Drill Baby Drill: Vaalco Energy

Jun. 04, 2022 9:00 AM ETVAALCO Energy, Inc. (EGY)SSL, WTI71 Comments28 Likes

Summary

  • Vaalco's growth program continues to drive production upwards.
  • EGY is not impacted by ESG concerns and regulation to a significant degree.
  • Following 200%+ gains since we initiated coverage, EGY still does not look expensive.
  • This idea was discussed in more depth with members of my private investing community, Cash Flow Kingdom. Learn More »

Offshore-Bohranlage bei Sonnenuntergang

nielubieklonu/iStock via Getty Images

Note: This article was, in a longer and more in-depth version, released on Cash Flow Kingdom. It was produced with Darren McCammon.

Introduction

As should be apparent to all by now, upstream oil firms do better in an inflationary environment when oil prices are rising. Are oil prices benefitting from rapidly increasing inflation? Or are oil prices a primary driver of inflation? The truth is, from an investor's point of view it doesn't matter. Because oil prices are rising largely due to government policy, malinvestment, lack of investment, ESG investment criteria, and so on.

When COVID resulted in greatly reduced consumption, oil prices went negative. Owners were paying to store worthless oil. However, now we find ourselves in a world of increasing demand that is outpacing gains in production. As investors we should ask, what company is capable of operating profitably, is not subject to government and ESG challenges, and can grow production in order to gain a windfall from the situation? Our answer to those questions is Vaalco (NYSE:EGY).

Vaalco Energy

Vaalco benefits greatly from higher oil prices. Management does tend to contract prices (i.e. hedge) on a volume sufficient to cover all costs of production, but they also profit significantly from selling excess production at spot prices. Interestingly, EGY is also in the enviable position where the spot prices it receives are frequently at a premium to Brent spot prices. As you can see in the chart below, Brent Oil prices have increased significantly in recent months and are now trading at the top end of the five-year trading range:

Chart
Data by YCharts

Vaalco operates in a region of West Africa where it drills wells in the Etame Marin Block off the coast of Gabon, Africa. After acquiring a large stake from Sasol (SSL), Vaalco now owns about a 60% stake in the block. The great thing about operating where they do is that they are unrestricted by unfriendly government policy and, to a large extent, from ESG investors and protestors. The following image shows Vaalco's key asset in the Etame Marin Block:

VAALCO production

Offshore Energy

Unlike many other firms, VAALCO has not been significantly held back by unfriendly regulation, legal issues, boardroom takeovers, offtake capacity problems, and/or other all-too-common challenges E&Ps experience. It also benefited from having gone into Covid with a very strong balance sheet (no debt) that put them in a situation where it could buy out Sasol's working interest in the Etame Marin project at an attractive price. This purchase became transformational for the firm as it essentially doubled VAALCO's reserves and net production per day with negligible extra G&A costs. Below we see the historic production capacity and the expected capacity for the current quarter:

Chart, bar chart Description automatically generated

Vaalco presentation

This increased earnings power from the Sasol purchase has yet to be fully expressed. We expect Vaalco to sell over a million barrels of oil in Q2, with Q2's adjusted EBITDAX alone exceeding the firm's entire adjusted EBITDAX for all of the pre-Covid 2019 fiscal year. This is due to their ability to increase production during a period of increasing prices even as others struggle to do so. With 46% of EGY's Q2 production barrels locked in at an average price of $72 and an estimated average Q2 price of about $110 on the rest, we forecast EGY's average realized price in Q2 to exceed $90 per barrel. Additionally, the average cost per barrel is falling and is expected to fall further in September, when their new Floating Storage and Offloading vessel (FSO) comes online.

Graphical user interface Description automatically generated with medium confidence

Company presentation

This will provide a hefty amount of extra cash flow, as suggested by the above chart -- which uses a $90 oil price, which is still significantly below current spot prices. Actual results could thus be even better.

Vaalco's Valuation

All three of the offshore E&P firms below are rated 1.0 (strong buy) by analysts, due mainly to high oil prices. VAALCO's total enterprise value (EV) per Q2 expected flowing barrel is $38.4K. For comparison, W&T Offshore (WTI), another offshore producer, trades for less at $34.9K, but that's about the only valuation measure where WTI leads:

EGY versus peers

Author's calculation

Additionally, EGY grew reserves at twice the rate as WTI last year, is expected to grow flowing barrels much more than WTI this year, and there is a drastic difference in debt. VAALCO also stands out as currently enjoying a net margin of about 58.5% vs WTI's 40.1%. Additionally, VAALCO's costs are expected to decline significantly more than WTI's on a per-barrel basis this year, as the new FSO comes online, and their relatively fixed G&A costs are spread out over more barrels.

