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Laredo Oil (NYSE: LPI) acquired more profitable land than the company already owned. Now, commodity market prices can slow down this strategy. But oil and gas always move in cycles.

This strategy is therefore still viable in the long term. But in the short term, the focus could be on operations. The price of raw materials is much higher than I thought when I started the article. The acquisition strategy could therefore well be put on hold in the short term until prices pull back somewhat.

Fortunately, the newly acquired profitable area is enough to keep management busy for years. Meanwhile, efficiency improvements and higher commodity prices are making the legacy acreage more profitable than it has been for some time. These two elements should allow the share price to outperform in the future.

Laredo Petroleum Effect of drilling on acquired acreage

Laredo Petroleum Effect of drilling on acquired acreage (Laredo Petroleum January 2022, corporate presentation)

Management has a drilling strategy commensurate with the acquisition strategy. This strategy consisted of drilling on the newly acquired area because it is very profitable while retaining the inherited area. Acquisitions have already “primed” the shift to a higher percentage of oil production. This led to accelerated margin improvement, as shown above, due to both the new strategy and improved commodity prices. In effect, the company receives a double boost which has a greater effect than much of the industry which only benefits from rising commodity prices.

To maximize the benefits of the new square footage, management is likely to control costs so that costs remain the same as the inherited square footage when possible. Then, some costs like transportation costs are higher for oil. But these increased costs should be offset by improved margin from the higher percentage of oil produced to increase profitability.

What has not been discussed so far is that the growing margin combined with tight cost control should lead to higher profitability at different pricing levels. This superior profitability should show up in the next corporate downturn.

Management also has greater flexibility to vary the percentage of oil and natural gas produced. In the long run, this should lead to adequate (or better) profitability in a wider variety of industry scenarios. Flexibility is often the key to survival in commodity industries. This company has acquired a good dose of flexibility.

Laredo-owned sand mine saves on completion costs

Laredo-owned sand mine saves on completion costs (Laredo Corporation January 2022, company presentation.)

The focus on a company-owned sand mine further demonstrates that many companies have much higher potential for returns other than by focusing on sand quality. Investors can expect improvements in well design and longer wells or other innovations in the near future. The quality of the sand is usually something that adds to the life of the well near the end of the life of the well. The actualized yield of this potential upgrade is clearly not competitive with other production upgrades.

The good news for consumers is that the cost of producing oil should continue to fall. We could potentially be in for a generation of low oil costs as current technological progression continues.

For oil companies, the slide above seems to signal a continued trend of cost cutting. This likely means that the current high price cycle is not sustainable. All anyone has to do is be patient and let the market sort out the current imbalances. In the meantime, currently high commodity prices are an attractive lure for an industry that tends to show little restraint on expanding production.

The main difference between this recovery and the last two seems to be the lack of inexperienced (and speculative) money. After two periods of major losses, the inexperienced crowd seems somewhat disenchanted with the oil futures price curve ((good!)). If outside money were to flow into the industry, it would likely signal the start of the next cyclical downturn.

Laredo Petroleum Debt Reduction and Coverage Guide

Laredo Petroleum Debt Reduction and Coverage Guide (Laredo Petroleum corporate presentation, March 2022.)

Many have been upset that management is not taking advantage of currently high oil prices by not hedging. Since I have followed this industry, very few managements that use time hedging are able to time the program successfully. If the management had not been covered for the 2020 financial year, the result could have been disastrous. The source of the dissatisfaction is the low curve of the futures contracts which causes Laredo to realize prices significantly lower than the quoted prices.

It is very likely that this situation will change soon enough. A company like this that hedges all the time designs the program to be revenue neutral while reducing cash flow volatility. Some directorates also use the hedging program to justify a minimum return on their capital investments. Even though Mr. Market hates the hedging program right now, he loved it in fiscal 2020. Hardly anyone predicted 2020 the way it played out. This is really the key to the hedging program.

This industry has notoriously low visibility. Things can literally change overnight due to things that were not anticipated when planning the capital budget. It is clear that the security provided by the hedging program can be justified simply by looking at the 2020 financial year.

In the meantime, the management has increased its liquidity so that it can continue to seek offers. Small transactions are likely to be available because small “add-on” acquisitions are only attractive to nearby acreage holders. There is less competition for this acreage, resulting in a lower price even in times of high commodity prices.

This management has started the acquisition of areas at prices much lower than what is currently the case. There still seems to be a fair amount of acreage on the market. But rising commodity prices make a big deal less likely. Investors should hope management remains disciplined as there is always another cyclical downturn “around the corner” in this industry. If the bargains aren’t there now, they’ll likely be back in the next downturn.

Laredo development activity focused on acquired acreage

Laredo development activity focused on acquired acreage (Laredo Petroleum Corporate Presentation January 2022.)

In the meantime, management will drill the most profitable acreage first. The good news above is that these wells produce 100,000 barrels of oil typically in 6 months. This level of production often results in a payback of less than a year at current commodity prices. Therefore, management can often drill 2 wells in the same fiscal year with the same capital. This ability accelerates the movement towards a higher percentage of oil production.

The biggest news for shareholders is that acreage profitability appears to be consistent with much more expensive Permian areas (like Reeves County). The less expensive area allows for greater profitability of the business and a lower cost of profitability.

Laredo Petroleum Increases Oil Production Percentage

Laredo Petroleum Increases Oil Production Percentage (Laredo Petroleum March 2022, corporate presentation)

Laredo is expected to show a significant improvement in earnings in the current fiscal year due to the higher amount of oil produced and a lack of integration costs that occurred in fiscal 2021. The current price seems indicate that the market could experience a significant upside surprise. on this profitability. Higher natural gas prices have also greatly increased the value of legacy production. This company is highly likely to have a record year for profits unless commodity prices crash.

This should significantly benefit ordinary shareholders. This company will benefit from both the higher percentage of oil in production and higher commodity prices. Mr. Market may not be expecting these results.