin Smith: I think what you’re asking is what happens to the 1x leverage target. And I would say in our discussions with debt and equity investors, based on our analyses internally, we realized that the absolute debt target is the key one here to help us get through any commodity price volatility. So for us, achieving that $2 billion milestone is going to represent a strong balance sheet. And I would say also that $2 billion is just the first stop. So we’re going to look to continue to reduce debt and one to reach what we call an optimal level. And that optimal level is less than $1.5 billion and less than 1x debt to EBITDA. And we say optimal, because at these levels of debt, we feel very comfortable with what our leverage metrics would look like down to a low $40 WTI price for a prolonged period of time. Does that help?

Paul Diamond: Just one quick follow-up on kind of just more of the macro inflationary environment. Through your conversations, are you seeing anything of, I guess, particular bright or dark spots across the complex? Is there anything that — conversations that are going well versus those that are going poorly kind of how you see those ramping out over the debt when we get down to the micro.

Kevin Smith: Very relevant question. I’m very happy with how we’ve addressed our 2023 needs earlier in the year in 2022. And so I feel like we have a very strong foundation from a contracting standpoint. We’re not in the market to get any new equipment right now relative to the drill bit and the completion side, which are our primary spends. But we are very foundationally solid relative to the pricing. If we see some break over in items like tubulars and casing, chemicals, some of the ancillary service items, we should be able to realize some cost savings of those things going forward into 2023. So that’s kind of where we sit.

Operator: Your next question will come from the line of John Annis with Stifel.

John Annis: Referencing Slide 11, I wanted to ask what in your view is driving the out-period productivity in the Delaware. Is it better fracture conductivity, rock quality? Any color would be much appreciated.

Joe Gatto: It’s one of the strong foundational items of Callon, I would suggest. If you look at the inventory and then the very thoughtful development programs that we put in place in the Delaware, that those multiple year thoughtful life afield development decisions that we’ve made have yielded what we see here on Page 11 as far as the co-development philosophy. And it’s fairly complicated, of course, and it adds in a number of items, the correct spacing and stacking, understanding the geology and the geologic barriers the existing natural fracture systems that you have in the area, the faulting systems that you have and then also how we propagate the systems based upon existing wells, so the parent-child relationships, et cetera.

And Callon has really been able to flex its muscles on its knowledge base. Primexx was a great example where they — that group had a tremendous subsurface data set that we were able to leverage everything from seismic all the way up to induced fracture propagation. So that whole aggregate set of disciplines, when you put that all together, that’s what’s needed in order to really put together a strong development program over multiple years, not just 1 year at a time. So it’s a little bit of a broad answer with some discipline specific items that roll into that. But we see the Delaware Basin has a strong competitive advantage for Callon.

Kevin Smith: And I’d just add there, I think that really well sums up our life of field development in a little bit more detail. We saw the power of that overlaying the model on Primexx. And also, what you’ll see life of field is not something just cookie-cutter overlay on something. There’s things that we continue to tweak, like completion designs that we’ve tested some larger proppant loadings there last year, which have a nice impact. We’ve sort of optimized some of our artificial lift programs over time with ESPs. So the Life Field model is very powerful, but we continue to look for ways to continuously improve that.

John Annis: Then shifting to the Midland, you showed some sticks on the map on Slide 21, planned for 2023 that are in or close to Dawson County. That appears to be the most northern wells drilled to date. Could you share any color on pre-drill expectations based on your subsurface work or industry activity?

Joe Gatto: They should be pretty much in line, that there are some geologic changes as you go up into the northwest in that area. We feel, again, we’re a very experienced Midland Basin operator. And we’ve taken advantage of being thoughtful about how we progressed our development programs in those areas. So we’ve seen very, very good well results in the center portion of that and feel good about expanding that up into the Northwest.

Operator: Next question will come from the line of Tim Rezvan with KeyBanc.

Tim Rezvan: I’d like to start with the, I guess, the 5-year free cash flow plan. I know it’s a volatile oil tape. That plan is predicated on $80 oil. We’re below that and we get continued bearish macro statistics. So I’m just curious, have you sort of stress tested this model? Is this something that will hold in a $50 to $60 kind of environment? And if we are in a sort of lower for longer environment, and you mentioned earlier, you could pull back rigs in the low 60s world. What is that free cash flow program kind of look like longer term? And is this sort of that in stone for better for worse, longer term?

Joe Gatto: I guess, Tim, I want to emphasize, those were scenarios based on, as you pointed out, the assumptions of $80 oil. So this is not set stone. There really meant to be scenarios. And as much as we’re trying to provide a 5-year outlook, I think the key point to take away from that is that capital efficiency profile, which really highlights the ongoing efficiencies within our inventory program that are relatively consistent over time that we don’t see any periods. We’re going to hit a cliff on capital efficiency because we’ve co-developed our asset base over time. That’s the biggest takeaway, Tim. So don’t take away from that. Well, they’re locked and loaded. Damn the torpedoes. This is what we’re going to do. But if you look at that capital efficiency, it gives us a lot of flexibility through ups and downs and tweaking the program to continue to deliver free cash flow, and that’s going to be used for debt reduction and returns of capital.

But the key point there is really just looking at that profile of capital efficiency, we think over time is going to be differentiated. That exact plan might not come to pass, but given that the tools that we have to work with gives us a lot of flexibility for the right outcomes on free cash flow.

Tim Rezvan: And then I just want to circle back, Joe. You mentioned kind of repurchases earlier. I wasn’t clear on what you were sort of referring to. I know there’s a pretty clear arbitrage and that’s sort of underscoring everything you’re doing here with the long-term strategy. But I guess, I know you can’t talk about the plan, but I think the concern would be if you implement it before a 1x leverage target that the intensity could have negative effects of oil declines. So can you just talk about the repurchases, what you’re referring to? And I guess how you’re thinking about the intensity of capital returns if you initiate something with leverage over 1x.

Kevin Smith: I think there’s a couple of questions there. One, you’re kind of asking what does the shareholder return program is going to look like. And that is the repurchases, right? We with the compelling value of our equity today, we think that the share buyback program is the first initiative, and we will definitely evaluate other potential methods and over time. And I would say this, we don’t have specifics as approved by the Board in terms of size, but we do believe a multiyear share repurchase authorization is going to allow us the most flexibility. Does that provide you enough guidance?

Tim Rezvan: Yes. I just think boxing yourself in with something rigorous could have a negative effect. So that’s . That makes a lot of sense. That’s all I was trying to understand.

Kevin Smith: Overall, when we’ve talked about this over time with investors, and we’ve had the chance to watch other programs get released over the last year plus, see how those age over time. But what was really clear to us was that we wanted to maintain flexibility. That was the #1 priority for us. So getting locked into things that were overly formulaic or maybe fixed in nature. At this juncture, I don’t think are appropriate for Callon because as a mid-cap company and the opportunities that we have, we want flexibility to be nimble and pinning us down, especially with leverage not exactly where we want to be long term yet, keeping flexibility its capital return program while still delivering on something in the near term that are really guiding post on this.

Operator: We have no further questions at this time. I’ll hand the call back over to Joe Gatto for closing remarks.

Joe Gatto: Thank you, and thanks again for joining. Hopefully, everyone joined this call. And obviously, please feel free to reach out to the team here with any questions, and we’ll look forward to talking to you next quarter. Thank you.

Operator: Ladies and gentlemen, that will conclude today’s meeting. Thank you all for joining. You may now disconnect.