PetroQuest Energy (PQ) is an independent oil and gas company with assets in the Gulf of Mexico, the Woodford Shale, South Louisiana, the Mississippi Lime Region, and East Texas. My bull thesis for PetroQuest centers around the imminent explosive growth to PetroQuest's margins, which will allow PetroQuest to invest heavily in the development of their prolific liquids-rich assets. The main driver of this explosive margin growth is the expiration of PetroQuest's NYMEX plus $0.85 transportation agreement and the recent increase in natural gas prices, which are both poised to significantly boost cash margins. This rapid increase in margins will be transformational for PetroQuest; it will fuel the development of a prolific liquids-rich asset base and accelerate debt repayment. The stock currently trades right below the $4 level; I believe the company's margin growth in conjunction with the company's asset diversification and growth strategy will drive the price of PetroQuest to $9 by year-end.
Overview and Operations Update (February 5)
PetroQuest recently released a very strong operations update and management gave strong guidance. PetroQuest CEO, Charles T. Goodson stated, "Our leasing campaign and producing property acquisition in 2013 lay the foundation for what we believe sets up 2014 to be the strongest year in the company's history." PetroQuest's most recent numbers appear to agree with Mr. Goodson; PetroQuest announced a company record 302 bcfe of estimated proved oil and gas reserves, with a PV-10 of $479MM or $7.40 per share in proved reserves. The company also expects to see production and reserves growth in excess of 20% during 2014 with the main growth coming from the company's liquids-rich Woodford assets.
Management's initiative to diversify and focus on developing a more liquids-rich asset base was clear in the product mix of the company's proved reserves, which were 84% natural gas, 6% oil, and 10% natural gas liquids. Management also gave its 2014 production guidance of 125 to 140 mmcfe per day with a product mix of 70% natural gas, 13% oil, and 17% natural gas liquids. While this production guidance appears to be conservative given the company's growth prospects, the most promising aspect of the guidance is the emphasis on oil and liquids production. Not only is this beneficial to the company because it diversifies their revenue streams, but it supports strong cash margins for the company, which will be a driving factor to the company reaching the price target of $9 per share by the end of 2014.
The company also released its capital expenditure guidance for 2014. The company's capital budget for 2014 is expected to range between $140MM and $150MM, which includes $25MM of capitalized interest and overhead. The capital allocation for 2014 is shown below:
The allocation shows that the company is assigning roughly 80% of its capital to develop its liquid-rich assets, which will be the driving factor behind the company's margin expansion and asset diversification. The most positive aspect of the 2014 capital allocation report is that the company expects the 2014 capital budget to be fully funded out of internally generated cash flow. The fact that the company will not need to take out additional debt to pay for the capital expenditures highlights the company's financial strength and management's commitment to managing and lowering the company's debt levels.
In the recent press release, PetroQuest provided an operations update. The most promising aspect of the operations update is the company's progress in the liquids-rich Woodford region, which will be the main source of production and reserves growth for PetroQuest and the driving force behind the company's margin expansion and product mix diversification.
PetroQuest plans on drilling 50 gross wells during 2014 in the Woodford shale region. The company completed the drilling of its first pad in the liquids-rich acreage in West Relay field. The company is completing this 5 well pad (38% Net Revenue Interest), as well as another standalone well. These wells are expected to come online in the end of February. The company also began drilling its second pad (31% Net Revenue Interest) in the West Relay field and expects first production from these four wells to begin around the beginning of the second quarter. PetroQuest's recent progress in the Woodford bodes well for an extremely strong 2014.
In East Texas, the company is drilling the lateral section of its PQ#10 horizontal Cotton Valley well (55% Working Interest). This well is part of a two well pad that is expected to be completed during the second quarter. The company expects to drill six gross horizontal Cotton Valley wells in 2014.
In the Gulf Coast, the company re-entered its 2008 Pelican Point discovery well that previously produced 1.6 million barrels of oil and 18 bcf of gas from the Rob L-0 sand. The Company plans to deepen the well an additional 700 feet to test the Rob L-1 and Rob L-2 objectives. The deepening operation is expected to take approximately four weeks and the Company holds a 55% working interest.
