E&P Bottom Of The Barrel Club #17-4: From 'Buy, Buy, Buy' To 'Bye, Bye, Bye' (Part 3)

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Includes: AXAS, CHK, CRC, CRK, DNR, ECR, EPE, EVEP-OLD, GST, HPR, JONE, LGCY, MCEP, MCF, NOG, PQ, REN, REXX, SN, WTI, XCO
by: Raw Energy

Summary

Parts 1 and 2 of this article have presented information and analysis about companies, activities and reserves.

Production, pricing, income statement and cash flows data is disclosed and analyzed here for the BOTB Club members.

$/BOE disclosures are calculated and analyzed for estimates of profitability.

Balance sheet data is presented and analyzed, with further discussion to come about the extreme and critical differences  between full cost and successful efforts accounting.

Readers who missed the first two parts of this article can find them here: Part 1 and Part 2.

Most articles focus on current-year results because that is what is presented in earnings releases and 10-Qs. Part 3 will focus on six-month disclosures for the BOTB Club companies, focusing on (1) production and income statement items, (2) cash flow statements and EBITDA, and (3) balance sheet items. I present balance sheet data last simply because by the time all of the other items are considered, they must flow into the balance sheet in some way.

2Q '17 Disclosures

Production, Income and $/BOE Metrics: Rows 77-126 reflect the items that go into constructing the income statement, including production volumes, pricing and all items of revenue and expense. The data is not presented in GAAP formats, but rather reflects items at the property level first, then corporate cash items and finally non-cash or non-recurring items; it is the latter item that is often to separate out since details may not be disclosed separately. Row 106 is a particularly important one because it includes only property related items, which can often be compared to property values in constructing net asset values for those properties alone (i.e., property cash flows/multiples), separate and apart from corporate valuations that may be valued in a different manner (EBITDA multiples, etc.).

The $/BOE calculations in rows 128-139 are very interesting to me, in large part because companies do not disclose each item or their cumulative impact they have on the bottom line. The biggest surprise to many readers is often the Revenue/BOE line #129. Companies are very quick to refer to specific oil prices (i.e., $50) without also disclosing the impact that natural gas prices have on the overall production totals. As you can see by looking at the Rev./LOE figures, even with $50, a relatively small number of companies have overall Rev./BOE above $30/BOE.

The three items shown in lines 130-132 are almost always shown in guidance and in operating results, almost always without being tied to revenue. That is primarily because companies focus on their property management results as their key metric, rather than net cash or net income. Comparing these disclosed numbers to the $50 oil reference figure makes it appear that the properties are more profitable than they are, but substituting the real Rev./BOE figure allows a side by side comparison.

Some companies will disclose G&A and/or interest /BOE, but sporadically and not universally. Obviously, they are actual costs, and they affect the net cash a company generates with its investments. Many companies will have seen their net cash/BOE shrink to the low single digits per BOE after taking all cash costs into account.

DD&A is a non-cash item when it deals with past capex, right? Well, maybe so, but maybe not. A company that already has producing properties does not have to spend that same capital again, but any future capex with the same sort of results would have to consider returns based on such investment. DD&A is based on historical F&D costs, so if future results are comparable, it is the most appropriate figure to consider when assessing capex vs. returns. Most companies are guiding to lower DD&A going forward, but companies which have already written off/impaired their properties are already reporting DD&A figures that may be lower than the future. Also, and this is a key result ignored by management, if the company has legacy debt, it really has not paid for that past capex, so whatever debt remains must be considered in calculating profitability. In some cases where asset values are not sufficient to cover past debt, new capex must recover not only its capex but also that "stranded" capex/legacy debt. That net income figures are so small reflects the current marginal economic state of the industry, even without any recovery of legacy debt.

Row #139 is often a key ratio for analysts. The "recycle ratio" indicates how much cash is returned for each $ invested. Obviously, the higher the number the better because it indicates the ultimate return a company will receive over time if the results are duplicated. Ratios of < 1:1 are a danger sign and an indication that capital is being flushed away.

Although management discussions will often leave readers with the impression that all barrel of oil equivalents (BOEs) are created equal, they are decidedly not. As I pointed out in one of my articles, "Caution E&P Investors - BOE Disclosures May Be Hazardous To Your Wealth," revenues are dependent on the product type: oil produces revenues of roughly $48/BOE currently while natural gas produces revenues of $18/BOE (at $3/MCF). Company announcements tend to emphasize $/BOE figures when they discuss LOE especially, and whether the figures quoted are low or high may depend on the revenue stream. A "$12/BOE" LOE figure may appear low when compared to a $48 oil price (25%), but is extremely high (73%) if the production is largely natural gas (since $12/BOE is equal to $2/MCFE). BOE disclosures by companies are calculated on a 6:1 ratio of oil to natural gas, the heating equivalency, not the economic value equivalency.

Therefore, in addition to the raw data on production and MBOE calculations that are often disseminated without specific mention of the product mix, I have included rows that show the percentage makeup of each. The cells highlighted in green show the 10 companies with the highest percentage of each product.

