Forest Oil (NYSE:FST) stock took a 16% nose dive in the three trading sessions following the Company's July 9 operating update to close at $5.72 a share on July 12. This represents a staggering 85% decline from the highs of around $40 just eighteen months ago.
The harsh market reaction is understandable. In its press release (FST Q2 Operating Update), Forest announced that it may now pursue a "go-it-alone" plan for the 103,000 net acres it has leased in the highly sought after Eagle Ford's oil window. The announcement implies that the Company's long running and well publicized effort to finance its Eagle Ford development via a joint venture has essentially failed. With lease expirations approaching fast (I understand, a substantial portion of the leases expires in 2013 and some in 2014) and the estimated 140 additional wells required to hold the entire position by production, Forest is effectively running out of time to implement a sizable JV transaction before the leases' deadlines. I estimate that Forest has so far been able to secure approximately 12,000-13,000 acres. Under its go-it-alone plan, the Company believes it will ultimately retain up to 40,000 acres with a two-rig program and may try to monetize the unused leases in small divestitures or farm-outs, effectively undoing more than a half of its lease acquisitions in the area.
The news is clearly disappointing. Based on the frenzied JV activity in the Eagle Ford in the past several years with implied per acre valuations of $10,000 and above, it may have been tempting to assign a value as high as $1 billion to Forest's Eagle Ford acreage based on comparable JV transactions and expect that the Company would have little difficulty bringing in a 50% JV partner for half that amount in drilling carries and a sizable upfront bonus payment. Instead, it looks like Forest now has little other choice but to finance 100% of its development program on its own.
Forest's failure to find a JV partner does not come as a complete surprise. Despite its success in building a sizable acreage position, the Company has yet to demonstrate that its wells can deliver strong economic returns. Forest's drilling results in the play have been steadily improving as a result of better frac designs and better placement of laterals, but still fall far behind the play's leading edge wells. FST's latest three reported wells had an average 24-hour maximum production rate of 787 Boe/d (96% oil), "meeting or exceeding" the Company's projected 300 Mboe EUR type curve which implies a pre-tax drilling rate of return of approximately 25% based on a $80 WTI crude price and a $6 million well cost.
In comparison, EOG Resources (NYSE:EOG) has been reporting IPs for multiple individual wells in the Gonzales County where Forest operates in the 2,000 to 3,000 barrels of oil per day range plus additional volumes from natural gas liquids and natural gas (EOG Q1 2012 Report). In an optimistic scenario, Forest's relatively underwhelming results may be explained by the learning curve: the Company is a newcomer to the Eagle Ford and has been operating just one rig versus the total of 279 rigs currently active in the play (as reported by Baker Hughes on July 6). However, Forest's well results may also indicate that at least a portion of its acreage is located outside of the play's sweet spots and is therefore less productive.
Forest's financial situation may have also played a role in deterring potential JV partners. The Company's scarce financial resources are thinly stretched across four highly capital intensive operating areas. Forest's ability to mobilize additional funds necessary for an accelerated drilling program in the Eagle Ford, now and in the future, will likely be crippled by its $1.8 billion debt (FST Q1 2012 Report), which is dangerously high when measured against the Company's discretionary cash flow run rate of approximately $400 million a year.
Forest's recent loss of its operating leadership has likely made further complicated the discussions with potential JV partners. The Company lost its COO J.C. Ridens in May. The CEO Craig Clark resigned at the end of June (FST 6/22/2012 Press Release). The search for a new CEO is currently underway. The July 9 press release hints that the Board is in the process of re-evaluating the Company's operating and financial priorities. Naturally, it will take some time before the new management team is in place and the new strategy is defined. With uncertainties of such magnitude looming, any JV transaction with Forest as operator has slim chances of going ahead.
The Company may have counted on some cash proceeds from its proposed JV offer. As a result of the negative outcome, the over-levered balance sheet will see no relief. This may have contributed to the capital budget cut decisions announced on July 9. Forest plans to idle three of the eight rigs it is currently running. Asset divestitures will likely follow. It would not be surprising if Forest will also have to slow down or postpone its development plans in the promising horizontal oil plays in the Permian and other new undisclosed locations.
From an investor's perspective, a fresh look at the value of the Company's various assets is timely, in the context of possible radical strategic choices that the Board may be forced to make soon.