Will Kelt Exploration Survive?

| About: Kelt Exploration (KELTF)

Summary

Kelt Exploration bit the bullet and will let its production rate decrease in a controlled manner.

This was the only possible way to reduce the cash outflow rate.

The net debt will increase because even after slashing the capex by 41%, Kelt will remain free cash flow negative.

As the oil and gas price glut remains ongoing, several oil and gas producers have started to "revise" their opinions and expectations for the current financial year. Kelt Exploration (OTC:KELTF) is one of those companies, which has presented a new plan for 2016 where it will slash its capital expenditures. I'd give them an "A" for effort, but a "C" for the final result.

KEL Chart

KEL data by YCharts

Kelt Exploration is a Canadian company; it might be a better idea to use the Canadian listing to trade the company's shares for liquidity reasons. Kelt is listed on the main board of the Toronto Stock Exchange with KEL as its ticker symbol. The average daily volume is in excess of 1 million shares and the current market capitalization is approximately $355M, even after seeing its share price fall by 80% since the summer of 2014.

Kelt Just Released Its Plans for 2016

Kelt has now published its production results for 2015 as well as an outlook for 2016. But let's start with 2015.

The average annual production was approximately 18,600 boe/day, a sharp increase of 46% compared to the previous calendar year. Both the production of liquids (+54%) and of natural gas (+41%) was up quite sharply. But as the oil and NGL production still represents "just" 36% of the total oil-equivalent production, Kelt should be seen as predominantly a gas producer with some oil (and other liquids) as secondary production.

Source: Company press release.

What's important is that Kelt ended the year on a relatively strong note. Even though the annualized average daily production rate was 18,600 boe/day, the production rate in December was much higher at almost 21,600 boe/day (with approximately 37.4% of this output consisting of "real" oil and natural gas liquids). That's a pretty good result, especially when you realize the company had to shut in almost 1,900 boe/day in the last quarter due to third-party pipeline restrictions. This means that if Kelt would have been able to transport all of its potential production, the average daily output would have been pretty close to 23,500 boe/day.

Click to enlarge

Source: Company presentation.

Unfortunately, this production level won't be sustainable. As the company's decline rate is pretty high (around 31%-34%), the producing assets require a continuous investment in order to keep the production rate stable. And unfortunately Kelt won't be able to afford to do so. Its previous guidance for 2016 was calling for a total capex of C$110M, which would result in an average production rate of 22,000 boe/day. Unfortunately, the low oil and gas price will make it very difficult (read: impossible) for Kelt to be able to cover these capital expenditures with its operating cash flow.

Even Using Its Optimistic Assumptions, There Will Be no Free Cash Flow. How Dangerous Is This?

So Kelt had to rethink its 2016 investment plans, and has now come up with a new strategy. Instead of borrowing a ton of cash to fund the capital expenditures, Kelt Exploration elected to let its production rate slip by investing less in its properties.

Source: Company press release.

That's probably the smartest move Kelt could have made as protecting shareholder value should be priority No. 1 for any oil and gas company out there. Yes, the production will be lower, but that's fine as a 41% reduction in the company's capex will result in just a 5% drop in its average daily output. In the 2016 budget, Kelt is now proposing to spend C$65M on capital expenditures and aims to cover the majority this with its operating cash flow.

Click to enlarge

Click to enlarge

Source: Stockcharts.com.

But there's one problem (and critical flaw) with this plan. The company's guidance to generate an operating cash flow of C$55M is based on a gas price of $2.5 and an oil price of US$39/barrel. And it's pretty obvious we aren't anywhere near those levels (as you can see on the two previous charts), so shareholders had better prepare themselves for a weaker performance. Should oil and gas prices remain at current levels, we would anticipate the operating cash flow to be 50% lower. So even though Kelt thinks there will be a capex funding shortfall of just C$10M (which would be great), I'm a little bit more pessimistic as those projections are based on much higher oil and gas prices.

So it's pretty likely Kelt will have to draw down more debt from its existing credit facility to cover its capex program for 2016. That's not a huge issue as the amount of debt on the balance sheet is moderate, and the company can draw down roughly C$90M from its credit facility. However, you should be aware the total bank indebtedness will very likely reach C$250M by the end of this year, and the credit facility will no longer be revolving from April on (unless the company cuts another deal with its lender).

Investment Thesis

Kelt is making the right decision by investing less in its properties to protect its balance sheet. It wouldn't have made a lot of sense to borrow much more cash to realize a marginal output increase (which would have to be sold at abysmal prices anyway). Unfortunately, this won't be sufficient to become cash flow neutral, and Kelt's net debt will increase by the end of this year.

Will Kelt survive? Well, it does have a good chance as its balance sheet is still OK compared to other oil and gas companies. But it will have to cut its capital expenditures even more in 2017 should oil and gas prices remain below $45 and $2.5, respectively. It's a tough one, and I'm on the sidelines.

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.