Talos Energy Inc. Q2 FY2022 Earnings Call

Good morning, everyone, and welcome to our second quarter 2022 earnings conference call. Joining me today to discuss our results are Tim Duncan, President and Chief Executive Officer; Shane Young, Executive Vice President and Chief Financial Officer; and Robin Fielder, Executive Vice President, Low Carbon Strategy and Chief Sustainability Officer. Before we get started, I'd like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in yesterday's press release and in our Form 10-Q for the quarter ending June 30, 2022, filed with the SEC yesterday. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures was included in yesterday's earnings press release, which was filed with the SEC and which is also available on our website at talosenergy.com. And now I'd like to turn the call over to Tim.

Thank you, Sergio. As I mentioned in our earnings release, it was a great quarter for our company that included record revenues, strong margins and significant free cash flow facilitating rapid debt repayment. This quarter, we achieved our lowest leverage multiple and our highest liquidity in the company's history, positioning Talos well for the second half of the year that will focus on our deepwater drilling campaign, continued growth in our CCS business and ongoing debt reduction. All of these developments are continuing to strengthen the company for sustainable and profitable growth, enhancing a solid credit profile and positioning the company to build long-term shareholder value. I'll first address quarterly results and recent updates from our Upstream business. We delivered a record quarter, which included over $500 million in revenues, nearly 80% adjusted EBITDA margins before adjusting for financial hedges and over $130 million of free cash flow after hedges and before changes in working capital. Shane will provide more details on our financial performance during the quarter in his prepared remarks. But I want to recognize our team for their strong cost control efforts and a diligent focus on ongoing operations that generated strong earnings despite an inflationary macro environment. As we have discussed in previous calls and in our Analyst Day, our intention is to use a constructive commodity environment to accelerate higher impact drilling opportunities in our portfolio starting in the second half of 2022 and throughout 2023. These opportunities exemplify how we utilize our core skill set and organic growth strategy to leverage our existing acreage set, proprietary seismic reprocessing expertise and well-positioned operating infrastructure to unlock meaningful additional resources with attractive economic returns, even when accounting for the risk of an occasional dry hole along the way. The projects we are undertaking later this year and early next year are both operated and non-operated opportunities that we expect will provide reserve and production growth over the next 12 to 18 months. On the operating front, we expect to take possession of our contracted Seadrill Sevan Louisiana deepwater drilling rig in the coming days and launching our open water drilling campaign, which will run through the remainder of 2022 and into 2023. As previously announced, we extended the rig contract to take additional slots, allowing us to perform 6 straight operations in which we plan to target at least 4 prospects totaling 65 million to 100 million barrels equivalent of gross resource potential. With individual potential well rates between 5,000 and 15,000 barrels equivalent a day gross. All of those were in proximity to our owned and operated facilities, which will help accelerate first oil and deliver attractive economics on those projects. We have recently brought in industry partners into our Lime Rock, Venice and Rigolets prospects, allowing us to reach our target working interest of 60% on each of these wells. This has multiple benefits for us. First, it provides industry validation on our drilling program. Second, we have a better diversity of our capital allocation and concentration risk. And third, it allows us to further monetize the value of our physical infrastructure by receiving a production handling fee on the production volumes owned by our partners that will flow through our facilities. We're excited to begin this campaign and expect these projects to provide a solid foundation for the future as we expect to bring successful wells into production over the coming 12 to 18 months. Separately, we are also participating in a number of non-operated projects. Most notably, we expect to spud the Puma West appraisal well early in the fourth quarter this year with our partners, BP and Chevron. That well has been permitted to a depth of 26,000 feet and will be drilled with the Diamond Ocean BlackHornet rig following the completion of other rig operations BP is currently undertaking. We are also actively working to finalize a 5-block exploration unit in the Green Canyon and Walker Ridge areas with another large Gulf of Mexico operator that will lead to a high-impact exploration well in 2023, targeting both subsalt myosin and Wilcox targets across nearly a 30,000-acre unit. More details on that opportunity will be provided in due course, but we are proud of our track record of pulling our acreage together with some of the most sophisticated Gulf of Mexico explorers and producers to better execute our drilling inventory, and we hope to announce additional partnerships