Petrobakken finally realizing its high leverage

Petrobakken (TSX: PBN) gave a quarterly status update with respect to its production and indeed, it is around what it stated (43,000 barrels of oil equivalent per day).

Most interestingly is the paragraphs they devoted towards recent speculation concerning their debt levels, with me bold-facing some of the quoted material below for emphasis:

At the end of September, PetroBakken had $1.14 billion drawn (essentially unchanged from the end of June 2011) on our three year, $1.35 billion credit facility, leaving us with over $200 million of credit capacity available on the current line in addition to our growing cash flow. Recently, there has been some market focus on our convertible debentures which mature in February 2016. The debentures have a one-time, one-day early put option on February 8, 2013 that allows those holders that elect to exercise the option to request payment in full for their debentures. In the event that holders request payment, PetroBakken has the option to repay in cash or through the issuance of PetroBakken shares based on the then current share price.

The Company has been, and will continue to be, pursuing various options to provide additional flexibility in order to repay any bonds that may be put back to us with either cash or shares. In addition to our growing production base and the potential for increasing cash flow over time, those options include: modifying our capital program and/or altering our dividend to provide additional free cash flow; issuing additional debt instruments; instituting a dividend reinvestment program; renegotiating the terms of the existing convertible debentures; or realizing on asset sales. Early in the second quarter of 2011, the Company engaged TD Securities Inc. as financial advisor, to assist the Company in our assessment and pursuit of certain options to provide increased liquidity, and we continue to actively evaluate alternatives going forward. Further announcements on the progress of this process will be made at the appropriate time.

We have positioned our asset base to focus on value creation for our shareholders, and decisions on how best to manage the business are made with both a short term and long term strategic outlook in mind. PetroBakken has built a strong portfolio of assets with a multi-year inventory of light oil drilling locations from which we can generate accretive, long term, growth. This portfolio includes over 440,000 net acres with over 1,400 net drilling locations in the well established Bakken and Cardium light oil resource plays; more than 480,000 net undeveloped acres and 300 light oil net drilling locations for conventional opportunities in southeast Saskatchewan; over 120,000 net undeveloped acres on new potential light oil resource plays (many that have seen significant attention by the industry in recent land sales); and a material land position in northeast British Columbia for future natural gas opportunities. With this asset base, and based on our current activity plans, we intend to deliver year-end 2011 production of 46,000 to 49,000 boepd. At the mid-point of this range, and based on US$85 WTI per barrel, we would expect to generate annualized cash flow of approximately $850 million. With expected continued growth in production in 2012, we would anticipate funds flow from operations (based on a similar WTI price) to grow further to equal or exceed our total capital expenditures and dividend payments. However, if conditions change, we will not hesitate to evaluate the other alternatives available to us, including altering our dividend and/or capital spending levels.

Current economic conditions and market rumours have caused shareholder focus to be turned away from the high quality, light oil assets that underpin the Company, to the perceived strength of our balance sheet in light of the convertible debenture put date (that is 16 months away) and our current capital and dividend plans. We are aware of the concern over our debt position and, as outlined above, we have several options at our disposal which we are actively assessing to effectively manage this situation in varying commodity price environments while continuing to pursue our strategies for long term, accretive, growth.

Some notes that went through my head:

1. The company’s current market capitalization is CAD$1.26 billion; the amount of the convertible note is US$750M. At present prices a share conversion would result in a 38% dilution of shareholder interest in the company. In addition, the additional amount of shares would virtually guarantee a dividend decrease (the convertible note’s coupon is 3.125%).

2. How much in capital expenditures does it take to sustain a production level at 43,000 boepd, or even to expand it to 46,000-49,000 boepd? If the company decided to pare back capital expenditures, how fast would production decrease? The large problem with the wells the company is producing is that the majority of oil obtained comes from the first year – production tapers off rapidly from the initial production.

3. Is WTIC at US$85 a valid assumption? Obviously this is something the company can’t control but is an obvious factor in the market price. At 47,500 boepd, WTIC at US$85 for CAD$850M operating cash flow will drop significantly as WTIC goes lower (more than a CAD$10M decrease to a US$1 drop in WTIC!). The operating cash flow is ultimately an incomplete figure since it goes back to question #2 where you have to ask yourself how much in capital expenditures will it take to actually keep production at that level. However, they do have 8000 boepd (roughly 17% of expected production) hedged with an average floor of US$76.09 WTIC in the year 2012. This still will not protect them from more significant decreases in oil prices.