I also included row 29a for MBOE/day/well to show how much, or how little, a company produces from its average well. Low production figures per well are an indication of older, more mature production, and they are also an indication of a caution to look at a particular company's general & administrative (G&A) expenses. Lots of marginal properties may be a burden administratively, especially considering that production units may include hundreds or thousands of other working interest and royalty owners.

Not surprisingly, the companies that fall to the bottom of this ranking (in red) are primarily MLPs, whose strategy was to buy just those sorts of properties. Included in the list are EV Energy (EVEP-OLD), Mid-Con (NASDAQ:MCEP), Legacy (LGCY). On the flip side are Eclipse (NYSE:ECR), W&T (NYSE:WTI), Sanchez (NYSE:SN) and EP Energy (NYSE:EPE).

To readers who critically analyze these data, the $/BOE or $/MCFE may be the most surprising, harkening back to my comment earlier about such disclosures. When the contribution from natural gas volumes is factored in, many companies report $/BOE that are 50% or less of reported wellhead oil prices even with significant production of natural gas. Factoring in price differentials as well, the industry's reliance on NYMEX oil prices to create an impression of higher profitability is clearly misplaced.

Hedging has changed over the past 3-5 years. Whereas in 2014 companies had collars or hedges that protected them from downside, and which grew to become a large part of asset value and cash flow, today's hedging activity has been done on a shorter-term basis and more often takes the form of swaps of future volumes at a fixed price. Open hedge contracts can be examined on company presentations but are of too little value to include here, in my opinion. The cumulative impact of derivate gains or losses is included in the balance sheet, and current period activity flows through the income and cash flow statements.

The way I break out an income statement is different from most investors. I start with property revenues less lease operating expenses (LOEs), which establishes the cash flow that a company's properties alone generate, before taking into account things like G&A and interest that are corporate items. Asset valuations and sales of properties are based off the properties' net revenues, not corporate cash flow or net income, a key point when many companies must sell assets. I have highlighted companies with the lowest 1H property net revenues and will not mention them again since they are largely the same companies that have financial difficulties.

The next row (227) I have highlighted is earnings before interest and taxes (EBIT), which in effect measures cash flow available to service debt (including interest), at least in normal situations. In 1H, little debt could have been repaid, and interest charges alone (row 225) were almost 33% of EBIT. That does not cut... anything.

I have highlighted the companies with the largest "Exploration" expenses. Critics of FC accounting usually point to the fact that FC companies can capitalize dry holes while SE companies expense them. The total for the entire BOTB Club was only $51 million (around 1% of property net revenues). Without going into more detail, I believe those costs are more likely expenses that other companies might classify as G&A (employee expense) rather than actual dry holes.

Bottom line net income was pretty bad, around 10% of property net revenues. Some of those "profits" were due in large part to previous impairments (largely from full cost companies) which reduces their DD&A rate going forward. The 1H numbers were improved from 1H '16 primarily from a price standpoint, but the overall indication for the E&P sector is still negative, especially for those companies with legacy debt.

Cash Flow and EBITDAX: Rows 172-190 use the Cash From Operations statement to convert the income statement into those items that constitute actual cash recurring items only. These statements and some of managements' discussions about EBITDA may take different factors into account, and rather than try to reconcile all 21 companies, I simply use the statement that appears in their financials since it is computed the same way for all companies. Personally, I prefer to look at Discretionary Cash Flow ("DCF") or make adjustments to EBITDAX that exclude non-recurring items like derivatives, which are short term in nature and not permanent sources of cash/income. DCF plus interest expense might also approximate EBITDA, but be wary of disclosed numbers because there are so many different variations and calculations. If you have other ways of looking at the numbers or other definitions, by all means use them.

The biggest differences between DCF/EBITDA and income statement presentation are (1) DD&A (depletion) is added back to net income as a non-cash charge; (2) likewise, impairments are added back to net income as non-cash; (3) the non-cash portion of taxes shown on the income statement are added back; (4) the gains/losses for derivatives are subtracted/added back as they relate to non-cash adjustments; and (5) the actual cash settlements on derivatives are accounted for as additions. The Cash Flow From Operations figure often used in calculating Free Cash Flow takes into account changes in assets and liabilities.

I have highlighted companies with the highest/lowest DCF (ex-derivatives) figures, which illustrates how little "cash flow" was being generated even with hedged prices in 1H. As you can see, all companies had positive EBITDA, which is not surprising even for leveraged companies. With leveraged companies, their creditors have usually stepped in before actual EBITDA/DCF goes negative, so in a way, the highlighted companies might serve as an additional watch item for future bankruptcies/restructurings. Cash flow from operations (row 182) after interest payments reinforces that.

The second part of the spreadsheet relates to sources and uses of cash, including cash flow from operations (CFFO), cash from investing, capex, and cash from financing (offerings). Also included are computations of changes in cash and balances, along with a calculation of free cash flow, which is an indication of which companies are spending capex within their cash flow from operations.