in the months to come. In Mexico, at our Zama project, we're continuing to work with both our Block 7 partners as well as Pemex to finalize a field development plan ahead of the March 2023 submission deadline. Simultaneously, we are also discussing the formation of an integrated project team or IPT, which is common in international projects and would provide a variety of roles in the project for all of the partners and enhanced governance rights for all the parties. In our opinion, that will significantly benefit the Zama project going forward. While the project has experienced significant delays during the unitization discussions, we're encouraged that the project is advancing towards the submission of the final field development plan. The approval of the FTP is the last major hurdle before a final investment decision can be taken on this project by all the partners. As a reminder, the contingent resource of Zama as prepared by an independent third-party engineering report was over 700 million barrels equivalent gross. So progress here still represents meaningful value for Talos' shareholders as we continue to move toward FID. Once the project distinction, we would expect to be able to book proved reserves that in this case would represent multiple years of reserve replacement, and we would have more certainty around final development timelines, financing and ultimately, first oil. Each step we achieve in the coming months is important as we move closer to realizing significant value from this important discovery. Navigating Zama has not been easy, to say the least, but I would like to reiterate that we are doing everything we can to maximize the value of this discovery for our shareholders. Finally, on the upstream front, we have begun the process of mobilizing our HP-1 facility for the regulatory required dry dock maintenance to satisfy Coast Guard requirements, a process that we expect will defer approximately 6,000 to 9,000 barrels equivalent a day net in the third quarter, but at the same time, ensuring long-term high uptime in our tornado and Phoenix deals. This downtime has already been included in our full year 2022 guidance, that is now expected to be isolated in the third quarter instead of being spread across the second and third quarters as we had initially expected. In the end, the delay has allowed us to take advantage of strong commodity prices over the full second quarter. Moving into our carbon capture business. I want to applaud the Talos Low Carbon Solutions team for delivering an important transaction in May that brought Chevron into our Bayou Bend CCS joint venture, joining us alongside Carbonvert. Financial terms for the transactions delivered upfront cash as well as material capital cost payments by Chevron that we expect to cover all the expenses for the project through the project's FID, and that capital is being put to good use as we finalize plans to drill our stratigraphic well test in the fourth quarter. The strat well will allow us to collect rock property data that will provide critical information for our Class 6 permit for permanent CO2 sequestration. We are excited to have a major partner like Chevron in Bayou Bend. Not only do they provide critical sequestration experience and an unquestioned balance sheet to the project, we believe it's also another strong endorsement of the solid platform we are building as one of the CCS leaders in the United States. Our overall portfolio today includes close to 1 billion metric tons of storage capacity across our 4 project areas in Texas and Louisiana, all operated by Talos, all with strong partners and all in key industrial regions, where we are aggressively working to secure long-term anchor customers. We're very proud of our rapid success in this new business unit, and we're working hard to enhance our leadership by continuing to advance these projects as well as expanding our storage footprint in these core areas in the future. Lastly, I'll also quickly address recent developments in Washington with the proposed Inflation Reduction Act of 2022, but I'll not comment on any political views. While we recognize this bill may be subject to change and acknowledge the remaining process for potential passage into law, we think it's important to highlight the potential impacts for Talos if this bill were to pass in its current form. As no other company in the small and medium cap E&P space in the U.S. has both the level of exposure to offshore Gulf of Mexico and to carbon capture and sequestration, and both of these areas are key focus areas of this proposed bill. On the upstream front, if signed into law, as initially proposed, the Inflation Reduction Act would reinstate Lease Sale 257 from last November, in which we were one of the most active bidders and one deepwater block. This bill would also ensure future lease sales in a prescriptive manner and remove more regulatory uncertainty. On the carbon capture side, the bill proposes an increase of the 45Q credit from $50 a ton to $85 a ton and introduces direct pay mechanisms, both of which we believe are key attractors for potential industrial partners around our projects and moving towards long-term carbon sequestration solutions. We believe this bill will be meaningful for Talos in both of our business lines and we're closely monitoring future developments. With those key updates, I'll turn it over to Shane to address some of the financial details of the quarter.

