Ladies and gentlemen, good morning, and thank you for participating in Magnolia Oil & Gas Corporation's third quarter 2018 earnings conference call. My name is Adam, I will be your moderator for today's call. At this time, all participants will be placed in a listen-only mode as our call is being recorded. I would now like to turn the program over to Mr. Brian Corales, investor relations, for prepared remarks, which will be followed by a brief question-and-answer session. Thank you, Mr. Corales. You may begin.
Thank you, Adam, good morning, everyone. Welcome to Magnolia Oil & Gas's third quarter 2018 earnings and inaugural conference call. Participating on the call today are Stephen Chazen, Magnolia's Chairman, President, and Chief Executive Officer, and Christopher Stavros, Executive Vice President and Chief Financial Officer. As a reminder, today's conference call contains certain projections and other forward-looking statements within the meaning of the federal securities laws. These statements are subject to risks and uncertainties that may cause actual results to differ materially from those expressed or implied in these statements. Additional information on risk factors that could cause results to differ is available in the company's proxy statement filed with the SEC. A full safe harbor can be found on slide two of the conference call slide presentation with the supplemental data on our website.
You can download Magnolia's third quarter 2018 earnings press release, as well as the conference call slides from the investor section of the company's website at www.magnoliaoilgas.com. I will now turn the call over to Mr. Stephen Chazen.
Thank you. Well, seems like just yesterday I ended my 63rd earnings call at Oxy. Given my current age, it's unlikely that I'll be able to do 63 here. In my remarks, I'll refer to both GAAP and pro forma financial information. Chris will discuss this in more detail, but for reference, the pro forma information includes the results of the Karnes assets, Giddings assets, and the subsequent GulfTex assets that were acquired by EnerVest on March 1st, 2018, for all periods presented and excludes transaction costs. Literally, the financial statements to read are fairly complicated and the most useful, I think, is to talk about the pro forma.
When we originally set out to create a publicly traded independent E&P company, which is now Magnolia, we did so with the understanding that it had to be investable within an energy sector that has generally struggled to perform both absolutely and relative to the S&P 500 over the last decade. Our business model was designed to be differentiated and with a primary objective to generate stock market value over the long term. Our strategy was to establish a company's characteristics would demonstrate a certain basic set of criteria that would appeal to generalist investors who are more accustomed to an industrial model. There are several basic elements to our business model, and we're off to a good start so far as we've exceeded on the delivery of our objectives. We've summarized this on slide four of the presentation slides.
We expect to generate real GAAP net income and growing earnings per share over time. Magnolia's pro forma net income for the third quarter of 2018 was approximately $58 million and $151 million in the first nine months of this year. One of our goals is to generate high operating and full-cycle margins. As you can see on slide eight, we generated pre-tax operating margins of 23% on a GAAP basis and more than 41% on an adjusted basis during the period that Magnolia owned the assets in the third quarter of 2018. We plan to spend within 60% of our annual EBITDAX or gross cash flow generation on drilling and completing wells, in order to achieve moderate production growth of 10%-15% a year.
We'd originally set this level of spending, was expected to deliver approximately 6,000 BOE per day of annual organic production growth for the company. As our organic production growth is well ahead of our expectations this year, we're in the midst of recalibrating our outlook for 2019, we'll have more to say about that production as we move forward into next year. In any event, this level of spending and growth is expected to result in meaningful free cash flow generation. For the nine months ending September of this year, $285 million of capital was spent on drilling and completing wells, which represented 50% of our pro forma EBITDAX for that period, shown on slide nine. Our third quarter 2018 pro forma production, approximately 55,200 BOE a day, exceeded our previous guidance and provided year-over-year organic production growth of 59%.
Bear in mind that much of this growth was achieved during a period when we're only running one rig in our Karnes County assets. Our strategy is to maintain a very strong balance sheet with a low amount of leverage. We have approximately $400 million of long-term debt at the end of the third quarter, which was less than a half a turn of our annualized pro forma EBITDAX for the most recent quarter. We have an undrawn revolving credit facility of $550 million at the end of the quarter. As part of our plan, we expect that approximately 40% of our annual gross cash flow to be free cash flow or undesignated and beyond our needs required to achieve our moderate annual production growth targets.
The free cash flow will be used for accretive acquisitions, share repurchases, and debt reduction. During the third quarter, we announced the acquisition of substantially all of South Texas assets of Harvest Oil & Gas Corp. for $133 million in cash and 4.2 million Magnolia shares. The assets produced approximately 4,800 barrels a day during the first half of 2018 and added approximately 114,000 net acres to our Giddings Field position and 15 net undrilled locations to our core Karnes County inventory. The transaction closed at the end of August. We continue to evaluate several small to medium-sized bolt-on acquisition opportunities that fit our business plan and have similar financial and operating characteristics to Magnolia's existing assets.
