Exploring Hydrocarbon Depletion
Page added on March 22, 2017
Oil prices are difficult to predict.
Some North American oil producers are leaner and less risky than they used to be, especially those that have wiped out billions of dollars in debt via bankruptcy.
I identify one such bankruptcy rebirth, which, despite less risk, trades at significantly lower multiples than its peers.
There is potential for a 70% increase over the next year if oil gets back into the mid-$50s and it trades at similar multiples to competition.
There is also a reasonable chance an outright purchase of this firm could realize value before then.
Back in 2014, I wrote this article arguing that the House of Saud’s main motivation for allowing oil prices to fall was not economic but power based, concluding:
“So, when we investors consider how long oil prices are likely to stay at current levels, we should not just think about monetary influences. In this case, the maintenance of political power by the House of Saud is at least as big a driver. How low oil prices can go and for how long is still as dependent on the geopolitics of the Middle East as the boardrooms of the Mid West.”
Later, I argued three indications of when this particular war was “at the end of the beginning” might include:
A September 2016 comment posted in that same article declared these conditions had largely been met (the Algiers conference being the final trigger), and in this December 2016 blog post, I revealed the positions I took because of this view.
This article in a sense is merely an extension of that theme. I wanted to look further into production companies to see if any warranted inclusion in my portfolio. I want to acquire a post-bankruptcy oil producer in order to exploit what I see as an opportunity in the hope it delivers the return desired.
While the rest of the article will deal with a narrowing down of the choices, ultimately landing on specifics of the investment I settled on, I don’t want to lose the forest for the trees: ultimately, what is really going to matter here is the price of oil. Oilprice.com has positive things to say, and in “The Oil Market Is At A Major Turning Point,” it concludes we will soon be in the $60-70 range. However, I don’t want to rely on that. Instead I hope to pick an investment which will do a little better than others regardless of oil price. As one hiker said to his buddy, “I don’t have to outrun the bear, I only have to outrun you.” I thus want to find the leaner competitor should such a bear suddenly appear.
Narrowing the Universe
In the blog post already linked, as well as my YMBCi series of articles, I mention some of the energy-related plays I have already invested in: XES, YMLP, APLP, OTC:BRYFF, OTCPK:SFTBY, CPLP, TGP, TNP, and TK. Some may notice, none of these are actual oil and gas producers. Instead they represent ancillary providers of transportation and services to the industry. This was purposeful. These were the survivors in the sector that I felt not only had decent upside, but also were likely to continue to survive should my short-term expectation of higher prices prove wrong. I could not say the same thing about the actual producers at the time, so I by and large stayed away from them. In short, I was too scared to invest in most of the actual producers.
As it turned out, that may have been to my detriment or it may have been a wise choice depending on which producer I might have chosen. Many of the producers which were on life support subsequently went bankrupt; others survived and saw rebounds even greater than the names I did invest in. Looking back, I do not begrudge the choice. The risk inherent in investing in a leveraged producer was extreme, and for many still is; most needed oil prices to increase in order to survive. Some did not survive even with those oil prices up 60% from their lows.
Despite the recent decline in oil prices, I see enough light at the end of the tunnel that I do want to dip my toes a little further into the actual producers. The YMBCi portfolio’s recent purchase of Chinook Energy (OTC:CNKEF) is one such example. That company has been well covered by Value Digger in a series of articles, so I won’t go into it further here. I do recommend you read those articles. It does seem a good opportunity: small, cheap, nimble, and it’s operating on the edge of the energy production industry. So more than most, it has the opportunity to succeed spectacularly. Once again, though, what is going to really matter here is the price of energy (CNKEF is more gas than oil). If it goes up the sector will do fine, if it doesn’t it won’t; size your position accordingly.
In addition to my small holding in Chinook, I wanted to put more money to work in oil production. I however still wanted to stay away from most of the survivors in the production arena, particularly the one’s with high debt levels (You will notice the Chinook Energy after the Craft spin-off has no debt). I also decided to stay away from mega caps, as I feel in that arena my research skills are unlikely to provide any meaningful insight that has not already been priced in.
