Let's state upfront that an investment in Whiting Petroleum (NYSE:WLL) is predicated on oil prices going higher. There's simply no other way to "spin" this thesis, and it's the primary driver in determining what Whiting is worth and whether it will be able to realize this value in the face of "lower for longer". Having said that we also know that there's a vast difference between "lower for longer" and "lower for forever", which is why we think investing in Whiting could prove profitable if/(when oil heads higher).
As a heavily indebted company, Whiting either has to sell assets, sell stock and/or bring down production significantly with today's lower oil prices and tightening credit markets. The company's debt load prevents it from reducing production too dramatically as the corresponding reduction in EBITDAX increases liquidity/default risks. On the other hand selling assets (either noncore or operational assets) and issuing stock reduces the value of the company over the long-term for shareholders.
Coming into Q2 results, we were watching how the company would balance these options to reduce its debts. Whiting reported quarterly results on July 27 and overall we are positive on the moves and the path forward.
In summary, we saw Whiting sell three things this quarter: noncore assets, company stock, and some wells. Let's review:
1. Sale of North Ward Estes Properties
Whiting announced the sale of its non-core North Ward Estes Properties for $300M and potential $100M in contingency payments. A few articles have already discussed this transaction (see Elephant Analytics latest article), and we'll refrain from repeating the details. Suffice it to say at $35k per BOE/D (8.6K BOE/D flowing), the valuation is depressed, but understandable with WTI in the $40s. For the North Ward Estes property to be of any worth, the buyer has to believe that +$60/barrel oil is likely, but buyers have more leverage today and will use it. The immediate cash infusion is welcome, and has been used to pay down the credit line.
The contingency payment, however, is merely a headline number and monetarily immaterial. The extra $100M contingency payment was likely an attempt to bridge a valuation gap between Whiting and the buyer. The contingency payment provides that if the average strip prices for NYMEX WTI in 2 years exceed $60/barrel, Whiting could receive the full $100M in cash. The buyer though may elect to pay Whiting via a note which accrues interest at an 8% rate and matures in 2022. Since the buyer could exercise this option, it's likely Whiting will see no cash payment until July 2022, a full five years after the sale. When we discount this on an NPV basis and adjust it for credit risk and the probability that oil prices do not rise beyond the threshold for a $100M payout, the contingency payment has little value.
2. Selling Stock: Debt / Equity Conversion
In Q2, Whiting converted $1.6B of debt into common stock, which is another way of saying the company sold $1.6B worth of stock to repay debt. While severely diluting shareholders, the conversion decreases Whiting's overall balance sheet leverage and improves its credit ratios (an important point as the Company is relying on its credit line to survive the downturn). This was a necessary move given where we projected Whiting's EBITDAX to consolidated interest expense would be at year-end (which we previously discussed here). In the Q2 conference call, we were looking to hear if Whiting had any further plans to convert debt to equity.
Jim Volcker, Whiting's CEO, provided that the current debt levels were appropriate given current WTI prices.
". . . I'm not certainly ruling out any other moves to reduce debt. I'm all in favor of that. But I think we can do some of that internally without having to turn necessarily to the capital markets unless, well, things improve."
Although the analogy he used (i.e., WTI prices falling from $70 to $45 (a 33% decline) means debt levels should also be 33% lower (i.e., $5.6B to $3.7B)) at first blush appears strained (i.e., even if you decrease debt by the same proportion as falling oil prices, leverage ratios still rise because margins compress faster), the comment gives us some insight into management's current thinking. For now we'll give them the benefit of the doubt; updating our EBITDAX calculations also reconfirm that further debt/equity swaps may not be needed if the strip holds.
One thing to note about the dilution is that it significantly affected Whiting's ability to use previously generated tax losses. Whenever a company undergoes an ownership change (i.e., when more than 50% of shareholders turnover, previous tax losses that could be used to offset future income tax become constrained and may expire. The recent stock issuance means such an ownership shift has occurred, and as a result, much of Whiting's prior net operating losses will expire. Consequently, Whiting disclosed in its quarterly filing that it would have to write-down $500-600M in deferred tax assets. It's debatable whether this deferred tax asset would have ever been used since oil and gas companies typically generate significant upfront deductions that mitigate income taxes, but it's important to bear in mind that tax assets have value, and the stock issuance diluted shareholders and impaired this economic asset.
