Obsidian Energy: It Is Those Debt Levels

Summary

• The NYSE listing application will be a major milestone in the recovery of this company.
• Debt levels remain high and are declining.
• The company may need to do a deal that uses stock to accelerate debt level reduction.
• The heavy oil project is extremely profitable during good times.  But margins can completely disappear during downturns.
• Decommissioning expense remains high and could stay that way well into the future.
• This idea was discussed in more depth with members of my private investing community, Oil & Gas Value Research. Learn More »

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Obsidian Energy (NYSE:OBE) has had a long climb back. The application for the company to list on the NYSE again represents a full circle as the company used to be listed on the NYSE years back when I covered the stock as Penn West Energy. The challenges of the past few years still remain as debt levels are on the high side and the company still has a current decommissioning liability (that for many companies is a future liability). Still, the company was lucky enough to survive until the currently strong commodity price environment took over. That may finally give the company a chance to get to the investment grade strength that has eluded management for some time.

Management expects to report in excess of C$400 million of debt. In the current business environment, that debt load can be properly serviced, and the debt ratios are likely to be satisfactory to many. The available credit on the bank line is now about C$35 million at fiscal year-end. That amount of available credit for the size of the company operations indicates some concern among lenders of the ability to repay the debt load.

The good news is that the unexpectedly strong commodity prices allowed the company to report cash flow in excess of C$200 million for the fiscal year. That unexpectedly robust cash flow and continued strong commodity prices will accelerate the debt reduction program. The key will be to convince the market that the debt is reasonable during the total industry cycle, not just at the current time when commodity prices are extremely strong.

Therefore, a priority will continue to be to repay debt. Most likely there will be an informal debt level agreed to by the company and the lenders that would be appropriate to have during the next cyclical downturn. The currently strong commodity pricing environment could well allow for a combination of production growth and debt repayment to reach a suitable debt ratio.

The company acquired the rest of the heavy oil project interest to become the sole owner. The debt load may prevent a lot of expansion into this very profitable Peace River located project. Currently, the project is developing the Bluesky formation with the Clearwater formation as upside potential. There is a lot of industry interest in the Clearwater interval because it is very profitable.

However, a conservative balance sheet is called for because heavy oil is a discounted product. Oftentimes, that discount expands to erase the margin during cyclical downturns. The result is that heavy oil producers often shut-in production while they await the inevitable industry recovery. Margin reduction tends to affect discounted products far more than the light oil products during a downturn.

To combat this tendency, competitors like Headwater Exploration (OTCPK:CDDRF) have a no-long-term debt balance sheet. Headwater also maintains a decent cash balance on the balance sheet. A company with such a conservative strategy can shut-in production and simply wait out a period of low prices until adequate profitability returns.

Obsidian, on the other hand, is in the position of very much wanting the generous cash flow that heavy oil produces during the better part of the industry cycle. But the balance sheet cannot withstand the margin disappearance that frequently happens to heavy oil during the downcycle. So, there is likely to be some sort of balanced development that allows the company to take some advantage of current pricing while also growing the production of more desirable products like light oil.

The presence of heavy oil production may also mean that the lending group will have a lower acceptable debt ratio for the company than would be the case for straightforward light oil production. This would "cover" the extra risk of the very volatile heavy oil production. Investors will have to see how this all evolves in the future.

Note that management did sell some stock to pay for the remaining interest of the Peace River project that the company did not own. Using stock to acquire interests or to acquire companies is a very good way to accelerate the debt ratio reduction process. The company may need to do another transaction or two like this in order to get the debt ratio down to acceptable lender-approved levels.

Much of the industry appears to be heading to a debt ratio of less than 2.0 as calculated by their lenders. The current strong pricing environment will likely bring the debt ratios into acceptable territory as of the end of 2021. But the key will be what is acceptable to lenders as the whole industry gets ready for the next cyclical downturn. Generally, companies do not delever adequately without using stock for an acquisition or selling some assets. The next downturn seems to come too fast.

Management has provided some limited insight into well profitability. But many key profitability numbers are not there (like ROI, IRR, and breakeven pricing). This lack of disclosure may be a sign that there is still some competitive work to be done to "catch-up" to industry leaders. Profitability is a combination of many factors. So, a high or low flow rate often does not indicate profitability all by itself.

The other consideration is that this company remains with a fair amount of older production. Management at times has practically given away some of that older production to small operators with low overhead to get the decommissioning liability down. Yet they still report a significant amount of decommissioning each year. That means that relative to current activity, the company has a fair number of wells turning unprofitable from when the company was considerably larger. This continuing issue of decommissioning may well be a consideration for the indefinite future until older production comes into balance with current activity.

This older production issue also may be reflected in the operating costs. Those costs remain above some of the better operators in the industry. It is therefore harder to tell if operations are lagging behind competitors, or there is simply a lot of older production remaining on the books (despite the efforts of the past few years) keeping the average production levels high. Those high production costs tend to agree with the decommissioning costs to lead to the (same conclusion as before) conclusion that decommissioning will be an issue for years to come.

In summary, Obsidian has come a very long way from where it was some years back. A lot of challenges have been overcome for the company to get to the point where it can reapply for an NYSE listing that it had years ago. But there still appear to be some issues that hinder cost competitiveness. Management needs to keep surmounting the continuing legacy challenges while developing a better future for the company.

Currently, strong commodity prices are likely to accelerate the company's return to investment grade if they last long enough. But this industry is notoriously low visibility. So, investors need to watch an investment like this one very closely. Industry conditions can change to have an outsized effect on the stock price of a company like this.

Growth is likely to be limited by financial strength considerations and the resulting debt repayment goals of the lending group. The company is clearly in better shape than it was a few years back. However, it is apparent there are still some issues to be resolved. Hopefully, the currently strong commodity price environment remains in place long enough to resolve the debt ratio issues. This management continues to defy the odds when it comes to company survival. That should continue into the future. The payoff to shareholders of this strategy may take a while.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of OBE, CDDRF either through stock ownership, options, or other derivatives. 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.

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.