Magnolia Oil & Gas: Let’s talk about managing investment risk (NYSE: MGY)

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(Note: This article originally appeared in the June 14, 2022 newsletter and has been updated as needed.)

There is a general feeling that smaller companies are riskier than larger companies when investors try to determine the relative risks of an investment. While this is generally true, there are smaller companies such as Magnolia Oil & Gas (NYSE: MGY) that mitigate small business risk effectively enough to compare very well to much larger companies that are said to have greater diversification and deeper management in their favor. Sometimes these supposedly “riskier” smaller companies are more likely to bet on an upside that far exceeds the potential downside.

Magnolia Oil & Gas Strategies to Minimize Risk

Magnolia Oil & Gas Strategies To Minimize Risk (Magnolia Oil & Gas Aug 2022 Investor Presentation)

For many potentials investors (and real) investors in the business, managing downside risk in a particularly volatile industry is a primary consideration. This company tends to keep the leverage ratio well below 1. This is one of the most conservative ratios of any company I follow. This allows management to seek offers during downturns when there are few buyers and many struggling sellers. This conservative ratio allows management to increase production at a time when it is particularly profitable to increase production. All of this allows for profitable growth to offset the normal downward pressure when commodity prices weaken.

This company also had the wherewithal to buy back shares whenever management felt it was the right thing to do. A share buyback program adds to the demand for the company’s shares. Therefore, a stock buyback program helps reduce the downside risk of an investment. So many times stock buyback programs are conducted at the top of the market. These same companies have too much debt (and sometimes too much high-cost production) to buy back shares when the stock price is very low.

Organic growth combined with complementary acquisitions and the share buyback program have enabled this company to post impressive growth rates per share. Mr. Market loves a growth story, and this company has been posting one almost from the start.

Those bolt acquisitions also minimize acquisition risk. The company buys small acquisitions that have a much better success rate, and it sticks to the areas it knows best. This strategy, when combined with the other management strategy, makes this company a much lower risk investment than is normally the case for growth companies. Yet the focus on low-cost production also allows for above-average profitability to ensure an above-average balance sheet to add to potential buying interest in the stock.

Probably the most obvious way to demonstrate confidence in the company’s future was an unusually large purchase by the 2 million share company from the recent offering by EnerVest of certain of its shares to the public. Financially sound companies can do this, and it shows that management believes stocks are cheap. This is in addition to stock purchases on the open market under the ongoing program. It can also be interpreted as an attempt to circumvent the period of share price weakness that often follows a public offering of shares. This can work very well too since it is the company that is buying back a significant number of shares of its own stock.

Magnolia Oil & Gas Acreage Performance and Benefits

Magnolia Oil & Gas Acreage Performance And Advantages (Magnolia Oil & Gas Aug 2022 Investor Presentation)

Whenever an investor sees a breakeven point as low as the one shown above, the business will be highly profitable. This company is also likely to generate adequate cash flow during industry downturns.

The Eagle Ford has a few advantages over the more desirable Permian acreage. Transport capacity has long been adequate and future transport problems are unlikely as there is no focus on this profitable basin. Therefore, the growth is relatively moderate and intermediate volume increases have so far been easily managed by existing operators.

Lack of attention has also (in the past) allowed Eagle Ford production to sell for more than the benchmark. This turned out to be a significant advantage for the Permian. Take-out problems would develop to cause operators to cut production while paying for expensive trucking to get product to market. Given the continued focus on Permian acreage and production growth, it wouldn’t be out of line to predict that additional takeaway issues are likely to develop in the current recovery that translates with more discounts on products.

Magnolia Oil & Gas Key Operating Costs and Margin

Magnolia Oil & Gas Key Operating Costs and Margin (Magnolia Oil & Gas August 2022, Corporate Presentation)

The first thing to note is that the low costs shown above confirm the low price management statements very well. Most breakeven costs involve some percentage of profit (which is likely but covers some expected complications). As the costs above demonstrate, the true break-even point of these wells without taking into account any risk is considerably lower.

In addition, the most significant increase in costs has been royalties. These costs decrease with prices. Some of the other costs may also decrease during periods of low prices. But royalties are the most notable cost that varies with industry pricing.

Another cost that decreases as the business grows is general and administrative expenses. This is usually a sign of tight management. Along with this, another slide (not shown here) shows a huge increase in cash flow due to the increased margin.

There are many companies that tout a large margin while mitigating a lack of production to generate sufficient cash flow even with a large margin. This is a notorious practice among secondary recovery experts. As a result, I followed several of them to bankruptcy, even with these large margins.

This company, on the other hand, seems to balance costs with expected benefits in a way that results in above-average profitability. Therefore, the margins shown above have more credibility because these margins are backed by a generous cash flow. This cash flow also gives the reserves report a credibility that it may lack in the event of insufficient cash flow.

The future

Management will likely continue to make small add-on acquisitions. This often leads to accretive trades because small positions are difficult to sell. Often, management can bundle small add-on transactions into a valuable, larger, and much more marketable stake that creates shareholder value before the first well is drilled on the property. This process often involves extra work for management that many managements cannot care about.

Organic growth is expected to be above average due to the low breakeven price quoted for drilled wells. The Eagle Ford will continue to be a superior place to do business as long as there are no future takeout issues like there have been in the Permian for many midsize and smaller operators .

Investors pay management to make profits where many don’t see the profits to be made. Yet this rarely happens when it comes to actual execution. This company is likely to be an important exception for many of the reasons given above. It also means that investors are investing in damn good management.

Good management often surprises on the upside. Therefore, it’s not a bad idea to consider a long-term stake in a growing business like this. The results are often much better than some of the more obvious proposals. Good management is often the most valuable asset, and it’s not on the balance sheet. This management could easily be one of the best I follow.

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