So, I decided to focus on low debt re-births: those oil companies that had already gone bankrupt shot their shareholders, cleared the decks of debt, and been reborn stronger, nimbler, and more resilient. One can get just as good of prices and valuation ratios with these oil producer re-births, one can even sometimes get experienced management and crews, but because they have less debt, they can withstand more adverse circumstances than many of their survivor brethren. Also, because they went bankrupt and were reborn, they will be much less followed than some of the bigger names. Undiscovered, higher return potential, and relatively less risk of imploding due to debt covenants is what I went looking for.
There is no dearth of bankrupt oil companies to choose from: Energy XXI (NASDAQ:EXXI), Samson Resources, Linn Energy (NASDAQ:LINEQ), Berry Petroleum, SandRidge Energy (NYSE:SD), Stone Energy (NYSE:SGY) to name a few. Indeed, many seem to have timed their bankruptcy emergence until a recovery was in process. In this way, they sought to maximize benefit and minimize risk for those in control, their management and former debt-holders (This unfortunately simultaneously left the shaft for their former shareholders, but this is not the place to debate what is right or fair about our system). Rather, my intention is to move forward, learn from the past, and more importantly make money where possible. The landscape is littered with hundreds of bankrupt oil producers, more than a few have been reborn, even those which haven’t have typically sold their assets to someone else ready and able to exploit them. So, there is plenty of opportunity out there. One thing I think the Saudi’s may have misjudged is the resilience of American business. American oil producers died; long live American oil!
My choice of oil producer to add (more of) in my portfolio is one of these reborn companies, Energy XXI.
Specific Oil Producer Choice
Energy XXI is an oil producer which recently emerged from bankruptcy. It also has warrants which trade under the symbol EGXGW (right to purchase one share of EXXI for $43.66 through December 31st, 2021, potential 6% dilution). Energy XXI specializes in shallow water wells on the Gulf of Mexico shelf off the Louisiana coast. It is exceedingly unpopular with its former shareholders, who likely just want to forget they ever owned it. Because it is off the Gulf Coast, it also carries significant risk should a spill occur (ex: Deepwater Horizon). For shareholders however, that kind of risk can be controlled by limiting position size, so let me just make it clear up front that Energy XXI is a speculative position and should be sized accordingly.
I first looked into Energy XXI to try to get a better handle on whether another holding of mine which had bought one of EXXI’s pipelines, CorEnergy Infrastructure (NYSE:CORR), was likely to continue getting paid. I concluded it would (No matter who owned EXXI, ultimately if they wanted to get that oil to market, they were going to need to pay CORR to get it there. Luckily this proved correct).
In the process of doing my due diligence, I also became aware one of the EXXI notes, the EPL 8.25% notes. In my judgment at the time, they had a lot of leverage in the bankruptcy, and thus were likely to get a good settlement. This too ended up being correct; those notes received shares and warrants in the new EXXI which as of this writing represent over a 300% gain (so far) from my original bond purchase price. However, I have not only decided to keep those shares and warrants, I recently decided to add to those holdings at current prices.
Admittedly, part of the reason I chose Energy XXI is familiarity; I feel I know it better than others. But also in researching some of the other names mentioned, I kept coming back to EXXI. I didn’t find one that was clearly a superior investment to it. Some had comparable valuations, the CNKEF I mentioned buying earlier was even cheaper, but it was gas heavy at 80% gas (so kind of apples and oranges). EXXI is a larger, more proven oil play, with known attractive economics. We have history on the cost per barrel (lower now that the debt is gone). We have a decent idea what the production and drilling costs per well might be. EXXI has proven access to market, a clear growth path, and as I keep emphasizing, almost no debt. As a matter of fact, because of the bankruptcy, EXXI went from over $4 billion worth of debt to less than $100 million. A 97%+ reduction in debt is a fundamental change in the company structure, it matters! I only regret it did not also change the name; keeping the Energy XXI name in my mind comes with baggage (but as you will see later, this too may be about to change). It’s poor marketing. New management, a restructuring of operations, almost no debt, this is a completely different company (If it is any consolation to bitter shareholders, trust me, none of the original debt-holders are walking away whole either).
