EP Energy: Selling $90 Oil In A $30-$40 Market

| About: EP Energy (EPE)

Summary

This article discusses EPE's industry leading hedge strategies, allowing it to sell oil & natural gas at 2013-14 highs in a multi-year low pricing environment.

EPE is trading in reaction to low commodities prices, yet its hedged portfolio flies under the radar as they remain one of very few drilling companies currently earning a profit.

A value opportunity for traders seeking growth in the energy sector via an undervalued company with solid assets, strong management, and a brilliant, forward-thinking trading desk.

The potential impact of weather and economic factors as a driving force that could lead the energy industry towards recovery sooner than currently projected.

EP Energy Corp. (NYSE:EPE) closed Friday at $3.67, down another $0.09 or -2.39%, with total pullback on the week at a loss of $0.71/share or -16.21% since Monday's open of $4.38. With a significant dip in crude oil prices settling at an unnerving $33.16/Bbl, such a reaction would seem logical. That is, until, you take into account the actual impact these figures factor into the company's financials. I first took notice of EPE around the time it announced 3Q earnings in the fall of 2015, finding it intriguing that the company was not only making a profit -- but actually had an earnings surprise of 30% ($0.26 EPS Actual vs $0.20 EPS Consensus). Considering the bear market we had found ourselves in, such results were impressive when taking into account that most companies at this time were experiencing significant losses. And to date, has only gotten worse with oil seemingly preparing to test a new $30 support level.

These earnings results became less of a surprise after analyzing EPE's transcript of the company's 3Q '15 earnings report. The formula to this success was quite clear ... a top-notch trading desk that has hedged the majority of its 2015-16 oil and natural gas production at 2014 highs, right around the time the company IPO'd and energy-related commodities prices were beginning to see swift declines across the boards. Furthermore, the company has focused on increasing drilling efficiencies as a means to reduce overall capex costs, as well as implementing a successful strategy of deeper drill depths along with the use of horizontal wells vs traditional lateral wells. With 4 earnings beats in the last 7 quarters since the company went public and hedges at $91.21/Bbl for crude and $4.26/MMBtu for natural gas to finish out the year, I find the consensus estimate of $0.16 EPS to be reported this February to be very conservative, and believe this stock is going to see considerable retracement once the actual results are made public. Listed below are EPE's fixed-price hedges, as reported in their last transcript:

Total Fixed-Price Hedges 2015 2016 2017
Oil Volume (MMBbls) 5.6 18.0 5.1
Avg Floor $ ($/Bbl) $91.21 $80.29 $65.87
Percentage Hedged 97% 79% 23%
Nat Gas Volume (TBtu) 15.6 7.3 N/A
Avg Floor $ ($/MMBtu) $4.26 $4.20 N/A
Percentage Hedged 89% 11% N/A
Click to enlarge

Now, the contrarian argument against these numbers might be that after the hedges drop off in price protection and overall production coverage, EPE will end up like the rest of the various companies in this specific sector ... should commodities continue on the path they are currently on. However, I would argue against that for a handful of reasons -- and add that I think the reduction over the coming years is well-timed and exactly what they need to survive this bear market, yet prevent themselves from selling their assets short at prices that may be inferior to future levels come 2017.

First, we have already seen positive signs over the past few weeks that should help us start to see the bright light at the end of the tunnel. This would begin with our first dip in oil & gas inventories back in mid-December, when bearish sentiment across the sector left us to believe we would see nothing but further increases in reserves. I believe this to be a combination of the following: Record auto sales on a global basis, with an emphasis on gas-guzzling truck & SUV sales in the U.S. and Chinese auto markets; Winter weather that hit late this year, and could continue over the next couple months to help stabilize natural gas, as well as crude oil when factoring the heating oil crack spread correlations; A clear reduction in rig counts as we see capex spending cuts by the majority of energy producers for the foreseeable future; And most importantly, the end of a four decade-long ban on crude/nat gas exports that will in turn, further help reduce record level reserves to help balance the scale in regards to supply & demand. Hence, why we have already experienced a 37.18% recovery in natural gas prices in Feb '16 contracts since they hit a low of 1.802 in December, working its way back to a close of 2.472 as of today's settlement.

