The Problem With The Growth Strategy Of Paramount Resources Ltd.

| About: Paramount Resources (PRMRF)


Production has more than doubled in the third quarter comparison, yet cash flow is under C$40 million.

Long-term debt is now $1.79 billion and the cash flow is not sufficient to service that debt.

At current pricing, there is a good chance that the company's main properties do not have a sufficient IRR to justify drilling more wells with current commodity pricing.

Property sales and the sale of a significant amount of equity will be needed for this company to turn things around.

Therefore, even though the stock price is down a lot from its highs, it is still a very good short sale candidate.

Paramount Resources Ltd. (OTCPK:PRMRF) (and also POU.TO in Canada where it is far more liquid) had a very aggressive growth strategy that involved leveraging the company, gaining leases, but delaying production increases to keep up with the leverage. Now with the current commodity pricing, the company will have a very hard time meeting all of its obligations.

The long-term debt of the company increased from C$1.3 billion to C$1.79 billion. That increase of roughly C$490 million is a little more than the capital budget for the year. Despite spending hundreds of millions of dollars to increase production, the cash flow for the third quarter from operations was C$36.9 million, and for the nine-month period was C$72.2 million. Even though the fourth quarter will hopefully be higher still due to more well completions that offset some maintenance and other items that cost some production, these numbers do not inspire much confidence.

This company is an unconventional gas company, its wells have production that decreases sharply initially, leading to large cash expenditures to keep production growing. Yet the cash flow is nowhere near what is needed to finance the debt and invest in the drilling needed to expand production. Even though the majority of the production is gas and NGLs, the decrease in oil prices will hurt the cash flow as oil has an outsized contribution to cash flow in comparison to its percentage of production.

The company did decrease its working capital deficit from C$183.3 million to C$38.6 million in the current fiscal year primarily by issuing more debt (as well as some shares). But it has also used up a fair amount of its bank line. In the summer, the bank increased the credit limit from C$900 million to C$1 billion. It has currently borrowed nearly C$642 million on that facility, leaving a maximum unused amount of C$358 million at the end of the third quarter.

Since spending more than C$490 million resulted in cash flow of C$36.9 million from operations (with about three million in help from the working capital accounts), there aren't not sufficient lines of credit to get the cash flow to a comfortable level. This company probably needs about C$500 million in cash flow to service its debt and meet its drilling needs. However, there is only $358 million left on the credit line as of the end of the third quarter. This is a company that was issuing stock and borrowing quite a bit to grow as fast as it did.

Production has even cooperated by more than doubling in the latest quarter from the previous year (same quarter). However, that is not enough when much of the production is natural gas, natural gas liquids, and then some oil. To the company's credit, it is in compliance with most of its loan terms. The group of bonds, C$450 million is not due until 2019, so there is time to work this out. However, the bank line comes up for renewal each year, and with the drop in commodity prices, the results next summer could be very scary for a company in this situation.

The company showed operating expenses of C$5.67 BOE and transportation and processing costs of C$4.23 BOE. While the operating expenses were down 26% and the transportation expenses were down 19% in the third quarter comparison, both will have to decrease a lot more for this company to obtain long-term viability. The transportation and processing cost, in particular, appears to be running high.

Commodity settlement contracts added C$1.66 BOE to the netbacks which ended at $15.23 for the quarter. Next year, the company has hedging on 6,000 BOD, which is a little more than ten percent of production. That is hardly the kind of hedging protection that a company in this situation needs. Interest and financing took the lion's share of the netback at C$6.26 BOE, and then there were some other small charges to get to funds flow from operations of C$8.02 BOE. While that funds flow from operations per BOE is about 33% higher in the quarter than the YTD figure, there is not enough volume yet to enable the company to make money and meet all its obligations without borrowing more money.

Also, the return on some of the company's core properties is not that good in current pricing. For example, the Montey "Ultra Rich" well economics have a 37% IRR when the AECO is at C$2.75 MCF, and oil is at $45 WTI. The payout was 2.3 years at this level, a marginal payout level at best. Now with oil prices far lower and gas prices moving up from their lows, the return on this property is less.

The Cretaceous Economics using the same AECO and WTI assumptions as above are 23% IRR. So likewise, this project will not help the company catch up its cash flow to service its debt and maintain production.

When it comes to cost cutting, it seems most of the companies that I have covered have decreased their costs substantially over the last two years. Most of the decreases range anywhere from 50% to 75%. This company only refers vaguely to cutting costs, and therefore, one has to wonder how effective its cost-cutting campaign is or if it even has one. This company must grow production next year and it has to grow production in a way that the long term debt-to-cash flow ratio improves. Right now, the resources are not there to do that, so how the company survives long term is a very big question. Plus, the common stock is not worth anything until the company solves its cash flow problem or commodity prices lend a very substantial helping hand (something that really no one forecasts right now).

The company has investments in various other public companies and wholly owned subsidiaries. There have been some statements about selling some non-essential properties, but nothing concrete has been announced at this time. Its investments in other public companies are too substantial to be able to liquidate for anything approaching the current value of the investment (and that value is also depressed).

So where does the company go from here? So far, it has stated that it expected to make it to the end of 2015 using its credit line and the available cash flow. But that does not leave much borrowing ability for 2016. So shareholders can probably look forward to substantial dilution as well as some additional financing. Right now, the fourth quarter looks to have decent production comparisons, and there is probably enough room on the credit line for a good first quarter. Then the company has to do some financing. The company does have substantial assets, but this is a depressed market and many of those assets are worth nowhere near what they were worth a year to eighteen months ago. Given that the company's cash flow and production will drop quickly and substantially without some fairly substantial expenditures to maintain production, this company has some very hard decisions to make.

The bank line may have no covenants, but it will still need to be paid back in the future somehow. Same for the rest of the debt which is mostly unsecured. The warning should have been in the summer when the bank only raised the credit line $100 million and yet the company spent several times that in its capital budget. Industry conditions have deteriorated substantially since then, even for a company with mostly gas production. So converting the assets to producing properties with enough cash flow may well be a very uphill if not impossible battle. It would be a similar story to try and sell some assets, but the company clearly needs to take some concrete actions to survive.

That makes this company's stock a good short candidate, and it will remain that until commodity prices rally substantially or until the company sells enough assets to bring its long term debt-to-cash flow ratio down below four-to-one. This company needs $3 MCF AECO and, at least, $45 WTI with all that debt. Those prices will probably not happen this year except for maybe a short period of time. So the ability of this company to see next year should be a very interesting adventure.

Insiders do own about half of the stock, and some of them have purchased a fair amount of the bonds. However, the bonds are unsecured and the bank line is senior. There is a decent chance that should the worst happen, there would be nothing left for the common stock or the unsecured bonds.

In Canada, there are options listed for this stock, so puts would be another way to play this stock. However, investors need to realize that puts have a limited life and sometimes stocks do not cooperate within that lifespan. So an investor should go at least nine months out if possible to maximize the possibility of the stock decrease within the lifespan of the put.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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