Thank you, Tim, and thank you, everybody, for joining our second quarter earnings call this morning. I will focus my remarks today on the following 3 areas: first, our strong financial results in the second quarter; second, the strength of our balance sheet, which we believe positions us with significant financial as well as strategic flexibility for the future. And finally, I'll provide some insights into the outlook for the third quarter as well as the balance of the year. During the second quarter, we generated revenues of $519 million from production of 65,400 barrels of oil equivalent per day. Realized prices were approximately $108 per barrel and $8 per Mcf before the impact of financial hedges. This represents the company's highest ever quarterly revenue over our 10-year history. On the cost front, our lease operating expenses were $88 million, equating to approximately $14.70 per barrel equivalent, inclusive of $11.5 million of HP-1 dry dock preparatory costs and approximately $12.80 per barrel equivalent, excluding those nonrecurring costs. Cash G&A for the quarter was $18 million or approximately $3 per barrel equivalent. Despite broad inflationary pressures, our continued focus on efficiency and cost controls have kept our per barrel expenses in check year-to-date. For the second quarter, we generated adjusted EBITDA of $251 million. Before the impact of cash settlements on financial hedges, adjusted EBITDA was $411 million for the quarter. These equate to EBITDA margins of 70% and 79% or $42 and $69 per barrel equivalent, respectively. Net income for the quarter was $195 million or $2.33 per diluted share. Adjusted net income for the quarter was $101 million or $1.20 per diluted share. Capital spending during the second quarter totaled $86 million. Free cash flow before changes in working capital was $134 million, resulting in free cash flow of $226 million for the first half of 2022, allowing for significant deleveraging year-to-date. Turning to our balance sheet strength. With the strong financial performance during the quarter, Talos repaid $146 million of debt between our credit facility borrowings and the retirement of the final $6 million of our 7.5% notes, a legacy of the 2018 Stone merger. As of June 30, we reached a leverage multiple of 1x and available liquidity of over $700 million. Both of these are best in the company's history. Cumulatively, over the past 15 months, we have reduced our net debt by nearly $350 million or approximately $4.20 per share of net debt reduction. Over the same period, commodity prices have increased significantly. The combination of these 2 factors has significantly increased the intrinsic value of Talos' shares. We expect to continue reducing our debt levels during the remainder of 2022, even with our capital program being significantly weighted towards the second half of the year. We are pleased with the free cash flow generation of the business in recent quarters and expect to accelerate those strong trends into 2023 as our legacy hedges roll off. It is important to note that while strong commodity prices have been a positive tailwind, the $350 million of net debt reduction since the first quarter of 2021 and associated improvement in our leverage ratios were based on average unhedged prices in the mid-70s per barrel and in the high 4s per Mcf. Even more, including the impact of our legacy hedges, those blended realized prices to Talos have averaged in the mid-50s per barrel and in the mid-3s per Mcf. Therefore, we are excited about the long-term cash flow profile of the business on mid-cycle pricing and see our exposure to higher commodity prices increasing in the coming quarters as our weighted average pricing increases. Lastly, I'll address our financial outlook for the remainder of the year. For the third quarter, we expect production to be reduced by between 6,000 and 9,000 barrels of oil equivalent per day as a result of the scheduled HP-1 dry-dock process that has just begun. Additionally, we expect 4,000 to 5,000 barrels of oil equivalent per day impact from third-party midstream downtime at Pompano and other miscellaneous planned downtime activities during the quarter. On the cost side, the HP-1 dry dock should have a similar impact on lease operating expense in the third quarter as we experienced in the second quarter. For the full year, we expect capital expenditures to be within our guidance range, albeit near the high end due to further inflationary pressures and expectations for nonoperated capital project timing. The balance of capital spend for the year should be split roughly evenly over the third and fourth quarters. With that, I will hand the call back over to Tim.

