Petrobakken short squeeze

For other articles I have written about Petrobakken, you can click here.

A lot of people are asking “Why did Petrobakken go up 14% in a day?”.

The quick answer is because this is a classic short squeeze, fuelled by a cascade of stop orders taking the stock up higher.

We have the following 6-month graph:

Nearly everybody that has invested money in the company is sitting on a losing position. Conversely, those that were short Petrobakken are sitting on money. In order for short sellers to maintain their fraction of PBN, they must be able to add to their short positions. Short interest in PBN has been about 3 million shares since October and about 4.8 million shares in June. Short interest in Petrobank (which owns 59% of PBN) has also been proportionately higher, so one can’t automatically assume that the short position in PBN is hedging off ownership in PBG.

Eventually there has to be a spike as marginal short players have to cover their tracks – it is nearly impossible to tell when this happen, but when they do, the liquidation is swift and sharp:

PBN continues to trade above my fair value estimate and I will continue spectating as I have no position in this or PBG. My guess, from a trader’s perspective is that there is a good probability that we will see one other sharp spike up and then the shares will continue their steady descent down to fair value. The valuation mismatch between today and what it was a year ago, however, is much less than when the shares were trading at $25. The company also still has the material financial issue of figuring out how to spend more money and issuing dividends beyond the cash flow coming in.

Petrobank / Petrobakken – How to play Petrobank

I noticed that one of the most bullish people on Petrobank (TSX: PBG) / Petrobakken (TSX: PBN) that I know of on the internet has stated they have “Caved to a moment of weakness” and increased the concentration of their PBG holdings to 40% of their equity portfolio. This is as close as you can get in finance to an “all-in” bet without actually going all-in.

I wrote about portfolio concentration in a previous post, and if your portfolio size is a sufficiently small fraction of your annual income, then making concentrated bets is not only acceptable, but ideal.

PBG owns 59% of PBN, so PBG is joined at the hip with PBN’s performance. Indeed, looking at the consolidated financial statements of PBG is quite challenging since one has to mentally sort out what PBN is doing away from the main figures and this takes a bit of work. They do some segmenting in the management discussion and analysis, but the relevant component is that PBG’s business unit does not make any revenues and spent about $54M in Q1 for capital expenditures. Also, when subtracting the market capitalization of PBG’s ownership in PBN, PBG’s price is around $40M. If you believe PBG’s operations have any value at all, it would make PBG the better bet between the two companies.

A very relevant issue for PBG is that they depend on PBN’s dividend stream to provide approximately $100M/year of cash. PBN’s dividend level is at a point where I would expect it to be dropped at some point in the future. PBG also has a mostly untapped $200M line of credit at its disposal and it has the option to selling more of its PBN stake, although I am sure management would not want to press down PBN further from current levels.

A believer in PBG’s operations (but not PBN) would likely be better served by going long PBG and shorting PBN. Calculating the ratio is an exercise in arithmetic: an investor purchasing 100 shares of PBG can offset the PBN ownership by shorting 104 shares of PBN.

Petrobakken – Bank Debt – Due 2012?

Investors in Petrobakken (TSX: PBN) are continuing to discover why yield is not something that should be chased lightly – although they are probably looking at their 6.7% current yield on the $14.27 share price are feeling smug, the approximate 36% depreciation in share price over the past year is something they likely would have not wanted in conjunction.

The latest news out of Petrobakken is something they didn’t announce. Specifically, the following comes from their last quarterly financial release (for the 3 months ended March 31, 2011):

Note 9 – Bank Debt
The Company maintains a covenant based revolving credit facility with a syndicate of banks. The facility’s lending amount has a borrowing capacity of $1.2 billion. The current term for the facility ends June 3, 2011 and can be extended by the lenders for an additional year. If the lenders were not to extend the term, the drawn amount would become due on June 3, 2012. The credit facility bears interest at the prime rate plus a margin based on a sliding scale ratio of PetroBakken’s debt to earnings before interest, depletion, depreciation and amortization (“EBITDA”). The facility is secured by a $2.0 billion demand debenture and a securities pledge of Company’s assets.

