Baytex Energy: The Good The Bad And The Ugly

Summary

• Eagle Ford light oil production needs to become a great enough percentage of total company production to properly fund the company needs.
• The heavy oil acquisition was ill advised because heavy oil still loses money and produces relatively little cash flow.
• Management has made no progress according to the company presentation reducing the heavy oil breakeven or reducing the heavy oil cost structure.
• Eagle Ford cost structure appears to be lowering and production performance exceeds expectations.
• The company loaned money to meet its first quarter needs and sold stock to make the acquisition.  The increasing debt is a step in the wrong direction when cash flow is insufficient.

Baytex Energy (NYSE:BTE) made an acquisition earlier in the year that expanded a money losing division. Even though the purchase was made by concurrently selling stock, the acquisition was probably ill-advised. The WTI price needed for success was just too high. Now there may be a way for the company to increase its cash flow despite the expansion of that money losing division. But it will be a tussle and until the market sees a clear direction, the stock price could continue to suffer. The stock will probably continue to decrease until the Eagle Ford production generates sufficient cash flow. That could be awhile for this cash constrained company. But it is probably the main survival chance for the company.

The Good

Eagle Ford production grew another 7% in the second quarter over the first quarter. Company production is now 72,500 BOED with most of that production growth coming from the high margin light oil Eagle Ford production. Operation improvements continue to exceed expectations. Currently, the news would indicate that those operational improvements will continue (maybe even accelerate). Since the company has nearly C$2 billion of long term debt, more cash flow is needed to support that debt. So the Eagle Ford production growth is sorely needed as cash flow up until how has been woefully inadequate.

(Canadian Dollars Unless Otherwise Noted)

Source: Baytex Energy June, 2017 Corporate Presentation

As shown on the first slide the Eagle Ford has the lowest breakeven. So the obvious way to lower the corporate breakeven is to increase the percentage of Eagle Ford production when compared to the total company production. So far that is exactly what is happening. The second slide demonstrates that as the WTI approaches $45, the Eagle Ford remains competitive. In fact, the company should make decent money on the Eagle Ford at WTI $40. Continuing operational improvements should lower both the breakeven and the free cash flow threshold in the future. The outlook for this part of the company is pretty good.

The Bad

(Canadian Dollars Unless Otherwise Noted)

Source: Baytex Energy First Quarter, 2017, Earnings Filing

Clearly the heavy oil margin lags quite a bit. The product price is discounted from the WTI but production costs are higher. That can be a deadly commodity combination. During the first quarter, heavy oil (which is primarily produced in Canada), clearly lost money. The losses were large in fiscal year 2016. In the 2016 first quarter, production was shut-in to avoid even larger losses. The Canadian division also has some light oil and gas production but both are very minimal and not a significant driver of profits in the Canadian division. As shown previously, the heavy oil production needs a WTI of at least $50 to perform adequately. But so far this year, the WTI has been barely there and lately prices have declined quite a bit.

A decent proxy for cash flow is net income plus depreciation. In this case clearly the heavy oil is not going to produce much cash flow even though it is half of the corporate production. For heavy oil, combining the depreciation and income is about C$33 million. That is about one-third of the Eagle Ford cash flow. That lack of cash flow will keep this company from profitable growth and subject this company to some serious financial stress should commodity prices decline.

The oil supply appears to be a little more than the market can absorb. Michael Filloon has categorized the latest EOG (EOG) success in the Permian. If the rest of the industry is able to adapt some of the latest well completion techniques, then the industry could be about to embark upon another round of production improvements and cost decreases. This is good news for the Eagle Ford production outlook and cost structure.

But that is very bad news for heavy oil producers because any cost decreases for light oil impair the ability of the market price to rally. Supply of oil increases at various points and industry production will increase with the same capital dollars now spent. Any rally in the WTI increase will be met with increasing production from the unconventional fields. Those areas can adapt very quickly to commodity price changes. If the production increases and costs decrease along the lines of the EOG wells, then ramping up production becomes much easier and costs less. Even before those findings unconventional oil production has surprised many observers. Now it looks like those same observers are in for a very pleasant shock over the next year. So the chances of the price of oil sustaining a price in excess of WTI $50 are now slim. An average price for the remainder of the year of WTI $45 is very possible.

The Ugly

The production agreements of some of the larger producers in the world can end at anytime. That would lower the price of oil considerably. The overhang of that potential production should warn investors away from high cost production such as heavy oil (which is also low margin from the discounted pricing). Some thermal projects may become less viable in the near future also. WTI prices, for the reasons noted above, are unlikely to rally significantly from current levels and could decline some.

This company recently announced some hedging. It should have opportunistically hedged all the relevant production as far out as possible to assure success of the acquisition. Instead commodity prices are now below what is needed to assure that success. The acquisition was paid for using stock. But the company did not have the money to meet all of its needs, so it borrowed a fair amount in the first quarter. But low cash flow and losses could put an end to that route sooner than the market may anticipate. There is a real question as to the ability of the company to fund its capital budget at current pricing.

This company needed to drastically lower the costs of producing heavy oil in order to compete in the new lower commodity price environment. But as the slides show, there has been no change in the various profitabilities of the heavy oil rates of return and breakeven. So despite some record production of wells, the company appears to have not made significant cost reduction progress on the Canadian part of the business. Investors could pay the price of that relative inaction.

That could portend some very ugly second quarter results and a grim expectation for the second half of the year. The company reported about C$80 million in cash flow for the second quarter. That was woefully insufficient for the nearly C$2 billion of long term debt. Now commodity prices have declined. So despite the increase of Eagle Ford production, the results of the heavy oil will impede cash flow progress.

The company needs to lower the breakeven of the heavy oil to below WTI $35. Until that happens this company will struggle even if there is no debt due for awhile. Sooner or later the lenders will demand adequate cash flow for the amount of debt on the balance sheet.

(Canadian Dollars Unless Otherwise Noted)

Source: Baytex Energy First Quarter, 2017, Earnings Filing

The company has a covenant based loan that is not subject to six month reviews. Currently the company was in compliance with the loans. But the company loaned more money in the first quarter. In fact as shown above, it loaned nearly the amount of the capital budget. If cash flow does not increase significantly, this company could be looking at lower production in the near future with no way to fund growth.

Continued lower commodity prices will put pressure on covenant compliance. So this management needs to work on the heavy oil cost structure quickly or it needs to sell that production. Clearly, the heavy oil production will not produce much cash flow. Plus should the WTI decline into the thirties, then the company could be faced with shutting in production again, yet having to maintain the leases and the faciltities.

This company needs oil prices in the mid-fifties to begin to generate decent cash flow. That does not appear to be a viable future forecast at the current time.

Record production by one producer will not affect oil pricing. But the spread of practices of that producer that led to the record production will eventually affect oil pricing if economic growth does not absorb the increasing supply at current commodity pricing.

So the hope is that the improvements in the light oil production with outweigh any corresponding lower commodity pricing that hurts heavy oil profitability. Clearly that is going to be one heck of a gamble. The company loaned about C$80 million to meet its needs in addition to selling stock to pay for the acquisition. The last thing this company needs is more debt. So the prospects of the common stock are not good. This stock continues to be a good short candidate will remain one until the commodity prices strengthen or until the Eagle Ford has a commanding percentage of total corporate production so that cash flow is sufficient to meet company needs.

Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.

Analyst’s 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.