During the third quarter of 2018, we operated three drilling rigs across our acreage, with two rigs in Karnes County and one rig in the Giddings Field, with a plan to continue this level of activity for the remainder of the year. Our third quarter production partially benefited from a step-out in non-operator-related activity. Our production in Giddings saw a sequential quarterly increase of 3,800 BOE a day to 13,800 BOE per day in the third quarter as a result of completion of several new wells during the period, plus one month of production from the Harvest acquisition. We expect to see further growth in production at Giddings for the fourth quarter as a result of additional well completions. Looking into next year, we expect to add a second rig in Giddings in the first quarter of 2019 to appraise and delineate the opportunities within our large net acreage position.
All in all, we're off to a terrific start, and we're very pleased with what our assets have delivered so far. Our 2018 development plan continues to exceed our original expectations while generating significant free cash flow after capital. Our pro forma EBITDAX of $575 million for the year to date is running at a pace that is well ahead of what we had forecast when we announced the original transaction with EnerVest back in March. As we look forward into 2019, we are very optimistic regarding our prospect of opportunities, which should allow us to continue to deliver on our business model objectives and help enhance Magnolia's stock market value. I'll now turn the call over to Chris Stavros, who will review our third quarter financial items and operating highlights in greater detail and also provide some guidance for the fourth quarter. Chris?
Thank you, Steve, and good morning, everyone. Before I walk through some of the numbers, I'd like to talk for a moment about the corporate structure and financial reporting implications that you may notice as a result of the business combination. As a result of the closing of the transaction with EnerVest in the third quarter, US GAAP requires us to present the financial statements of the period prior to the acquisition, which include the results of only the Karnes County assets as the predecessor, while the financial statements on or after July 31st include the results of both the Karnes County and the Giddings Field assets and one month of the results of the Harvest acquisition, which we refer to as successor. We're also required to allocate the fair market value of the acquisition to our individual assets, including oil and gas properties, based on their estimated fair values.
As a result, the financial statements on or after July 31st lack comparability with those prior to that date. We recognize that this required presentation format may make it difficult to compare the predecessor/successor periods, so wherever possible, we will try to provide additional context between the two periods in order to try and help you understand the underlying financial and operational trends of the business. We will also sometimes refer to pro forma information, which includes the results of both the Karnes and the Giddings assets, as if they had been combined as of January 1st, 2017. As Steve noted, the pro forma results also include the results of the GulfTex acquisition that occurred on March 1st, 2018, as if it had been included in all periods presented but exclude any non-recurring items such as transaction costs.
Additionally, it's important to note that Magnolia has adopted an Up-C structure in order to preserve certain tax benefits to both Magnolia and the sellers of the Karnes County assets. The consequence of this structure is two classes of shares, A and B, which have equal voting rights. This also means that we report a non-controlling interest line for the shared income associated with the Class B shares. The important thing is that from an investor standpoint, the Up-C structure is generally neutral, with the exception of taxes and in the current period's earnings for Magnolia, the one-time transactions cost of $22.4 million that were incurred in connection with the business combination. Our Class B shares associated with the non-controlling interests are not included in the diluted share count because they would be anti-dilutive.
We reported an average diluted share count of approximately 157 million shares in the third quarter, which includes the dilutive effect of warrants of 5.1 million shares. However, for EPS modeling purposes, you should use our full net income, including the non-controlling interest and our combined total of Class A and Class B shares outstanding, as well as the dilutive effect of warrants during those periods of solidly positive income. Looking ahead to the fourth quarter, we met the third and final tranche of our Karnes County earn-out consideration. So we expect the Class A and Class B share count to be approximately 250 million shares outstanding, which is reflected on the face of our 10-Q that will be filed later today. Moving on to the numbers.
Magnolia reported net income of $6.7 million on a GAAP basis, or $0.04 per diluted share for the two-month successor period ending on September 30th. Net income, including the non-controlling interest, was $25.5 million for the two-month successor period. Earnings for the successor period were affected by a number of non-recurring one-time cash charges, including $22.4 million of transaction costs related to the business combination, $11 million associated with a seismic license purchase, and a $6.7 million loss associated with a payment made to EnerVest as an early settlement of a liability in lieu of a $47 million contingent earn-out payment based on certain net revenue thresholds that were payable in 2021. Revenues totaled approximately $178.6 million for the two-month successor period and $267.7 million on a pro forma basis for the third quarter of 2018.