The Company is in the process of evaluating rig availability, reviewing permitting requirements and finalizing partner participation in the Thunder Bayou prospect. The company currently expects to spud this well during the second quarter of 2014. The company's Sawgrass well (47% Working Interest) has reached total depth and has been determined to be non-productive.
Overall, the operations update was very positive, with the exception of the failure of the Sawgrass well. The company's rapid progress in East Texas, Woodford, and the Gulf Coast shows that the company is effectively executing their plan to develop a more diversified asset base with an emphasis on growing liquids production.
PetroQuest has a very experienced management team in place that has the ability to properly execute the shift to a more diversified product mix, with an emphasis on the development of a liquids-rich asset base. The CEO, Charles T. Goodson, is a 37-year industry veteran, having worked in Mobil Oil Corporation, Callon Petroleum Company, and American Explorer (as president and owner). With roughly 30 years of experience in the Gulf of Mexico, Mr. Goodson is the perfect candidate to oversee the company strategy to utilize the cash flows from PetroQuest's Gulf of Mexico assets to fund the development of a more diverse, liquids-rich asset base. Management has shown their ability to shift their focus to a more liquids focused product mix, with a 90% increase in oil production from the second to the third quarter of 2013. The management team in place is experienced and has a track record of developing high-return onshore resource assets from Gulf Coast cash flow, which has been, and will continue to be, transformational for PetroQuest.
Huge Increase in Margins Will Boost Profit Significantly and Fuel Strong Growth in 2014
The massive increase in cash margin expansion, which is the basis for the huge potential upside in PetroQuest come from two main sources: the increase in the company's liquids production and the recent rise in natural gas prices. In the most recent conference call PetroQuest announced the expiration of their NYMEX plus $0.85 transportation agreement which will allow the company to price all of their Woodford gas off of the Centerpoint East Index and "will provide approximately 25% mcf uplift to PetroQuest's total average gas price realization." Since the time of the conference call the price of natural gas has increased roughly 25%, this increase in natural gas prices combined with the expiration of the company's NYMEX plus $0.85 contract will be the source of the massive growth in cash margins. Management has capitalized on this recent rise in natural gas prices by hedging a majority of PetroQuest's 2014 production at these high natural gas prices.
After executing the above transactions PetroQuest has approximately 360,000 barrels of oil and 16bcf of gas hedged for 2014 at an average floor price of $98.18/bbl and $4.13/mcf. These recent hedges confirm the massive increase to cash margins, which will be apparent in the company's next earnings release at the end of February. The most important thing to note about this boost to the company's realized natural gas price is that PetroQuest is not incurring any additional costs to capture these additional revenues; the added funds should turn directly into profits, leading to cash margin expansion and substantial upside to the stock price.
Starting with an average realized price of $2.99/mcf from the end of the third quarter in 2013 and a new average realized price of $4.20/mcf we can see that the company will be getting an additional $1.20 for every mcf of natural gas. Using the production number from the fourth quarter of 2013, which was 10.2bcf, and the realized price increase of $1.20/mcf implies a roughly $12MM increase in quarterly revenue, the majority of which would go directly to the company's bottom line.
The second source of cash margin expansion for PetroQuest is their increase in liquids production. As we can see from the most recent operations update, management is effectively developing and producing a strong liquids-rich asset base. As PetroQuest continues developing its liquids-rich assets, specifically its Woodford assets, we will continue to see a product mix with a greater emphasis on liquids. This focus on having a more oil-heavy product mix will further fuel the company's cash margin expansion. Also, the product mix diversification gives PetroQuest substantial downside protection in the event of a long-term drop in natural gas prices. The main concern for PetroQuest is that its profits are so levered to natural gas that in the case of a long-term drop in natural gas prices, the company wouldn't be able to repay its debt. The product mix diversification helps in this regard because it offers a more diversified revenue stream allowing PetroQuest to meet its interest payment obligations regardless of a drop in natural gas prices. The cash margin expansion and product mix diversification will be transformational for PetroQuest and push the stock to reach the $9 price target.
