EP Energy (OTCPK:EPEG) is clearly on its last legs, and the only question is when it will file for Chapter 11 protection. My view is that the company will stave off filing for as long as possible in order to provide for a consensual solution amongst its debtholders, as the equity is worthless and trades accordingly.
While it is clear that the company will file for bankruptcy no later than early 2020 absent a massive (and largely unwarranted) increase in commodity prices, I think that its debt presents some intriguing possibilities.
Recent pricing for EPEG’s debt securities and corresponding valuations as of 6/5/2019 follow:
Using only the company’s year-end proved reserves of 233.6 MMBoe, this implies a value of $6.42/Boe using the average of the bid and ask prices for its debt and resulting valuations. To test this value, I selected fourteen other exploration and production companies and calculated enterprise value (EV) per Boe, as can be seen below:
Note that the average EV/Boe is akin to the $6.42/Boe value implied by recent pricing on EPEG’s outstanding debt securities. I would note that the average EV/Boe and average non-gas EV/Boe values are buoyed by the values for Continental Resources (CLR) and Diamondback Energy (FANG). One might argue, based on this admittedly simple (and arguably facile) metric, that these equities are overvalued.
Using the average EV/Boe value of $6.75 to value the company’s reserves leads to the following waterfall analysis:
This implies that the remaining value will be shared ratably between the 9.375% Senior Secured Notes due 2024 and the 8.00% Secured Notes due 2025 (commonly referred to collectively as the “1.5 Lien Notes”). Notice that as a simplifying measure, I have not incorporated any administrative claims or fees but do believe that trade creditors will be paid in the ordinary course. What this analysis does suggest is that the 8.00% Secured Notes due 2024 (the so-called “Priority Notes”) could prove to be an interesting investment at the levels indicated, provided the implied value cushion does not disappear.
This then begs the question of whether this “value cushion” will disappear. In 1Q19, EPEG generated $56 million in negative free cash flow and borrowed $80 million under its reserves-based lending facility (the RBL Facility) to fund operations and to repurchase debt. Another four quarters of comparable cash burn (~$60 million per quarter) would effectively cut the calculated value cushion in half. This would imply that the 1.5 Lien Notes at current levels are overpriced.
What is the likelihood of the cash burn rate being at least $60 million/quarter? To answer this question, in part, I look to the company’s 2Q19 guidance. In it I note that the midpoint for the company’s lease operating expense guidance for 2Q19 ($37-40 million and $5.50-6.10/Boe) implies production of approximately 6.4MMBoe, a decline of almost 3% from 1Q19 volumes to just less than 71 MBoe/d compared to guidance of 70-73 MBoe/d. Based on my model which relies on the guidance provided by management, I estimate 2Q19 cash burn at over $100 million, as can be seen below:
At this level of cash burn, the value of the 1.5 Lien Notes will likely decrease dramatically. Since the 1.5 Lien Notes are the fulcrum security, I would expect that management is engaged with the holders of these notes and the remaining junior securities to preserve as much value as possible for these stakeholders and management. Given how management ended the last two earnings calls without allowing for a Q&A session lends credence to my belief that a bankruptcy filing is imminent once the expected consensus among stakeholders is reached. After all, even a small dollop of value is better than nothing.
In addition, the expected quarter-end DUC (drilled but uncompleted) inventory is expected to increase 41% to 65. This inventory represents wells that can be completed and brought on-line in the event commodity prices improve (which I believe to be highly unlikely given the forward curve for crude oil and natural gas). While this seems counterintuitive (why drill DUCs when there is a greater need to preserve liquidity?), it could be the case that management believes a Chapter 11 filing would likely eliminate the remaining unsecured obligations and a significant portion of the 1.5 Lien Notes, thereby significantly reducing debt service requirements. The freed-up cash could then be used to attack the DUC inventory.
The presence of Apollo as an equityholder could complicate a restructuring, but I think any complications would be less likely to affect the more senior debt in the company’s capital structure and more likely to affect the 1.5 Lien Notes and the unsecured notes.
Given my belief that bankruptcy is likely for EP Energy, my waterfall analysis suggests that the 8.00% Secured Notes due 2024 appear undervalued, and so, I would recommend buying these. The 1.5 Lien Notes are likely to comprise the fulcrum securities, but the value of these notes could be volatile depending on the timing of any Chapter 11 filing.
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.