Folks who have read my articles on this site know that I don’t usually set price targets on stocks that I like. However, the current circumstances pertaining to Penn West (PWE) requires that an exception be made to this rule.
PWE is a Canadian Royalty trust (“Canroy”) about which I wrote an article three weeks ago. This follow-up article will build on what I said in the previous article, so I will assume you have read that article before proceeding to read this one. The reason for writing this update is that oil and gas have increased significantly since I wrote my article three weeks ago, essentially guaranteeing an outrageous earnings report when PWE reports its second quarter in a little over two months.
As we all know, oil has been hovering in the $120s the past couple of weeks, and broke decisively into the $130s this week, hitting an unprecedented high of $134 yesterday (5-21-08), as (I wrote this article). And PWE has risen more than 10% since I recommended it at $31 three weeks ago. However, what the market has failed to appreciate is that given the recent rise in oil and gas prices, PWE’s projections of a few weeks ago are very likely to be surpassed by a substantial margin.Speaking very simplistically, the metric most commonly used to value the Canroys is the “funds flow” (“FF”). FF is used by a Canroy for three general purposes: (1) to pay large dividends (PWE’s dividend yield is about 11.7% at yesterday’s closing price of $34.82), (2) to fund capital expenditures, and (3) other things are done with any FF left over.
Traditionally, not much is usually left over after dividends and capex are paid out of FF. Indeed, in 2007, several of the Canroys had to cut dividends because the FF barely even covered the dividends alone. A second issue for Canroys is that even if FF fully covers dividends, often the Canroys have to do equity offerings in order to fund their capex, which of course dilutes the metric of FF per share (which are called “units.”)
In contrast to the “normal” situation (eg. 2007), here is what PWE projected for 2008 when it announced earnings three weeks ago: FF of $2.7 to $2.9 billion, minus around $1 billion in capex and around $1.4 billion in dividend payments. These numbers would therefore leave $500 million in category (3) monies in 2008--monies that have never been available at these levels before. Because PWE had substantial debt as a result of some recent acquisitions, PWE announced that they would use these monies to retire debt and strengthen their balance sheet.
The above numbers were sufficiently compelling for me to suggest, in my previous article, that a 30-40% appreciation rate in this calendar year (ie. in 8 months) was a very reasonable expectation, with relatively little downside risk (unless one believed in early May that $80 oil and $7 gas was just around the corner, in which case PWE would be a terrible investment). But, as we all know, oil has not gone to $80 nor gas to $7.
So the question now is, what has changed that has prompted me to now call for a target of $50, which represents a further appreciation exceeding 50% (in you include the dividend) from yesterday’s close?
What has changed is that oil and gas prices have continued to increase, and although the debate continues as to what the “correct” price for oil and gas should be, very few people have made a compelling case that oil will ever go below $100 or gas below $9 (my short answer to this - OPEC will never allow oil to go below $100, and OPEC can easily prevent $100 oil simply by trimming production by 2-3%). In fact, more experts now believe that oil is more likely to see $150 this year than $100.
Although I’m far less convinced than others that we will see oil averaging $150 this year, I highly doubt we’ll see $100 oil because OPEC won’t allow it.
And here is where the recent change in oil and gas prices is critical to the evaluation of PWE: When PWE projected funds flow of $2.7 to $2.9 billion this year, it did so based on the assumption that oil would average $107 and gas would average $8.50 this year. If you believe, as I do, that these numbers are conservative, the upside to cash flow is substantial. For example, if oil averages $120 (it’s $134 yesterday) and gas averages $10 (closed at $11.72 yesterday) in 2008, my back-of-the-napkin calculations suggest that funds flow will be closer to $3.2 billion than $2.8 billion.
After deducting $1 billion in capex, that will leave $2.2 billion that can essentially be considered the equivalent of “earnings” (this is not strictly true, but will do for our purposes). If PWE were a normal corporation, this would translate into a PE of about 5. To look at it a different way, if PWE were to distribute all of these “earnings” as dividends, the dividend yield would exceed 20%. To look at it a third way, PWE’s “net profit margin” (or operating margin) would be in excess of 20%, and not too many companies can claim that level of profitability.
Obviously, this whole analysis depends on oil averaging at least $107 and gas at $8.50 this year. If you believe these are not realistic assumptions, you should avoid this stock and almost any stock in the oil and gas fields. If you believe, however, that oil is likely to average in excess of $110 and gas at least $9 this year, then you should load up the boat on this one. In addition to the risk of lower oil and gas prices, there is always risk of new taxes being passed, but this is a wild card that I can’t really properly value.
For various reasons, however, I think it is unlikely that the Canadian govt will pass additional onerous taxes given that it has recently already done so.It should be noted that there are several other Canroys I like, including Provident Energy Trust (PVX) and Advantage Energy Income Fund (AAV), but PWE is the most compelling of the group.
One final thought: Unless oil crashed to $100 and gas went to $8 tomorrow and stayed there until the end of the second quarter (and I consider this rather unlikely), PWE is just about guaranteed to announce a blowout second quarter in a couple of months because oil and gas have already substantially exceeded the $107/$8.50 averages in PWE’s projections, and because we are almost 2/3rds of the way through the second quarter. It seems to me this provides substantial downside risk protection for PWE and most of the other Canroys.
Disclosure: As you may have guessed, I am long PWE.