CWEI

1. CWEI • About CWEI • Clayton Williams Energy, Inc is an independent oil and gas company engaged in the exploration for and production of oil and natural gas primarily in Texas, Louisiana and New Mexico. CWEI’s portfolio of oil and natural gas reserves is weighted in favor of oil, with approximately 77% of proved reserves at December 31, 2011 consisting of oil and natural gas liquids (“NGLs”) and approximately 23% consisting of natural gas. CWEI has two reportable operating segments, which are oil and gas exploration and production and contract drilling services. • Porter’s Five Forces Classification • Buyer Power: Are consumers sensitive to product prices? Partly yes, in the same way that I might complain about higher coffee prices, and then go right along drinking my 2-4 cups per day. I admit the analogy is not perfect but I need coffee to get through the day like the U.S. needs fuel to drive to work to power the economy and because of that, demand may decrease but there will still be demand. It would take a substantial lifestyle change to substantially decrease demand. Likewise, energy products derived from oil and gas production are on the inelastic end of the elasticity spectrum. Market prices are based on several variables such as supply and demand, technological advances making the cost of extracting relatively cheaper (although resources are now harder to get to – the low hanging fruit has been picked), consumer demand, and international markets (for an example of how international markets impact the price of crude oil, refer to the Finance & Industry Discussion section). “A weaker U.S. dollar makes commodities sold in dollars such as oil cheaper for investors with other currencies, thus increasing non-U.S. demand for the commodity…” • Supplier Power: Oil and gas companies may own or lease land for extraction of oil and gas. This topic alone deserves its own discussion and contains many intricacies that extend past my area of expertise. What’s important to differentiate as an investor is the company’s skill in acquiring valuable land rights at a reasonable cost. The companies with the best geologist s and lowest overhead cost structure generally win this game. It’s also imperative to maintain a portfolio of commodity products that allows emphasis to the commodities that are priced highest. CWEI’s largest concentration proved reserves (about 80%) is in West Texas in the Permian Basin. The Permian Basin is an oil- and NGL-rich formation. In a commodity pricing environment such as the current one (where oil and NGLs are priced high compared to natural gas ), it’s advantageous to be able to focus capital in regions such as the Permian Basin. While some U.S. energy companies have rights to only natural gas plays, CWEI’s exposure to oil and gas proves beneficial when natural gas prices are as low as they are. More than 15% of the company’s proved reserves are

2. CWEI • located in SE Texas in the Eagle Ford Shale basin, a relatively newly discovered and promising natural gas formation. Refer to the Finance & Industry Discussion section for a discussion of oil/gas price parity to follow in the near future. • Rivalry Among Existing Firms: The U.S. energy industry has been booming with the discovery of shale gas accessible via new drilling techniques. With the discover of up to 100 years of domestic gas production and improvements in technology making extraction of oil and gas from rock formations once thought to be unavailable or tapped, there has been an explosion in investments made to the U.S. energy industry. The space has been crowded and because of that, it’s important to differentiate the haves and have nots. It’s important to identify those acquiring land rights at a reasonable price vs. those paying too high a premium, most likely as a result of getting to an asset base after a commodity-rich basin has already been discovered. CWEI has maintained a prudent and selective capital management program by funding ~62% of their capital program over the last four years with cash flow from operations. • Threat of New Entrants: The threat of new entrants in the industry is low given how capital-intensive the industry is, aside from the industry and geological expertise and experience required to operate. The biggest challenge all oil and gas companies face is acquiring commodity-rich land right necessary to replace product extracted and delivered to the market. Again, it’s the companies with the best geologists and strategically prudent management teams that will maintain a long-term competitive position in this industry. • Threat of Substitutes: Oil and gas companies will continually face the threat of substitutes as new technology continues to evolve creating more sustainable sources of energy such as nuclear, solar, wind, and biofuel sources of energy. For oil-only producers, I’d argue natural gas to be a substitute as well as more petrochemical companies use natural gas-based derivatives for the production of plastics and more companies (ex. UPS) consider using natural gas powered vehicles. The development of alternate energy is an exciting time, both for consumer choice and for the environment. In the foreseeable future, domestic oil and gas is necessary to provide energy to the U.S. • CWEI rates low on buyer power, medium on supplier power, high on rivalry within the industry, low on threat of new entrants, and low on threat of substitutes.