The company's average realized oil price was $70.79 per barrel for the successor period, or $72.55 on a pro forma basis for the third quarter. Overall revenue benefited from strong relative price realizations as our oil realizations are indexed to LLS waterborne prices. As such, our realizations were 105% of WTI during the third quarter. Turning to the cost side, unit costs for the quarter highlight our field efficiencies. For the purpose of modeling the company, we would recommend using the per Boe cost metrics shown in slide eight of the conference call slides for the successor period. As these costs are representative of the current basis of accounting for the assets.
LOE came in at $3.14 per Boe for the successor period and $3.46 per Boe on a pro forma basis for the third quarter of 2018. Lower than expected as a result of the Harvest acquisition, as well as new wells brought online in the third quarter. DD&A costs were $19.25 per Boe for the successor period and reflects Magnolia's plan to focus on near-term development of PUD reserves. Exploration expense was $11.2 million in the successor period. This reflects a one-time purchase of a seismic license for $11 million. In the future, we would expect that our exploration expense to be lower as our operations are largely focused on development. G&A expenses of $10.3 million, or $2.94 per Boe during the two-month successor period, were higher than normal and due to additional G&A costs related to acquisition and professional service fees.
We would expect our per-unit G&A cost to gradually fall over time as some of these fees subside and as our production continues to grow. The effective tax rate for the successor period was approximately 12%. We expect our effective tax rate to remain in the range of approximately 13%-15% due to the accounting treatment of the non-controlling interest. At the close of the business combination which formed Magnolia, we had $115 million of cash on hand. On a pro forma basis, adjusted EBITDAX, as shown on slide nine, was approximately $216 million for the third quarter ended September 30th, $575 million for the nine-month period of 2018. Capital spent on drilling and completing wells was $112 million during the third quarter. Well within our objective of spending within 50%-60% of cash flow.
The cash consideration for the Harvest acquisition was $133 million. We spent another $2 million on other leasehold acquisitions, $11 million on the seismic license during the third quarter. We paid EnerVest $26 million in cash during the quarter as an early settlement for an earn-out obligation. We ended the third quarter with $37 million of cash inclusive of the outlays I just mentioned. We ended the period with $388 million of long-term debt on the balance sheet. Our revolving credit facility was undrawn with a capacity of $550 million. A summary balance sheet can be seen on slide 10.
As we noted in the press release, we increased our production guidance for the full year to 53,000 BOE per day from 50,000 BOE per day previously due to better than expected results from our drilling program in the third quarter, the completion of the Harvest acquisition, as well as higher non-operated activity. Turning to guidance for the remainder of the year, we expect our total production to grow sequentially and average approximately 59,000 BOE per day during the fourth quarter. The improvement is primarily due to additional wells expected to be turned in line during the quarter, and also partly due to a full period of capture from the Harvest acquisition. Giddings is expected to see solid sequential growth with expected fourth quarter production of 17,000 BOE per day as additional wells are completed and turned in line.
We continue to expect that our total capital will be in a range of 50%-55% of our full year 2018 EBITDAX and in line with our earlier guidance. We expect to drill and complete approximately 60 net wells through our asset base during 2018. Looking into 2019, we expect that our capital spending will be in a range of 50%-60% of our total EBITDAX for the year and in line with our business model. We currently plan to run a total of four rigs next year, continuing with two rigs in Karnes, and as Steve mentioned, adding a second rig in Giddings early in the year in an effort to further appraise our large net acreage position.
Product price changes at current prices affect our earnings before income and taxes by roughly $12 million on an annualized basis for every dollar per barrel change in oil prices, and $3 million on an annualized basis for every $0.10 per Mcf change in natural gas prices. We're now ready to take your questions.
Thank you. Ladies and gentlemen, we will now be conducting our Q&A session. If you would like to ask a question, please push star one on your telephone keypad now. A confirmation tone will indicate your line is in the question queue. You may push star two if you would like to remove your question from the queue. For any participant using speaker equipment, it may be necessary to pick up your handset before pushing the star key. One moment while we poll for questions. Our first question comes from the line of Neal Dingmann from SunTrust. You are now live.
Morning, guys. Congratulations on a great first quarter. Steve, for you or Chris, my question is really just when you add that second rig or maybe talking about both the rigs in the Giddings field, could you talk about where you believe the focus will be there, at least initially, to start off next year?
With the second rig especially, we'll be looking at different areas. Not necessarily where we've drilled so far to try to see what might be there. Probably some in the south, then some probably in our northeast, northwest corner of it right now. As the results come in, that rig isn't in a development mode, we'll probably move that around as the year progresses. We're still really in early days of this, and I think the planning should be viewed as flexible for next year.
