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Water Tower Research was founded by Wall Street veterans after witnessing a fundamental shift in the investment research industry with the result being a declining knowledge base among investors, a lack of awareness and a shrinking pool of fundamental research being conducted on companies across the small-cap and micro-cap spectrum. The same issues are now increasingly occurring in the mid-cap space. This sea change within the investment community is impacting not only the companies themselves but also current shareholders and potential investors. With significantly less active sell-side sponsorship by Wall Street, a substantial information gap has developed between companies and various constituents in the financial community. The net result is fewer channels for insight and information to flow between companies and investors.

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<h3>KEY POINTS</h3>
<ul>
<li>Acquisitions have positioned Earthstone to generate significant free cash flow. 4Q22 financial and operating results will be the first to include the cumulative effect of three major acquisitions that closed in the first eight months of 2022.</li>
<li>The midpoint of 4Q22 production guidance (98-102 MBOE/d) reflects a ~230% Y/Y increase from 4Q21. Our 4Q22 EBITDA estimate reflects a near 300% Y/Y increase from 4Q21.</li>
<li>Earthstone’s Permian Basin asset base provides the flexibility to allocate development capital across a deep inventory, depending on the prevailing cost and commodity price environment. Management estimates its ~256,000 net acres in the basin expose the company to 890 gross operated development locations, including 528 acquired during 2022 in the Delaware Basin.</li>
<li>Results from 3Q22 development drilling met or exceeded management’s estimates. Earthstone operates five rigs across its acreage, including three in the Delaware Basin and two in the Midland Basin.</li>
<li>We expect Earthstone to provide operating and financial guidance for 2023 in 1Q23. The current five-rig pace is expected to sustain production level with 4Q22.</li>
<li>Our FY23 earnings and cash flow estimates are predicated on 100 MBOE/d of production and costs similar to 4Q22. We estimate FY23 EBITDA of $1,378 million. Estimated free cash flow could be used to reduce borrowings, fund incremental acquisitions, and possibly a cash-return-to-shareholders’ scheme at some point next year.</li>
<li>On an adjusted EV/EBITDA basis, Earthstone is trading at 1.7x our FY23 estimates.</li>
</ul>
<h3>ESTIMATES</h3>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/354/original/image_459496684151670869807507.png?1670869809" class="editor-image img-responsive" data-smartkarma-image-id="315354"></figure>
<h2>ENTERING 2023 WITH PERMIAN SCALE</h2>
<p>Acquisitions closed over the past year and a half have transformed Earthstone’s Permian Basin asset base (see Figure 1). A combination of cash and common equity has allowed management to close six significant acquisitions for total consideration of ~$2.5 billion (70% cash / 30% equity). When the transactions were announced, Earthstone estimated the proved developed PV-10 of the acquired reserves was ~$2.7 billion, equating to a purchase price discount of nearly 10%.</p>
<p>The three most impactful transactions closed during 2022 for an aggregate ~$2.1 billion. At year-end 2021, Earthstone’s proved reserves, under SEC guidelines, totaled 148 MMBOE (63% proved developed). Pro forma for the Chisholm, Bighorn, and Titus acquisitions, which closed during 2022, estimated proved reserves as of October 1, 2022, were 354 MMBOE, a 139% increase. Likewise, the PV-10 value using September 30 NYMEX strip pricing adjusted for differentials more than doubled to ~$4.8 billion from ~$2.0 billion. It’s worth noting that Earthstone’s current ~$2.9 billion enterprise value is a ~39% discount to the October 1 PV-10 value.</p>
<p>Figure 1: Scale Provides Capital Allocation Options&nbsp;(1)</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/355/original/image_694082757161670869834311.png?1670869835" class="editor-image img-responsive" data-smartkarma-image-id="315355"></figure>
<div class="content-remarks">
<p>(1) Year-end proved reserve and PV-10 are based on SEC guidelines. Pro forma reserves and PV10 estimates were prepared by Earthstone management as of October 1, 2022, using NYMEX strip pricing and basis differentials as of September 30, 2022.</p>
<p>Source: Company reports</p>
</div>