June 3 has come and is nearly three weeks past. No extension of the credit facility has been announced so it is probable that the $966 million in bank debt (which will be higher for the second quarter financial release) will be called on June 2012. So this means that the clock has started for PBN to shop around for a billion dollars of financing – will they sell more debt? Or will they give the banks some more interest?

In terms of the rate that is being charged by the banks for the facility:

The applicable margin charged by the bank is based on a sliding scale ratio of PetroBakken’s debt to earnings before interest, taxes, depletion, depreciation and amortization (“EBITDA”). The facility is secured by a $2.0 billion demand debenture and a securities pledge on the Company’s assets. The credit facility has financial covenants that limit the ratio of secured debt to EBITDA to 3:1, limit the ratio of total debt (total debt defined as facility debt plus the value of outstanding debentures in Canadian dollars) to EBITDA to 4:1, and limit secured debt to 50% of total liabilities plus total equity. The Company is in compliance with all of these covenants.

I couldn’t find explicitly what the rates were from the financial statements, but doing some arithmetic on the 2010 annual financial statements and subtracting the interest they paid from their US$750M convertible debenture issue, I believe Petrobakken paid prime (3%) for their bank debt in 2010.

You can be sure that the banks want something more than prime for this round of financing – if the renewed credit facility charges prime plus 100bps, this will be another $10M/year in pre-tax cash that will be going out the window for PBN shareholders as the cheap financing dries up.

Petrobakken continues to remain on my radar, but as I stated in my “value trap” article, even at present valuations I will not be touching it. My guess continues to be that we will see a dividend cut or even floating a very unattractive (for them) equity financing in conjunction with a renewal of the credit facility. PBN still has a market capitalization of $2.6 billion and they could sell off 10-15% of the company and raise roughly $250-$500M which would reduce the debt-to-equity and keep their costs of borrowing at prime-like rates.

Petrobakken – Watch for a dividend cut

I wrote earlier about how Petrobakken (TSX: PBN) was a value trap. After PBN reported their first quarter results, my assessment has not changed that much.

Serious investors will just look at their financials, but you can also look at their press release.

The most salient point (and note that this analysis is not exhaustive by any stretch of the imagination – I will leave it to the reader to punch holes in this summary assessment) is that the company has maintained their production at around 41,500 barrels of oil equivalent per day. However, in order to maintain this production they needed to spend about $300 million in the quarter in capital expenditures. Operationally, the company did roughly $140 million in cash, so when you subtract another $45 million out in dividends, you are left with a negative $200 million cash flow quarter.

The company is expecting to spend another $600 million in capital expenditures this year. Doing some paper napkin calculations, if you assume for the rest of the year the company will be able to maintain a rough $150M/quarter operating cash flow, a $45M/quarter dividend rate, and $200M/quarter capital expenditure rate, you are still net negative $315M cash. Their bank facility has about $240M room left. The difference in cash is a $75M gap.

If they get lucky, they can bridge this gap with increases in revenues from increased crude and gas prices or an increase in production (via drilling new wells), but their margin of error is tight. The only other realistic option that management has (since I do not foresee them doing another debt financing) is cutting their dividend.

Anybody investing in PBN for yield is going to receive a nasty shock if this occurs. Petrobakken shares do have value, but I believe they are still trading above their fair value.

He has power to move markets

John Hempton of Bronte Capital writes very entertaining articles. Most of his extensive postings are about companies that have “issues”, such as his strong suspicions of financial wrongdoing at the Chinese company Universal Travel Group (NYSE: UTA).

His latest spread is regarding Northern Oil and Gas (NYSE: NOG), which I found thoroughly fascinating, for a few reasons.

The first reason is that my earlier article on Petrobakken (TSX: PBN) and its steep decay rate of oil flowing from newly drilled Bakken-shale wells assisted his thinking with respect to NOG’s depletion rates. He is very gracious to link to my article.

