CJES – A Play on North American Unconventional Resource Exploration

Overview

In combing through the IPO filings this year, I came across an interesting company that looks significantly undervalued: C&J Energy Services (CJES). This is an oil and gas services company that specializes in hydraulic fracturing, pressure pumping, and coiled tubing services, all of which are experiencing massive demand currently because of the interest in service intensive North American shale plays. For more information on why these services are in demand now, click here: http://www.pttc.org/aapg/lafollette.pdf

About a year ago, it was near impossible for E&P companies to get someone to fracture new wells in certain high demand plays like the Haynesville in Louisiana. But now, oil services companies are ramping up the available horsepower in their hydraulic fracturing fleets. This is spelling big growth numbers for the major players.

CJES attracted me because of its Trailing P/E of ~10, and its forward P/E of ~5. Further, it is trading at 42% below its IPO price, suggesting that it is well below proper valuation. I believe this is due to a mix of factors: the markets decreased demand for IPOs (almost all of which are down sharply), the recent downgrading of several onshore oil and gas service companies on concerns over the capital expenditure budgets of the major producers, and the recent drop in oil and natural gas prices. I think that all IPOs should not be traded similarly, so this cause is moot, the concern over capital expenditures is overdone, and oil prices have recovered substantially from their recent lows. The low natural gas prices are a cause for concern, but perhaps not as large as the market assumes. More on this in following paragraphs.

Business description

CJES has “fracking” fleets and coiled tubing units in the following areas: the Haynesville, the Eagle Ford, the Permian Basin, and the Granite Wash. Currently they have 172,000 horsepower available in 5 fracking fleets. They will get 2 more fleets in 2012, providing them with a total of 7 fleets and 270,000 horsepower. This is a 57% growth in available horsepower, and, if demand is sustained, should translate into large revenue growth numbers. CJES can adapt its fracking fleets to conventional, vertical wells, or unconventional, horizontal wells, utilizing one fracking fleet to handle either one horizontal well or two vertical wells at a time. This gives it greater flexibility in case the interest in horizontal drilling decreases, and greater utilization in areas where vertical drilling is used more, like the Permian Basin.

CJES also has 15 coiled tubing units, and 26 pressure pumps.

Since becoming public, their net profit margin is approaching the level that I really like: 20%. Of course, this is a very cyclic industry, depending on the forecast pricing for oil and gas. The financial strength of this company depends on the capital expenditure budgets of CJES’s major customers, which include: EOG Resources, EXCO Resources, Anadarko Petroleum, Plains Exploration, Penn Virginia, Petrohawk, El Paso, Apache and Chesapeake, along with some smaller players.

Risks

There are several major risks I see. One is that if all the major suppliers of hydraulic fracturing services are ramping up their fleets, we could actually run into a glut of supply in the next few years. To acquire the two new fracking fleets, CJES had to issue significant amounts of debt, and without revenue growth from those fleets, CJES will be hard-pressed to pay that off.
The new fracking fleets were not the only reason CJES issued new debt. CJES recently acquired Total, the manufacturer of almost all of CJES’s hydraulic fracturing pumps. This could be a great thing – the vertical integration can help reduce costs, increase maintenance efficiency, and provide opportunities for new growth in research and development of hydraulic pumping technology.  However, if demand falls, or if a supply glut is reached, this only means more debt that CJES is saddled with.

Demand for natural gas drilling is probably not sustainable with natural gas prices below $4. And, as you can see, the trend is clearly down:

These low natural gas prices are caused by over-production of natural gas from unconventional plays. I will write more on this situation in a later post.

However, CJES’s management has been shrewd enough to focus on liquids rich plays; three out of the four areas they are in are liquids rich: the Granite Wash, the Permian Basin, and the Eagle Ford. The demand for liquids is still high, because it is linked to oil prices, not gas prices. And with WTI prices creeping above $90 once again, this demand should be sustained for a while.

Conclusion

Unless the supply of fracking fleets and coiled tubing units outpaces the rising demand, I believe CJES will be able to pay down all its debt, and grow its earnings at phenomenal rates. This could be a huge gainer.

Disclosure: I have no position in any stock mentioned, but I may purchase a position in CJES in the next 7 days.

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