Zargon Oil and Gas – debenture offer

I haven’t written about Zargon Oil and Gas (TSX: ZAR) as they are a very obscure small oil and gas producer with some small producing properties in Alberta and North Dakota. They have been trying to sell themselves for years as they have admitted they are not at the scale where they should be a viable standalone entity.

They did manage to successfully sell off an asset a couple years ago, and in conjunction with that reduced their bank debt to zero and extended their 8% convertible debenture (TSX: ZAR.DB.A) to the future.

In this case, the future meant December 2019.

Financially, Zargon is not in completely awful shape (by virtue of the prior asset sale) but even before the collapse in Western Canadian Select oil pricing, they were barely treading water on their income statement. They are now burning cash when factoring in capital expenditures and the interest bite on the debentures. Their only major debt on the balance sheet was their convertible debenture, approximately $42 million face value. They also have a large provision for asset retirement (which suffice to say, they will not be executing on given the lack of money they have to perform such a function – reassuringly, they expect to pay for this over the next 55 years according to their financial statements!).

Because they had no other viable sources of financing, on November 2, 2018 they were forced to borrow US$3.5 million of secured debt financing at the rate of 11% to conduct a drilling operation on the North Dakota side.

I had previously took a speculative and very small (emphasis on VERY) position in Zargon debt which I eliminated immediately after reading the November 2 press release, taking a small loss.

Recently, on November 21, 2018 Zargon proposed an offer to their debenture holders to convert them at the equity price of 10 cents per share. The debenture holders would have to approve it in a special meeting.

I cannot figure out why the debt holders would agree to such a proposal, especially given the shares of Zargon are now trading at half of the proposed amount (5 cents per share). I know clearly the reason why management wants to do this – to wash their hands of a huge debt and pray that they keep control.

Unlike most of these convertible debenture offerings where the company can choose to equitize the debt, Zargon gave away that privilege in their early 2017 debt extension – Zargon does not even have the right to redeem the debentures into stock unless if Zargon equity is trading at 125% above the $1.25 conversion price, which they are nowhere close to.

Zargon is forced to pay debenture holders the 8% coupon between now and maturity. Zargon management cannot compel the debenture holders to redeem their debt for equity.

This has a Twin Butte Energy saga written all over it – if Zargon doesn’t offer the debenture holders a better deal, I can’t see this arrangement passing. They will likely threaten CCAA proceedings, but that will simply accelerate the realization of value (or whatever is left) in the subsequent bankruptcy liquidation.

The question is how much these producing assets would fetch in a fire sale in relation to the amount of debentures outstanding, net of the liabilities of the company. My suspicion is that it is more than the current implied value of CAD$16 million, but the actual realization of this would take quite some time and be somewhat dependent on a recovery in the oil markets (who knows how long that will take, if ever).

The obvious safety valve for management and the company is to sweeten the offer and change the conversion price to 4 cents a share. Instead of getting 93% of the company, debenture holders would get 97%. I am still not sure whether the debenture holders would go for this, although there is a reasonable chance they could realize more value with a flat-out CCAA proceeding, this would be more riskier than what happened with Twin Butte debenture holders compared to Zargon debt holders owning virtually the whole company if they went with a sweetened proposal.