Okay. Just lastly, anything you can add, just I know you guys have been great on these bolt-on acquisitions, on timing behind these, anything, and the size, potentially. Thank you so much.
Well, we look at a lot of stuff. We expect there'll be some in this quarter, probably fairly small. We're not interested in large public deals, and there are not very many large private deals either. I would expect there'll be some modest growth from that in the fourth quarter and maybe more in the first quarter. This volatility that we're currently enjoying or experiencing, however you want to describe it, probably makes more acquisitions likely as people get more nervous. To some extent, we're set up to respond to that.
Very good. Thanks so much, Steve.
Thanks.
Thank you. Our next question comes from the line of Jeffrey Campbell from Tuohy Brothers. You are now live.
Good morning. Congratulations on your first call. Can you disclose how much.
You always remember that you only have one chance to make a good first impression.
Yeah, well, your record precedes itself. Can you disclose how much your Giddings average working interest increased due to the Harvest acquisition?
I think it was about 15 percentage points.
Thank you. It was mentioned that you're going to add a rig in Giddings first quarter next year. Will Giddings still be a self-funding program with a two-rig program?
Yeah.
Okay.
It probably won't be a 50%, 60%. It'll probably be closer to 100%.
Okay.
We'll probably use all the cash flow from Giddings to work Giddings, and Karnes will probably continue at sort of around 50%, I would guess.
Okay. If I could ask one last one, because I didn't see it in the presentation. Are you currently hedging any production?
No.
What's your approach to hedging going forward?
If we had to, we would buy insurance, but that's the only reason we would hedge. My track record for predicting oil and gas prices is pretty crummy. I could prove that to you if I had to. The idea is that you hedge when you need to. You need to protect your capital program, or you need to protect your balance sheet. We're designed to do that. I assume the good folks who sell hedging products actually make money on it. I'm really not in the business of enriching Goldman Sachs.
Okay, great. Thank you. Congratulations again on the quarter.
Thank you. Our next question comes from the line of Irene Haas from Imperial Capital. You are now live.
Yeah. Hi. I was noticing that your NGL pricing was quite strong this quarter. Could you give us a little color on that? Should we expect the same trend next quarter? Secondarily, how is your in-house staffing coming along? Because you still probably have that service contract with EnerVest team. When would you bring in a COO?
Well, we actually hired an operating executive, I think it was announced, a guy named Steve Millican. We hired an operating executive a few weeks ago.
Okay.
We filed because he is a reporting person. He was at EnerVest. He ran their the stuff we bought, essentially.
We have an operating person, and we're in no hurry at all. Right now, the EnerVest people are doing a great job for us at a reasonable cost. And there's no real reason to change that unless it changes. As far as the NGL pricing goes, NGL pricing has been strong, and there's no reason to think it's going to change for this quarter. It's just been running pretty good as a percentage of WTI. Probably its percentage is up as the WTI price seems to want to decline above a barrel a day.
Right. Also gas price is looking pretty good, so you guys should be positioned to enjoy that as well.
Yeah. We produce about $80 million a day, roughly, in gas. We've had a dollar change, basically. It's $80,000 a day. Roughly speaking, I think that's not so bad.
Okay, great.
Thank you. Thank you, Irene.
Thank you. Our next question comes from the line of Jeff Grampp from Northland Capital Markets. You are now live.
Good morning, guys. Sticking over on Giddings, can you guys maybe touch a little bit on how maybe some of the recent wells that you've recently completed, how those have been performing and maybe how some of the longer-term performance has been from the first few batch of wells that you guys announced earlier this year?
I think when we started this, we said that one of our goals was not to provide a lot of detail because they're still open acreage. We'll file when we have to. Generally speaking, the wells have been performing in line with the ones we disclosed in the offering. There's been some small decline, but clearly, a lot of these wells, we've got a well making 1,000 barrels a day of oil. It's been making it for six months. I mean, it's pretty good, but it's not perfect. Obviously, there's things that some are a little better than others. We haven't drilled any really bad wells, but given enough time, enough wells, I'm sure we will. We'll file when we have to, and you'll be able to see the wells as we file them.
Generally speaking, we've been pleasantly surprised.