Some view PetroQuest's debt levels as problematic; this view is likely a major cause of the market's pessimism towards the company. PetroQuest has $425MM in long-term debt, and for a company with a market cap of only $250MM, on the surface this may appear like an unsustainable amount. The company should have absolutely no difficulty in repaying its debt however; with a Debt to EBITDA ratio of 2.9x and a target Debt to EBITDA ratio of 2x, interest coverage of 3.7x and target interest coverage of 5x, PetroQuest should be able to comfortably repay its debt. As of the third quarter of 2013, liquidity stands at $144MM, giving the company more than enough liquidity to pay back its debt and fund capital expenditures. The company's margin expansion along with its product mix diversification will help accelerate debt repayment and allow PetroQuest to comfortably meet all of its interest payment obligations. While PetroQuest may appear to have a large amount of debt, the company should have absolutely no trouble meeting its debt obligations.
PetroQuest is fundamentally a very strong business with strong margin expansion and an increasingly diversified revenue stream. The valuation is where PetroQuest truly sets itself apart from its peers, and a very lucrative opportunity presents itself. For the valuation of PetroQuest, the most appropriate metric would be price to cash flow using a peer group average multiple.
PetroQuest currently trades at a deep discount to its peers at 2.54x projected 2013 cash flow. The peer average in the same period is approximately 6x projected 2013 cash flow. This substantial discount is unwarranted as PetroQuest is a fundamentally strong business, with its upcoming massive margin expansion and a diversifying asset base PetroQuest should, at the very least, trade in-line with its peers.
In the upside (expected) scenario I assume PetroQuest meets its 2014 production guidance implying a 2014 cash flow per share of $2.17. In this scenario I assume that PetroQuest trades in-line with its peers at a peer group average multiple of 4.5x 2014 cash flow. This scenario yields a target price of $9.22, implying a staggering 145% upside from the current price.
In the downside scenario I assume actual production is 15% below management's 2014 guidance implying a cash flow per share of $1.85. In this scenario I also assume PetroQuest remains valued at a discount to its peers and further multiple contraction to a 2014 cash flow multiple of 1.75x. This scenario yields a target price of $3.24, approximately 14% below the current price. The risk reward ratio is favorable in this case, as the upside stands at a massive 145% while the downside stands at -14%. This heavily skewed risk reward ratio highlights the exceptional value in PetroQuest.
As you can see below the performance of PetroQuest's stock has been lackluster. The stock trades at the bottom of its 52-week range of $3.55-$5.10. The performance of the stock, however, does not appear to be correlated with the performance or the strength of PetroQuest's business and prospects.
The market has been excessively pessimistic on PetroQuest, beating the stock down consistently to the point where the risk reward ratio is extremely lucrative. Purchasing the stock at current levels involves minimal risk as most of the downside has already been realized in the stock. PetroQuest is already very cheap compared to its peers on a valuation basis and any further decline in the stock would be temporary as the fundamentals of PetroQuest are consistently improving and the outlook for PetroQuest in 2014 is very strong.
As PetroQuest continues to provide more clarity on its operations and future prospects the market will realize the strength in PetroQuest's fundamental business. With massive margin expansion and product mix diversification being realized the stock price will not remain depressed for long. The near-term catalysts for the company are PetroQuest's fourth quarter earnings and conference call, any further clarity on operations and 2014 production, and any further increase in the price of natural gas or oil. Fundamentally, these catalysts will highlight the strong increase in cash margins, product mix diversification, and the value in PetroQuest's future prospects in the Woodford. These fundamental catalysts will provide the clarity that investors need to realize the full value of PetroQuest, and will push the stock price to my year end price target of $9 per share.
The market has been extremely pessimistic on PetroQuest. This pessimism is unwarranted, however, as PetroQuest's business is fundamentally strong and its future prospects are very positive. The upcoming rapid increase in margins will be transformational for PetroQuest; it will fuel the development of a prolific liquids-rich asset base and accelerate debt repayment. The stock currently trades right below the $4 level; I believe the company's margin growth in conjunction with the company's asset diversification and growth strategy will drive PetroQuest to $9 by year-end. PetroQuest's recent operations update highlights a very lucrative opportunity with minimal downside that the market is not seeing.