Evolution Petroleum's Stock Price Appreciation Is Over

Summary

• The Delhi Field is managed by Denbury Resources.  This company has a lot of financial challenges and its outlook is very poor.
• The financial challenges of the operator, Denbury Resources, will trump the bright outlook of the Delhi field prospects and Evolution Petroleum future prospects.
• Instead Evolution Petroleum will have to navigate the Denbury Resources financial challenges as they apply to the Delhi field operations.
• After the probable reorganization there will be a period of high expenses due to the deferred maintenance caused by all the Denbury Resources financial health challenges.
• Evolution Petroleum does not control its future and the stock will be priced accordingly.

Evolution Petroleum (NYSE:EPM) stock is going nowhere except possibly down. The problems of Denbury Resources (DNR) are casting a long shadow over Evolution Petroleum common stock. Evolution Petroleum does not control its own future. Declining commodity prices are making the situation worse. So that shadow will prevent any Evolution Petroleum common stock appreciation for the foreseeable future. Instead, management should begin to prepare for the logical conclusion of the declining financial health of Denbury Resources.

Source: Evolution Petroleum April, 2017, Corporate Presentation

The main source of Evolution Petroleum income, the Delhi Field, is operated by Denbury Resources. This joint venture is therefore out of the control of Evolution Petroleum.

Current Denbury Situation

Source: Seeking Alpha Website, Market Close On July 10, 2017

The market perception of financial problems appears to be fairly accurate. A drop below $1 for the common shares is probably not that far off unless oil prices rally well above the WTI $60 price. Many of the operations are fairly high cost. So the decreasing oil prices this calendar year are beginning to put nails in the coffin. Denbury has a lot of debt that is not adequately serviced. Plus the company has yet to state how it would fund a capital budget that exceeds cash flow. The lenders will allow debt expansion to a point. However a crackdown by lenders will dampen capital expenditures fast.

But high cost operators are the first to experience reserve re-evaluations that end up as decreases. Unless the outlook for oil prices changes substantially in the near future, Denbury Resources could be looking at a very tough November borrowing base evaluation. Even though the company only has a small amount of debt on the credit line, the banks could still begin a domino effect. Right now, the company is in compliance with all of its covenants and there is about $600 million of potential liquidity.

However, it is very telling that the latest purchases will be paid for by the sale of assets. The amount borrowed will be paid back within a few months. Also, production is not growing, so unless operation costs decrease significantly, operation margins will be squeezed by the latest commodity price declines. The stationary and potentially declining production will exacerbate the situation. Potential property sales may not be accretive if they can be done at all.

Evolution Petroleum Future And Actions Needed

Evolution Petroleum as a non-operator needs to be prepared for the worst case scenario, reorganization. At the very least, production growth at Delhi will probably cease except for the benefits of the new plant. Denbury is rapidly approaching the treading water stage. It may be about to begin a debt spiral (which starts the drowning phase). All of that will decrease the emphasis of any capital growth projects to nil. Survival will come first.

So Evolution Petroleum needs to be ready for that. Evolution Petroleum cannot forecast any growth unless Denbury has the money to spend for its share of the costs. Denbury management is probably already borrowing to fund the capital budget. That would be a very temporary strategy. Declining commodity prices could bring on a covenant violation or a reserve reduction sooner than shareholders expect. A joint venture or partnership is only as strong as the weakest link. So this joint venture has a lot of problems ahead.

Even if Denbury manages to make it past the November redetermination intact, future redeterminations rate to be very threatening short of a major and sustained commodity price rally. So Evolution needs to first prepare for a time period where the operator, Denbury Resources, will be financially unable to pursue growth prospects. Short of a Denbury merger or buyout, the future prospects are not good until Denbury has a sure source of funding its share of the partnership expenses. Hopefully that period will not last long. A year to 18 months appears to be about average.

Should operations begin to deteriorate at Delhi, then Evolution Petroleum needs to decide what it can possibly do about the situation. Replacement of the operator by a financially more healthy operator may be logical but in practice is very hard to accomplish. Most likely Evolution will just have to grin and bear the situation. A lawsuit could push the operator into bankruptcy faster. Management will have to decide if that is desirable should that course of action be practical. The Evolution stock price could take a beating.

Should the worst happen and Denbury declares bankruptcy (an increasing possibility as shown by the stock price), then Evolution Petroleum will experience a period of no production growth. In fact production will probably decline and management of the field could prove erratic under the guidance of the bankruptcy court.

Source: Evolution Petroleum April, 2017, Corporate Presentation

As shown above, the future costs of the first slide could easily reverse and increase as the operator financial health deteriorates. The forecast of capital spending in the future is becoming more and more tenuous. As the financial health of Denbury continues to deteriorate, even necessary capital expenditures could be skipped for awhile. As a company's financial health declines, necessary takes on a different meaning. Usually that meaning is not very favorable to other partners. The stock price chart above shows the perception of Denbury financial health declining markedly over the last six months.

Probably once Denbury emerges from bankruptcy, there will be a period of high maintenance costs to make up for the deferred maintenance period. Then, hopefully a normal future can resume. Evolution Petroleum could easily have to manage through a very rocky two years of Denbury financial problems.

But reorganizations have their own challenges. All contracts are reviewed by the court for "fairness". There could be a period of no profit disbursements while the court gets things organized. Most likely Evolution will need significant legal representation during the process. There are simply a lot of unknowns that will worry Mr. Market. Most of the unknowns usually do not happen (thank goodness). Prepacked bankruptcies eliminate a lot of uncertainties but that is far from a foregone path through the current financial difficulties.

So even though many have cited a lot of potential growth catalysts for Delhi and a bright future. The uncertainties of the financial health of Denbury Resources will trump the partnership outlook. A financial problem is always far more important than just about anything else when projecting future prospects. Companies previously covered in this situation include Sandridge Energy (SD), Halcon Resources (HK), and Energy XXI (EXXI). All of these lasted about nine more months or so from the current financial situation and stock price of Denbury Resources. All filed during a period of commodity price declines.

Some may ask about an acquisition of Denbury Resources. The debt load which built up when oil prices were a lot higher will probably stop any acquisition attempts. The only exception may be if a potential acquirer can buy a fair amount of debt first at a very large discount before making an offer. That is before considering the challenges of the fairly high operating costs.

Many may notice that Evolution is going to have to successfully wade through the problems of Denbury Resources in the near future. To its credit, Evolution Petroleum management has built up a lot of cash . Shareholders can probably count on a fair amount of that cash going to legal bills in the future. Since Denbury currently generates a small fraction of the necessary cash flow, the chances are extremely small that Denbury will regain its financial health anytime soon.

Therefore, the chances of Evolution Petroleum sustaining some price appreciation in the future are not good. In fact chances are better that the Evolution Petroleum common stock price will mirror the financial health of Denbury Resources and quite possibly crash if Denbury Resources files for reorganization. Common stock price volatility of Evolution Petroleum may increase to the point where a put and a call may be the best way to take advantage of the price swings. Not being in control of your own future makes a big difference. Evolution Petroleum shareholders are about to find that out.

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.