Getting smaller can be a good way of cleaning up a balance sheet and improving a company's growth prospects. In the case of Forest Oil (FST), though, I have some real concerns about whether management hocked the family silver and kept the stainless steel instead. I do believe that Forest shares trade below their current NAV and that more experience could lead to better results (which in turn would lead to a meaningfully better NAV), but that upside has to be set against the reality that Forest Oil may be on the outside looking in when it comes to the Eagle Ford and may not have the capital or technical expertise to maximize the Permian assets anytime soon.
Years Of Bad Decisions Come Home To Roost
I don't want to belabor the various mistakes that Forest Oil has made over the years, but I do believe they still have relevance to the present-day situation. Prior management made repeated poor capital allocation decisions, including missing out on attractive acreage in leading shales. There may be an element of chance even in modern oil and gas exploration, but there is a reason why companies like EOG (EOG) have had the success they've had.
The ultimate result of these bad decisions was to leave Forest Oil with a lot of debt and below-average asset quality. In an attempt to shore up the balance sheet and monetize acreage that the company didn't really have the resources to hold by production, management turned to asset sales. Forest Oil sold dry gas assets for $650 million around mid-2013 and then sold its Texas Panhandle assets (Granite Wash) for $944 million.
Having sold out of the Granite Wash, the core asset for Forest is now its Eagle Ford acreage in Texas. Unfortunately for Forest, while the Eagle Ford was proven to be a very promising area for EOG, Marathon (MRO), and Penn Virginia (PVA), the same does not seem to be true for Forest. Forest Oil's acreage appears to lie just to the northwest of the "fairway" region where operators like EOG have been reporting very attractive initial production rates and expected returns.
Whereas Forest's IPs were in the mid-200's in 2012 and have recently ranged from 229 boepd to 715 boepd, EOG's 30-day IPs have been north of 1,000 boepd and Penn Virginia's have been trending close to 800 boepd. As Forest can't really get by with substantially cheaper wells, that means significantly different return prospects across these companies.
On the subject of drilling, it's worth noting that Forest has a quality partner in the Eagle Ford. In an effort to preserve liquidity (and perhaps to tap into technical expertise), Forest struck an agreement with Schlumberger (SLB) where Schlumberger carries $90 million in drilling costs in exchange for a 50% working interest. Although that implicitly values the acreage at $3,000/acre (a discount to the going rate at the time of the deal), that doesn't seem so inappropriate given the results. What's more, I would say that Schlumberger is a good partner to have on balance, and this may give Forest an edge in lowering well costs and improving well recoveries.
Other Assets Hold Some Potential As Well
If Forest Oil can drive well costs meaningfully below $5.5 million and/or estimated recoveries above 300M boe, the NAV would definitely improve (a 10% improvement in EUR would boost NAV by more than 15%). This Eagle Ford acreage isn't all there is to Forest, though.
Forest owns leases on 162,000 net acres in the Ark-La-Tex region, including 35,000 net acres in Arkoma and 103,000 net acres in East Texas that include the Cotton Valley play. This is a more gas-oriented area, though Forest has talked about a 40% liquids contribution in the Cotton Valley acreage. Forest isn't alone in this area, as Anadarko (APC), Chevron (CVX), and Exxon (XOM) have been involved in the area. Forest is taking it slow here, allocating about 23% of its 2014 capex budget to drilling in this region, but it holds some promise.
Forest also has about 60,000 net acres in the Permian. There are concerns in the market that this acreage will be a repeat of the Eagle Ford experience, with Forest's acreage lying just outside of the really attractive area. In any case, exploiting this resource is going to require capital and expertise that the company does not have right now. Valuing this acreage is tricky, as it could add 20% or more to the company's NAV if the play works out.
Valuing The Opportunity
Forest's guidance for 2014 was a little mixed, with the low end of the production guidance range a little below most sell-side expectations but an overall oilier mix. Production cost estimates were about 10% to 20% above most estimates, and capex guidance came in at the high end of the range. If there is a bright side to it, it's that one year doesn't really impact the net asset value all that much.
Turning to the NAV, I value the company's current proved, developed resources at $6.15, with another $5 per share from the development/exploration assets. Within that figure, I estimate $3.70 in value from Eagle Ford, $1.25 from Ark-La-Tex, and $0.25 from the Permian. Netting out debt, working capital, and so on, I come up with a NAV of $4.50 per share today. As I have mentioned previously, though, this NAV calculation is very sensitive to metrics like well cost and EUR, so real progress there would make a substantial difference in the valuation.
The Bottom Line
I believe Forest Lab's current operating characteristics merit a 5x multiple to 2014, leading to a $3.30 fair value estimate. I would note, though, that every half-point of multiple means $1 per share in fair value, so this is a pretty volatile approach.
A fair value of $4.50, and with meaningful upside to that number with stronger operating results, does leave upside to Forest Oil. I have real concerns about management's ability to actual deliver on that potential, though, and with many other stocks in the E&P space offering similar (or better) returns, I would not go out of my way to own this one today. That said, sentiment is pretty strongly negative on this name and about 20% of the float is short, so this may be a name for contrarians to examine more closely.