For Lonestar Resources (OTCQX:LNREF), the great operational improvement news continues to come in avalanches. Big improvements in many key areas. Yet, the price of oil keeps dropping and there is only so much room left for a positive netback. This company was born near the end of the top of the last cycle and was in a position to expand during all the misery and distress that accompanies the periodic down cycles of this industry without expensive in-place operations that needed to be rationalized during this down cycle. The question is, with the backing it has, can it make through that final washout, or will it go to its grave before it has the chance to enjoy the fruits of the supposedly good deals and good results that it has accomplished in the last few years? Also, did the company acquire too much leverage in the process?
Source: Lonestar Fourth Quarter 2015 Conference Call Slides
From the conference call slides (click on view file), it is easy to see the improvements. On the top slide from Beall Ranch, the production has improved 43%. The bottom slide for the Horned Frog area is even better with production improvements that are more than 80%. Management has indicated that service costs are probably as low as they can go, but more production improvements and recovery increases are on the way. Like others in the industry, the company has sharply decreased its drilling time throughout the year. The company already had great costs to start with, and this may lead to improved costs in the future. The first few wells are experiments, so lowest cost may not be the initial objective as costs can be improved once the process is correctly refined and finalized.
More than a few companies are experimenting with completion costs that are more expensive but promise greater yields when the well is producing. It will be interesting to see how the industry evaluates the various completion alternatives during the year and if companies begin to coalesce around a few (or one) completion methods.
The fourth quarter earnings release noted that the company recently partnered with Schlumberger (NYSE:SLB) in the hopes of finding more efficiencies and new technology. From the slides above, those hopes are beginning to pay off. The company plans to drill about nine or ten wells next year. It not only hopes to drill those wells from cash flow, but it also hopes to maintain or increase production up to 10%, thanks to the new techniques that it is learning from its partner. There is also the possibility of more joint venture wells, depending not only upon commodity pricing but also upon the performance of wells drilled lately.
Source: Lonestar Fourth Quarter 2015 Conference Call Slides
From the conference call slides (click on view file), operating costs are extremely good already, so if the company can harness these operating costs into reduced costs, that will help. It is true that the company has not shown much improvement over the last few years, but it also just got started, so there was no old production to contend with that had to become more efficient, and definitely no old wells in the depreciation. Still trend analysis is going to be very challenging when costs are changing dramatically and production improvements are also dramatic.
LOE was $7.35 BOE and that was 6% lower than the third quarter, and 22% lower than the second quarter of $9.43 BOE. The company is forecasting significant further improvement in the first quarter. It could be as much as 10% lower than the fourth quarter.
Production in the fourth quarter was 7639 BOE per day. That production was 15% above third quarter production, and above company guidance for the fourth quarter. The increase came despite the deference of two well completions into the first quarter of the new fiscal year. The performance of the latest wells drilled with Schlumberger is the reason for this positive variance, and the company sees room for more improvement in the first quarter. Management has already guided to higher production levels in the first quarter of fiscal-year 2016.
The company does have a joint venture to provide capital, and the joint venture partner has so far been willing to front the money to drill some wells. That means either some production was hedged before the latest price drop, or these wells are expected to provide a sufficient return in the current environment (or both partners may not have seen the latest price drop coming - not likely). Management has spoken optimistically of the joint venture drilling more wells because there is $100 million available, and preliminary results are favorable. With the operational advances shown above, that might just be possible if prices don't drop further and if those advances translate into sufficiently lower costs. The money available to the joint venture could fund the whole capital budget next year.
Using the joint venture money from IOG Capital, the company drilled several wells in the Horned Frog lease area during the fourth quarter. That means that the company paid 10% of the costs and IOG Capital contributed the other 90%. Lonestar has about a 15% interest in the joint venture wells until IOC Capital recovers its money and a specified profit. After that, Lonestar's share of the revenue jumps to 57.5%. Should these wells meet profit expectations in the current low commodity pricing environment, this company could be one of very few companies busy drilling wells next year for the joint venture. In this current industry environment, that proposal or prediction may be an uphill battle, but if anyone has the costs to make the joint venture work this year, it may well be this company.
The company actually produced an operating profit (before financing and miscellaneous costs) with the help of hedges for the quarter and the fiscal year. Very few companies are producing a profit with or without hedging, but because this company is so new, those old costly wells that the rest of the industry has to write down are not a problem for Lonestar.
"Currently, the company has West Texas Intermediate (WTI swaps covering 2,276, barrels of oil per day for calendar 2016 at an average strike price of $77.15 per barrel. for 2017, the company has three way collars covering 1,000 BOPD, which provide an effective floor of $55.25 per barrel with WTI prices between $40.00 per barrel and $60.00 per barrel but also gives upside to $80.25 per barrel. At December 31, 2015, the mark to market value of Lonestar's hedge portfolio was $32.6 million, and at January 31, 2016, the mark to market value of the portfolio is estimated at $32.8 million."
