Penn West Energy's Reassuring Earnings Update

| About: Penn West (PWE)

All figures CAD$ unless noted:
Operating cash flow held up in the fourth quarter, dropping only 2% from Q3 to $602M. Funds flow from operations (FFO) fell 26% on a sequential basis to $490M, due to changes in working capital. The standardized distributable cash ratio (basically the ability to cover distributons from free cash flow) remains elevated at 1.52 for Q4, 1.34 for all of 2008. Any figure higher than 1 has negative implications.

The balance sheet remained somewhat static from Q3, with the only notable change being some gains due to hedges as the price of oil has dropped. Subsequent to the end of the quarter, Penn West announced capital raising of $238M from a bought-deal units offering and ~$190M in asset sales. The company plans to apply proceeds to reduction of debt, which stood at $3.9B at year-end.

The income statement divulges little on the state of Penn West’s operations. Netback margins remained high at 58% despite the drop in oil prices but this doesn’t quite square with the fact that operating income, once adjusted for unrealized hedging gains, showed a loss of $2M. Full cost accounting and the high level of depreciation charges probably factors into this disparity. PWE has roughly 25% of 2009 production hedged at favorable prices, which does not assure cash flow levels for the year.

In my previous post on Penn West, I speculated on possible scenarios for the company’s cash flow in 2009. Interestingly enough, the company did not provide any financial guidance for the year, other than to project capex at $600M - $825M. However, CEO William Andrews did clarify that Penn West could maintain its current $0.23 distribution with oil prices averaging US$45 for the year.

Working backwards (assumptions: midpoint capex of $712.5M, $0.23 distributions on 390M shares, 1.25 standardized distributable cash ratio & OCF = FFO), I get projected 2009 FFO of $1.4B. This is very rough speculation and you could change some variables such as assuming management will try to live within cash flow or that FFO will exceed OCF like it does most years. The most important factor, though, is probably the oil price. Every US$10 change in oil prices equates to $190M in FFO.

I only engage in the previous exercise to get at a ballpark figure for this year’s expectations. I am relieved that my worst-case scenarios from last month are unlikely possibilities. Furthermore, the company shouldn’t have any liquidity problems as its credit line doesn’t come due until 2011.

Penn West also announced new reserve totals for 2008, which were unimpressive at 454MM BOE net proved reserves. However, the company did discuss three new prospects including the Shaunavon oil play in Saskatchewan and a new shale gas play near existing operations at Wildboy. These prospects sound promising but management has to deliver after Peace River (which is even more uneconomic in today’s conditions).

All in all, Penn West’s earnings update reassured me, despite the massive drop in its unit price. Its market price is probably wholly dependent on a recovery in energy prices but the company seems to be in position to weather sustained low prices through this year. In my eyes, management has lost some credibility over the last year or two but with the addition of Murray Nunns, hopefully they will be able to execute on their program of targeted capital spending, debt reduction and unitholder returns.

While I regret not selling my whole stake when I divested a third of it last year (let this be a final lesson — don’t let tax considerations get in the way of selling), it makes no sense to sell now. In fact, the stock could be undervalued at these levels but the uncertainty regarding the SIFT tax in 2011 precludes me from adding to the position. Perhaps management should clarify their intentions regarding Penn West’s trust status once tax loss shelters are exhausted.

Performance measurements:

  • Production: 180,000 BOE per day before dispositions
  • Capex: $600M - $825M
    • Higher-end target only if oil prices recover > $50
    • Execute on plans to drive costs lower for first half 2009
  • 2009 FFO: $1B - $1.7B
  • Reduce $3.9B debt load
  • Deliver results on new prospects:
    • Shaunavon
    • July Lake
    • Pembina