Conceptually. the overall point I want to make here is that $4 billion worth of debt, plus any money raised through issuance of shares, bought something. It bought oil producing assets off the Louisiana coast which, other than the $200 million pipeline sold to CORR mentioned earlier, largely stay intact. Now many of those may have been bad purchases, but they were not worthless. The new Energy EXXI is comprised of about 33 million shares each of which has rights to its own little chunk of those assets. If you divide $4 billion by 33 million, you will see each current EXXI share represents assets which were originally purchased for over $120. Don’t get me wrong, I’m not saying the assets are worth anywhere near $120 today, but that is what was spent. It did get something for that. What we need to decide is how much they are worth. To keep your interest, I will also tease that $97 billion in assets Oaktree Capital recently increased its holdings of EXXI above the 10% insider level. It clearly thinks there is value here.
Valuing Energy XXI should be much easier after the next quarterly earnings get released. They should be the first quarterly earnings of EXXI which are not jumbled up with a bunch of one-time impairments, purposely hidden value, bankruptcy fees, lack of growth and growth estimates during bankruptcy, etc. Unfortunately, when it becomes apparent to the world, it is usually too late. For now, be aware that our EBITDA figure is significantly reduced by the wells effectively being in run-off mode for more than a year. EXXI’s next earnings announcement might very well clear things up and provide a trigger point. It behooves us to make our best guess now with the information we have.
EXXI did put out an interim quarterly and annual report to bridge the June 2016-Dec. 2016 period; however, it too is somewhat hidden under the interim name, Energy XXI Gulf Coast (OTC:EGXG). There is also an interim presentation available on the company’s website.
I suggest all potentially interested investors spend a lot of time reviewing these sources. Do not trust my numbers; honestly, this one was confusing and I probably made some potentially meaningful mistakes. My hope is readers here will help me research, reveal, and correct my mistakes before the greater market does.
As you can see, EXXI’s business is currently profitable:
My analysis concurs with the picture above from EXXI’s presentation, at a realized pricing of $38 per barrel ($48 WTI becomes about $38 realized pricing after adjusting for mix), the company is going to be netting cash of approximately $15 per barrel (doesn’t include DD&A or growth capex). In my modeling, even with a 10% increase in some costs due to inflation in the sector, EXXI still nets over $10 per barrel. Free cash flow also stays positive each quarter in 2017 despite $155 million in capex costs and low production versus past results. In that model, I reduced barrels produced to 40.8k in the March quarter (current is 42.5k), then gradually increased it from there due first to an increase in rework capex, and then eventually towards the end of the year; some actual new wells start coming online. I feel this is conservative.
I have modeled Energy XXI producing an average of only 43k barrels per day this year, essentially no net rise, despite spending $155 million in capex. This may very well be overly cautious, but my thought here is because new drilling was halted for quite a while, there is going to be a significant delay between outlay of funds to produce more barrels and those barrels actually coming online. This effectively causes 2017 to have significant capex costs, with little in year benefit. Cash flow doesn’t really start to exponentially ramp up until 2018 with WTI pricing in the mid-$50s (WAG) and new producing wells eventually getting them back to their normal historic production (50k+ barrels per day).
Here you see PV-10 for proven reserves with oil priced at $42.74 per barrel. This is the required PV-10 using standard methods (e.g. average selling prices over the period). However, it is important to note that $48 not $42 is the current WTI pricing for a barrel of oil. With EXXI, and most oil producers, not only do higher prices pretty much drop directly to the bottom line, but also as prices go up, so too do recoverable barrels of oil. That exponential leverage is why we get a 1P chart jumping from $138 million to $988 million when WTI price goes from $42.74 to $54.77 per barrel (Note: EXXI’s recovery is generally over 70% oil).
Here EXXI has also provided a 2P PV-10 estimate of $2.074 billion (the $4 billion originally spent to buy and develop this field is starting to make more sense). EXXI’s current EV is only $942 million (it actually has more cash on hand than debt on the books). So, in a sense, at $54.77 per barrel, you would be getting $2.20 worth of assets, for every $1 you spend (=$2,074/$942). To give you a second sense of leverage, at WTI $54.77 per barrel, I have EXXI producing about $3.50 per share in free cash flow (FCF) for 2018 (this incorporates the oil/gas mix). If however, that price were to rise to WTI $75 a barrel, EXXI throws off over $14 per share in FCF.