The second reason is that apparently the rest of the market has “picked up” on Northern Oil and Gas’ low rate of expending of depletion and has decided to price this in (note the article hit the wires on Tuesday, although it seemingly was digested on Wednesday):

Interestingly enough, before this all hit the wires, NOG had about 20,000 shares available for borrowing at Interactive Brokers. Today there are none.

Thirdly, he writes good analysis. There is good reason to be skeptical of NOG’s management and their intentions. Even disregarding that, it does appear the valuation of the company is well above fair value. That said, the company’s balance sheet does show a net cash position (assuming those balances are truly there!), so the shares are most certainly worth something, unlike most of the other likely frauds that Hempton has been writing about.

Disclosure: No positions in any stocks mentioned in this article, nor do I intend on opening any. I’m watching this purely for entertainment value, although others likely have money on the line.

Petrobakken – Value trap

(Update, June 23, 2011: Readers may be interested in further coverage of Petrobakken by clicking here.)

Petrobakken (TSX: PBN) has been on the top of my radar screens for oil and gas companies for quite some time. The reason is fairly simple – it appears to be a high-yielding security that has a large amount of reserves and land rights. During my extensive investigations of this company during the autumn of 2010 (when the common equity was at around $23/share) I rejected PBN as an investment candidate.

The past three years of trading have had investors seen their better days in earlier times:

The drop in late 2008/early 2009 can be attributed to the economic crisis and the decrease in oil prices, but the price drop lately can be solely attributed to financial management. In 2009 and 2010 the company engaged in a series of significant purchases with companies with large holdings in the Bakken oil fields (southeastern Saskatchewan). It also has significant holdings in the Cardium (roughly northwest of Calgary and south of Edmonton). These acquisitions were very costly and ended up hurting shareholders.

The company is paying off about $180M/year in dividends to its shareholders when it is spending far above its operational cash flow to drill for more wells in order to keep its production levels steady.

The large dividend yield probably serves as a psychological crutch for investors, in addition to providing its parent company, Petrobank (TSX: PBG), with a cash stream. Petrobank owns roughly 60% of Petrobakken. This appears to be a classic example of knowing the risks of investing in companies that are majority-held or controlled – a retail investor’s interest may not be in alignment with the parent company, and when this is the case, you may receive an adverse outcome.

The big operational issue in the Cardium and Bakken fields is that your production falls off steeply after the initial drilling (as opposed to your typical Steam-assisted gravity drainage project that a company like Cenovus does):

Although the capital expenditure can be justified, the economics are not as pleasant as what most people may anticipate by looking at the “trend” of oil production based on first year results. Most of the growth in revenues has to be looked at with the knowledge that the first year of wells will be extraordinarily high, while the second and subsequent years will have slower, but steadier production.

In 2010, PBN took in about $562M in operational cash flow, but they also spent $36M repurchasing their common shares (questionable given their balance sheet), $812M in capital expenditures, $483M in corporate acquisitions (mainly for land rights discussed previously). When you net everything together, the company had to borrow $750M in cheap financing (6-year notes, 3.125% coupon) and also maintain a line of credit with a bank ($825M outstanding of $1.2B available) in order to finance all of this spending and payouts.

Although the company is producing a lot of operational cash flow (in particular, they like quoting the statistic funds flow from operations, which was $3.51/share in 2010), in order to maintain this cash flow they need to continue spending significant sums of money on capital expenditures.

The valuation then becomes a matter of determining the decay rate of the various wells drilled on the Bakken/Cardium fields and the prevailing price of oil – and there are smarter people than myself that can model the decay rate better.

Most retail investors, however, would just look at the dividend yield at the current $19.60/share and say “Wow, look, 4.9%!” and buy in, not realizing that the company has probably hit the point where it can’t borrow money as cheaply as it has in the past. If you look at the GAAP net income, 26 cents per share does not look that impressive compared to the share price. One does have to model for a significant amount of depreciation (which is a non-cash expense that represents money already paid for drilling) in order to receive a more relevant free cash-flow figure.

This is not to say that Petrobakken is not a legitimate oil company – just that to my knowledge, its equity valuation does not represent an under-valuation at present, even factoring in the existing price of oil.