<p>Earthstone now controls an inventory of 890 gross operated drilling locations on ~256,000 net acres in the Permian Basin. Nearly 80% of the inventory was added by the six acquisitions. The Chisholm (414) and Titus (114) acquisitions added 528 gross operated locations in the Delaware Basin portion of Lea and Eddy Counties, New Mexico. Of the total acreage, ~212,000 net acres are in the Midland Basin and the remaining ~44,000 net acres are in the Delaware Basin. The company’s year-end 2021 Permian acreage position totaled 102,122 net acres. Earthstone’s acreage in both basins exposes shareholders to a stacked section of primary and secondary target zones (see Figure 2). The primary zones have been delineated by wells across the acreage and by offset operators. Two large acreage positions afford management the flexibility to maintain a continuous development program targeting multiple reservoirs. Development can be allocated based on the targets that offer the highest return potential in the prevailing cost and commodity price environment.</p>
<p>Figure 2: Permian Acreage and Development Optionality</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/356/original/image_183522453171670869864453.png?1670869866" class="editor-image img-responsive" data-smartkarma-image-id="315356"></figure>
<div class="content-remarks">
<p>Source: Company reports</p>
</div>
<p>The 2022 acquisitions fulfilled the goal of building scale in Earthstone’s development inventory (Chisholm and Titus) and free-cash-flow capacity (Bighorn). Earthstone will enter 2023 with the flexibility to allocate cash flow to development drilling to sustain the production base and use excess cash flow for other options, including reducing leverage, incremental asset acquisitions, and possibly a cash-return-to-shareholders’ scheme. We expect incremental acquisitions to follow the pattern set by Earthstone’s recent history. Namely a balance between drilling opportunities supported by assets that generate free cash flow. The ultimate goal is to deliver profitable growth for the benefit of shareholders.</p>
<p>Earthstone is developing the asset base with three operated rigs in the Delaware Basin and two in the Midland Basin. The third Delaware Basin rig was picked up following the Titus acquisition in August. During 3Q22, Earthstone spud 12 gross (12.0 net) wells and brought seven gross (6.3 net) wells online in the Midland Basin. Six gross (3.3 net) wells were spud and 12 gross (5.2 net) wells were brought online in the Delaware Basin.</p>
<p>Results from 3Q22 drilling activity met and, in some instances, exceeded management’s expectations. Five wells on the Barnhart pad in Irion County averaged peak IP-30 gross rates of ~1,170 BOE/d (81% oil) from ~10,000-foot completed laterals in the Wolfcamp B formation. The wells were drilled on acreage acquired in the Tracker acquisition, which closed in July 2021. Over the life of the wells in Irion County the oil / natural gas ratio shifts toward natural gas. Management has identified 40 additional gross locations that could generate attractive returns when gas prices are strong.</p>
<p>In the Delaware Basin, Earthstone brought on the Cletus and Salt Draw two-well pads in Eddy County. The two Cletus wells had peak IP-30 average gross rates of ~1,370 BOE/d (69% oil) from ~9,750-foot completed laterals in the Wolfcamp A formation. The two Salt Draw wells had peak IP-30 average gross rates of ~1,570 BOE/d (77% oil) from ~4,700-foot completed laterals in the Second Bone Spring formation. Six wells that Titus drilled in Lea County were completed in September with average gross peak IP-30 rates of ~1,520 BOE/d (73% oil) from ~7,700-foot completed laterals in the First and Second Bone Spring formation.</p>
<h2>FINANCIALS</h2>
<h2>Earnings and EBITDAX Projections</h2>
<p>Earthstone’s 3Q22 production averaged 94.3 MBOE/d (41% oil / 68% liquids) compared with 25.8 MBOE/d in 3Q21. Production benefited from the cumulative effect of the Foreland, Chisholm, Bighorn, and Titus acquisitions, which have been closed since November last year. The cumulative impact of the ~$2.2 billion of acquisitions that have closed since 4Q21 will be felt in 4Q22. 3Q22 operating results included a contribution from the Titus acquisition from its closing on August 10, 2022. Management expects 4Q22 production will fall in the range of 98-102 MBOE/d. Earthstone’s 4Q22 guidance is outlined in Figure 3. We expect management to provide an FY23 outlook in 1Q23.&nbsp;</p>
<p>Figure 3: 4Q22 Guidance</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/357/original/image_9746267181670869893782.png?1670869895" class="editor-image img-responsive" data-smartkarma-image-id="315357"></figure>
<div class="content-remarks">
<p>Source: Company reports</p>
</div>
<p>Earthstone will enter 2023 with five operated drilling rigs working in the Permian Basin. Management has indicated its intention to retain three operated rigs in the Delaware Basin and two in the Midland Basin. Five rigs are expected to sustain FY23 production level with 4Q22. We have developed our FY23 earnings and EBITDA estimates based on average daily production of 100 MBOE/d and average NYMEX oil and natural gas prices of $85/bbl and $5.94/MMBtu, respectively.</p>
