The Street Is Too Timid On Penn Virginia

| About: Penn Virginia (PVAC)
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Penn Virginia (PVA) is another story of a company moving away from gas production to almost solely focus on its acreage in the oil window of the Eagle Ford Shale. They don't plan on growing this year, at least not in terms of absolute volumes, as they attempt to increase the oil mix without further stressing the balance sheet. This one has some debt, as you can see in the table below, and the major fears here are: a) a redetermination coming in April that will almost certainly reduce the size of their revolver commitment (but likely not impact this year's spending), b) that gas prices will stay low for a long time or even forever (I think people will be surprised by a shallower than usual injection trajectory this Spring/Summer), and c) that they won't execute on the Eagle Ford program to get further into oil fast enough. In the meantime, it's been beat down (go grab a daily chart) and it's cheap on Wall Street EBITDA estimates for 2012 and 2013.

First a table, and then a few more details, some more graphs on their metrics, and a final nutshell.

The Plays

Eagle Ford Shale - Their Current Focus. Approximately 23,100 net acres in Gonzales and Lavaca counties, Texas, probably moving to 25,000 net acres this year. Gonzales is firmly in the oil window, with Lavaca more of mix of the condensate and gas windows respectively. PVA plans to spend 85% of the 2012 budget of $300 to $325 mm here, drilling 26.7 net wells in the EFS.

Initial production rates from its core Gonzales county effort stack up well to the competition with an average IP of close to 1,000 (in line with recent comments by the biggest name in the play EOG Resources (NYSE:EOG) for Gonzales County). PVA puts its 30 day rate from 26 wells (those wells with enough history to date) as averaging 675 BOEpd (89% oil, 5% NGLs), nice wells that on current pricing yield revenues of roughly $1.8 mm in their first month and should pay out in less than 12 months.

In Lavaca County, they recently spud their first well and will drill a total of 6 wells this year to earn acreage in an AMI in far western Lavaca County (just to the east of their current program in Gonzales) with an undisclosed "major oil company." They will be targeting significant EURs here as well, but with closer to an 80% liquids profile as you'd expect as they move towards the eastern edge of the oil window in the play.

Notably, Magnum Hunter Resources (MHR) has drilled a number of strong Lavaca county wells with an average IP of 1,379 BOEpd from 8 wells and avearge 30 day rate of 572 BOEpd. PVA's acreage here is essentially on top of and to the east of MHR's Lavaca position. There should be room for 40 wells here with PVA acting as operator and I'm guessing, Hunt Oil as the AMI partner.

At the end of January 2012 EFS production was 6,300 BOEpd net (roughly 1/3 of 4Q11 total company production) and total company production was 42% liquids, a number they have put forth as the liquids target for all of 2012. Note: It's sort of hard to get liquids as a percent of total to fall flat from here through YE 12 as gas volumes are allowed to decline and the only thing they are really focused on drilling is roughly 95% liquids. Seems like they are bagging the Street a bit on this point.

Costs and EUR guidance look pretty typical of other oil window nearby players ($8 mm CWC and 400 MBOE expected recoverable reserves). Well costs have been coming down as they reduce proppant costs and move to pad drilling. Their sense is that since they plan to ultimately space wells as tightly as 60 acres they don't need to hit each one with as big a frac. They've also gone to a 50 / 50 mix of white sand and ceramic and have sourced some wholesale Chinese proppant to cut costs. Given their recent rate of well cost decline ($10 mm in 3Q, $8 mm in 4Q) we could see some slight further reduction this year (say to $7 to $7.5mm a copy) which would add a couple of more net wells to this year's plan.

I've heard some complaints on management's historical ability to execute, but they are pretty impressively adding wells in the EFS (added 12 net wells in the last operations update which was 3 months after their previous one, which isn't too shabby especially with the aforementioned rates). Still, execution risk is a bigger worry for them given the leverage and still gassy nature of the name.

Everything else is largely held by production or has long leases and is on the back burner for now, except for some modest spending in the mid-continent:

In the Granite Wash they hold 10,000 net acres in core and another 40,000 net acres in exploratory areas. A Viola Lime (fractured carbonate) test is set to spud in 1H12 and could be the one notable non-Eagle Ford catalyst for the name this year. They have room to run in terms of acreage if they get it to work, but otherwise all of their mid-continent assets will see less than 10% of 2012 budget.

Haynesville Shale - East Texas and no real cash.

Appalachia - Marcellus, but not planning to drill more wells until 2014 to 2016, and be could be a source of funds.

Mississippi - Selma Chalk, also a gas play, maybe on the sales block.

The Balance Sheet - Leveraged, But Not Overly So

Debt to cap stands at 45% debt to cap now and a borrowing base redetermination in April is likely to see the revolver commitment fall slightly, but not materially below its current $300 mm. They had $116 mm drawn in late February leaving them with availability of just over $180 mm. Given the capital budget of $300 to $325 mm this year vs EBITDA of probably $250+ less plus another $60 mm in interest, they should be able to complete this year's program without further ratcheting back drilling activity.

Nevertheless, they are actively marketing assets, but won't comment on size other than to say they would like to end the year close to $150 mm available on the revolver. Using their math on the midpoint, I'll be looking for a sale in the $75 to $125 mm range later this year. Later in the year, if we have only slightly higehr gas, and if the liquids percentage remains north of 40% (as expected) I would expect them to term out the revolver.

Nutshell: It's leveraged, but it's cheap (and probably cheaper than the Street thinks). The name is not growing total volumes, but that should have been factored in months back, and definitely when they laid out the 2012 plan in late February. I see it as 1) an EBITDA growth story, 2) a rising liquids as a percent of volumes story, 3) a we've got a play we can take a run at in repeatable fashion with good results that can be further honed, 4) a we've got our operating costs well in hand and 5) a leverage won't kill this one story (due to 1, 2, 3 and 4).

Yes they will outspend cash flow, and yes they will see their debt a little bit more this year (largely dependent on the size of their monetizations and the price of oil). But the name has taken much of that into account and is trading on cheap multiples of forward Street EBITDA already. Given their rising oil focus, a majority of which is garnering LLS pricing, and solid hedges on roughly a third of their gas volumes, I get bigger numbers for this year's EBITDA. Bigger by over 15% on my price deck of $3.50 gas and $105 WTI -- and again, they get a premium to that for a majority of their oil.

I would note that the Street consensus is essentially sitting at the mid point of EBITDA guidance. If I were to look for more gas-focused exposure as a play on a future rally (or slow slip higher) in natural gas prices, then it would be in a leveraged (but not overly so) name where the equity has already taken the brunt of the beating. I took a starter position in the ZLT yesterday and plan to slowly add from time to time near current levels until we get fresh data.

Disclosure: I am long PVA, MHR, EOG.