Penn West: All Eyes On Phase II Progress

| About: Penn West (PWE)

Summary

Penn West has transformed through its asset dispositions and debt reduction.

Remaining asset sales (phase II) critical to the success of remaining assets.

Current commodity price (WTI @US$45) supports production growth.

Penn West Petroleum (NYSE: PWE) has transformed itself under the leadership of its current management through asset dispositions and debt reduction. The current management has exemplified resilience and sees a clear path forward: make Penn West one of the leading low-cost operators in Western Canada with a focus on self-sustained production growth in its 3 main land sections.

2016 is critical to PWE's future as Phase II represents the high-grading of remaining portfolio including reduction in operating expense and remaining asset sales. Q2 2016 will be released on August 4th but expect nothing significant as the pro forma entity won't be fully reflected in the second quarter.

The imminent task of PWE management is the remaining asset dispositions. Management guided the end of 2016 as the expected completion for Phase II, which includes high-grading of the portfolio and remaining $100 - $200 million asset sales. The remaining dispositions are critical to the success of PWE because they are necessary to lower operating expense.

Click to enlargeSource: May 2016 Corporate Presentation

After the Saskatchewan asset sales, PWE has guided towards $10 - $ 12 operating expense pro forma for the completion of Phase II. The operating costs of the Saskatchewan assets sold were $14.75. Granted there are additional asset sales in Alberta for $140 million at the same time, as we can see that PWE's land positions in Alberta Vikings also shrank after the Saskatchewan asset sales. Phase II involves selling ~200,000 boe/d of production for $100 - $200 million. These assets must be high operating costs in nature and most likely are wells with negligible production and high ARO.

Source: June 2016 Corporate Presentation

Having a lower operating expense is the key to fetching higher netbacks and ultimately higher valuation. Raging River trades at a premium due to its high netbacks which enables it to generate positive FFO during current strip pricing and continue growing productions. Cardinal Energy, another company that relies on low-decline assets with high operating costs that resulted in lower netbacks but also lower capex needed to maintain production. PWE will need to keep its operating expense low because its assets will experience high declines, both now and when it starts drilling new wells.

Based on my calculations, at US$45 WTI pricing, PWE will be generating slightly over C$150 million in annualized FFO based on its current hedging, that is in line with management's guidance of C$150 million capex which will be within its FFO. A US$5 change in WTI pricing translates into C$30 million change in 2016 PF FFO, C$40 million change in 2016 FFO, and C$50 million in 2017 FFO. Company has guided 10% annual production growth based on C$150 million annualized capex, so we can infer that if WTI stays below US$45 for an extended period of time, its ability to generate the C$150 million needed for production growth will be impaired. The bottom line is that PWE will now be able to generate approximately sufficient FFO to sustain its capital program based on downsized portfolio with no need to access external capital or additional sales.

I have estimated 2017 EBITDA to be C$217 million (Based US$45 WTI) and C$175 million (Based US$40 WTI). What this means is that pro forma the Saskatchewan sales, which are now largely completed, net debt of C$600 million represents 3.3x net debt / cash flow and 2.5x net debt / EBITDA, which excludes the proceeds from Phase II sales and includes ~C$40 million of FCF from the remainder of 2016.

PWE has largely removed its going concern, as its newly amended covenant asks for maximum senior / total debt / EBITDA of 5.0x until Q2 2016, lower to 4.5x during Q3 2016 and 4.0x during Q4 2016. Senior debt / EBITDA needs to be less than 3.0x after January 1, 2017 and total leverage remains at less than 4.0x after Q3 2016. Given PWE only has senior debt which is projected to be 2.5x at the end of 2016 based on 2016 EBITDA ($217 million). Bank covenant is based on LTM numbers, so the leverage will be calculated most likely based on Q3 and Q4 in 2015 and Q1 2016 annualized since the asset sales altered the business drastically. I am projecting a C$186 million PF LTM EBITDA, which would represent a net leverage of ~2.9x at the end of 2016. Bottom line is total leverage is no longer a concern and only serves to limit PWE's future debt issuance (i.e. converts or second-lien), and senior leverage will need to be further addressed in order to avoid potential default. PWE technically has to the end of Q1 2017 to drop its senior leverage below 3.0x. Another lever is that the remaining asset sales would once for all remove any bankruptcy risk if PWE ends up fetching ~C$100 million or so in proceeds.

PWE currently trades at $55k per boe, representing a large discount to its light oil peers. Raging River trades at close to $140k per boe and Cardinal trades at $55k due to its heavy oil production and high operating expense due to widely-used waterflood program.

Q2 2016 results will be released on Thursday but I won't expect much news given Q2 wasn't pro forma for the Saskatchewan asset sales. Any update on the remaining Phase II sales and 2017 guidance would be helpful, and could serve as catalyst to close the valuation gap between PWE and others. If you believe in the management's ability to close the remaining sales and execute on its growth plan, the recent share price weakness due to WTI declines could be great opportunities to start accumulating shares.

PWE possesses significant torque to any rise in oil prices and valuation gap represents huge upside if Phase II is completed and senior leverage drops well below 3.0x as a result. I would allocate capital to this stock given the favourable risk / benefit, but would hedge PWE-specific execution risk by including other names. I will write about several other names in the near future.

Disclosure: I am/we are long PWE.

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.