<p>The transformation driven by Earthstone’s acquisitions is illustrated in Figure 4. The magnitude of the step change in production with FY23, ~230% higher than 4Q21, contributes to a ~300% EBITDA increase to ~$1.4 billion. We highlight that the step change in EBITDA comes on just a 2% increase in the estimated realized sales price per BOE. Our summary earnings and cash flow productions are shown in Figure 5.</p>
<p>Figure 4: Production and Annualized EBITDA Growth</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/358/original/image_93154360191670869956230.png?1670869957" class="editor-image img-responsive" data-smartkarma-image-id="315358"></figure>
<div class="content-remarks">
<p>Source: Company reports and Water Tower Research estimates</p>
</div>
<p>Figure 5: Summary Earnings and Cash Flow Projections</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/359/original/image_704563220201670869978747.png?1670869980" class="editor-image img-responsive" data-smartkarma-image-id="315359"></figure>
<div class="content-remarks">
<p>Source: Company reports and Water Tower Research estimates</p>
</div>
<h2>Hedge Profile</h2>
<p>Earthstone’s hedge profile includes a combination of swaps, collars, deferred premium puts, and basis swaps for oil and swaps and collars for natural gas (see Figure 6). Our model includes the company’s swap, collar, and deferred premium put positions. Based on our 4Q22 NYMEX reference price deck, we estimate a realized hedge loss of $26 million, bringing total realized hedge losses for FY22 to $196 million. The 2023 hedge profile is more weighted to collars and deferred premium puts. Our FY23 production estimates imply that oil downside is limited to 36% of production at an average price of $67.55/bbl and upside is capped at 24% of production at an average price of $80.23/bbl. For natural gas, 31% of our estimated FY23 production is hedged through a combination of swaps and collars at an average floor price of $3.69/MMBtu and an average ceiling price of $6.77/MMBtu. To shield against dramatic movements in Permian natural gas prices at the WAHA hub, basis swaps are in place on 140 MMBtu/d of FY23 gas production, representing 75% of our estimate at an average differential of ($1.674/MMBtu).</p>
<p>Measured against our NYMEX reference price deck, we estimate FY23 realized hedge losses of ~$47 million. Considerably lower estimated FY23 hedge losses will be much less of a drag on EBITDA and help support the expectation for significant EBITDA growth in 2023.</p>
<p>Figure 6: Oil and Natural Gas Hedge Profile&nbsp;(1)</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/360/original/image_568906330211670870011368.png?1670870012" class="editor-image img-responsive" data-smartkarma-image-id="315360"></figure>
<div class="content-remarks">
<p>(1) Oil downside protected volumes and floor price include swaps, collars and deferred premium puts. Oil upside capped volumes and ceiling price include swaps and collars. Natural gas average floor and ceiling price include swaps and collars.</p>
<p>Source: Company reports and Water Tower Research estimates</p>
</div>
<h2>Capitalization</h2>
<p>Earthstone’s balance sheet is strong (see Figure 7). As of September 30, 2022, $642 million was drawn on the company’s RBL credit facility. RBL borrowings include a fully funded $250-million term loan tranche as part of the elected commitment. The latest RBL borrowing base redetermination was completed on September 29, 2022, resulting in an increase to $1.85 billion from $1.7 billion. The elected commitment remained $1.2 billion.</p>
<p>Figure 7: Capitalization&nbsp;(1)</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/361/original/image_982172115221670870048122.png?1670870049" class="editor-image img-responsive" data-smartkarma-image-id="315361"></figure>
<div class="content-remarks">
<p>(1) Adjustments include 3.0 million shares repurchased from Warburg Pincus on October 11, 2022. Equity capitalization as of December 9, 2022.</p>
<p>Source: Company reports</p>
</div>
<p>Net debt, including $550 million of 8.0% senior unsecured notes, was ~$1.2 billion as of September 30, 2022. The leverage ratio was 0.9x annualized 3Q22 EBITDA. Exploration and development capital expenditures are expected to fall in the range of $519-534 million. Our FY22 discretionary cash flow estimate is ~$1.0 billion, suggesting that Earthstone could generate ~$500 million of free cash flow during FY22, including ~$125 million in 4Q22. As mentioned earlier, management has indicated that free cash flow could be used for debt reduction, funding incremental acquisitions, and possibly a cash-return-to-shareholders’ scheme in 2023. Debt reduction is the first priority. For FY23, we estimate discretionary cash flow of ~$1.3 billion. Our $775 million capital spending assumption implies free cash flow of ~$465 million. We estimate year-end 2023 net debt of $645 million equating to a leverage ratio of 0.5x.</p>
<h2>Valuation</h2>