There are far more robust hedging programs out there than this one for 2016. Last year, the hedging added $13.34 to the average price per barrel of oil equivalent. This year, depending upon production, that hedging will drop by about half of dollars per barrel of oil equivalent. If production exceeds guidance, the hedging could be even less per barrel of oil equivalent. While there is some protection, it is nowhere the protection needed for the current pricing environment, so the company is going to have to depend upon a lot of large significant operational improvements to pull through the current low pricing environment and literally pray that commodity prices don't go so low that it would be impossible for the company to have the cash flow to survive.
In the fourth quarter, the company reported an average price of $26.03 per BOE before hedging, so the company definitely has its work cut out for it if it wants to drill to maintain production. It has low enough production costs that it will have cash flow at those prices for anything already drilled, but maintaining production and servicing the debt could turn out to be one very large challenge, especially if prices continue to drop.
The company had LOE of $7.35 and taxes of $1.11 all per BOE. So the field netback was $17.58 BOE which is outstanding in the industry. The company does have some production from conventional assets. Those conventional assets have an LOE of nearly $18 BOE. So if the company sold those assets, even at a distressed price, the remaining properties have an LOE that is far lower and the company average would drop below the $7.35 noted above. Depending upon how low commodity prices go, management may have some tough decisions to make with those conventional leases and the respective production.
LOE expenses will jump around with the production levels and the addition (or lack of addition) of new wells because this company is so small. Newer wells with their higher initial volumes are much cheaper to produce and become more expensive as they age. That effect will fade over time as more oil wells are drilled and become producing wells. The cheapest LOE currently is the Western Eagle Ford leases which cost $6.37 BOE in the fourth quarter. However, the other leases are not so different that a couple of new wells using the latest production techniques could not make them less costly.
The general and administrative costs were $3.27 BOE and the depreciation was $21.09 BOE. While both of these costs are down 20% from the same quarter last year, subtracting them from the field netback gives a margin of (-$6.78) BOE. Normally, I am not a fan of using depreciation for forward-looking estimates, but since this company is relatively new, it is not a terrible comparison, especially since the company will perfect its new operating techniques on some wells this year. That will probably result in some above operating costs until the company and its partners decide the proper course of action (and then go for efficiency and lowest cost). With progress so far of a more than 40% in one field and 80% in the other field, there are some interesting possibilities.
Note that the company excluded about one million dollars of general and administrative expenses that are related to its effort to relocate its headquarters to the United States. These expenses are not expected to recur. It already has its new NASDAQ symbol reserved, and the process is under way. The company should be successful in this endeavor, and trading on the NASDAQ could easily result in increased liquidity of the common stock and hopefully better pricing.
For example, if the company holds well costs reasonably constant and recovers 50% more oil, that depreciation figure would decrease to $14.06 BOE (very roughly) from the $21.09 BOE above for the new and improved wells (going forward only). Some of the techniques described are increasing the amount of oil as a percentage of production, plus the company has promised further production improvements. If that seems farfetched, the weighted average of depreciation that the company reports is already down 20%, and that includes the older more costly wells along with the new (fantastically successful wells). LOE expenses would also most likely drop, which would definitely aid the cause. However, it should also be noted that these improvements can stop as fast as they started and their effects on profitability are not all that predictable.
A reasonable observation is that the new wells already being tested could get the depreciation down to that $14.06 already, and that further improvements could drive that depreciation down below $10 BOE for new wells. That would mean that the drilling costs (and product recovery) are so much better that wells drilled would earn a decent return because depreciation is the cost of those new wells spread over production. Definitely no promises on that one though, however, much of the industry appears to expect significant cost reductions throughout the new fiscal year.
There is another $8.67 BOE of financing costs that will probably not be covered next year even under the most optimistic scenarios. Therefore, the company will lose money this year unless oil prices rise to near $40 WTI. However, if oil prices can stabilize near current pricing, the joint venture funds of $100 million could pull this company through the next year. Most likely, the company will have the cash flow it needs to meet the pressing objectives, but it may have to borrow a little more on its credit line (even though management does not want to).
The cost to produce the oil and gas and sell it is roughly $10 BOE, so the company has cash flow of nearly $16 BOE if it does not drill or do any maintenance. It, therefore, should have enough cash flow with the hedging to survive next year, especially since any joint venture money would spread the fixed costs over a larger amount of activity. The company has no commitments to drill wells and the debt maturity is some time off.
The cash flow from operations was nearly $50 million, and the long-term debt to cash flow ratio was about six-to-one. While that ratio is definitely aggressive, it is also definitely workable, especially with at least two more wells coming online in the first quarter. The company elected to pay down about $18 million of accounts payable and some other miscellaneous items. The adjusted ratio before the accounts payable pay-down is a little better than four-to-one (a very comfortable ratio). As long as oil prices don't drop another five dollars and stay there, this company may be able to access the joint venture money and increase its production with minimal cash expense.
