Although I had no special interest nor professional background in the oil and gas industry, I have spent much of the past year researching companies operating in this space. I did it because I realized that the investment community was not paying enough attention to positive fundamental events that would enhance profitability at some of the companies operating in the industry. Whenever the investment community turns its back on a whole sector, an investor should start looking deeply at it since opportunities are easier to find. This occurs because investors often tend to treat every single company in the industry equally, making no distinction among quality and below-average companies.
Why Is the Oil and Gas Industry Untouchable for Most Investors?
I believe the main reason is not a fundamental but a cognitive one. We simply tend to put a tremendous amount of weight on previous events, believing that they will somehow influence future outcomes. This is a cognitive bias that can be called “availability heuristic”. We tend to use the most recent and readily available information to forecast the future. This cognitive bias is strengthened if those recent events were especially hard or had a strong negative impact on us. An example is the belief that the next recession would be a financial one and as tough as the financial crisis of 2008. However, if we take a look back, we would realize that the previous financial crisis was one of the toughest of all times and that the financial sector is currently very well capitalized compared to its pre-crisis situation. Peter Lynch, in his outstanding book “One up on wall street”, touches this concept. He called it “penultimate preparedness”. Quoting the outstanding investor,
“No matter how we arrive at the latest financial conclusion, we always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next…The great joke is that the next time is never like the last time, and yet we can’t help readying ourselves for it anyway”.
After analyzing the oil and gas industry, I reached the conclusion that the main reason for such low valuations could be due to the wounds suffered by investors during the oil price collapse of 2014-16. Brent oil prices dropped from US$ 120 bbl to US$ 35 bbl in 18 months; a 70% drop in oil prices that left the vast majority of the industry bleeding red ink. The extreme pain suffered in the industry is deeply embedded in today’s investors’ minds. Three years later, with a Brent price almost double from its bottom, many investors are still licking their wounds and avoid the industry.
How Can We Recognize an Out of Favor Industry?
A bulletproof sign to recognize an out of favor industry is that very positive fundamental changes do not have a corresponding impact in market prices. Oil prices have doubled since bottom and massive underinvestment in exploration and development of conventional resources should only contribute to higher prices. However, energy weighting in the S&P 500 is at the lowest in eighteen years.
This situation could be perfectly recognized as well on a specific company basis and particularly in the company of this analysis, Geopark (GPRK). On November 9th, 2018, I published a comprehensive overview of the company and its investment case. The point of this article is to analyze GeoPark’s recent certified reserves report and how the market seems to be “out of the office”, contributing to keep the company massively undervalued.
GeoPark Announces 2018 Certified Oil and Gas Reserves
On February 5th, 2019, GeoPark announced its independent oil and gas reserves assessment, certified by DeGolyer and MacNaughton (D&M). The results are as follows:
- Proven developed producing reserves up 55% to 44 mmboe.
- 1P reserves up 17% to 114 mmboe.
- 2P reserves up 15% to 184 mmboe.
- 2P value per share adjusted for net debt up 37% to US$ 39.0 per fully diluted share count.
Three days after the announcement, the company remains near the pre-announcement price. Let me review the value creation that could be inferred from the independent reserves report to understand the size of the opportunity that the market is offering.
Source: Image by author, using data from company filings and his own estimates
The most impressive number is the 37% increase year on year on 2P value per share. This means that if we start with 2P reserves at the beginning of 2018, deduct the reserves depleted and sold during the year, add new discovered, developed and acquired 2P reserves, deduct current net debt, take into account any potential share dilution and compute the calculations on a per share basis, the value creation amounted to 37% during 2018. These results are outstanding for a business that due to its extractive nature its poised for an end. The 2P reserves adjusted for net debt and computed on a per share basis figure is comparable to the company’s share price. This points to potential 123% upside from current US$ 17.5 share price.
In comparing GeoPark one year ago with its current position, even after a 60% increase in share price and due to its outstanding value creation throughout the year, I find that today the company still offers an upside of ~123%; similar to the implied upside it offered a year ago at US$ 11 per share. However, the company now produces 24% more, has increased its 2P reserves from 159 to 184 mmboe (15% increase) and has huge exploration upside.
Capital Allocation Excellence It’s a Must to Invest in the Industry
In order to achieve above-average returns investing in oil and gas upstream companies you must be sure that the management team has an excellent track record on capital allocation decisions. This is one of GeoPark’s key attributes. Its management team, through a very well-designed portfolio strategy has been capable in deploying capital at very high returns since 2012. This is why GeoPark has achieved a 22% CAGR in 2P reserves since 2012.
Let’s review how they allocated capital in 2018. They invested ~US$ 175 mm in capital expenditures which is ~US$ 2.9 per share. This investment includes sustaining and growth expenditures. The outcome of this investment is an increase in its reserves' value, measured by 2P NAV10 adjusted for debt, from US$ 1,772 mm to US$ 2,424 mm or an increase of US$ 10.9 on a per share basis. Considering the investment of ~US$ 2.9 per share it means that for every dollar invested they obtained almost US$ 4. These results are even more impressive if we focus on Colombia. In its core region, for every dollar invested they created US$ 6.3 in value, and they invested ~US$ 100 mm in the country.
This is GeoPark’s outstanding capital allocation track record for the year in terms of operations. Moreover, they do excel as well at non-operating capital allocation decisions.
- Share buyback: They took advantage of the recent market sell-off and announced a share repurchase program when GeoPark’s shares were trading at US$ 12 per share. The repurchase program began on December 21st, 2018 and will expire on December 31st, 2019.
- Minority interests: On November 27th, 2018 they announced the agreement to acquire all of the company’s minority interests from LG International Corporation, increasing GeoPark’s equity interest to 100% in its Colombian and Chilean businesses. The acquisition price includes a fixed payment of US$81 million payable at closing, plus two equal installments of US$15 million each, to be paid in June 2019 and June 2020, respectively and three contingent payments of US$5 million each could be payable over the next three years. If we assume as total payment the sum of all of the amounts, we reach a total cash consideration of US$ 126 mm which implies ~US$2 per share. This compares with US$4 of value per share acquired measured in terms of 2P NAV10. A highly accretive acquisition of GeoPark’s shareholders.
Upcoming Fourth Quarter Results Could Serve as a Catalyst to Awaken Investors
Although I would like the market to recognize the full value of the company, I do pay less attention to short term share price action. The company is buying back its shares. This is especially value accretive for an undervalued company in the resource space since it creates value without depleting its reserves. In the case of GeoPark, the lower the share price, the higher the value creation for shareholders that remain.
However, the company will present full year results in early March. This could help awaken investors and perhaps draw the share price a bit closer to my fair value estimate. In the meantime, I am very comfortable holding the stock of this company since it offers a high margin of safety. If share price drops from current price, they would create value buying back their own shares without depleting reserves and the lower share price will give investors the opportunity to accumulate the stock at cheaper prices.
Potential Risks: A Very Low Oil Price Environment Could Delay the Investment Thesis
Although I believe the current margin of safety is wide enough, an extended period of time with Brent prices below US$ 50 per barrel could delay potential returns. However, thanks to its high netbacks, low operating costs and strong balance sheet, GeoPark is very well-prepared to navigate a potential downturn. If a downturn is coming the investment thesis could take longer to materialize.
Disclosure: I am/we are long GPRK. 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.