Penn West Petroleum: 2017 Will Be A Break-Out Year

| About: Penn West (PWE)

Summary

Penn West's production in 2017 is expected at 28,000 BOE/day with operating costs expected at $11/BOE, which will lead to a rise in netbacks.

The netbacks this year could come in at C$380 million, and after deducting G&A expenses, it will deliver EBITDA of $269 million in U.S. dollar terms.

PWE has an EV/EBITDA ratio of around 6, which means that its enterprise value will increase to $1.6 billion this year as compared to the current $1.3 billion.

At its projected EV, PWE's market cap could rise 32% this year after accounting for the debt and cash position.

Canadian oil company Penn West Petroleum (NYSE:PWE) laid out its plan for 2017 a few days back. The company's latest presentation is indicative of the fact that it will continue with its theme of lowering costs and enhancing the production from core assets this year. In my opinion, this is a smart move from Penn West since its focus on its key development areas will lead to lower operating costs, which will eventually lead to a higher netback and profit profile this year. Let's see how.

What Penn West will do this year?

Penn West will be increasing its production by 15% from its key production areas as compared to the earlier forecast of 10%, with the company's total production forecasted at a midpoint of 28,000 barrels of oil equivalent per day. Penn West has laid special emphasis on the fact that the basis of its production in 2017 will be its core assets, with the contribution from non-core assets being only minimal.

Hence, it can be expected that Penn West's production rate can be pegged at 28,000 BOE/day, which is an increase of 15% over the company's fourth-quarter core area production. This effectively means that Penn West will be divesting around 10,500 BOE/day of production in 2017 as compared to the fourth quarter of last year.

This divestment is expected to bring proceeds of $80 million for Penn West Petroleum, which will contribute positively to the company's cash flow. More importantly, I believe that the 28,000 BOE/day of production for 2017 will further lower the cost base as the development costs in the core areas are quite low.

More specifically, Penn West's key development areas have an operating cost run rate of $10-12 per barrel of oil equivalent, or $11/barrel of oil equivalent at the midpoint. This is lower than the operating cost of $12.70/barrel that the company had reported in the last reported quarter, which indicates that a cost reduction of over 13% is possible this year from 2016 levels as it has shifted almost all of its production to the core areas.

This reduction in the cost profile will have another positive impact on the cash flow profile, apart from the divestment of non-core assets. This is because a lower cost profile will lead to an increase in Penn West's netbacks even if prices remain constant (netback indicates oil and gas revenue minus production, royalty, and transportation expenses).

Gauging the impact on the netback

So, I have arrived at an operating cost of $11/barrel of oil equivalent for Penn West Petroleum for 2017 as discussed above, and also assumed that the company will witness identical oil prices as compared to last year. This presents the worst-case scenario possible for Penn West since I am assuming a weak oil price environment in 2017 even though prices have been on the mend.

However, one variable that still needs to be worked upon is the hedging part. For 2017, Penn West has hedged half of its oil volumes for this year at a WTI oil price of around $50/barrel. In comparison, the price of WTI crude is projected at $52.50/barrel of oil this year by the Energy Information Administration, so there is a possibility that Penn West might have to take a derivative loss in 2017 to the tune of $2.50 per barrel of oil equivalent.

However, the hedge losses will be covered by a rise in oil prices, which will lead to an increase in the average realized price for Penn West Petroleum. In fact, as compared to the average WTI price of $44 per barrel seen last year, Penn West is anticipated to see a potential oil price of $52 per barrel this year, indicating a rise of 18% in the realized price.

Now I have all the variables needed to arrive at the company's anticipated netback this year:

PWE's projected netback for 2017

Net sales price/barrel of oil

$52

Royalties/barrel

($2)

Transportation/barrel

($1.75)

Operating expense/barrel

($11.00)

Netback/barrel

$37.25

Source: Author's calculations. Royalties and transportation expenses provided by PWE assuming WTI oil price of $50/barrel.

Valuation

Since netbacks indicate the amount left after deducting production, royalties, and transportation expenses from the selling price, Penn West's netback in 2017 should come in at $380 million (28,000 boepd X 365 days X $37.25/barrel). Additionally, Penn West's net general and administrative expenses dropped 7% last year to $2.59/barrel. If this rate of G&A is sustained this year, then its net G&A expenses for 2017 will be $26 million.

After deducting the G&A expenses from the netback, Penn West can be anticipated to deliver EBITDA of $354 million in 2017. However, this is in terms of Canadian dollars. Using current exchange rates, the EBITDA in U.S. dollar terms this year will be $269 million.

Now, Penn West has an EV/EBITDA multiple of 6, which will put its enterprise value at $1.6 billion for 2017. Now, after deducting the debt and adding its cash position, I can arrive at the company's market capitalization.

Since Penn West has a debt of $688 million and total cash of $337 million, its market capitalization will come in at $1.25 billion. This is higher than the company's current market capitalization of just under $1 billion, indicating upside of 32% this year. So, it won't be surprising if Penn West delivers strong gains on the market this year considering the points discussed above.

Conclusion

All in all, 2017 could turn out to be a break-out year for Penn West Petroleum. A combination of lower costs and higher pricing will lead to an increase in the netbacks, which will eventually lead to upside for Penn West Petroleum this year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

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