Thank you, Shane. I want to reiterate my admiration for our team that works tirelessly to continuously help Talos create significant value for our shareholders. We've done a fantastic job controlling costs in an inflationary environment, allowing us to aggressively pay down debt, leading to our lowest leverage metric and record levels of liquidity. We have a series of drilling and development catalysts that we are ready to begin working on this month and a growing CCS business that recently attracted a material partner. I truly believe the tremendous value we have created and are continuing to create for our shareholders is not currently being recognized by the market in our stock. But I'm fully convinced that it will be soon. We will not falter in that pursuit. We will continue to execute on our operational and strategic fronts. Now more than ever, we are excited about the momentum and the direction of the company as we move into the second half of the year. With that operator, we'll open up the line for Q&A.

So Tim, I have to ask the EnVen Reuters story. What are your comments there?

I think if you look back at our previous calls, you'll notice we often receive inquiries about mergers and acquisitions. We typically provide a consistent response, which remains the case here. M&A is a significant component of our inorganic strategy. We are continuously in the market and actively seeking opportunities. We've mentioned our interest in deals within the Gulf of Mexico first, as we believe we can create synergies given our familiarity with many of the assets there. We've also considered potential acquisitions outside the basin if we believe we can apply our skill sets effectively. The key aspect we're looking for is whether an acquisition is accretive, which can encompass various factors. This includes the sources and uses of funds, the assets involved, potential synergies, and overall upside. We want to ensure that any acquisition contributes positively to our free cash flow generation. There are numerous criteria we review when assessing deals, and we're quite pleased with the robust market we're observing. Currently, we see more opportunities available than we initially anticipated at the year's start, so we are enthusiastic about our efforts in this area. While I won't comment on any specific deal, I want to emphasize that we are focused on everything we're doing and exploring a wide range of opportunities.

So the Inflation Reduction Act has some good elements. I would like to get your thoughts on whether Congress can override a federal judge regarding the reinstatement of the lease sale.

Yes. I believe there are specific details we all need to grasp better. It's a question I share, and we need to see how the process unfolds. Generally speaking, concerning the legislation and the reconciliation bill, if it progresses as it currently stands, it could significantly impact us more than any exploration and production sector or carbon company I know of, likely including the major players, because we depend on and engage in lease sales. In that particular lease sale, I acknowledge your question, and we will ascertain the answer. We were one of the most active bidders, and several prospects we bid on are now part of our portfolio. Future lease sales have also been viewed as a risk factor, so it would be beneficial to remove that uncertainty and have predictable lease sales again. Therefore, this aspect of the legislation is particularly noteworthy for us. As for 45Q, we are observing positive developments, and Robin will provide some insights on those advancements.

Sure. There's certainly a lot of positive provisions in this proposed act that would both extend and enhance the existing 45Q IRS tax code and allow those taxpayers claiming that credit for CO2 sequestration also have a direct pay option. So we think this is a very encouraging development, not just for some of the projects that we may try to claim the 45Q, but for many of our large industrial partners or customer base who are looking to see this enhancement in order to move forward on their projects. And so we'll continue to work with all of our stakeholders along the Gulf Coast and in other regions as we try to put together these low-cost decarbonization projects.

Yes, I missed the direct pay aspect. That's great. Finally, as we look ahead to January and the refinancing period, what are your thoughts on it? My quotes might be outdated, but it seems the bonds are below par at this time. I hope I'm not tempting fate, but how do you envision the process of refinancing or repaying?

Yes. Look, I'll start. I'm going to hand it over to Shane on this itself. Shane will give you some thoughts on the strategy. But obviously, it starts with getting your leverage down to something that the market really is attracted with. And so Sam, why don't you talk about how your thoughts on the refi?

Our goal for 2022 has been consistent throughout the first and second quarters, and we aim to maintain that for the remainder of the year. We want to exit this year with the strongest credit profile possible to present to the marketplace. This priority will position us advantageously for refinancing when market conditions improve. We recognize that we cannot control the market itself, but it has indeed been challenging recently. We need the market to stabilize. There are cycles in capital markets, and 2020 was particularly tough. However, when the opportunity arose, we capitalized on it. Fortunately, we will have more time to consider our options this time. In 2023, we plan to address the existing notes. While we understand that we can't predict how credit agencies will respond, we make an effort to keep them informed about our progress. Considering our debt repayments and leverage position, along with significant repayment levels, we believe we have positioned ourselves well. The cost of our debt has been high, as you pointed out, but it's currently trading lower, and we aim to reduce it even further. We believe that our decisions regarding refinancing goals for the year were sound and that our teams executed them effectively.

