PrimeEnergy (PNRG) trades at a low valuation despite a shift away from natural gas to oil production, high insider ownership and a significantly shrinking share count.
PNRG is an independent oil and gas exploration company operating exclusively in the U.S. PNRG operates ~1,600 wells, owns non-operating interests in over 800 wells as well as provides well-servicing support operations, site-preparation and construction services. Oil and gas production is sold primarily to independent marketers and major gas pipeline companies.
A subsidiary (PrimeEnergy Management) acts as the managing general partner of 18 oil and gas limited partnerships and the managing trustee of two asset and income business trusts.
The market has been slow to respond to the recent shift towards oil production and away from natural gas. This provides a low risk entry point into a pure-play domestic producer with multiple valuation catalysts.
Shift to a less volatile and more profitable product deserves a higher multiple
PNRG is joining the industry-wide trend of reducing exposure to natural gas through acquisitions of oil properties as well as increased drilling on existing properties. In 2011 and 2012, PNRG reported successful drilling results from the West Texas and Mid-Continent areas. In 2012, PNRG completed the plugging and abandonment of all of its offshore properties.
The long-term outlook for oil is significantly better than natural gas as surplus oil byproducts (e.g. gasoline and heating oil) can currently be exported to meet growing global demand while it will be much longer until LNG export facilities are brought online.
PNRG currently sells the vast majority of its production at spot market prices. By selling a greater portion of its production on the forward market (e.g. minimum of one-third), PNRG can reduce the risk of another significant price decline as in 2008. Its credit agreement permits hedging of up to 90% of proved developed producing reserves. While by definition some of the upside potential would be removed, so would the downside. This should ultimately result in a higher multiple.
PNRG trades at a mid single-digit EBITDA multiple...
...and a significant discount to its peer group...
Diversified asset base reduces revenue volatility
PNRG is broadly diversified in three key areas:
Geography. PNRG operates and/or owns interests in properties located in Texas, Oklahoma, West Virginia, the Gulf of Mexico, New Mexico, Colorado, Louisiana, Kansas, Mississippi, Montana, North Dakota and Wyoming.
Development focus. PNRG owns a mix of mature properties with long-lived reserves and newer properties with development and exploration potential. The relatively stable cash flow from the mature properties provides the funds to develop more speculative projects with significant production potential. As a result, PNRG should receive a higher "blended multiple" than peers concentrated in one area (e.g. "value" multiple for mature assets combined with "growth" multiple for speculative projects).
Revenue sources. PNRG generates ~19% of revenues from field service work and reduces its dependence on more volatile oil and gas sales.
High insider ownership + shrinking share count = stealth takeover?
The high insider ownership (71%), low absolute size of the company and steady cash flow provided by increasing oil production (operating cash flow of $40 million in 2012) provide the perfect combination for a stealth takeover.
PNRG repurchased 3.5 million shares since the initiation of a repurchase plan in 1993 (including an additional 500,000 share repurchase plan in October 2012). Furthermore, PNRG simplified its capital structure by reducing the authorized number of shares of common stock from 10 million to 4 million as well as eliminated the preferred stock class (no shares were issued) effective 7/1/09.
Debt load is manageable given solid operating performance
PNRG has access to a $250 million credit facility (~$24 million available). Declining interest rates over the past several years resulted in significant interest savings (weighted-average interest rate of 3.57% compared to 4.78% at 12/31/11). Management said in the 2012 10-K that it expects to be able to continue accessing bank financing due to its successful drilling program and reserve growth.
Highly dependent on favorable energy prices. PNRG would be negatively affected by decreases in the price of oil and/or gas in the form of lower sales and reserves able to be developed economically. Furthermore, oil and gas prices are highly volatile and present unique challenges in terms of capex planning and capital raising.
Exploration risk. There is the inherent risk of drilling "dry holes" and the resulting inability to produce oil and gas and replace depleted reserves.
Competition for assets. There is intense and increasing competition for oil and gas properties, labor and equipment from both major integrated producers as well smaller independent producers.
Competition from alternative energy sources. The industry faces pressure from competing energy sources such as coal, nuclear, hydro, wind and solar. However, given the significant installed infrastructure (e.g. gas stations and autos), any threat to demand is measured in decades, not years.
Customer concentration. Plains All American and Sunoco purchased 57% and 26%, respectively, of oil production in 2012. Atlas Pipeline Mid-Continent and Unimark purchased 45% and 14%, respectively, of gas production in 2012.
The target price of $58.17 is based on a 5.5x EBITDA multiple.
A stop loss should be placed below the rising 20 DMA ~6% below. The time frame is one year.