3. CWEI • Investment Thesis • Based on free cash flow projections, CWEI is fairly valued but consider purchasing on a price pullback of less than $40/share. CWEI’s oil and gas producing properties are located in the oil-rich Permian basin in west Texas and the gas-rich Eagle Ford shale in southeastern TX. The revenue generated primarily by oil and NGLs (~89%) and the remainder from gas allows CWEI to sell the higher priced commodity while maintaining a significant gas reserve base in east Texas available for production when gas prices rise. Additionally, management has exercised reasonable capital discipline in a time when several companies have aggressively acquired and overpaid for land based on the expectation of significantly higher gas pricesthat haven’t yet materialized due to excess supply. Read Morningstar’s Chesapeake Energy Corp’s analyst report for an example of a company that has outspent cash flow generated from operations. • CWEI’s market share is 46% owned by institutional investors allowing plenty of room for institutional ownership growth. The P/E ratio is currently hovering at about 5.0, which uses a TTM EPS = $9.00/share, admittedly high compared to 2012 earnings expectations. Based on my 2012 projected EPS = $2.30, the forward P/E ~22.5. The mean estimate according to marketwatch.com for five analysts is $4.69, which implies a P/E ratio ~9.6. • Now let’s take a look at the Benjamin Graham securities metrics for the enterprising investor. • Financial Condition as of 12/31/11. • Current Ratio = 0.91, which is less than the 1.5 benchmark. While this is something to monitor, concerns about CWEI’s liquidity are relatively minor considering the company was borrowing $275MM with a borrowing base equal to $565MM as of 6/12 with an aggregate bank commitment totaling $475MM. • Earnings Stability. • The requirement to pass the test on earnings stability is earnings for the past five years. CWEI’s EPS from 2007-2011 was $0.53, $11.67, ($9.67), $3.04, and $7.71. CWEI doesn’t pass the test on metric #2 either but keep in mind the price of WTI Crude oil plummeted more than 75% from July 2008 to December 2008 when the credit markets were on the verge of collapse. While not a positive, I wonder how many oil and gas companies reported positive earnings in ‘09. What will be interesting to see is how companies prioritize capital in the midst of an economy that continues to experience benign growth (Google: “downward GDP revision” for more about the state of the economy). The weak state of the economy is definitely reason for caution in general. • Dividend record: The benchmark is that the company pays a current dividend. Many oil and gas companies, and especially small-capitalization oil and gas companies do not pay dividends (aside from MLPs and oil and gas royalty trusts). The argument for retaining 100% of earnings is that oil and gas companies have plenty of capital needs for investing in additional exploration and production (E&P) projects. Simply, management believes it can provide a higher rate of return to stockholders by allocating 100% of earnings to capital projects. CWEI does not pay a dividend.

4. CWEI • Earnings growth: The Company’s earnings in 2011 were greater than earnings in ‘06. CWEI’s ‘11 EPS = $7.71 while ‘06 EPS = $1.58. Oil and gas companies generally have a volatile earnings stream to match the commodity prices these companies sell and CWEI is no exception. The key is to invest/speculate in companies that sell the favorable commodity (in this environment that would be oil over gas) and will continue to do so in the near future. • Price: Price should be less than 120% of net tangible assets. As of today’s price compared to net tangible assets reported at 12/31/11, Price / NTA = 157%, which exceeds the threshold. • I own stock in CWEI and bought at a price = $45.15/share.

5. CWEI Appendix • Key Assumptions • Valuation & WACC Assumptions • Projected Free Cash Flows to the Firm • Price Sensitivity • Discount Rate & Long-Run Growth Rate Sensitivity

6. CWEI • Key Assumptions • 2012 Guidance: • Capital Budget = $405.2MM. • See chart for other assumptions used from CWEI’s most recent investor presentation. When a range is provided, the mid-point is used in the DCF model. • The base case price deck used is the NYMEX plus the guidance differentials for 2012 and the NYMEX futures prices for 2013-2020 and 2020 flat for ’21. The ‘22 revenue is simply the ‘21 revenue multiplied by the long-term growth rate. • WACC = 7.3% • Cost of equity estimate = 10.7%. • Wtd. Avg. before cost of debt = 6.1% • Wtd. Avg. after tax cost of debt = 3.9%

7. CWEI • CWEI Valuation and WACC Assumptions • The assumptions used in calculating CWEI’s WACC used to discount free cash flows to the firm are outlined below. As noted, the implied value of equity exceeds the current market value by 60%.

8. CWEI Projected Free Cash Flows to the Firm

9. CWEI • WTI Price Sensitivity Analysis • Approximately 85% of CWEI’s ‘11 revenue was derived from crude oil production. WTI crude is assumed to be flat for the valuation horizon (11 years) in the below chart. • HH Price Sensitivity Analysis • Approximately 11% of CWEI’s ‘11 revenue was derived from natural gas production. Henry Hub gas is assumed to be flat for the valuation horizon (11 years) in the below chart. • As expected given the revenue mix, changes in WTI crude oil prices have more significant impact to the company value and changes in Henry Hub gas prices.

10. CWEI • The base case discount rate = 7.3% while the long-run growth assumption is 3.0%. The values in the chart above illustrate the security value at various other discount and long-run growth assumptions all else equal. Cells labeled “na” are not calculated when the growth rate equals or exceeds the discount rate because the continuing value calculation becomes meaningless. • Continuing Value = (Year 11 Free Cash Flow) * (1/(RA - g)) * (1/(1 + RA)10 ) where RA is the expected return of asset A and g is the associated asset’s long-run growth rate. • As you see, the computed security value is closest to the 3% growth rate and between the 7%-8% discount rate.