4 Reasons Why Shares Of Callon Petroleum Could Be Poised To Drop

| About: Callon Petroleum (CPE)

Callon Petroleum (NYSE:CPE) shares spent this summer climbing higher, fueled by the rally in oil prices. But that appears to be unraveling now and the price of oil has actually dropped about 9% in just about four weeks. Callon Petroleum shares rallied from about $3.80 in June to over $6, but have started to pull back from recent highs. This new weakness combined with a few other factors could lead to additional declines in the coming weeks and months. Here are a few reasons why investors might want to take profits before it potentially evaporates:

1. The price of oil has dropped down to about $85 per barrel, but even that might be unsustainable based on global economic weakness and the current levels of supply in the oil market. Oil production in the United States is now at a 15-year high, and additional production is poised to come on the market in 2013. This could push the price of oil even lower early next year.

2. The valuation of Callon Petroleum shares appears inflated when compared to other oil stocks. For example, analysts expect this company to earn just about 10 cents per share in 2012 and 45 cents in 2013. This puts the P/E ratio at about 56 times 2012 earnings and 12.5 times 2013 earnings. Furthermore this stock does not offer a dividend. When it's possible to buy shares of Chevron (NYSE:CVX) for just over eight times earnings and collect a dividend yield of 3.2%, it is hard to justify paying the premium that Callon shares currently command, especially when you consider the balance sheet strength and financial stability of Chevron. Even when considering much smaller oil companies, many are also selling for about seven to eight times earnings. Stone Energy (NYSE:SGY) is a good example of a smaller company that trades at those levels. If Callon Petroleum shares were to trade at eight times 2013 earnings estimates, the stock could be worth just $3.60 per share, (which is close to where the shares traded in June). Even $3.60 per share might be generous considering the potential balance sheet risks at Callon Petroleum.

3. Balance sheet risk: As investors in ATP Oil & Gas have learned, investing in oil companies that have substantial amounts of debt and relatively little cash on the balance sheet, can be very dangerous for your portfolio. In tough times, investing in cash-rich and debt-free companies is the way to go if you want to greatly reduce portfolio risks. It might surprise many Callon Petroleum shareholders to know that as of the last quarterly report dated June 30, 2012, the company had only about $113,000 in cash or cash equivalents. That's down from about $43,795,000, that it had just six months before, which shows how quickly cash is evaporating. Meanwhile, with just around $113,000 in cash and cash equivalents, this company is still loaded with about $122 million of debt. The company does have the ability to borrow further, which means that if it has negative cash flow, it can go deeper into debt. The other option is to do another capital raise as it did last year. Some families and even individuals would not operate their households with just $113,000 cash in the bank, much less a company of this size. Running a company based on access to credit lines, especially when it already has significant debt levels can invite troubles and add significant risks for shareholders.

4. In February 2011, the company did a secondary offering and sold about 9 million shares, which raised over $65 million. With cash and cash equivalents down to minimal levels, the company might need to consider another secondary in the future, or make additional borrowings on existing credit lines.

Personally, I believe that management has been remiss to allow the $65 million that was raised in 2011 to dwindle down to a point where the company has just about $113,000 in cash or cash equivalents left. Management has also allowed the debt level to remain at high levels at about $122 million. I would never invest in any company that has managed cash resources and balance sheet debt the way this one has, and the $113,000 cash in the bank is ridiculous and risky in my view.

As we have recently learned, companies and countries that load up on debt, and allow cash to dwindle, make themselves potentially vulnerable to the mercy of banks and other creditors. If lending access is diminished or cut off in the future, it could significantly impair operations and shareholder value. Even if the extremely low cash balances and the recent negative cash flow does not lead to problems in the future, this stock looks expensive after the run it has had. With the economy weakening and oil supplies increasing, it might not be long before this stock is trading more in line with other oil stock valuations. This could put it back below $4, as it was a few months ago.

Key Data Points for Callon Petroleum From Yahoo Finance:

  • Current Share Price: $5.65
  • 52-Week Range: $3.80 to $7.95
  • Dividend: none
  • 2012 Earnings Estimate: 10 cents per share
  • 2013 Earnings Estimate: 45 cents per share
  • P/E Ratio: about 56 times 2012 earnings and 12.5 times 2013 earnings

Data is sourced from Yahoo Finance.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in CPE over 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.

Disclaimer: No guarantees or representations are made. Please consult a financial advisor before making investments.

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