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Much like the 1966 gunslinger film "The Good, the Bad and the Ugly" starring Clint Eastwood hunting for hidden Confederate gold, ATPG is in the hunt for oil riches. ATP Oil & Gas (ATPG - $15.50) announced 3rd quarter earnings and conducted its conference call this week. The latest updates contained much that is good, some that is bad, and about the same amount of ugly.

ATPG is a small-cap oil development and production company, rather than a true exploration company, that generates excessive passion from both long and short investors. ATPG is a speculative investment not well suited for investors seeking a steady 9% annual return on a relatively risk-free selection. Some claim the stock is best used as a trading vehicle, some believe it on the verge of a huge decline and financial ruin, while still others are convinced the company is on the cusp of finding the Confederate’s stash of gold.

The Good

Production continues to rapidly expand, growing from a 2009 exit rate of 13 MBOE to a 3rd quarter rate of 21 and a projected exit 2010 rate of 28.5 to 30. With this higher production rate and a strong oil market, operating cash flow (ocf) continues to expand. Unlike industrial firms, ocf is a far better valuation tool for oil and gas companies than earnings due to depreciation / depletion and the impact of large capital expenditures required to maintain and grow production.

Operating cash flow projections run the gamut, based on different evaluations of the company’s operations and perceived financial risks. The turn-around year appears to be next year with ocf estimates of $0.92 to $3.25 in 2010 and estimates of $5.50 to $12.00 for 2011. Capex for 2011 is expected to be around $10 a share.

Their latest GOM well started producing in Oct and has outperformed management guidance by about 50%, producing at a rate of 12.2/day, subject to normal well downtime. The importance of this well on ATPG’s short-term financial health can’t be overstated as it almost equals total company 2009 exit production levels.

The current strength of the oil market is well timed for APTG’s increase in production. Management is looking for new hedges in the high $80s to low $90s, substantially better than pricing in the spring.

Being heavily dependent on the GOM, APTG’s fortunes are at the mercy of the Fed's approval of additional development permits. Their state of the art production platform, the Titan, should be key in moving ATPG to the front of the permit line (see article specifically discussing the Titan here).

While no new drilling permits are currently in hand yet, management anticipates the next four will be approved soon. These are Telemark #3, Telemark #4 and Gomez #9, Gomez #10. With these wells completed in 2011, production could increase by an additional 7, 7, 5, and 5 MBOE, respectively. Telemark #3 should be producing 90 days after approval and Telemark #4 within 180 days.

The Octabouy, management’s latest production platform project, continues to advance to its 2012 deployment date. Being built in China, ATPG anticipates acquiring additional vendor financing from the Chinese as the project’s final payments come due late next year. While still a bit distant in the future, this capex project will incrementally add to ATPG’s infrastructure assets and to its North Sea natural gas production. While the overall fields are in decline, North Sea natural gas commodity pricing has been higher than domestic US and offers interesting potential returns.

The company should be generating upwards of 42 MBOE production within 6 months of acquiring the Telemark permits. To be ocf minus capex positive, management has to achieve this level of production. At 42 MBOE, the game will permanently change in favor of ATPG’s future.

Out of the nine Street firms that follow ATPG, five rate it as a “hold” and one as a “underperform”. In street-speak, these are considered “sells”, and a great contrarian indicator may be a 75% “sell” ratio.

The Bad

Operating cash flow for 2010 is anticipated to be greater than 2009, but still lacking consistency and ocf minus capex is still negative. Management, like most small-cap oil and gas companies, has been struggling with financing to build out their ambitious development plans. The 2008-2009 credit meltdowns and the moratorium on GOM drilling were severe, almost ruinous, setbacks.

It is not uncommon for small-cap E&Ps to hock the kitchen sink to acquire funds to continue their expansion plans and management has been masterful in developing debt with no covenants, vendor financing, NPI, and overrides. On a positive note, according to the recent cc, if oil stays in the high $80s and production targets are met, all NPI and overrides could be paid off within 18 to 24 months.

Capex in 2011 is expected to be in the $500 million range ($300 million for GOM and $200 million for North Sea), with $300 million generated from ocf and $200 million in additional vendor financing and drawn-downs on current credit lines. Importantly, however, for the first time in several years, management is not expecting to require additional debt financing or equity offerings to meet their capex needs.

While 2010 production of 30MBOE is a far cry from 2009 exit rate of 13, it is still about 30% below the critical mass needed to be ocf minus capex positive.

The Ugly

APTG has built an impressive collection of GOM pipelines, technologically advanced production platforms, and PUD oil/gas reserves. However, their selection of financing to acquire/build/develop these assets has been through debt financing, preferred stock, and higher levels of common equity offerings (however the float is a relatively small 50 million shares). Added to NPI, overrides, and vendor financing, ATPG is over-leveraged and pays a high price both in share value and interest payments.

ATPG’s main credit facility is a $1.2 bil note issued in the spring of 2010. During the first few quarters, interest was capitalized and did not affect cash flow. However, with the higher Telemark production levels, interest payments are now due in cash. Total debt is around $1.8 billion.

ATPG is a speculative bet on management’s ability to pump increasingly higher amounts of black gold and a strengthening of commodity oil prices. Highly leveraged assets with increasing production potential in a rising commodity market should, at some point, create investor interest.

At $16 a share, ATPG offers above average risks, above average controversy, and substantially above average potential rewards. Like Clint Eastwood, ATPG may be on the verge of finding the Confederate’s bags of gold. When production levels reach 42 MBOE of black gold, ATPG’s financial positioning will greatly improve and share prices should be 40% to 50% higher than today, and on their way higher.

Personally, I believe management, like Clint Eastwood, will reward long term speculative investors who are willing to stare down their adversaries, much like the film’s final Mexican Stand-off in the cemetery. To those who continue to short ATPG, my comment is, “Go ahead, punk, make my day.” Oh, wait, right actor, wrong film.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: Long ATPG and have been a shareholder since 2007

Source: ATP Oil & Gas: Above Average Risk, Controversy and Potential Reward