Penn West: A Play On Keystone Pipeline And Improving Commodity Prices

| About: Penn West (PWE)

Penn West Energy (NYSE:PWE) is a Canadian oil and gas company, with operations primarily in Alberta, Saskatchewan, and Manitoba. Like many other western Canadian producers, its share price has fallen to multi-year lows.

First, let's take a look at some of the factors that are holding the company back. The biggest headwind is coming from lower commodity prices. The company's production splits are approximately 54% light oil/natural gas liquids, 11% heavy oil, and 35% natural gas. Depressed natural gas prices hurt the company's results in 2012, and so far in 2013, depressed light and heavy oil prices have been disappointing.

Canadian heavy oil trades at a discount to West Texas Intermediate, and this gap has widened over the last few months, reaching approximately 50%. Canadian light oil also trades separately, but this discount is minor.

The reason for the price differential is simple. Heavy oil is, first of all, more expensive to refine. Oil produced in Alberta needs to be shipped to Illinois, and then off to refineries in Oklahoma or Texas, which is a long trip. American pipelines are also filled up with light crude, a result of the increased activity in the North Dakota area. Refineries aren't forced to settle for heavy oil anymore, so it trades at a discount.

During PWE's most recent quarter, the price of light crude was down 15% year over year, while heavy oil dragged down results even further, as it fell 22% over the same time period. Natural gas prices were relatively flat, falling just 5%. Commodity prices are the biggest drag on this stock.

The company has responded to challenging conditions in a number of different ways. They've refocused their efforts on light crude, moving away from less profitable heavy oil and natural gas. They've hedged approximately half of their 2013 natural gas production, in the $3.35 range, as well as hedging 55,000 boe per day between $91.55 and $104.42. This means approximately 55% of 2013 production is hedged.

The company has also improved the balance sheet. They sold off $1.6B in assets, using the proceeds for capital investment and to pay down debt. Debt levels dropped from $3.9B to 2.7B, improving the debt to equity ratio from 43.6% to 30.3%. Debt is secure, there are no major repayments due until 2016.

The company is carrying $2B worth of goodwill on their balance sheet. Considering the entire company is trading at a 40% discount to tangible book value, I suspect a goodwill writedown will be coming in the near future. The goodwill is from their acquisitions of Petrofund, Canetic, and Vault Energy, all acquired during the boom years of 2006-2008. Nobody can argue those companies are worth the same now as when WTI prices were $20-$50 per barrel higher.

Penn West currently pays a 27 cent quarterly dividend, a yield of 12%. Based on 2012 FFS of $2.62 per share, this is easily covered. I estimate 2013 FFS to be in the $2.30-$2.40 range, partially helped by increased natural gas prices but hurt from the production they lost from asset sales.

What does the company need to turn around? Getting some pipelines approved would be a huge help.

The main target is getting Keystone XL approved. The project, which would establish a direct connection between Western Canadian producers and Texas refineries, seems to be moving forward. A recent poll puts American public support for the project at an overwhelming 74%. There is speculation that the project will be eventually approved, but there is staunch opposition. Keystone's approval is hardly a sure thing.

An additional project, the Northern Gateway Project, would build a pipeline between Edmonton, Alberta and the port of Kitimat, British Columbia. From there, oil could be loaded onto ships, making it easier to transport to refineries around the world, especially China. This project is also facing fierce resistance from environmentalists, First Nations' groups, and the British Columbia provincial government.

The approval of either project would be positive for Penn West. It would help lower the spread between heavy oil and WTI prices, as well as decreasing transportation costs, since the pipeline would replace rail as the way to transport oil.

The other major positive for the company would be an increase in commodity prices. Considering the tepid world economy and relative stability in the Middle East, I'm assuming fairly flat commodity prices over the next few months. The recent improvement in natural gas will help the company if they stay at current levels when they negotiate 2014 hedging contracts.

Like other Canadian producers, Penn West will continue to trade at a discount until major pipelines come online or commodity prices improve. The 12% dividend is safe, and provides income while you wait for either catalyst to increase the share price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.