<p>Earthstone is trading at 1.7x our FY23 EBITDA estimate (see Figure 8). Adjusted enterprise value includes our year-end 2023 net debt estimate of $645 million. As referenced earlier, Earthstone’s current enterprise value reflects a ~39% discount to the October 1, 2022, PV-10 of ~$4.8 billion. Based on our adjusted YE23 enterprise value of ~$2.4 billion, incorporating estimated free cash flow, Earthstone is trading at a ~50% discount to October 1, 2022, PV-10.</p>
<p>Figure 8: Adjusted EV / FY23E EBITDA Valuation&nbsp;(1)</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/315/362/original/image_182945998231670870089678.png?1670870090" class="editor-image img-responsive" data-smartkarma-image-id="315362"></figure>
<div class="content-remarks">
<p>(1) Share price and equity capitalization as of December 9, 2022</p>
<p>Source: Company reports and Water Tower Research estimates</p>
</div>
<h3>DISCLOSURES</h3>
<p>Water Tower Research (“WTR”) is a professional publisher of investment research reports on public companies and, to a lesser extent, private firms (“the Companies”). WTR provides investor-focused content and digital distribution strategies designed to help companies communicate with investors.<br><br>WTR is not a registered investment adviser or a broker/dealer nor does WTR provide investment banking services. WTR operates as an exempt investment adviser under the so called “publishers’ exemption” from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940. WTR does not provide investment ratings / recommendations or price targets on the companies it reports on. Readers are advised that the research reports are published and provided solely for informational purposes and should not be construed as an offer to sell or the solicitation of an offer to buy securities or the rendering of investment advice. The information provided in this report should not be construed in any manner whatsoever as personalized advice. All users and readers of WTR’s reports are cautioned to consult their own independent financial, tax and legal advisors prior to purchasing or selling securities.<br><br>Jeff Robertson, who is the writer of this report, covers the Natural Resources sector for WTR. Mr. Robertson and members of his household have no personal or business-related relationship to the subject company other than providing digital content and any ancillary services WTR may offer.<br><br>Unless otherwise indicated, WTR intends to provide continuing coverage of the covered companies. WTR will notify its readers through website postings or other appropriate means if WTR determines to terminate coverage of any of the companies covered.<br><br>WTR is being compensated for its research by the company which is the subject of this report. WTR receives no more than a maximum of $10,500 per month from a given client and is required to have at least a 6-month commitment. None of the earned fees are contingent on, and WTR’s client agreements are not cancellable for the content of its reports. WTR does not accept any compensation in the form of warrants or stock options or other equity instruments that could increase in value based on positive coverage in its reports.<br><br>WTR or an affiliate may seek to receive compensation for non-research services to covered companies, such as charges for presenting at sponsored investor conferences, distributing press releases, advising on investor relations and broader corporate communications and public relations strategies as well as performing certain other related services (“Ancillary Services”). The companies that WTR covers in our research are not required to purchase or use Ancillary Services that WTR or an affiliate might offer to clients.<br><br>The manner of WTR’s research compensation and Ancillary Services to covered companies raise actual and perceived conflicts of interest. WTR is committed to manage those conflicts to protect its reputation and the objectivity of employees/analysts by adhering to strictly-written compliance guidelines.<br><br>The views and analyses included in our research reports are based on current public information that we consider to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness, timeliness, or correctness. Neither we nor our analysts, directors, officers, employees, representatives, independent contractors, agents or affiliate shall be liable for any omissions, errors or inaccuracies, regardless of cause, foreseeability or the lack of timeliness of, or any delay or interruptions in the transmission of our reports to content users. This lack of liability extends to direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, losses, lost income, lost profit or opportunity costs.<br><br>All investment information contained herein should be independently verified by the reader or user of this report. For additional information, all readers of this report are encouraged to visit WTR’s website www.watertowerresearch.com.</p>