I wanted to begin by discussing carbon capture. There are certainly many exciting developments as outlined in the Inflation Reduction Act. You mentioned the 45Q and direct pay incentives. I'm curious if there has been any conversation in Washington regarding state premises for Class 6 permitting. I understand that the permitting process is often the longest lead time, so any updates you could provide on that would be appreciated.

Thank you for the question, Cameron. You're correct that both Texas and Louisiana are pursuing primacy for their jurisdictions. Currently, the EPA oversees permits for Class 6 wells. Both states have been in discussions with the EPA regarding this potential transition. As we prepare to submit our first Class 6 permit, we're engaging with all relevant agencies to ensure we have necessary documentation and supplemental data in place for a strong application. Our goal is to streamline the process and expedite timelines. We fully support the states in utilizing their expertise on subsurface issues, particularly concerning injection and disposal wells, and we will continue to advocate for this collaboration as we advance these projects.

I think Robin made an excellent point. In the long run, transferring this responsibility to the state seems like a logical decision and should lead to a more efficient process. However, in the short term, the focus is on the application we are preparing and the data included within it. Our team is currently working on the first stratigraphic test in the area to gather essential rock property data, which is crucial. This data collection is necessary for us. We're concentrating on ensuring our application is strong, and if others experience delays in their class permits, it might relate to the strength of their applications. That's the best course of action for now while the political situation evolves. In the future, I believe handing this over to the state will be advantageous.

That's helpful. As a follow-up, I'd like to discuss the balance sheet and cash flow. The reduction in leverage has been quick and substantial over the last few quarters. It seems you are on track to finish the year below the target of 1 to 1.5 times. We've previously mentioned shareholder returns, and once leverage decreases, there might be a possibility of introducing a dividend or buyback program. Could you provide an update on any discussions with the Board regarding this? Any information would be appreciated.

Yes, I can start, and Shane might add to this as well. Clearly, we believe our stock is significantly undervalued, which leads us to consider the best ways to utilize our free cash flow. We've discussed this frequently, but I want to emphasize again that our debt costs are too high. Our primary focus moving forward is to lower that cost, which will then enable us to prioritize returning capital to shareholders. The strategy since last year has been to reduce leverage. Before the pandemic, we aimed for a ratio of 1 to 1.5 times, which we found comfortable and beneficial. Now, we believe aiming for a ratio of one time or less is more appropriate in the current environment. We're getting close to that target, and we plan to maintain that position. The key steps have been to improve our leverage situation to create a strong foundation, refinance our notes, and then concentrate on strategies for returning value to our shareholders.

I want to see if we could get a little help on some of the numbers, Shane, you mentioned the impact of the downtime you're anticipating for third quarter. So we just take those numbers and subtract from kind of the second quarter level of 65,000 BOE per day to get a third quarter number and then add them back for the fourth quarter. So you're back to the 65% in the fourth quarter. Is that the best way to look at it at this point?

That's a solid starting point. The second quarter was fairly straightforward. We encountered some disruptions in the first quarter, but the second quarter was relatively smooth. Looking ahead, we are aware of the scheduled downtimes. The unpredictable factor, as always, is the storm season, making the third quarter particularly challenging. We incorporate our own projections based on how we anticipate the overall season will unfold and distribute that information accordingly. Sometimes, we are pleasantly surprised, while in other instances, like two years ago, we face some unexpected negative outcomes. Nonetheless, this approach provides a reasonable foundation for your considerations, and you might also have your own perspective on the hurricane season to factor in.

Yes. And keeping in mind that we have to go look at the data, but I just memory would serve me that I think we've had some hurricane downtime. And again, maybe not material, but we've had it in each of the last several fourth quarters because it tends to be kind of the trailing season. So just again, Mike, as you do your modelling keep that in mind.