The near-term increase in production and intermediate-term increase in free cash flow (and hopefully shareholder rewards) is why we think VAALCO is a superior upstream investment from a risk/reward standpoint. In contrast, WTI's $606 million in debt represents more than half its total enterprise value.

Risks And Other Factors To Consider

Oil prices have been and will likely continue to be very volatile, dragging EGY's stock price up and down along with them. Historically, high oil prices have always led to overproduction, which in turn has led to lower oil prices, resulting in energy stocks plummeting. In our opinion, this time will not be too different. The good news, at least for oil investors, is that oil prices probably won't be falling in the near or intermediate term.

Worldwide demand is still recovering from Covid, and we are just heading into the prime travel season, yet refineries throughout the world are already close to being tapped out. This is because the world's older refineries were encouraged to shut down or switch to producing lower volumes of renewable diesel during Covid. Once a refinery is fully shut down with no intention to restart, many units in the system can become essentially unusable. Plus, there is naturally a significant decision-making and permitting process to work through to get them replaced.

Boardrooms throughout the energy complex -- upstream, downstream, and especially midstream -- are going to be very cautious about spending capex to increase production. The simple fact is that an unfriendly federal regulatory and legal environment has cost Keystone XL, MVP, DAPL, Line 5, and other pipeline investors billions of dollars after approvals were already obtained. Those investors are obviously going to be gun shy about throwing good money after bad. That the Administration has also emphasized shutting down fossil fuel rhetoric in the past and sought to prevent permitting of federal lands and offshore leases isn't helping to change that fear.

It is also debatable how much OPEC+ countries can increase near-term production even if they wanted to. This is due to a lack of production and development spending over the last decade. Most won't even want to see worldwide volumes increase as they faced existential threats when low oil profits resulted in less social subsidies and unrest in their countries.

The profit motive should eventually increase worldwide production and decrease energy prices. It's just a matter of how long that process is going to take. We are thinking in terms of multiple years, although there are naturally considerable uncertainties here. Our educated guess is that demand exceeding supply of this inelastic good (hence high prices) is going to continue for years, not weeks or months. Eventually, energy prices should head lower again, however.

The bad news is, that while the Etame Marin is likely to gush cash for VAALCO for years to come, we are not expecting much in the near term when it comes to shareholder rewards. Management prefers to continue developing the field and reinvest the cash into seismic surveys and new wells. Four new wells are scheduled to be drilled in 2022 at a cost of $76 million. Management even chose to buy an FSO rather than follow the more conventional path of leasing. Granted, at a cost of $29 million, owning the FSO is expected to have only a 3-year payback, and should lower the operating cost by 20% over the long term. However, the point is these decisions highlight management's inclination to prioritize growth over shareholder returns.

Increased shareholder returns would be a major positive catalyst if they occur, e.g. via a buyback program or a variable dividend policy. But we do not base our investment thesis on that happening, due to the aforementioned "growth focus".

When people refer to political risk, they usually think of negative potential risks such as government overthrow and nationalization. In Vaalco's case, however, we have always seen things differently. We chose EGY in part because it would not be subject to the risk of Western World ESG limitations yet would still have relatively easy access to Western markets.

We've noted that unfriendly regulation and legal challenges in the Western World would serve to limit oil offtake capacity, which in turn, would suppress oil production. These ESG forces did very little to suppress oil demand in the West, but they did limit oil supply and especially, transport. Every US pipeline project that is held up in court and/or not permitted, every well that cannot be drilled due to ESG-caused limited funding or a permit being revoked, discourages E&P. Every new regulation, windfall profit tax, or other tax on oil that occurs in the West, also serves to make African oil production that much more attractive to producers, buyers, and investors, by comparison. So as western production continues to remain stagnant, but demand continues to grow, companies like VAALCO will benefit from filling the void.

Takeaway

Though Vaalco stock has seen a 210% price increase since we wrote about it less than a year ago, we haven't sold a share and continue to find it attractively priced. In fact, we think it's the most attractive of the three offshore firms shown above, and maybe the most attractive firm in the space.

We expect to see EGY significantly improve its cost per barrel this year, more than the other firms. In addition, despite the price increase it continues to sport a lower valuation, higher growth expectations, and better realized prices and margins than most of its competition. Finally, EGY does not carry any debt, helping to reduce risk.

However, we warn that all upstream oil production investments are volatile and correlated to the price of oil. Only invest if this suits your risk profile.

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This article was written by

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Disclosure:

I work together with Darren McCammon on his Marketplace Service Cash Flow Kingdown.

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Disclosure: I/we have a beneficial long position in the shares of EGY 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.

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