KEY POINTS

Acquisitions have positioned Earthstone to generate significant free cash flow. 4Q22 financial and operating results will be the first to include the cumulative effect of three major acquisitions that closed in the first eight months of 2022.
The midpoint of 4Q22 production guidance (98-102 MBOE/d) reflects a ~230% Y/Y increase from 4Q21. Our 4Q22 EBITDA estimate reflects a near 300% Y/Y increase from 4Q21.
Earthstone’s Permian Basin asset base provides the flexibility to allocate development capital across a deep inventory, depending on the prevailing cost and commodity price environment. Management estimates its ~256,000 net acres in the basin expose the company to 890 gross operated development locations, including 528 acquired during 2022 in the Delaware Basin.
Results from 3Q22 development drilling met or exceeded management’s estimates. Earthstone operates five rigs across its acreage, including three in the Delaware Basin and two in the Midland Basin.
We expect Earthstone to provide operating and financial guidance for 2023 in 1Q23. The current five-rig pace is expected to sustain production level with 4Q22.
Our FY23 earnings and cash flow estimates are predicated on 100 MBOE/d of production and costs similar to 4Q22. We estimate FY23 EBITDA of $1,378 million. Estimated free cash flow could be used to reduce borrowings, fund incremental acquisitions, and possibly a cash-return-to-shareholders’ scheme at some point next year.
On an adjusted EV/EBITDA basis, Earthstone is trading at 1.7x our FY23 estimates.

ESTIMATES

ENTERING 2023 WITH PERMIAN SCALE
Acquisitions closed over the past year and a half have transformed Earthstone’s Permian Basin asset base (see Figure 1). A combination of cash and common equity has allowed management to close six significant acquisitions for total consideration of ~$2.5 billion (70% cash / 30% equity). When the transactions were announced, Earthstone estimated the proved developed PV-10 of the acquired reserves was ~$2.7 billion, equating to a purchase price discount of nearly 10%.
The three most impactful transactions closed during 2022 for an aggregate ~$2.1 billion. At year-end 2021, Earthstone’s proved reserves, under SEC guidelines, totaled 148 MMBOE (63% proved developed). Pro forma for the Chisholm, Bighorn, and Titus acquisitions, which closed during 2022, estimated proved reserves as of October 1, 2022, were 354 MMBOE, a 139% increase. Likewise, the PV-10 value using September 30 NYMEX strip pricing adjusted for differentials more than doubled to ~$4.8 billion from ~$2.0 billion. It’s worth noting that Earthstone’s current ~$2.9 billion enterprise value is a ~39% discount to the October 1 PV-10 value.
Figure 1: Scale Provides Capital Allocation Options&nbsp;(1)


(1) Year-end proved reserve and PV-10 are based on SEC guidelines. Pro forma reserves and PV10 estimates were prepared by Earthstone management as of October 1, 2022, using NYMEX strip pricing and basis differentials as of September 30, 2022.
Source: Company reports

Earthstone now controls an inventory of 890 gross operated drilling locations on ~256,000 net acres in the Permian Basin. Nearly 80% of the inventory was added by the six acquisitions. The Chisholm (414) and Titus (114) acquisitions added 528 gross operated locations in the Delaware Basin portion of Lea and Eddy Counties, New Mexico. Of the total acreage, ~212,000 net acres are in the Midland Basin and the remaining ~44,000 net acres are in the Delaware Basin. The company’s year-end 2021 Permian acreage position totaled 102,122 net acres. Earthstone’s acreage in both basins exposes shareholders to a stacked section of primary and secondary target zones (see Figure 2). The primary zones have been delineated by wells across the acreage and by offset operators. Two large acreage positions afford management the flexibility to maintain a continuous development program targeting multiple reservoirs. Development can be allocated based on the targets that offer the highest return potential in the prevailing cost and commodity price environment.
Figure 2: Permian Acreage and Development Optionality