And then I guess on the OpEx side, it sounds like third quarter is going to be similar to the second quarter and then that would step down in the fourth quarter. Is that right?

Yes. Look, I think we'll have exactly like you said, we'll have a similar level of HP-1 dry dock maintenance expenditure that's going to flow through in the third quarter based on our outlook. That obviously goes away after that. So I think you're right. That's probably a pretty constructive way of thinking about the next 2 quarters. And look, typically, we do some of our repairs and maintenance. You're seeing a little more higher run rate, for example, on P&A and the CapEx side in the second quarter because we typically have our best weather. So we're going to do a lot of work when the sun shines, if you will. And so some of that tails off as you get late to the third and fourth quarters as well.

Okay. And then I want to see if you talk at all about the exploration unit you're looking to form the Walker Ridge and Green Canyon area. Do you know what your working interest would be there yet? And is this a prospect Talos that you guys have generated or has the larger partners done that and maybe timing of a well or do you need more size there? Anything more you could say on that?

I was hoping to finalize that deal before the earnings call, but I haven’t been able to. It’s a significant opportunity that we’ve been working on for several years and we are optimistic about it. It encompasses a large area, and we managed to consolidate multiple blocks with another major operator in the Gulf of Mexico. As we present more materials and attend additional conferences, we will provide further updates. This situation brings to light the concept of how to effectively leverage a large acreage position, which we've discussed previously and highlighted on Analyst Day. It’s not just about one or two blocks; for instance, in the Puma West area, our strategic aggregation of BP and Chevron into three or four blocks adds value. We recently made a discovery there and are currently appraising it. The challenge now is how to replicate this success in different regions with our portfolio of prospects. Some of these are independent projects while others involve partnerships, and there are also nearby blocks operated by other companies. The goal is to effectively manage our acreage to maximize its potential and create opportunities for growth. This will be representative of our approach going forward. Once we have more specifics, we will share them later this year or early next year. We are not just adding or shedding rigs; we are looking at the entire basin and seeking the best long-term strategies. The smaller joint ventures we are developing are crucial for achieving our broader objectives. We will provide more information in future presentations, but the key takeaway is that we are committed to this direction, which was a significant point I wanted to convey in our earnings release and our communication.

Our next question will be a follow-up from Cameron Lochridge with Stephens.

I'm back. You can't get rid of me. I just wanted to be clear on something. I know in the release, we said that the HP1 dry dock as well as some of the other downtime, which factored into prior guidance of 60,000 to 64,000 barrels a day for the year. I know hurricanes no one can predict that, right? But barring any like absolutely crazy hurricane season. Is that still a good range, 60,000 to 64,000 for the year?

Yes, we haven't made any changes to our guidance, which implies our expectations remain consistent. Looking at the first half of the year, despite significant downtime due to a third-party pipeline near the Phoenix field in the first quarter, we are averaging around 64% for the year. We anticipate real downtime in the third quarter, which we have already factored in, and we'll see how things progress in the fourth quarter. We felt there was no need to alter the guidance at this time. The team has done an excellent job managing costs in this aspect of our guidance. Additionally, offshore and capital guidance often depend on timing related to large rigs, and we now have improved clarity on that timing. Also, on the CCS front, we're receiving some reimbursements from Chevron. Therefore, we've maintained our guidance, and I believe that addresses your question. Thank you for joining the call. Looking back at our goals for the year, we were confident about generating significant free cash flow. The team performed exceptionally well in the second quarter by optimizing the price environment. Our operating and CapEx costs were lower than expected, allowing us to accelerate debt repayments, which is a positive outcome. We're enthusiastic about the catalysts we've introduced and plan to drill numerous wells over the next year. We're eager to see the results as we move into the latter part of '23 and into '24, with fewer hedged volumes that will provide substantial price opportunities. We're also excited about our developments in the CCS sector. Partnering with Chevron, who will support our initiatives, is promising for expanding other areas of our portfolio. The team has invested significant effort, and we believe the company is undervalued. We see a lot of potential momentum and appreciate your ongoing support and attention. We look forward to visiting with many of you soon. Thank you for attending, and we’ll speak again next quarter.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.