All right. That's fair. I appreciate that, Steve. I'm curious, as you guys look into 2019 here with the added rig in Giddings, do you guys need a frac crew that would support each of the activities in each kind of operating area? Would you look to keep the one crew and bounce it back and forth in 2019? Is that kind of-
We'll probably keep the single crew. Unless we pick up the Giddings, because the other well's going to be drilling sort of one-off wells rather than development wells. It's going to be a little slower than we might have in a development mode. We ought to be able to make do with a single crew. It makes the production a little lumpier than we might like, because all of a sudden it's going along, you think you know it, then all of a sudden you turn on some wells and you get a big run-up. If you're watching quarterly numbers, it may be a little confusing.
Okay. That's helpful. I appreciate that. Last one from me. We've seen a couple non-energy SPACs lately do some tender offers on some warrants, was just curious if you guys have given that any consideration. Obviously, generating a lot of free cash, and that's kind of a roundabout way of a buyback, which you kind of referenced earlier. Was just kind of curious to get your all's thoughts on some sort of transactional thing related to the warrants.
We view the warrants as having exceptional value. I think that's probably all we can say about it.
All right. Fair enough. Appreciate the time, guys.
Thank you.
Thank you. Our next question comes from the line of Michael McAllister from MUFG Securities. You are now live.
Thank you very much. Welcome back to all.
I don't know about that. I'm just thinking about how I'm going to get out of this in the future.
Ooh. Leading question.
Oh, I'm sorry. Go ahead.
If you could, what was Harvest production at the close of the deal at [crosstalk]
About the same as it is now. Same as what we said.
Okay.
It was heavily towards the Giddings. The production was almost entirely Giddings, I think. You can see where the Giddings production is. It's about what we said from the beginning from when it closed. It'll mirror pretty close the growth that's in our outlook for Giddings. Maybe a little better on average because some of the locations are better.
Okay. With the thought of getting bigger, what about going outside of the two core areas in acquisitions?
Well, I think what we said to that question over time is, it has to fit the business model. 50%-60% of the cash flows to grow the business 10%-15% a year. High operating margins of 40%-50% EBIT margins. That implies a high-quality reservoir. It would take a considerable reduction in purchase price to make that work because I count purchase price as part of the EBIT calculation. A lot of people ignore the purchase price because it's the non-cash charge at DD&A. Once was cash, but now it's non-cash. I think we're just cautious about going out. If we could find exceptional value, we'd consider that. We spent a year looking for that and didn't find it. I think there might be something, but it's probably not imminent.
Okay. That's what I have. Thank you very much.
Thank you.
Thank you. Ladies and gentlemen, once again, if you'd like to ask a question, please push star one on your telephone keypad now. Our next question comes from the line of John Evans from SG Capital. You are now live.
Hi, it's John Evans. I was just curious.
No, the thing doesn't work for us.
Yeah. No, I was just letting you know. Just from the standpoint, you're building this kind of unique company from a generalist standpoint. I guess I was hoping maybe you could help me understand how you guys go about thinking of spending the extra EBITDA that you have relative to dividends or stock buybacks, as opposed to just buying more oil and gas properties, et cetera. A lot of industrial companies obviously do that over time, and I'm curious to understand your guys' thought process towards that.
Okay. The oil and gas, if you can buy oil and gas properties that fit the business model.
As you say, you earn decent, good EBIT that doesn't dilute us. Good EBIT, you can generate an aggregate growth out of it, 10%-15% organic growth, with under 60% of the cash, that's a non-dilutive acquisition, we go do that. Eventually, you would think there'll be more happiness in the oil industry and the opportunity to do that goes away. Once we can't do that anymore, we'll turn our attention to either dividends or share repurchases or both. There's not hardly any float anyway, you wouldn't want to go in the open market now to buying shares.
Sure. Okay.
Obviously EnerVest has shares, but I'm not sure they're sellers at current prices. I think it's just a matter where the value would be at the time. The bias, if it's neutral, that is between share repurchases and dividends, my bias has historically been for dividends. Easier to count.
Okay. Just a follow-up question. With this tumultuous slide that we've seen in crude, do you think that gives you better opportunity as you go into next year to make some more of these accretive bolt-on acquisitions?
I hope so.
Okay.
It's the old line about when everyone is frightened, we're greedy, and when everyone is complacent, we doze off. Generally speaking, in a buoyant environment where everybody's all happy, probably less opportunities for sure. In a more volatile environment, people get more frightened, and we've set the company up so we don't have to be frightened.
Great. Thank you for your time.
Sure. Thank you.
Thank you. Ladies and gentlemen, we have no further questions in queue at this time. I'd like to turn the floor-
Thank you.
to management for closing.
We're done.
Thank you. Appreciate y'all's time today.
Thank you, ladies and gentlemen. This does conclude our teleconference for today. You may now disconnect your line at this time. Thank you for your participation, and have a wonderful day.