Description

Background:

PXP is primarily engaged in acquiring, developing, exploring and producing oil and gas properties in North America. PXP has strategically positioned itself as an oil-levered play, with approximately 60% of its pro forma 12/31/09 reserves comprised of oil. Historically, PXP has been an onshore producer that has used tremendous free cash flow generation from its California assets to fund capex needs in other regions. In recent years, management has taken the opportunity to buy cheap acreage and enter the offshore Gulf of Mexico. This decision has been a good one as PXP has been successful with the drill bit with significant discoveries at Lucious (Anadarko is the operator), Friesian, and Davey Jones (McMoRan is the operator). However, despite its tremendous drilling success, PXP's stock implies little valuation credit for these assets. Receiving little valuation credit, combined with the fact that the offshore GOM is not core to PXP's strategy, has led management to undertake a sale process to exit the GOM.

Key Recent Events:

1) Sale of GOM Shelf Properties to McMoRan (9/20/10)

- PXP sold 100% of its shelf production and rights under jointly-owned properties to McMoran for 51mm shares of MMR stock and $75mm in cash. When the deal was announced, this represented a sale price of $818mm. Given MMR's stock price appreciation, the sale price has increased to $922mm, or an incremental $0.74 of value per PXP share.

- This transaction does two positive things for PXP, 1) allows Plains to retain a significant amount of the upside from those assets (through MMR stock); 2) eliminates capex requirements of over $200mm per year.

- This transaction structure was my preferred outcome, as I would have been disappointed to see PXP take only cash and then watch the GOM shelf "ultradeep" drilling program become an industry-changing success.

- There are several major catalysts in the next three months in this drilling program that could represent substantial upside to MMR's stock (Davey Jones offset well, Blackbeard East drilling results, Blueberry Hill flow-test/production, Lafitte drilling results). These catalysts each have enormous potential implications for MMR stock and, if successful, could make MMR a 2-5x bagger. By owning the 23% stake in MMR via PXP shares, an investor is effectively getting a free option on this MMR appreciation. In addition to my investment in PXP, I also am a significant investor in MMR.

2) Purchase of Eagle Ford Oil Assets (10/5/10)

- Consistent with the management's previously announced strategy to purchase oily assets at around $500-$600mm, PXP acquired 60k net acres in the Eagle Ford oil window for $578mm.

- These assets are attractively located and came at a substantial discount to two other recent deals in the Eagle Ford. PXP paid $9,633/acre versus CNOOC's $10,800/acre price for Chesapeake acreage (11.5% discount) and StatOil/Talisman Energy's $13,660/acre price for Enduring Resources acreage (29.5% discount).  

- Importantly, PXP's management stated on the October 5 conference call that this transaction marks the final material acquisition for the foreseeable future.

3) Announced Sale Process for Deepwater GOM Assets (8/5/10, updated 10/5/10)

- PXP began an auction process in September for its deepwater GOM assets and expects to announce a deal in late November. The deal is expected to close by year end.

- Initial guidance for after-tax sales proceeds was in the range of $1.2bln. This range was updated on the October 5 conference call to a range of $0.9bln to $1.9bln. This represents between $6.35-$13.50 per share of PXP. I believe little value is currently being ascribed for these assets in PXP's stock price.

 4) Q3 Production Pre-Announcement

- Average daily sales volume for Q3 2010 is estimated at 89MMBOE per day, up 5% sequentially from Q2 2010. This result was slightly ahead of street estimates of 88.5MMBOE.

- PXP will announce final Q3 2010 results on Friday, November 5

Valuation:

On every traditional valuation metric, Plains is remarkably cheap, especially considering the pro forma company (excluding GOM assets) has an oily on shore asset base. At a current price of $28.69, PXP currently trades at a 33% discount to its sum of the parts.

Sum-of-the-Parts (Based on the Current MMR Stock Price of $16.63)  

Additionally, when one appropriately backs out value for the MMR stock and deepwater GOM sales proceeds from the enterprise value, PXP trades at an adjusted EV/2011 EBITDA of 4.2x versus the mid-cap E&P universe of 6.3x (using JP Morgan Weekly Comp Tables as of 10/29/10).

