Penn West: When The Dust Settles (Q2 2016)

| About: Penn West (PWE)

Summary

Penn West reported mixed 2016 Q2 results.

Share price slightly decreased to reflect investor sentiment.

Valuation gap persists and future catalysts are higher oil price and 1 - 2 strong quarters.

Penn West (NYSE:PWE) reported Q2 2016 results this morning. Overall, great progress on Phase II program with $75 million in signed sale agreements. Leverage is at 2.3x, well below 3.0x covenant. Capital spend is increased and it is planning to drill 5 wells in the Cardium, 11 wells in the Alberta Viking and 19 gross wells in the Peace River area, with expectation to add 3,000 boe/d to 2016 exit production. Capital efficiency of $8,300 per boe is not bad.

However, interesting observation from the conference call today is that only one analyst from Credit Suisse asked about the accounting difference between Funds Flow and FFO, and no other question were asked on the conference call. Q1 2016 also only had two analysts asking questions. My sense is that PWE has downsized to become a small player in the Canadian E&P space and the plan forward from here is to grow production through drilling and other development activities. PWE won't be an acquirer for some time and likely won't access the capital markets in the near future.

Q2 2016 Results

Looking at numbers, Q2 were mixed as CFPS came in lower than consensus due to higher financing costs and G&A, offset by lower operating expenses and royalties. Not much to say at this point on the operational side besides that further operating costs reduction depends on the remaining asset dispositions. There is nothing surprising in this quarter, as expected.

Hedging

PWE has been criticized for its inadequate hedging in the past. This quarter we are seeing PWE showing 6,000 boe/d hedged for the remainder of 2016 and 3,000 boe/d hedged for 2017 Q1 only, both at ~C$70 WTI price (not the price PWE is getting). PWE's core areas have 73% oil weighting, which means that at 25k boe/d, PWE would be producing ~7k boe/d of natural gas. PWE hedged 19 mmcf, which translates into ~6k boe/d, basically eliminated the entire exposure to AECO pricing. Looking into 2017 PWE has also hedged majority of its gas exposure.

Why did PWE not hedge its oil exposures as much as it did for gas? PWE is self-sustaining at US$45 WTI. PWE generates $150 million in FFO at US$45 WTI, which could pay for its $150 million capital budget. Overall gas revenue only accounts for ~10% of PWE's overall revenue. The sensitivity below shows that each 10% change in AECO results in FFO change of $3 million, while a 10% movement in WTI results in $33 million swing up or down at the FFO line. PWE does not have much to lose if oil stays at $40-$45. There is always a trade-off between hedging and losing the upside vs. not hedging and getting exposed to the commodity market. PWE must have chosen to leave themselves open to the swing in oil market, which I must say is probably the best idea. Why? Because Penn West needs to be exciting again.

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Path from Here

Penn West is not your typical E&P peers that have pristine balance sheet, a track-record of productions, fears more of getting exposed to drop in oil price so hedges most of the production to ensure sufficient funds are available for maintain production and drilling programs. If Penn West sits on its production and hedges most of its production, who would invest in this name? There are plenty of larger players with lower operating expense, larger land, higher inventory and better drilling results. One example is that I would rather buy Raging River than Penn West if I were to look for organic growth.

Penn West is not appealing to many investors because it does not pay dividends, has no track record and is a tiny company now. Why would someone invest in a company that pays no dividends and hedged a lot to make sure that it stays like this for years. To me doesn't sound too smart.

To me Penn West is doing the right thinking as to how best position this company, which has fallen out of favour. Investors are reluctant to look at this na me unless there is a reason to. Penn West now has the best torque to any oil price recovery, and it won't go bankrupt if oil dips to US$30. The worst is just to cut capital budget.

Bottom line, if oil drops to US$30 and stays there for a while, Penn West would look stupid not to hedge but will just lose $30 million a year with US$5 change in WTI, you do the math. Management must believe in oil price recovery to make this decision, but I think it is important to understand the trade-off here if you are investing in this name.

Valuation

So the big question is…how much is PWE worth? There is a valuation gap, let's be clear about it. Penn West trades at 6.0x 2017 EBITDA, most peers are trading at 9.0x - 10.0x. Implied EV / boe is $50K, well below its peers with similar netbacks. With $14 in operating costs and $20 netback, PWE should receive ~$100k per boe given its strong growth profile.

Why did the share price decrease today when oil price actually rose slightly? PWE had a mixed quarter and although we are seeing great progress on the disposition front, the quarter shows nothing that investors do not know yet. Back to my previous point on why should investors look at this stock again. People need 2 - 3 quarters to assess the new story put out by the management. The company has done a tremendous job of realigning its balance sheet, and it is time to show what it is worth through positive drilling results, production growth, and hopefully oil price rally!

Comparing to some companies at other industries, Penn West's story is fairly straightforward and easy to understand. The driver is oil price, cost structure is simple, capex is clear, and valuation should be very easy to complete. I would expect valuation to approach its peers after 1 - 2 quarters of good results. Investors should be patient and start to add to their positions if oil price fluctuations create buying opportunities. This company is no longer going bankrupt and has little execution risk, in the sense that its state today already warrants a much higher valuation, not to mention the upside from further Phase II progress and other surprises.

Share Price

As a side note here, some fellow readers have asked if low share price could be an impediment to large institutions investing in PWE. I asked people working in the industry and, in Canada, most large buy-side shops do not have limitations on share price. If a stock is trading $0.5, and is projected to go to $1, to me sounds like an awesome investment and most institutions will pile into.

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.