Source: Company reports

The 2022 acquisitions fulfilled the goal of building scale in Earthstone’s development inventory (Chisholm and Titus) and free-cash-flow capacity (Bighorn). Earthstone will enter 2023 with the flexibility to allocate cash flow to development drilling to sustain the production base and use excess cash flow for other options, including reducing leverage, incremental asset acquisitions, and possibly a cash-return-to-shareholders’ scheme. We expect incremental acquisitions to follow the pattern set by Earthstone’s recent history. Namely a balance between drilling opportunities supported by assets that generate free cash flow. The ultimate goal is to deliver profitable growth for the benefit of shareholders.
Earthstone is developing the asset base with three operated rigs in the Delaware Basin and two in the Midland Basin. The third Delaware Basin rig was picked up following the Titus acquisition in August. During 3Q22, Earthstone spud 12 gross (12.0 net) wells and brought seven gross (6.3 net) wells online in the Midland Basin. Six gross (3.3 net) wells were spud and 12 gross (5.2 net) wells were brought online in the Delaware Basin.
Results from 3Q22 drilling activity met and, in some instances, exceeded management’s expectations. Five wells on the Barnhart pad in Irion County averaged peak IP-30 gross rates of ~1,170 BOE/d (81% oil) from ~10,000-foot completed laterals in the Wolfcamp B formation. The wells were drilled on acreage acquired in the Tracker acquisition, which closed in July 2021. Over the life of the wells in Irion County the oil / natural gas ratio shifts toward natural gas. Management has identified 40 additional gross locations that could generate attractive returns when gas prices are strong.
In the Delaware Basin, Earthstone brought on the Cletus and Salt Draw two-well pads in Eddy County. The two Cletus wells had peak IP-30 average gross rates of ~1,370 BOE/d (69% oil) from ~9,750-foot completed laterals in the Wolfcamp A formation. The two Salt Draw wells had peak IP-30 average gross rates of ~1,570 BOE/d (77% oil) from ~4,700-foot completed laterals in the Second Bone Spring formation. Six wells that Titus drilled in Lea County were completed in September with average gross peak IP-30 rates of ~1,520 BOE/d (73% oil) from ~7,700-foot completed laterals in the First and Second Bone Spring formation.
FINANCIALS
Earnings and EBITDAX Projections
Earthstone’s 3Q22 production averaged 94.3 MBOE/d (41% oil / 68% liquids) compared with 25.8 MBOE/d in 3Q21. Production benefited from the cumulative effect of the Foreland, Chisholm, Bighorn, and Titus acquisitions, which have been closed since November last year. The cumulative impact of the ~$2.2 billion of acquisitions that have closed since 4Q21 will be felt in 4Q22. 3Q22 operating results included a contribution from the Titus acquisition from its closing on August 10, 2022. Management expects 4Q22 production will fall in the range of 98-102 MBOE/d. Earthstone’s 4Q22 guidance is outlined in Figure 3. We expect management to provide an FY23 outlook in 1Q23.&nbsp;
Figure 3: 4Q22 Guidance


Source: Company reports

Earthstone will enter 2023 with five operated drilling rigs working in the Permian Basin. Management has indicated its intention to retain three operated rigs in the Delaware Basin and two in the Midland Basin. Five rigs are expected to sustain FY23 production level with 4Q22. We have developed our FY23 earnings and EBITDA estimates based on average daily production of 100 MBOE/d and average NYMEX oil and natural gas prices of $85/bbl and $5.94/MMBtu, respectively.
The transformation driven by Earthstone’s acquisitions is illustrated in Figure 4. The magnitude of the step change in production with FY23, ~230% higher than 4Q21, contributes to a ~300% EBITDA increase to ~$1.4 billion. We highlight that the step change in EBITDA comes on just a 2% increase in the estimated realized sales price per BOE. Our summary earnings and cash flow productions are shown in Figure 5.
Figure 4: Production and Annualized EBITDA Growth