Up until now, the company borrowed money to maintain its production. Now the company will emphasize other people's money to maintain its cash flow and increase production. In the first quarter, it has two wells with a nearly total working interest coming online, and several more wells from the joint venture where it will start with a 10% interest until the partner recovers the money it is entitled to.
Supposedly, the company can access some joint venture money to acquire distressed leases this year, but it will be interesting to see how that works out. If the company does not drill, production could drop sharply because many of these wells are fairly new and it takes a few years for production to reasonably stabilize (at a fairly low level compared to the initial IP rates).
The company reported a profit from operations before finance charges, some minor impairments, and other miscellaneous charges of $4.6 million, and then reported net income of $(-4.9) million. That is a very strong performance compared with many companies in the industry. However, the company does have $303 million in debt with a bank and while the bank is comfortable with that debt so far, that is not the best financing to have in the current industry environment. The company has also warned of a non-cash impairment charge in the new fiscal year due to lower commodity pricing.
If the company decides not to produce, it should rake in at least $10 BOE under the worst of circumstances because of its low production and G&A costs. However, production could well decline sharply from current levels, so the big question would be how much operational improvements would be needed to maintain production from a minimal level of new wells. It is extremely hard to forecast future costs for this scenario with production costs changing so dramatically.
The company had about $7.7 million in cash flow for the fourth quarter from operations. Decreasing the cash flow by half was a decision to pay down accounts payable. Without that decision, cash flow from operations would have been closer to $15 million. While cash flow has decreased some during the year, it is not that much lower than the average cash flow of $17 million per quarter before the pay down of accounts payable and other miscellaneous accounts. Lower commodity prices in the first quarter may decrease that cash flow further, especially since the hedging will be less comprehensive in the new year. Much of the past fiscal year, the company blunted the effect of commodity pricing declines through the hedging program and production increases. However, at some point, this company may decide to wait out the lower commodity pricing environment.
The company does have a major shareholder known as Ecofin which is a specialist fund. Its founder and Chief Investment Officer, Bernard Lambilliotte, sits on the board, and in the past has significantly aided the company's development. That may happen in the future should the company need help, but of course there are no guarantees. That extra help could be another source to help the company survive this downturn.
While the company is leveraged, it is not as leveraged as some, and it does have unused credit. Plus, so far the bank has been unusually comfortable with this company and its management. That trend should continue barring unforeseen circumstances. The cash flow is exceedingly strong even when the hedging is considered for the drop in commodity pricing. There are far larger companies that don't report anywhere near this kind of cash flow in the current environment. So even though the company has a lot of long-term debt when compared to shareholders equity, and with the impairment charges coming in future quarters, that long-term debt ratio will worsen, the cash flow is strong enough to offset the balance sheet leverage. So financially, the company is stronger than would appear just by looking at the balance sheet.
Should prices rally later this year so that the company realizes $40 BOE (with its hedging program), the company would definitely be out of danger. If the operational improvements keep coming, and right now they seem to be, the depreciation could drop more than predicted above, but definitely don't count on that.
So if oil prices drop to WTI $10 and stay there, this company has had it. Nothing can save it or a lot of other companies. It will probably need WTI of $35 on average for this year (with hedging) to make it through the year in decent shape. Cost improvements could drop that figure significantly during the year. There are several website tracking capital budgets, and they are down on average quite a bit from this year's decreased amount. The problem is that companies are able to maintain production on ever lower amounts of capital as operational improvements keep pouring in. Nevertheless, there are some observers who think that overall oil production will decline in the world and at some point the economies will quit sputtering and grow. That could sop up the excess supply quickly. If so, this company with its low costs could be a prime beneficiary. With slightly higher pricing, this company could easily be earning $2 per share 5 years out.
I would, however, recommend purchasing a basket of these companies and rather than time the market, do some cost averaging over a few months to spread the risk. Because of the long-term debt level, this company is at a little higher risk, even with the backing it appears to have. However, it could be a very rewarding investment over the five-year period if prices work out as I expect. The company has clearly gambled that an aggressive activity schedule during the industry downturn will leave it in a good position to take advantage of rising oil and gas prices when that happens.
Right now, there is reduced cash flow, but with its low costs (and promises of significantly lower costs), its joint venture, the unused credit line, and the financial backing shown so far, the company has a lot going for it in the long term. Plus as discussed in previous articles, management is top notch with experience from blue chip companies.
If current prices hold and production is the same as the fourth quarter, the company should show about $13 million in cash flow in the first quarter (at least) before hedging and maintenance. That would pay the interest on the debt and leave about $7 million or so for other expenses. The company is predicting an increase in production which should cushion the commodity price declines. Cost decreases should steadily add to that figure.
Long-term debt is approaching two times shareholders equity, but the current ratio is a sound more than one and one half to one. Cash flow is unusually strong for the amount of long-term debt this company carries. This makes the company a speculation, but one that has a decent chance of succeeding in the long run.
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.
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