Next, I would focus more on weather patterns and cycles that have recently impacted the lower-than-average demand seen this winter, and point towards expectations over the next 12 months. When El Nino is in effect, you see warmer temperatures globally that typically do not peak until the spring, finally tapering off as we move through the summer season. With this in mind, a stabilized market over the coming months could really see another push as we experience an early summer with extreme heat waves, followed by an increase in the utilities natural gas consumption due to an increase in A/C usage. Couple this with your seasonal trend of increased driving that spikes around Memorial Day weekend (and let's not forget our record year in car sales), which should provide a bullish uptick in crude oil prices.

We then look to fall 2016 when El Nino officially shifts back to La Nina, and can find some interesting correlations that have held true over the years. When charting the extent of these weather patterns, this years El Nino is projected to reach higher levels than we have seen since the 1960s. And each alternating year, you can clearly see the two cycles swing back & forth in pairs to the same extent/extreme on the opposite side of the spectrum. This would mean in winter 2016-17, we can expect to see a similar inverse effect with the coldest temperatures we have seen in decades. Meaning the energy sector, specifically producers, could be in for an incredible recovery in prices over the next 10-12 months ... should history happen to repeat itself.

This theory takes me back to my prediction that EP Energy's hedging strategy could not be timed better, and will benefit by minimizing exposure out past 2016 until we start to see these rebounds take effect. And would go a step further to say, I believe EPE is one of the few companies that will be able to walk away from this disaster having never reported a single quarterly loss. Which makes me look to other energy producers (whether it be the majors or small/mid-caps) and question how these companies that are reporting massive losses, and could be in for another terrible year before realizing gains from a potential recovery, could possibly be trading at a higher P/E ratio and overall valuation in comparison to EP Energy. The only answer I can give you, is simply this ... EPE's brilliant hedging strategy implemented by solid management, has been completely overlooked by most investors and has not garnered the praise & attention the company deserves. I hope I am not alone when I say that I see considerably more value in a company that is able to profit in tough times over those currently depleting proven reserves at an operating loss.

Because of EP Energy's significant cash & liquidity position, a revolving credit line of $2.75B which is expected to go unchanged when 4Q '15 is reported, no debt maturities over the next two years, and the ability to raise further cash through the issuance of corporate bonds and preferred securities down the road, which it has yet to tap ... The company is in an excellent position to acquire future assets at record low prices, while many of their competitors in distress struggle to improve their own balance sheets. And in many cases, are simply doing what little they can to avoid bankruptcy. M&As such as these would be a smart, affordable investment for the future, and a great way to ensure success for many years to follow. Not to mention the organic growth potential they already possess with their four primary core assets.

Conclusion: With a 52-week low of $3.40 and a high of $15.80, I believe EPE to have little downside at $3.67/share. It is likely this stock has seen the worst of the pessimism over this current bear market and recent destructive tax-loss selling season. I project a short-term price target of $7.47/share with an upside potential of 103.5%. Looking out 2-3 years I expect a long-term price target of $15.00/share with an upside potential of approximately 308.7%, and believe these levels to be fair value going forward as we start to see energy markets stabilize.

Key Fundamentals To Consider:

  • EPE currently trades at a 4.77x P/E Ratio ($3.67/$0.77 EPS Annualized) vs a 9.7x industry average.
  • Return on assets of 6.36% vs -14.96% industry average.
  • Return on equity of 15.29% vs -26.92% industry average.
  • Net profit margin of 21.14% vs -44.76% industry average.
  • Total assets of $10.352B - Total liabilities of $6.007B = Equity value of $4.345B. Divided by 248.8mm shares outstanding, EPE has an implied value of $17.46/per share.

EP Energy is a Houston-based oil & gas exploration and production company, with significant core assets located in some of the nation's richest and most abundant oil plays, including: Eagle Ford (91,675 Net Acres) located in South Texas; Wolfcamp (138,130 Net Acres) located in the West Texas Permian Basin, along with an adjacent property (37,000 Net Acres) located in the Southern Midland Basin; Altamont (173,110 Net Acres) located in the Uinta Basin of Northeastern Utah; Haynesville Shale (Acreage N/A) located in Eastern Texas and Northern Louisiana; Various non-core assets located throughout the country via structured leases and partnerships.

Disclosure: I am/we are long EPE, EPE JANUARY '18 CALLS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.