I still believe Petrobakken equity is trading above fair value. They will be going through a painful de-leveraging as they figure out how to cough up US$750 million in 16 months.

14 thoughts on “Petrobakken finally realizing its high leverage”

  1. Sacha – you are still missing 90% of the story: the assets and the comparable transaction values around each of PBN’s properties.

    My responses to the notes in your head:

    1. No way PBN dilutes shareholders by 38%. To assume that, you have to assume Management are inbred morons. They are not. Just look up their track record.
    2. The nature of these wells is simple to understand: 2 year payback on capital, then 23-25 years of free cash flow to the company. Everyone that knows anything about the Western Canadian oil basin recognizes the sharp decline curve of a well… that’s the nature of their business. But the IRRs are still +50%. That’s 2.5x as good as Buffett’s investment record. I’ll take that any day.
    3. You have a point on #3, but you’re not uncovering something here that is not widely recognized by the market… that the price of their product is the single most important input in the model. Something to be aware of: in ’08 – ’09 – in the middle of the worst global pullback we’ve seen in our lifetimes, oil demand decreased by only 2% (before shooting back up). Sure, oil declined to the $40 level, but that was much more a liquidity-induced puke than a fundamental shift in the demand curve. And it was very, very temporary. Can oil go to $50 in the next month? Sure, anything can happen. But you can bet your @ss it doesn’t stay there. The global supply / demand curve has shifted upwards and will dictate higher and higher prices going forward. Take this simple stat: in the US, there are 858 vehicles per 1,000 people. In China, it’s 10.

    Since posting about PBN, you’ve been right on the price, but your thesis has been weak. You’ve benefited from a 1-in-100 year spring breakup in Canada and a bear market in stocks. Here’s what I propose…

    Let’s revisit PBN in 2 years. By then, the fundamentals will have had a chance to play out your “fair value” will look rather silly.

  2. Jon:

    1. If they were to do it today, it would be a 38% dilution. If it got to the point where it was clear that they were going to do an equity exchange, the dilution would go higher, which is why it is indeed good for shareholders that management figures out their de-leveraging sooner than in January of 2013.

    2. Not really answering the question of “how much capex does it take to maintain 43,000 boepd”? IRR doesn’t make much difference when there is an overriding financial consideration, i.e. how to come up with US$750M in 16 months, and another CAD$1.1B a year after if the markets aren’t letting you borrow a dime – the leap of faith required is that credit will open up like the spring thaw.

    3. Obviously they are very sensitive to WTIC prices, along with every other oil producer on the planet. Not something the company can control to any huge magnitude (unless if you want management to speculate on crude futures, which is something an investor generally doesn’t like to see).

    I am not long or short PBN, never have been either, but obviously our diverging viewpoints is why there is a market – the shares you are buying are sold by somebody with differing views. One thing I am reasonably sure of is a dividend cut will have to occur. They cut it too closely with their credit facility and shareholders will pay the price.

  3. You: 2. Not really answering the question of “how much capex does it take to maintain 43,000 boepd”?

    Me: Let’s look at it this way… if they stopped CapEx completely then they would be a 33k boed in 12 months… that’s $500MM in FCF or $2.57 per share, assuming $80 Edmonton price (where they sell their product).

    If you look at it your way, they need to add 1500 boed per month to maintain their current production. That’s 6 new wells per month. At $3MM per well (that’s probably high), that’s $18MM per month or $216MM / year. Now, that also adds to their steady-state base of production (meaning if they stop development, they will produce at a higher base going forward 25 years). And remember how the economics of the wells work – high CapEx in the beginning. Free cash flows for the next 20+ years.

    You: IRR doesn’t make much difference when there is an overriding financial consideration, i.e. how to come up with US$750M in 16 months, and another CAD$1.1B a year after if the markets aren’t letting you borrow a dime – the leap of faith required is that credit will open up like the spring thaw.

    Me: Yes, I am looking through the current malaise and working under the assumption that – with plenty of coverage and room in their financial gearing plus assets that are highly coveted by other producers – they can find a lever to pull that will solve their non immediate financing needs. In that case, what matters is most definitely IRR.

  4. Sacha your wasting your time.

    IRR of 50% on new wells? Who is he kidding?

