Penn Octane Corp.: MicroCap Oil and Gas Property Developer with Big Potential

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Includes: POCC, RVEP.PK
by: Prudent Speculations

Penn Octane (OTC:POCC) is a micro-cap company whose upside will be driven by the migration of U.S. oil and gas properties into the MLP structure. Penn Octane owns 75% of Rio Vista Energy Partners' (RVEP) general partner, entitling Penn Octane to an ever-increasing share of Rio Vistas’ distributions.

Upon first glance, making an investment dependent on growth in the distributions at Rio Vista Energy Partners may seem like a bad idea given Rio Vista's performance since its IPO in 2004. For years, Rio Vista languished under management that did not seem to know what they were doing.

However, Rio Vista seems to have found a path of growth under its new CEO who took over in November of 2006. Since November 1, 2006, Penn Octane has risen from $0.44 to $2.31 while Rio Vista Energy Partners has risen from $3.91 to $12.31. Over this period, Rio Vista has also paid out $3 in distributions.

If you have read any of my past articles on MLPs you will know that general partners are levered to growth at the limited partner through their ownership of incentive distribution rights [IDRs]. As a result, it would be fair to conclude that Penn Octane will grow much faster than Rio Vista Energy Partners will.

Over the last 18 months, Rio Vista's growth has been due to acquisitions. Going forward Rio Vista's growth looks to be levered to a combination of acquisitions and an aggressive drilling program. This is similar to other, mid-cap MLPs. Rio Vista has been able to grow significantly over the last several years due to the premium valuation given to oil and gas properties under the MLP structure when compared to the valuation given to them when they are in the standard corporate structure. This premium allows the limited partners, such as Rio Vista, to easily sell new units to fund future growth possibilities. This difference in valuation is caused by the tax efficient nature of the MLP structure (it avoids double taxation) and the appetite for tax-deferred MLP income by members of the investment community.

Because oil and gas properties are given a premium valuation when they are owned by an MLP it gives management an opportunity to arbitrage this valuation difference to add value. This process can be repeated as long as the valuation difference continues to exist. As less than 3% of oil and gas properties in the US are under the MLP structure there are plenty of properties available for companies looking to expand their footprint. For a company of Rio Vista’s size they have the opportunity to profit from every opportunity that comes their way, with Penn Octane’s IDR ownership the company should benefit immensely from Rios Vistas’ opportunities.

Demand from the investment community for investments in oil and gas properties continues to increase as energy prices rise, when coupled with the fact that many baby boomers are transitioning their investment portfolios away from common stocks into income producing assets, such as MLPs, the demand for these securities should be insatiable. This will support these companies access to the capital markets and their growth ambitions, which will subsequently help their general partners tremendously.

If these future prospects were not enough, there is an enormous discount between the company’s near term valuation and what the market is assigning it. Most exploration and production MLPs trade at yields of around 11%. Due to Rio Vista’s higher growth rate, the company trades at a yield of 8.2%. To give you an idea of how accretive future growth can be for Rio Vista, recent transactions in the sector have been at an EBITDA multiple of 4.5x or about 22%, well above the company’s current yield. Generally, the smaller the property the cheaper the valuation and even the smallest acquisitions are meaningful to Rio Vista Energy Partners and Penn Octane.

Over the last 18 months, Rio Vista has made $39.4 million worth of acquisitions. If Rio Vista behaves similarly over the next 18 months the benefit of such a level of transactions could look something like this: 

 

Prior to Potential Acquisition

Current Units Outstanding

2,515,518

Unit Price

$12.25

Current Distribution Per Unit

$1.00

 

 

 

After Potential Acquisition

Hypothetical Acquisition Price

39,400,000

Units to Pay for Acquisition ($12.25)

3,216,327

 

 

EBITDA (4.5x multiple)

$8,755,556

Annual Cost of New Units

$3,216,327

Accretion to EBITDA

$5,539,229

Maintenance Capex

$1,107,846

Additional Distributable Cash Flow

$4,431,383

Total Units After Acquisition

5,731,845

Increase in DCF Per Unit

$0.77

If Rio Vista simply repeats its past acquisition performance over the next 18 months, it could easily create an additional $0.77 in DCF. This significant growth at Rio Vista will produce tremendous returns for Penn Octane, as Penn Octane will be getting incentive distributions on the new units issued by Rio Vista Energy Partners along with distributions from its current ownership stake. Penn Octane’s leverage to the future growth of Rio Vista, especially given its small size, allows for shares of the company to potentially be an incredibly successful investment for those willing to deal with its speculative nature.

Another item worth mentioning is the significant growth Rio Vista is projecting as a result of its drilling program. Assuming Rio Vista Energy Partners meets its guidance, Rio Vista Energy Partners could generate $3.18 per unit in distributable cash flow during 2009, allowing for a substantial increase in distributions at Rio Vista and earnings at Penn Octane. It should be noted that these results exclude any potential acquisitions by Rio Vista, which would create even more upside to the company’s guidance.   

 

2009

EBITDA

17,800,000

Total Capex

9,800,000

DCF

8,000,000

Units Outstanding

2,515,518

DCF per unit

3.18

Rio Vista and Penn Octane are not without risk given the poor performance of the prior CEO and the company's micro-cap size. I do not know if Rio Vista’s drilling program will return results as impressive as management is currently expecting. However, the arbitrage opportunity available in Rio Vista Energy Partners and Penn Octane is significant given the companies’ small size and the growth possibilities at Rio Vista. The benefits of acquisitions at Rio Vista for Penn Octane as a result of the IDRs that it holds leaves tremendous upside in the shares of Penn Octane.

If Rio Vista continues with its acquisitions Penn Octane’s small market cap should allow for an outsized benefit for the share price as a result of its IDRs in Rio Vista. Management has stated that they intend to pursue expansions through more accretive acquisitions, and I expect them to continue once certain contractual agreements relating to the company’s most recent acquisition expire in the fourth quarter of 2009.

Rio Vista Energy Partners and Penn Octane in particular have more growth potential than just about any other stock in my coverage universe. I just hope management realizes the potential of their two companies. With these two stocks, it is important to keep in mind that as with all micro-caps they are likely not suitable for the typical investor. 

For Further Review: RVEP presentation

Disclosure: Long POCC