I think the Market has it wrong with Jones Energy (JONE)

The most frustrating thing that has happened in the last few weeks has been to watch Jones Energy get clobbered from $18 to $14.  Frustrating because I think the market has it wrong.

The drop has been precipitated by Jones cautious comments about the test of a new frac design.  To recap, Jones initiated a 20 well program that increased the cluster density per frac and the amount of proppant used (which resulted in a bigger frac per stage).  The program was done to evaluate whether this would increase production and EUR’s enough to justify the increased cost (about $900,000 per well).  The company provided progress when they released their February 14th company update.  They basically said that the evidence so far is not strong enough to justify moving to the new completion technique and that more data is required:

Of the 14 wells with 30 or more days of production, 12 have produced at or above historical type curve. Over the next two quarters, the Company will monitor production data on the test wells and undertake additional optimization techniques, prior to making a decision on whether the level of production is significant enough to justify the incremental capital investment per well, and which design to utilize going forward. In the interim, Jones Energy will be employing its traditional open-hole completion technique in the Cleveland, which is the basis for its guidance for the balance of 2014. Going forward, the Company expects its average Cleveland AFE to remain at a best-in-class $3.1 million, which we expect will allow us to continue to generate compelling rates of return in our core play.

I honestly didn’t think that the move up in the stock was simply speculation about the success of the new frac design.  I thought it was a recognition that the company, which is expecting 30% production growth in 2014 and already has tremendous IRR’s in Cleveland, was simply undervalued.  Apparently not.

The market is acting like a failure of the new frac design is a significant setback for the company. I think it’s time for a little perspective.  As the table below, which was provided on slide 16 from the Barclays Conference presentation, notes, IRR from the Cleveland using the current frac design is 118% at $90/bbl oil and 151% at $100/bbl oil.

These are incredible economics.  At $100 oil they rival some of the best in North America.  They also represent a huge hurdle that any new completion technique has to overcome.

Its not a sure thing that the new completion technique is a failure.  The company made it clear on the conference call that Cleveland’s overall production profile is not predictive from its 30 day rates.  Typically 120-150 days of data is needed before the true decline and EUR can be estimated.  In 2011 when the company made the move from an 11-stage frac to the current 20-stage frac, their experience was similar to now; early  30-day production results did not produce a clear of enough improvement to justify moving to the new design, but once 120 day became available the trend clearly showed incremental reserves that justified the costs and the company made the decision to use 20 stages going forward.

Thinking of this from an engineering perspective, I get the impression that the Cleveland, which is not a true shale, is more naturally fractured and higher permeability than your typical shale play.  Therefore I would suspect that the more muted early-time response is simply a consequence of the near-wellbore reservoir already doing a pretty good job draining itself on its own.  The upside kick may very well occur as more reservoir is accessed from the larger frac job.

Its conjecture of course and we will just have to wait and see, but I wouldn’t be surprised if the market turns out to be premature in its dismissal of the results.  I also wouldn’t be surprised if regardless of how the new completion design turns out, Jones meets its production guidance for 2014 and the stock trades up to $20 by year end.

I was very impressed by the disclosure and content provided by the company in the conference call.  Jonny Jones is an impressive sounding CEO who sounds like he has a firm grasp on the technical side, which is refreshing. The guidance about the future prospects in the Tonkawa and other horizons was encouraging.  Jones holds a stacked play on its acreage with multiple potentials beyond just the Cleveland and the Woodford.  The company noted that they are having only limited success in acquiring acreage because private equity is outbidding them at prices above both what they are will to pay and what the market is currently valuing Jones at.  So private equity, which is typically quite focused on cash flow, sees value here.

None of this is reflected in the current share price.  I added to my position on Friday at a little under $14.