    Here is the problem. Every oil company in Canada has a fancy presentation that says they can earn 50-100% IRR’s drilling wells. Hmmm, if that is the case why isn’t it coming out of the back end of the company, in their financial statements? PBN has never drilled a 50% IRR well, ever. They have never, ever earned a return on equity of 50%, ever. Given their large amount of leverage you would think they would be able to do it, but they can’t. PBN’s return on capital employed is so small it’s embarrasing (if not negative).

    Who should we believe, Jon or the financial statements?

    You are debating someone who 1) doesn’t understand oil and gas and 2) doesn’t understand business.

    IRR’s are 2.5x better than Buffett… give me a break.

    Best Regards,

  5. @Kevin – ad hominem attacks are the mark of an uneducated man.

    Not knowing the difference between “you’re” and “your” confirms it.

    I suggest readers visit YOUR blog and judge YOUR ability to make a coherent investment thesis for themselves. No doubt they will be left disappointed.

  6. Hi Jon,

    Thanks for the ad hominem attack. My writing may be terrible, but my facts are right. Thanks for encouraging readers to my blog. Perhaps they will learn how real returns are actually generated.

    I thought pointing out the logical inconsistency in your IRR argument would be enough, but instead of responding you revert to insulting my intelligence. I will leave the readers decide for themselves.

    How about an actual rebuttal to the facts I raised?


  7. Kevin – Aren’t you the same guy that thought the Cardium was worth zero last year because it didn’t have any booked reserves? Funny how it is now producing 14,000 boe/d. My previous comment was simply pointing out how consistent you are. In both writing and investing.

    On IRRs… the company’s growth masks it on a per well basis, which is why you have to build a unit model to see them. Prediction: In two years, the logic of my argument will be proven out and you will take your blog down in embarrassment.

  8. Jon,

    You sound like an economist. Have you ever considered a career change?

    If anyone can make sense of Jon’s comment please interpret.

    Don’t worry, I will review their reserves report again and will measure the value created on a per share basis. Your free to ignore the facts right in front of you. That is why it’s not worth the debate. All this talking about black box unit models and future pie in the sky returns speak loud and clear.


  9. Kevin – you need to stop writing because every time you put pixels up, you confirm your lack of knowledge.

    Auditors don’t book reserves on (most) undrilled land. Therefore, when a company goes out and makes lots of acquisitions (as PBN has done), you won’t see it immediately. Booked reserves grow over time as the play is proven. If you want an accurate read on the real value of their properties, look at precedent transactions. Simple as that.

    One day you will understand, young Padawan.

  10. Why do you people treat each other with so much vitriol? How about simply presenting your argument and leaving it at that. The “reader” doesn’t need to be told to make up his or her own mind, and smarmy signoffs, grammar-nazism, and patronizing familiarity all serve only to weaken your position.

  11. I guess they didn’t want the 2 billion in debt that comes with PBN.

    The reason why markets exist is differing opinions. If you want to put 50% of your portfolio in PBN because you think it represents a great value, do so and come back in a couple years when it goes to $40 a share and gloat. I’ll be happy you did, but I don’t think it’s happening.

  12. The only thing you can say about PBN’s results is: outstanding.

    This was a big time turn-around from 2Q spring breakup.

    They are already at 47,500 per day and expect to exit 2011 at over 49,000 per day (49k was their previous year end exit number, so this is a production beat and raise). BMO’s analyst was at 39k. How wrong he is.

    Assuming a go-forward production rate of approximately 49,000 boepd (87% oil weighted), the estimated discretionary cash flow would be approximately $905 million in 2012, assuming US$90 WTI, foreign exchange of 0.975, AECO CDN$3.50 and a 5% differential. A $10 change in oil = $100MM change in cash flow.

    Analysts are expecting this year’s $900MM capital program to be repeated next year… Management gave hints it might be much less (perhaps ~$500MM). This which would mean FCF could be $400MM or more. So much for their balance sheet problems.

    Their covenants are easily being met.

    Looks like the cross-over point when cash flow will meet spending needs + dividends will be sometime in 2012 (based on $90 oil and reasonable production growth).

    Three wells have been drilled in the new plays and they aren’t saying much. That is a good sign.

    @Kevin @Sacha – you still have time to reverse course. I would suggest it’s much better to focus on this deep value opportunity than Yellow Media or BAC. Poor souls.

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