3. Selling Some Core Assets: Well Participation Program
Similar to the first quarter, Whiting announced another well participation program in which a partner has agreed to pay 65% of the well costs to earn a 50% working interest. In Q1 Whiting sold a 50% working interest in 44 wells and in Q2 30 wells.
This well participation program means that Whiting is selling 50% of 74 wells for a 15% carry. Focusing just on Q2's program, we believe Whiting sold the 50% working interest in these wells for about $30M (using $6.8M per well * 30 wells and the partner paying 15% more for the costs to drill these wells). Unlike the first program in Q1, this second program will require Whiting to increase capital expenditures ("CapEx") by $50M to add a third rig. The second program, however, will "stabilize" production for Q4 2016 (4 wells drilled) and add momentum to 2017 production volumes (remaining 26 wells drilled), so in some ways the $50M is largely a front-loading for 2017 oil production.
We view Whiting's well participation programs as really an asset sale to fund its drilling program. If oil prices were higher, Whiting would have opted to increase CapEx to drill these wells and reap all of the economic benefits. For now, it's selling economic interests to maintain production and stay within its capital budget. So long as this isn't a longer-term strategy shift, we see this as neutral. Jim Volcker's comments assuaged us on this point
"So, I sort of think of the joint ventures as being an accelerator, if you follow me, beyond that, something that will help us accelerate the development, make production grow faster, improve our metrics. And so, again, I would say below $60, you'll probably see us trying to do some of these JVs because we have such a large acreage position. Above that, maybe not so much." (emphasis added)
Lastly, we noted that Whiting is guiding down oil production for 2016. It's fair to say that without the two well participation programs guidance would have fallen even more. In looking back a few months, the production guidance for 2016 has tightened and will likely end at the lower point of initial guidance.
2016 Production Guidance (MMBOE)
With the reduced guidance we see EBITDAX declining to $585M, a level that gives Whiting sufficient room to continue borrowing from its credit line (subject to any adjustments when the November redetermination comes up).
Moving into 2H 2016 and 2017, there are a few items/risks to watch-out for:
1. Credit line redetermination (November 2016). Liquidity currently stands at $1.8B, but the credit line may be reduced, how much?
2. Gas plants (keep or sell). We'd prefer that Whiting retain their remaining working interests in the Robinson Lake and Belfield gas plants as they lower Whiting's overall operating costs and enhance gas and NGL pricing. Retaining these plants instead of selling them is a call on the potential of the Bakken and DJ Niobara plays. Selling now would be selling the future benefits of that upside.
3. Unmet volume commitments will continue to increase differentials (as the penalties are imbedded in differential guidance), what will 2017 look like?
4. Debt maturity 2018 (October), the most immediate debt maturity is the 2018 notes, so unless oil prices increase or credit markets loosen for E&P companies, Whiting will need to sell additional assets and/or convert the debt into stock sometime in 2017.
Overall Q2 was a positive quarter given Whiting's ability to de-leverage. Although extremely dilutive to shareholders, the company's ability to even sell stock in this challenging environment is surprising. At the end, the value of this company lies in its vast reserves and the operational assets it has to exploit those reserves. It's in the company and shareholders' best interests to preserve as much of those assets as possible to maximize value. If you believe that oil prices are headed higher in the future, then the Bakken and the DJ Niobara regions will eventually prosper. If, however, you believe that oil prices will remain at these levels for the next 2-5 years, then yes, Whiting will need to further dilute itself to pay of its secured debts as they come due or continue selling assets. We view Whiting's current strategy to decrease production, reduce balance sheet leverage, and spend within cash flow as prudent. Survive today, and eventually we'll see a better tomorrow.
Disclosure: I am/we are long WLL.
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.