Warren Resources: No Hope For The Common Equity

| About: Warren Resources, (WRES)

Summary

Warren Resources is another distressed E&P company with high debt levels and high interest costs.

Its unhedged breakeven is around $75 oil and $4 natural gas and it has limited cash remaining.

Interest costs may reach nearly 50% of revenue during 2016.

Warren is in restructuring negotiations and the first-lien debt may be impaired.

Common equity is extremely likely to have no value.

During discussions about other distressed companies such as Linn Energy and BreitBurn Energy Partners, a commenter brought up Warren Resources (NASDAQ:WRES) as a comparable company to look at. After examining Warren, I think that it is in an even worse situation than those companies, with limited hedges remaining and the first-lien debt facing potential impairment. A restructuring agreement or bankruptcy filing appears imminent. As a result, the common equity probably should be avoided even by speculators.

On The Brink

Warren Resources appears to be in an extremely challenging position right now. It skipped making its unsecured bond interest payment in February and is in a default position for its first-lien, second-lien and unsecured debt. However, lenders have been willing to negotiate for now.

Warren Resources is in discussion with first-lien, second-lien and unsecured lenders about restructuring its debt obligations. It also mentioned that a voluntary bankruptcy was a possibility. Warren indicated that the first-lien lender presented a restructuring proposal that would convert "a substantial amount of debt to equity". However, the other lenders have not agreed to the proposal.

Breakeven Point At Around $75 Oil And $4 Natural Gas

At the midpoint of 2016 production guidance, Warren Resources will generate approximately $127 million revenue at $75 WTI oil and $4 Henry Hub natural gas without hedges. This represents Warren's breakeven point to maintain production at 2016 levels without hedges.

 

Units

$ Per Barrel/Mcf

$ Million

Oil (MMbl)

803

$68.00

$55

Natural Gas (Bcf)

22.4

$3.00

$67

Atlantic Rim Pipeline Revenue

   

$5

Total

   

$127

Click to enlarge

Expenses are taken from Warren's 2016 guidance as well, while it is estimated that Warren can maintain those production levels with approximately $40 million in capital expenditures.

 

$ Million

LOE, Gathering Fees and Taxes

$39

Cash G&A

$11

Cash Interest

$37

Maintenance CapEx

$40

Total

$127

Click to enlarge

These numbers are probably slightly favorable to Warren as production taxes should increase over 2016 levels if oil and gas prices increase. As well, Warren is likely to exit 2016 with production below the midpoint of guidance since production will decline throughout the year.

2016 At $45 Oil And $2.50 Natural Gas

If we look instead at what would happen in 2016 with $45 oil and $2.50 natural gas instead, we'd find that Warren would generate approximately $80 million in revenue including $9 million in hedge value.

 

Units

$ Per Barrel/Mcf

$ Million

Oil (MMbl)

803

$40.00

$32

Natural Gas (Bcf)

22.4

$1.50

$34

Atlantic Rim Pipeline Revenue

   

$5

Hedge Value

   

$9

Total

   

$80

Click to enlarge

However, even with minimal capital expenditures (leading to Warren's estimate of an 18% decline in oil production and a 20% decline in gas production), Warren is expected to have $90 million in cash expenditures, resulting in $10 million in cash burn.

 

$ Million

LOE, Gathering Fees and Taxes

$39

Cash G&A

$11

Cash Interest

$37

CapEx

$3

Total

$90

Click to enlarge

Thus, even if Warren completely sacrifices production, it will burn $10 million during 2016 partly due to its massive interest costs.

High Interest Costs

Warren's problem is that in addition to having a significant amount of debt, its debt has very high interest costs. Warren's debt to EBITDA ratio is estimated at over 10x at $60 oil and $3 natural gas. This decreases to a bit under 6x at $80 oil and $4 natural gas. This level of leverage puts it roughly in the same category as other highly leveraged companies such as Linn Energy and BreitBurn Energy Partners. However, while those companies have an average interest rate around 6%, Warren's average interest rate is around 8%. Based on 2016's forecast at $45 oil and $2.50 natural gas, cash interest is expected to equal 46% of Warren's revenue (including transportation revenue and hedge revenue). This is clearly an untenable situation that will likely get worse due to Warren's inability to maintain production. A significantly shrinking level of production is having to support those very high interest costs.

Valuation

If one were to value Warren based on 6x its unhedged EBITDA at $60 oil and $3 natural gas and 2016 production levels, it would be worth approximately $252 million. At $50 oil and $2.50 natural gas, this decreases to around $150 million. The PV-10 of Warren's reserves at SEC pricing is $96 million, while at modified strip pricing, its PV-10 increases to $215.5 million.

Warren Resources had approximately $235 million in first-lien credit facility debt, $52 million in second-lien credit facility debt and $167 million in unsecured debt at the end of Q1 2016. It appears that the first-lien debt is likely impaired, which probably resulted in a first-lien proposal that converted some of the first-lien debt and all of the second-lien and unsecured debt into equity. With the first-lien debt likely being impaired and the second-lien and unsecured debtholders not happy with current proposals, the chances of there being any recovery for the common equity is slim. Probably the best that can be hoped for is some warrants with a high exercise price, but the most likely outcome is nothing for the common equity. This is certainly true if a restructuring agreement is not reached, in which case Warren indicates that the second-liens might not even see a recovery.

To be competitive, Warren probably needs to reduce its interest costs to under $10 million per year, which would mean that it could only have $100 million in first-lien debt outstanding based on the current 9.5% interest rate. The first-lien lenders are probably going to end up with the majority of Warren's equity.

Conclusion

Warren Resources is in tough shape due to very high debt levels and high interest costs. It currently needs around $75 oil and $4 natural gas to breakeven without hedges and would burn cash in 2016 even with capital expenditures reduced to the point where production is expected to decrease by nearly 20%. Warren's first-lien debt faces potential impairment, which means that its unsecured notes and common equity should be avoided. I believe that Warren is even in a more challenging position than companies such as Linn and BreitBurn since those companies at least have hedges and reserves that should allow the first-lien debt to see a full recovery.

Note From The Author: If you found this article informative, please scroll to the top of the article and click on follow to see my newest articles as they are published.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.