As such, it is probably the more comparable of the two. W&T Offshore, however, has not gone bankrupt (at least not yet) and thus has not had the benefit of washing away its debts. Thus, while W&T is a good comparable, because of its much higher debt load (123% debt/assets vs. EXXI at 5%), it is also more risky than Energy XXI.
Despite being less risky than W&T or Kosmos, EXXI trades at significantly cheaper multiples (lower $/flowing barrel, $/Reserve barrel, EV/PV-10). The Energy XXI EV/EBITDA ratio is more expensive; however, as I explained earlier, that is probably due to the EBITDA figure being abnormally low (due to wells essentially being in run-off mode for the last year). I think the valuation difference between EXXI and its competitors mainly stems from EXXI still being relatively hidden from investors. This is something I expect to start to correct with the next earnings release, but which will also probably take a while to be fully recognized.
As Energy XXI ramps back up drilling, there will be a delay between capex expenditures and increases in flowing barrels. This in turn will challenge FCF for the next couple quarters. I have modeled continued decreases in flowing barrels for EXXI over the next two quarters, down to 41k barrels per day in June. The capex program starts that rebounding in Q3 and finishes Q4 back up at 45,000 barrels per day (eventually in 2018, it rises to a steady state of 57,000 barrels). So, it’s going to take a while for EXXI’s FCF generation power to show through, and of course, where the ultimate barrels per day and oil price ends up in 2018 is an unknown. Here is a chart I prepared with 2018 FCF expectations given different production and oil price assumptions:
I don’t know how much a delay in ramping back up flowing barrels might slow down the market’s realization that Energy XXI should be priced closer to W&T Offshore’s multiples. I do applaud Energy XXI’s recent choice to switch to a big name auditor, Ernst & Young, in order to reassure potential future investors. We will just have to see how long it takes for the market to become away; however, there is another much quicker potential possibility.
Is Energy XXI for Sale?
A recent press release indicates Energy XXI has retained Morgan Stanley to “assist the Company’s Board of Directors and senior management team with the evaluation, development and implementation of a strategic plan, including a stand-alone financial plan and select strategic alternatives.” Sometimes this means just what it says, advice on how to proceed forward to maximize value for shareholders. Sometimes it is a precursor to a larger development deal with a PE firm. For Energy XXI, this would also make sense. However, sometimes press releases like this are also precursors to a sale.
A way to effectively put a for sale sign on one’s proverbial front lawn. I would note the CEO of Energy XXI is considered interim. He might not only be willing to step down for the right price, but also it might even be the plan. Chevron (NYSE:CVX) (and SandRidge) have platforms in close proximity to Energy XXI. A merger with either of them should provide some attractive synergies. Maybe Energy XXI’s assets are even more valuable in someone else’s hands than just developing them itself. This would also be the original bondholders, whose charters may not include long-term ownership of common shares in oil wells, an efficient way to cash out.
While I personally think we have seen “the end of the beginning” in the oil price war, I also do not pretend to know what oil pricing will be next month or next year. Rather my point here is more if you want to have an investment in oil production, Energy XXI seems a good choice. Indeed, the company was chosen in part because its lack of debt will make it more resilient should times end up being more challenging than expected.
For now, I am putting a target on EXXI of $50 a share, a 70% increase from current pricing, but I think it’s going to take a little over a year and a $55 dollar WTI oil price to get there (unless it gets bought out). At $50 per share, Energy XXI’s $/flowing barrel and EV/PV10 would be in line with what investors are currently paying for W&T Offshore. At $50 per share for EXXI, an oil price of about $55, and 57,000 barrels per day in production, an 8% FCF yield is implied. This does not seem too rosy of a projection; however, admittedly it is rough and I am not experienced in this sector.
Again, as always, I look forward to further scrutiny from knowledgeable readers. I encourage your comments and criticisms. If you find this article interesting, and would like to get notification of updates and/or other articles, please click on my follow button above. At worst, you will get to make fun of my ideas (preferably before they become lousy trades).