Forest Oil's (FST) Board and the interim management have taken the first painful step aimed at stabilizing the Company's balance sheet by putting the recently acquired Permian Basin acreage on the block. The measure is logical and does not come as a surprise (see my earlier note "Forest Oil: Operating Update Highlights Strategic Challenges"). This follows the earlier decision, announced on July 9, to monetize the less strategic 63,000 Eagle Ford acres (while attempting to retain the remaining 40,000 core acres with a two-rig drilling program) and divest miscellaneous non-E&P and non-core assets.
The loss of the exposure to multiple high-potential horizontal oil prospects in the Permian is a minor sacrifice relative to the more substantial, and difficult, steps that the Company will likely have to make in the very near future. The management team estimates that the announced divestitures are likely to generate "couple hundred million dollars over the next several quarters." In my estimate, the potential proceeds may be a bit higher, in the $300+ million range. Still, this amount falls short of what is needed for the full resolution of the credit issues while the timing remains uncertain and the execution risk high.
Forest needs to refinance $600 million of its bonds maturing in February 2014. Under normal circumstances, the refinancing would be done in advance of the maturity date, perhaps as early as this fall. However, several factors make the offering very difficult, if at all possible, to execute. Forest's credit profile has substantially weakened over the past year and cannot be repaired "through the drill bit," at least not in any relevant time frame. Forest does not have permanent management in place. The Company's ability to accelerate the development of its core assets is impaired by the over-levered balance sheet. The failure of the Eagle Ford JV process has damaged the Company's credibility, and investors will likely be assessing the Company's unproved assets with great scrutiny and deep valuation discounts. Technically, Forest has the option of using its credit facility to refinance the bonds, as it still has over $850 million of availability under the bank revolver ($366 million was outstanding as of July 25, 2012 under the $1.25 billion facility, as per the Q2 2012 10-Q filing). However, that route is the absolutely last resort option and if used, would signal a major distress to the market.
Forest does not face any imminent liquidity crunch. However, with all the above considerations in mind, it would be highly imprudent to leave the refinancing unresolved for long. Additional, more sizeable asset divestitures seem to be required. The Company may need to offer for sale assets that are: (i) almost certain to generate significant buyer interest; (ii) can raise sufficient proceeds, and (III) preferably, have low cash flow associated with them. That means Forest may need to tap into some of its most valued assets with significant undeveloped potential.
One could think that the 40,000 acres in the Eagle Ford that Forest views as core is the next logical asset to be considered for monetization given the high interest in the play, sky-high valuations and the asset's low cash flow relative to its potential price. The most recent transaction between Comstock Resources (CRK) and Kohlberg Kravis Roberts (KKR) announced on July 30 translated in a $25,000 per acre valuation (although the complex JV terms make this data point not directly comparable to a sale of acreage). In addition, the most recent "monster well" results in the Gonzales County where Forest operates announced by EOG Resources (EOG) last night will likely motivate potential interested buyers to take a fresh look at Forest's acreage (EOG's the Boothe Unit #10H well began initial production at a staggering 4,820 barrels of oil per day, 972 barrels per day of NGLs and 4.5 MMcf per day of associated natural gas).
Arguably, it may make sense for Forest to monetize a portion of its acreage that has already been proven. The Company has most recently reported four relatively strong wells located in a close proximity from each other. In the event step-out wells deliver positive results, the delineated part of the acreage could perhaps be sold for over $15,000 per acre. Assuming, for illustrative purposes, that 20,000 Eagle Ford acres can be sold towards the end of this year for $250 million in after-tax proceeds (excluding any existing production) and the other divestitures discussed above can bring in an additional $250 million, the credit issue would be essentially resolved. Forest would end up with a more manageable $1.4-$1.5 billion of debt and preserve a meaningful, albeit unproven, position in the Eagle Ford.
A more radical approach would be to sell the entire 40,000 core Eagle Ford acres and fully address the leverage problem. Clearly, without the upside associated with the Eagle Ford and the Permian, Forest's "story" looks somewhat less exciting. The strong appeal of those two assets has been in the opportunity to capture the early stage of the plays' value appreciation through proving up geological concepts and the delineation activity. The returns could have been accelerated through a partial monetization (as was intended with the proposed Eagle Ford JV). That component of the value would be gone from the stock. But so will be the discount associated with the potential financial distress and lack of operating focus.
Other divestiture alternatives are also conceivable. Forest may be able to sell a portion of its core Panhandle assets and still preserve meaningful exposure to its Anadarko Basin plays. Selling the gassier East Texas/North Louisiana properties may be more difficult for the moment given the depressed natural gas price environment but also not impossible.
An equity or subordinated convertible offering is yet another alternative available to Forest. A $200 million offering in combination with non-strategic divestitures may partially solve the credit problem and would buy Forest time and the bargaining power needed to trim down its portfolio in an orderly fashion. The dilution and short-term stock impact are likely to be considerable, but the Company will be able to better preserve value in its most valued assets and avoid the fire sale.
Forest certainly has alternatives to choose from. None of them is easy. Each of these options will mean making significant sacrifices and giving away value, the unavoidable price to be paid for bringing the Company back on track. Clearly, the Board and management are acutely aware of the parameters of the problem and the radical steps that may be required to resolve it. Given all the circumstances and the direction of the most recent Board decisions, it would be naive to think that anything less than "all possible alternatives" are currently on the table. Equally, it is probably safe to assume that all potentially interested buyers of Forest's individual assets, or the Company as a whole, are fully aware of the opportunity (that list would include E&P companies, private equity funds, activist funds, large internationals with appetite for the US unconventional resources, and even rich individuals). Potential acquirers and investors are also probably aware that very little is currently standing in the way of an attractively priced transaction. There is only one problem. It's a buyer's market out there in which even high-quality assets may occasionally end up unsold.