If PXP garnered its peer EV/EBITDA multiple of 6.0x-7.0, and raises between $1.2 and $1.5bln of proceeds from the deepwater GOM auction, then the stock is worth between $42.94 and $52.90 per share. Below shows the sensitivities and highlights the midpoint of the PXP guided range on sales proceeds.

Another way to think about the valuation for PXP is that the California assets are expected to generate at least $500mm of FCF through at least 2015 based on management's operational plan (see page 15 of October 5 presentation). If we apply a 10x FCF multiple to these long-lived assets, it ascribes a value $5bln for California alone. The current EV of $6.7bln implies a value of just $1.7bln for all other assets including, Granite Wash, the deepwater GOM, the MMR stake and the Hayneville JV acreage.

Why does this attractive investment opportunity exist?

1) The market continues to view PXP's sale of its deepwater GOM assets with a high degree of skepticism. Sell-side analysts and investors question whether a deal gets done at all, let alone receiving sales proceeds in the guidance range that management has publically stated.

- Management has stated that there are at least 10 parties in the process and that they have had to keep the data room open longer than anticipated due to new interest and high demand. Additionally, commentary made on recent Q3 earnings conference calls by Conoco Phillips (anticipate buying $2-$3bln of assets in the GOM) and Nexen Inc. (starting to see pre-Macondo terms again in deal market) gives me confidence that a robust market for world class assets still exists in the GOM.

- Using conservative assumptions in a DCF, the Lucious discovery alone can derive a valuation of between $1.2-$1.5bln, Any contribution from Friesan, Phobos or any other PXP acreage that is included in the package would be all upside.

2) There is a misconception in the market that PXP's management, led by Jim Flores, will take the GOM sales proceeds and erode value through poor acquisitions like the Chesapeake purchase in 2008.

- Management stated very clearly on the October 5 conference call that the Eagle Ford assets would mark the end to acquisition activity for the near-term, with the exception of perhaps $25-$50mm in tuck-in acreage.

- Management outlines uses of proceeds as acquisition of oily assets (already announced deal for Eagle Ford assets), repay debt and the repurchase of stock (page 4 of October 5 presentation).

- CEO Jim Flores is a substantial shareholder, owning nearly 1.3mm shares directly and another 3.3mm share of restricted stock. His interests are well-aligned with shareholders through this ownership stake.   

3) Investors are ascribing little or no value to PXP's 23% stake in McMoRan Exploration.

- McMoRan's core assets are worth $8.00 per share (see table below), with no value ascribed to Davey Jones (discovery in Jan 2010) or Blackbeard East (currently drilling, hydrocarbons have been found, but has not been designated a commercial find yet). MMR is currently drilling an offset well at Davey Jones in order to confirm the size of the discovery. McMoRan's partner, Energy XXI, has received a third-party appraisal (see 8/10/10 press release) from Netherland, Sewell & Associates for the discovery at 5.0Tcfe (gross). I believe the discovery will ultimately be significantly higher than 5.0Tcfe, but for this analysis, I will use the appraisal estimate. At 5Tcfe gross, this estimate equates to approximately 2.4Tcfe net to MMR. At a valuation of $1.25/mcfe, this amounts to about $13.50 per share of value to MMR. So the core business and a conservative estimate for Davey Jones justify a MMR stock price of $21.50 versus the current price of $16.63.

- McMoRan is expected to be drilling through the most promising sands at Blackbeard East in the next few weeks. If a commercial discovery is made there, it will be incremental to the current MMR stock price. If the partnership hypothetically finds 200 ft of net pay, this would be a gross find of 3Tcfe at 1.5 acre/ft. At the same $1.25/mcfe valuation used for Davey Jones, this would add $9.50 of value to MMR and justify a valuation of $31.00.

- It is important to note that McMoRan has 12 very promising GOM shelf prospects that amount to gross potential discoveries of over 100Tcfe. I have only discussed two of these 12 prospects, and this is why I believe MMR has enormous upside potential. It's important to restate that PXP investors are getting a free option on this MMR upside.

Catalyst