Source: Company reports and Water Tower Research estimates

Figure 5: Summary Earnings and Cash Flow Projections


Source: Company reports and Water Tower Research estimates

Hedge Profile
Earthstone’s hedge profile includes a combination of swaps, collars, deferred premium puts, and basis swaps for oil and swaps and collars for natural gas (see Figure 6). Our model includes the company’s swap, collar, and deferred premium put positions. Based on our 4Q22 NYMEX reference price deck, we estimate a realized hedge loss of $26 million, bringing total realized hedge losses for FY22 to $196 million. The 2023 hedge profile is more weighted to collars and deferred premium puts. Our FY23 production estimates imply that oil downside is limited to 36% of production at an average price of $67.55/bbl and upside is capped at 24% of production at an average price of $80.23/bbl. For natural gas, 31% of our estimated FY23 production is hedged through a combination of swaps and collars at an average floor price of $3.69/MMBtu and an average ceiling price of $6.77/MMBtu. To shield against dramatic movements in Permian natural gas prices at the WAHA hub, basis swaps are in place on 140 MMBtu/d of FY23 gas production, representing 75% of our estimate at an average differential of ($1.674/MMBtu).
Measured against our NYMEX reference price deck, we estimate FY23 realized hedge losses of ~$47 million. Considerably lower estimated FY23 hedge losses will be much less of a drag on EBITDA and help support the expectation for significant EBITDA growth in 2023.
Figure 6: Oil and Natural Gas Hedge Profile&nbsp;(1)


(1) Oil downside protected volumes and floor price include swaps, collars and deferred premium puts. Oil upside capped volumes and ceiling price include swaps and collars. Natural gas average floor and ceiling price include swaps and collars.
Source: Company reports and Water Tower Research estimates

Capitalization
Earthstone’s balance sheet is strong (see Figure 7). As of September 30, 2022, $642 million was drawn on the company’s RBL credit facility. RBL borrowings include a fully funded $250-million term loan tranche as part of the elected commitment. The latest RBL borrowing base redetermination was completed on September 29, 2022, resulting in an increase to $1.85 billion from $1.7 billion. The elected commitment remained $1.2 billion.
Figure 7: Capitalization&nbsp;(1)


(1) Adjustments include 3.0 million shares repurchased from Warburg Pincus on October 11, 2022. Equity capitalization as of December 9, 2022.
Source: Company reports

Net debt, including $550 million of 8.0% senior unsecured notes, was ~$1.2 billion as of September 30, 2022. The leverage ratio was 0.9x annualized 3Q22 EBITDA. Exploration and development capital expenditures are expected to fall in the range of $519-534 million. Our FY22 discretionary cash flow estimate is ~$1.0 billion, suggesting that Earthstone could generate ~$500 million of free cash flow during FY22, including ~$125 million in 4Q22. As mentioned earlier, management has indicated that free cash flow could be used for debt reduction, funding incremental acquisitions, and possibly a cash-return-to-shareholders’ scheme in 2023. Debt reduction is the first priority. For FY23, we estimate discretionary cash flow of ~$1.3 billion. Our $775 million capital spending assumption implies free cash flow of ~$465 million. We estimate year-end 2023 net debt of $645 million equating to a leverage ratio of 0.5x.
Valuation
Earthstone is trading at 1.7x our FY23 EBITDA estimate (see Figure 8). Adjusted enterprise value includes our year-end 2023 net debt estimate of $645 million. As referenced earlier, Earthstone’s current enterprise value reflects a ~39% discount to the October 1, 2022, PV-10 of ~$4.8 billion. Based on our adjusted YE23 enterprise value of ~$2.4 billion, incorporating estimated free cash flow, Earthstone is trading at a ~50% discount to October 1, 2022, PV-10.
Figure 8: Adjusted EV / FY23E EBITDA Valuation&nbsp;(1)


(1) Share price and equity capitalization as of December 9, 2022
Source: Company reports and Water Tower Research estimates

DISCLOSURES
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Permian Scale Supports Free Cash Flow Capacity

Earthstone Energy

Permian Scale Supports Free Cash Flow Capacity