Pengrowth Energy's Second Quarter Wasn't As Good As I Hoped

| About: Pengrowth Energy (PGH)

Summary

Pengrowth Energy generated C$85M of free cash flow in Q2, but 90% was the result of monetizing hedges.

Once these hedges start to roll off after the end of this year, shareholders should brace for a much, much lower free cash flow at US$45 oil.

Pengrowth won't be able to repay the debt due in 2017 unless it starts using its credit facility (which it very likely will).

The survival of the company beyond 2017 completely depends on the oil price and the willingness of the 11-bank consortium that has provided the credit facility.

Introduction

When I was looking to find some good oil and gas stories, I came across Pengrowth Energy (NYSE:PGH). I didn't buy the stock but was very interested in its convertible debt. Not because I was expecting the debentures to be converted into common shares, but because it's (slightly) more senior than common stock and does pay its annual coupon, whereas Pengrowth has suspended its normal dividend payments (which absolutely was the smartest thing to do).

PGH Chart

PGH data by YCharts

I previously also argued Pengrowth could be saved by its hedges, but after seeing the results of the second quarter of the year, I'm not so convinced anymore as the underlying result (excluding hedges) really wasn't good at all.

The adjusted cash flows were weaker than I expected - the hedges are very important

It's great to see how Pengrowth Energy has been trying to reduce or improve its cost structures, trying to get the best out of its assets in an attempt to survive the current downturn in the oil and gas markets. The company definitely tried to make a difference and the fact it now expects its annual operating costs to be C$65M lower ($49M) than originally anticipated proves this.

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Source: company presentation

That's obviously positive news, but upon double-checking the numbers of the income and cash flow statement, Pengrowth will need a higher oil and gas price more than ever before as cutting costs simply won't be efficient.

The average production rate in the second quarter of the year was just short of 57,000 boe/day, which is approximately 9% lower than the 62,000 barrels per day in the first quarter of this year. The Q2 production rate is right in the middle of the official full-year guidance of 56,000-58,000 boe/day, and as the average production rate in H1 was 59,500 barrels per day, it's not unreasonable to expect the H2 production rate to slide towards 55,000 barrels per day.

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Source: financial statements

The revenue from the oil and gas sales was approximately C$137M ($103M), and the additional income from the realized gains on the hedge program of $77M ($57M) increased the total revenue to C$214M ($161M) before seeing an outflow of C$224M ($168M) related to the changes in the fair value of these aforementioned hedge contracts. The total operating income was negative to the tune of C$206M, despite Pengrowth being able to reduce the operating and transportation expenses by approximately 40%. The bottom line was obviously also showing a net loss, despite a C$66M tax recovery. The net loss was C$173M ($130M), or approximately C$0.32 ($0.24) per share.

This sounds alarming, but the good news is that this loss was entirely caused by non-cash issues. The loss on the fair value of the commodity contracts is non cash, as is the depletion and depreciation rates of these assets. If you would remove these parts from the equation, Pengrowth's adjusted operating cash flow (adjusted for changes in its working capital position) was approximately C$115M ($86M). And yes, this was definitely sufficient to cover the C$18M ($13.5M) in interest payments as well as the C$12M ($9M) capital expenditures, resulting in a pro-forma adjusted free cash flow of C$85M ($64M).

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Source: financial statements

Your first thought is probably 'well, that's just great! Well done, Pengrowth!', but there's a catch. Remember the total revenue was boosted by a C$77M realized gain on its hedge book. Well, once those hedges start to roll off, Pengrowth's operating cash flow would have been C$77M lower, resulting in an adjusted sustaining free cash flow of just C$8M if you would ignore the hedge benefits.

The plan is to increase the production rate at Lindbergh - but the clock is ticking

So, yes, Pengrowth generated a massive amount of free cash flow (which was subsequently used to reduce its net debt by repaying existing debt and adding cash to the balance sheet), but once the hedges start to roll off, the company will have a very difficult time to be free cash flow positive at $45 oil and a differential of $13.31/barrel for its heavy oil.

Despite this, Pengrowth is planning to increase the production rate at its Lindbergh asset. That project actually is a good one as Pengrowth was able to produce approximately 17,500 boe/day versus the official nameplate capacity of just 12,500 barrels per day. The company has received the approval to increase the production rate to 30,000 barrels per day, which is the company's next step before ultimately reaching the 40,000-50,000 barrel per day mark.

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Source: company presentation

That's great, but the water has now almost reached Pengrowth's lips as the net debt increased to C$1.58B ($1.19B). The total fair value of the remaining hedge contracts is approximately C$150M ($112M) so if you'd count in Pengrowth being able to monetize all the hedges, the pro-forma net debt will be C$1.43B ($1.08B) which is in line with the pro-forma net debt at the end of last year.

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Source: financial statements

In the previous article, I recommended to have a look at the convertible debentures, as these are maturing first, which practically makes the convertible debt more senior to the senior debt by 'seniority by maturity'. I don't anticipate Pengrowth to have any issues to repay the convertible debentures on March 31st next year, but it's pretty clear 'something' will have to be done to fund the US$400M repayment of a senior unsecured note due in July next year.

Investment thesis

Pengrowth remains alive for now. 'For now,' because it will have to repay in excess of $500M in debt within 11 months and that will be quite tough with an existing cash position of less than US$45M and the fair value of its short-term hedges (US$75M). This means Pengrowth will have to find a way to refinance the $400M bond, and the main question will be how many lenders will be happy to support a company with a net debt of $1.1B and a sustaining free cash flow of less than US$10M at $45 oil. Spoiler alert: it will be difficult, if not impossible to refinance the debt, and it looks like Pengrowth will have to tap its existing credit line to repay the bonds.

Unless the credit facility is being revoked or downsized, Pengrowth should be able to repay the 2017 bond, but as long as the oil price remains below $50/barrel, the company is just kicking the can further down the road, as an additional $275M+ is due for repayment in August 2018.

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.