In that section of the spreadsheet, I have highlighted the top 5 companies in terms of specific factors in green, with the lowest 5 companies in red. The first thing that jumps off the page is that, in total, companies generated roughly $0.9 billion in CFFO, yet spent over $3 billion. How is that possible, one might reasonably ask (in addition to simply, "Why?").

The final row for free cash flow shows how few companies were spending within cash flow during 1H. Only 30% of E&P companies did so, and some of those did so only by including property sales, which is actually not a recurring cash flow item; nevertheless, that is the way the financials account for them. They might be better considered a financing source for capex or other uses.

As I indicated in Part 1, free cash flow is neither good nor bad in isolation; it depends on what the capex is accomplishing in the way of increased production, cash flow and/or reserve value. With current prices, though, there is certainly an inclination to ask why any company would want to operate with negative free cash flow.

Balance Sheet: The key thing to remember when looking at any E&P company balance sheet is what accounting method the company uses. While the difference between successful efforts and full cost accounting will not be evident in the numbers, in general, successful efforts companies will show higher PP&E book values and therefore higher book equity than their full cost counterparts. The difference relates to how each method treats impairments of properties; full cost companies must test their book value against the present value of their reserves, calculated using 12-month average trailing prices and costs held constant and discounted at 10%, while successful efforts companies test book values against undiscounted future net revenues and can consider strip pricing and other factors. In effect, successful efforts companies in many cases are still reflecting book values at original cost which took into account prices of $80/$4 or up. Successful efforts companies are in effect continuing to take "impairments" over time through higher DD&A, but the result in the interim is very distortive; algorithms and traders often do not understand the distinctions, which is why you often see folks citing a low price to book value or some other (meaningless) stat to justify a value perspective.

I assume that readers know what a typical balance sheet looks like so will not present Chesapeake's (NYSE:CHK) as an example here. Instead, the spreadsheet presents detailed balance sheet data in rows 141-170. While many investors believe that book value is a key factor in identifying under or overvalued companies, that is not the case with E&P companies... at all. Several of my previous articles have dealt with the different balance sheet treatment of full cost (FC) vs. successful efforts (SE) companies, which in a weak pricing environment such as this results in SE companies projecting higher book values than their underlying proved reserves likely possess, sometimes materially so. There will be more discussion on that in a later section.

So, what is useful for investors to look at on an E&P company balance sheet? Certainly, cash is important. However, the absolute amounts of cash may not do anything more than identify the largest companies that by their size alone need higher levels of cash for operations. However, low cash amounts are certainly a caution for readers, especially when taken in the context of other current assets against a company's current liabilities. Banks and other creditors typically have covenants requiring a company to maintain a 1:1 ratio of current assets to current liabilities (the "current ratio"). Where a company has adequate liquidity/debt availability, this itself is often not much of an indicator because companies often borrow enough at quarter end to meet the covenant than pay the debt back soon thereafter.

The striking thing about looking at the spreadsheet as a whole is that the bank debt (or credit facilities) attributable to all of the companies is $5 billion... and the long-term debt is over $35 billion. So, while there is a lot of discussion about the issues facing companies with bank debt borrowing base issues, that impacts a fairly small portion of the E&P sector. The total debt figure, though, indicates that companies that are unable to refinance their existing long-term debt as it comes due over the next 2-4 years (with the market currently in complete collapse for such offerings) are likely to undergo continuing financial restructuring.

The other rows and details present a wealth of information that may be useful to some and not to others. Analyzing one company or the sector as a whole provides an insight that is not to my knowledge available anywhere else. There are lots of numbers and therefore lots of potential for mistakes, but in double checking my figures, I found few obvious errors.

The last row I will discuss here is "Equity" (row 166), which is equity attributable to common shares/units only. The cells highlighted in red show companies with negative common equity, a result in the case of 12 or 21 companies. Included in that list with negative book equity are Chesapeake, EXCO (XCO), Sanchez, W&T and California Resources (CRC). The 2016 period forward will present interesting paths for full cost vs. successful efforts companies. From a balance sheet standpoint, full cost companies have written down assets to a level that is likely lower than with today's prices, but their income should benefit from lower DD&A and reported reserve values should increase. Successful efforts companies will report higher book assets and higher DD&A (because of the relative lack of impairments), and their reported reserve values should also increase. Analysts adjust for updated reserve values in net asset value calculations, separate and apart from balance sheets.

Conclusion

Part 3 of this article has focused on the balance sheet, production, income and cash flows that are disclosed in the quarterly financials and earnings releases. The benefit to me of being able to screen many companies for potential further, in-depth review is extremely valuable, but I realize that readers who want to focus simply on "their" company may not find the analysis directed enough even though the data presented is voluminous.

Part 4, the final chapter, will present debt and financial metrics that are fun to play around with, if play is the right word. Analysis, even with formulas to calculate results, is a much more powerful tool than simply presenting what is in the financials.

Disclosure: I am/we are long CDEV, SRUN, VEAC, KAAC, TPG.E.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.