Penn West Energy Trust (PWE) is the sole shareholder of Penn West Petroleum Ltd. (PWPL), which is actively engaged in the business of oil and natural gas exploitation, development, acquisition and production in Canada. PWE, with increasing operating costs and worrying debt levels, needs to prove its case to investors. (You can refresh your memory with my earlier reports and and updates here.)
All results are in C$.
- Operating cash flow for the full year increased 12.2% to $1.2B, with free cash flow up 2% to $545M. Per share, OCF was down 5.4% and FCF/share came in at -14.1%. This is the result of 19% dilution due to the various acquisitions (Canetic, Vault).
- Debt increased by 51% to $1.9B, mainly due to funding capex, acquisitions and the distribution yield. Currently, distribution covers 176% of free cash flow and is trending the wrong way. Management mentioned the possibility of divesting assets to pay down $200M - $300M of debt as well as terming out an additional $500M.
- On the income statement, operating income fell 44% YOY, mainly due to a 30% bump in operating expenses and $182M in unrealized losses on their hedges. Backing out the paper loss on the hedges, operating income was down 7.2%, which is still disappointing in a year of record oil prices, but all in all, not horrible. The combination of a bigger asset base (thus higher depreciation charges) and significant hedging explains the poor income results. EBITDA was up 17% YOY. Netback margins slipped to 59.8% from 62.1% a year ago. More troubling, this number sat at 58.7% for Q4 so management will need to focus on reversing that trend.
- Capex is budgeted at $960M.
- Production targets were lowered to 195K - 205K BOE/day from Q3 2007 guidance of 200K - 210K BOE/day.
- Cash flow is projected at $2.0B - $2.1B based on par exchange rate, $80 WTI & $6.75 nat gas. This compares unfavorably to Q3 guidance of $2.0B - $2.2B cash flow based on par FX, $75 WTI & $7 nat gas.
- 40% of nat gas production is hedged through March 2009 at roughly $7/mcf and 41% of liquids production is hedged at approximately $73 per BOE on a pre-royalty basis.
Penn West is struggling a bit here and is approaching “show-me” status. Operating costs are a bit out of hand. Debt levels are climbing higher, which would not be a problem if PWE was a corporation, but as a trust with nearly $1B committed to unitholder distributions, the company cannot sustain its growth plans if payout ratios are over 100% of free cash flow.
Management signaled debt levels were becoming troublesome, with intentions to manage its debt levels as outlined above. A cut in the payout may be warranted if management cannot markedly increase cash flow in the intermediate-term. Management has guided to $2.05B cash flow with $960M capex budgeted and $977M in committed distributions.
Furthermore, the realized netback margins are trending in the wrong direction despite record high oil prices and bears close watching. They are targeting a 10% reduction in finding & development costs. Some of the high F&D costs are due to spending on Peace River and Pembina, which are long-term projects, but regardless, these costs are too high and need to be brought down.
Management has taken some steps to address the situation. They've brought in Murray Nunn as COO who has shifted the capex away from Peace River and Pembina and into more conventional E&P efforts. While this is an implicit admission that realizing value on its oil sands & CO2 assets is currently a distant prospect, it does give the company more focus.
Over the last year, management has talked a lot about Peace River and Pembina, acquired a few smaller trusts and in general grew its balance sheet without adding any obvious value. The company sounded positive on E&P prospects on some of the newly acquired acreage and is putting its money there.
I will be monitoring PWE closely going forward. If 2007 results persist into 2008, I would expect an eventual cut in the distribution, which I don’t think is priced into the stock. Here are the performance measurements going forward:
- Hit guidance, specifically a sustainable standardized distributable cash payout ratio. Using midpoint guidance, projected FCF per share for FY 2008 is ~$4.37 vs. $4.08 in distributions for a ratio of 0.93.
- Organic growth in reserves. The company has been acquiring reserves but it needs to start converting acreage into reserves.
- Execute its debt management program — selling $200M - $300M in assets to pay down debt and terming out an additional $500M.
- Move closer toward realizing value on Peace River. Following the company over the last year suggests to me that the scope of the project may be beyond the reach of the company. During the conference call, management was directly confronted with selling the project and was resistant. Management needs to put up or shut up on this prospect.
Disclosure: Long PWE.