Why the Market Is Wrong on Warren Resources

Jun.28.11 | About: Warren Resources, (WRES)

It is extremely rare to find a significantly mispriced stock in the market without there being some “tension” in the story. It is the job of the skilled investor to understand this “tension” and exploit situations where the market is incorrectly predicting the wrong outcome. Let’s delve into the market’s misperception on Warren Resources (NASDAQ:WRES) and the resulting opportunity for investors.

Company Overview:

Warren Resources is an energy company engaged in the exploration and development of domestic oil and natural gas reserves. WRES activities are focused on oil properties in the Wilmington Field in California, and natural gas in the Washakie Basin in Wyoming. WRES derives roughly 80% of revenue from oil and 20% from natural gas.

Investment Thesis:

In the most basic terms WRES is trading at a fraction of the value of its assets. It is no great revelation that the easiest and cheapest oil in the world has already been tapped. As the world strives to meet its perpetually increasing thirst for oil we have extended the exploration frontier into more volatile and less accessible locations. However despite this macro trend there are still a few companies producing oil right here in the United States. In a world of heightened unrest in the Middle East and Africa as well as issues with offshore drilling one should not underestimate the value of domestic oil production, yet that is exactly what the stock market is currently doing with WRES.

Develop mature oil fields with new drilling and production technologies.

The oil production activities for WRES are based in the Wilmington Oil Field, which is located in Long Beach, CA. Admittedly Long Beach is not the first place one would expect to find a flourishing oil company these days. Nevertheless the Wilmington Field is the third largest oil field in the United States. Wilmington has been producing oil since the 1930s and predictably saw a steady decline over the past 60+ years as the field was harvested. However in the past several years, companies such as WRES have been deploying advanced drilling and production technologies, which have given new life to this field with dramatically increased production rates. Here is a fascinating chart, which shows how WRES has been able to operate the Wilmington Tar Formation wells at production levels not seen since the early 1940s.

(Click charts to expand).

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Market misperception on production growth, permit approval is positive catalyst

The stock has been absolutely crushed since announcing disappointing production guidance in mid-February. At that time WRES announced a delay in receiving the necessary permits for water injection wells from regulators at the California Division of Oil, Gas & Geothermal Resources (DOGGR). For reference, water is an important part of the production equation as WRES wells produce and require a significant amount of water. WRES needs roughly one water-injection well for every three production wells. These water injection wells allow WRES to increase pressure in the reservoir and to sweep residual oil toward producing wells. The wells are also used to dispose of used water from the producing wells. It is important to note that WRES is not consuming any water from external sources but rather simply pumping underground water back into the ground. WRES does not mix chemicals into the water so the water it pumps into the ground is the exact same water it is pulling out of the ground.

Without the necessary permits WRES had to temporarily shut-in 110,000 barrels of annual production, which impaired the FY 2011 guidance given in mid-February. The stock market hates to see declining production for energy companies, however it is important to differentiate between declining production due to a decline in the yield/lifespan of energy assets in the ground versus declining production due to operational issues, financing, etc. The opportunity in WRES is that the market has myopically failed to differentiate the cause of the company's declining production. The oil reserves have not been impaired whatsoever and if we add back the production that has been temporarily shut-in, you can see that production in 2011 would have increased year over year (yr/yr) had it not been for the permitting delays.

The catalyst for why WRES is so compelling right now is that last week the DOGGR finally approved the first 2011 water injection permit for WRES. WRES still has 11 additional permits pending, however last week's approval is a significant step toward ramping up production and also demonstrates that the WRES production process is viable and not harmful to the environment.

Stock trading at a substantial discount to net asset value and peer group

The company stock's precipitous decline has led to an extremely attractive valuation. Analysts estimate the net asset value of the company to be between $6.50 - $8 per share depending on which price you assume for oil and natural gas going forward. To be conservative I estimate the NAV to be $6, which means the stock is currently trading at 57% of its asset value. In addition to this value from the proved and probable reserves, WRES has roughly 80,000 net acres of deep rights for an area that is potentially prospective for the Niobrara Shale in Wyoming. The stock price is currently attributing zero value to this acreage. If we assign a value of $450 per acre this asset is worth an incremental $.50 per share. While this WRES acreage is unlikely to be in the Niobrara sweet spot, it does hold the potential to produce and at the current stock price investors are getting this acreage as a free “call option.” To demonstrate a potential “fat tail” outcome, this past April Marathon (NYSE:MRO) sold Niobrara acreage to the Japanese firm Marubeni at a value of roughly $4,500 per acre. While it’s unlikely WRES will realize a deal that rich, if it were to sell this acreage for $3,000 per acre it would be worth almost as much as the entire market cap of the company.

If we attribute zero value to the Niobrara acreage and the pending production improvements associated with the permit approvals, WRES is still cheap on an operating basis. WRES currently trades at 7x trailing 12 month EV/EBITDA vs. the peer group average of 8.5x. At the current enterprise value the stock is giving investors an opportunity to purchase proved developed BOE (barrel of oil equivalent) for only ~$21 per BOE. The current 12 month futures strip for oil is $93 per barrel, which is down from the highs earlier this spring. However, the last time oil was at $93 WRES was trading at $4.82 or +37% higher than where the stock is today.

Oil 12 month strip vs. WRES stock price

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Another way to look at this divergence, the last time WRES traded this low was when the 12 month oil price was $79. It is clear there has been a compelling divergence between the value of the energy assets in the ground and the stock price. I estimate fair value for the stock to be $6 per share with a significant “tail” on that should oil prices increase dramatically or the Niobrara acreage prove more valuable than anticipated.


Disclosure: I am long WRES.