Sometimes, little things start an investigation as to what is going on. In this case it was two quotes from the conference call.
"Thank you, David. We had a very solid quarter, despite average WTI prices in the $45 range. We reported after tax net income of 1.8 million for the quarter on revenues of 7.6 million. And I'll let that sink in for a minute.
In a $45 oil price environment, we were able to drop 24% of revenues to the bottom line after all cost, cash and no cost, cash and non-cash, after DDNA expenses and after taxes. "
The above quote was stated by Randy Keyes, President and CEO.
"I should mention for purposes of comparison to other companies that this lifting cost is an all-in production cost including severance taxes, because the Delhi field is a qualified tertiary recovery project in the state of Louisiana. As such we pay no severance taxes until all costs of the project have been recovered including an interest factor."
The above quote was also stated by Randy Keyes, President and CEO.
Differences this large in reporting income are definitely acceptable, as the tax reporting is very different from the income reporting to shareholders. Still when the difference becomes that large (there is a 24% margin one way and no margin the other), then it is time to investigate and see what else might be material to the investment evaluation. The company is telling the taxing authorities in a legal fashion that it will not recover its costs for 2 decades. Many times, nothing of significance will turn up, but being careful often has its own rewards.
So, this article is first going to look at the bright Evolution Petroleum (NYSEMKT:EPM) picture and then review the "trouble" to come up with an overall picture of what lies ahead. After all, investors do not find 24% net margins every day, so why not look at this company more in depth?
Evolution Petroleum is headquartered in Houston, Texas. But its main asset is located in northern Louisiana. The main asset, Delhi field, is operated by Denbury Resources (NYSE:DNR). As such, Evolution Petroleum is in many ways a passive investor and a partner in this venture.
Recently, the shareholders received the happy news of a dividend increase to $.065 per share each quarter. The company can well afford this as it is debt free and the pro forma cash balance is nearly $20 million after redeeming the preferred shares. Not including the preferred stock called for redemption the company had about $3.5 million in current liabilities. So the current ratio is strong. The company also has a $10 million line of credit that is unused. The cash balance received a big boost from the receipt of a settlement payment from Denbury Resources.
Source: Evolution Petroleum, October, 2016, Corporate Presentation
There is a natural gas liquids process plant coming online this month that is expected to upgrade and potentially increase the products produced in the field. It could potentially reduce some production costs and save on electricity through associated projects. The company plans to used some produced methane to power electric generators and save on purchased electricity. Other parts of these leases offer various growth opportunities for the future. So overall, the revenue growth picture from more production and higher priced production looks good.
As a side note, it is rather fascinating that for tax purposes, the cost of this whole project (plus an imputed interest rate) will not be recovered for decades. On the other hand using a very different reporting basis, the company for accounting purposes has that large margin quoted above. The accountants had to have worked overtime to present these two items. Both are legitimate, acceptable, and approved by the public auditors, but that does not make the contrast any less fascinating.
In any event, the company has an over-riding royalty as well as a working interest and is very profitable. Clearly, the project was originally financed with a lot more equity than debt, so financial leverage is not a worry. The profits at least appear to sustain a debt free mode of operation for the foreseeable future.
Source: Evolution Petroleum, October, 2016, Corporate Presentation
Currently, the company's share of production is less than 2,000 BOED a day (largely oil). However, the new natural gas liquids processing plant may change that figure materially starting with the next reporting quarter. The company already has some decent reserves in this low commodity price environment, but the operations of the plant may expand the reserves some what as higher value products are produced, and more of the production is selling price maximized.
Management has made some forecasts with oil prices as high as $60 per barrel. But lately, oil prices have headed in the wrong direction, and may reach $40 per barrel first and stay there for awhile. There have been too many significant production improvements lately to justify any kind of price rally. Since company after company is reporting lower breakevens on the new projects, production can expand in the industry without a price increase. That is exactly what appears to be happening.
As shown above Evolution Petroleum appears to have some good costs and has cut itself a pretty good deal. But lower prices, especially if oil heads into the low $30 or worse as it did this past winter could put a very large damper on the current shareholder celebrations. Traditionally, these type of recovery programs have higher lease operating expenses and generally need higher commodity pricing to make a reasonable profit. This project appears to have relatively low costs for a tertiary recovery or even a secondary recovery project. How long those low costs will last is an educated guess; the company needs diversification before the profitability ends.
But the really big trouble revolves around Denbury Resources, the operator. As was reported earlier, Denbury Resources has now begun to use the "Troubled Company Accounting" because the latest swap appeared to be a distressed transactions in the eyes of accountants. Furthermore, the company has now begun in some later filings to begin to show the latest updates about "going concern" uses in reporting.
Cash flow for Denbury was not sufficient by many measures in the June quarter, and not much improvement was expected for the September quarter. So while the company made some progress paying down long term debt, there is a lot of operational work needed to improve the cash flow generation.
Lately, management discussed how higher debt pricing (a result of financial progress made lowering the long term debt) will hinder further progress. This opinion may result in a strategic error. Usually these kind of problems need to be resolved promptly, even if the cost rises. Should management continue to avoid this problem due to the higher debt prices, the company could easily join other companies such as Sandridge Energy (NYSE:SD) and Halcon Resources (NYSE:HK) that reorganized earlier this year.
Should things continue to deteriorate, Denbury may have to get some decent legal and financial advice, or (in a worst case scenario) file for bankruptcy. Bankruptcy of an operator can pose all kinds of challenges for the partners. While Evolution Petroleum is reporting great profits, Denbury may not be having the same experience with this same asset. So the court could order this main asset sold or closed down. The court could even order a review of the relevant contracts and agreements to determine if the agreement is burdensome. A burdensome finding could result in some contract revisions. Six months of payments could be reclaimed by the court if they were not prudent. Any of these possibilities could cause Evolution a lot of headaches and challenges.
Even without the reorganization. The current low cash flow of Denbury could result in the delay of necessary repairs and the cancellation of growth projects. Bankruptcy courts, should a reorganization happen, have a very different view of necessary, growth, and other relevant topics. A cash constrained operator could also delay necessary repairs and projects. So rather than all that lovely growth that Evolution Petroleum management was predicting, there could be a few years of turmoil instead.
In any event, investors need to do a thorough evaluation of Denbury Resources as well as Evolution Petroleum before making an investment in Evolution Petroleum. An evaluation of future oil prices is particularly critical here because sustained lower oil prices really could bring on the worst case scenario promptly. There is a decent possibility that the events at Denbury Resources will affect the stock price of Evolution Petroleum. So while everything appears rosy and maybe even undervalued at Evolution, the problems of Denbury may allow that undervaluation to persist for awhile. This stock is a little more speculative than it appears until the Denbury Resources management solve their financial challenges.
Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.
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.