Description

 Amplify Energy (ticker: AMPY) is a collection of disparate E&P assets that produce roughly 28k boe/d (37% oil, 46% natural gas, 17% natural gas liquids). The company’s operations consist of high operating cost, low decline, long-lived conventional oil assets; as well as mature shale gas properties that are now in the slow decline phase of their lifecycle. Maintenance capital spending to maintain the integrity of the assets(not to maintain level production) is relatively low at $10MM or less per year.  In response to COVID-19, the company eliminated its $34mm recurring dividend and the stock is down over 85% - at $0.80 per share, the market cap is $29mm and the company has $259mm of net debt.

AMPY shares at this level of strip pricing in my opinion offer clear equity value of more than $3 in addition to offering a free call on improving oil and natural gas/NGL prices

Thesis

1. Unlike almost any other E&P that is mostly gas or mostly oil, the asset base in the aggregate is leveraged to both oil and to natural gas pricing – investors do not have to choose one fuel versus the other. 

2. The company’s equity value has been greatly enhanced by the jump in natural gas pricing.  The natural gas market is highly dependent upon supply associated with shale oil drilling. Decline in shale oil activity has contributed greatly to strengthening of the forward curve for natural gas 

3. The time value of the option on the company’s long-lived, low-decline oil assets is extreme 

4. Solvency risk is being reduced as they aggressively deleverage.

At this stage in the lifecycle of US oil production, natural gas provides a natural hedge against oil for E&Ps that have exposure to both.  Much of the growth in natural gas demand has been met by increased supply that is associated with shale oil production. The rapid growth of shale oil brought with it enormous amounts of natural gas, but as a low value byproduct. This led to negative gas pricing in the Permian and created a glut that drove prices below break even for many pure play gas producers. This natural gas associated with shale oil drilling came as an afterthought, but it now accounts for one-third of total US natural gas production.   At $40 oil pricing, I believe it will be impossible for US shale basins to produce oil at levels seen in late 2019 and early 2020.  Indeed, recently big operators from EOG, FANG, PXD to the majors have indicated they will not grow oil production in an oversupplied market. WHile they may hold production flat, hundreds of smaller operators, including the most reckless PE sponsored operators, are going to shrink production and will be forced to go into run off.  Drilling Rig counts are currently too low to offset natural declines – higher oil prices are required to incentivize meaningful new drilling. Absent higher oil pricing, natural gas production associated with shale oil drilling will continue to decline.

This benefits Amplify in two ways.  First given its 63% gas/NGL production weighting, the company will see dramatically higher EBITDA going forward from its gas weighted assets that will largely offset the decline in EBITDA from its oily assets, which were previously the crown jewels.  Second, given Amplify’s oil assets are conventional, shallow decline assets that at $40 are simply in run off mode it can still generate meaningful EBITDA from these assets at $40 crude.  (For a deep description of the company’s 5 operating areas please see my previous write up on the MPO/AMPY Pro forma merger write up).

The prolific natural gas companies in Appalachia and the Haynesville shale produce negligible levels of oil, making them minimally leveraged to improvements in oil pricing. Shale oil players receive a limited boost from higher natural gas pricing. There are no single basins in the US that are positioned to benefit as meaningfully from oil, simultaneously with natural gas, as does Amplify as a whole. Most publicly-traded companies are largely dependent on either one fuel or the other. Amplify is diversified in that three of its operating areas produce almost entirely oil (98%), while its remaining two areas are largely natural gas and natural gas liquids (NGLs). It has financially material exposure to both oil and to gas, making this natural hedge a unique feature of the company 

Amplify offers extreme value in a $50s pricing environment for oil, and it is positioned to withstand current or slightly lower oil pricing given its natural gas exposure. The company trades below intrinsic value at strip pricing and thus represents mispriced optionality.

Sum of the Parts Valuation 

This break-up value methodology is applicable given that the company has assets in five different operating areas. The oil-only assets in California and Wyoming are valued on a commonly-used production metric ($15k per flowing barrel at $40 oil, sliding up and down with oil price changes) – this is based on publicly-traded comparable companies Berry Petroleum and Denbury Inc. 

For the remaining areas, the net present value (PV10) of the company’s proved developed producing (PDP) reserves is calculated at a range of oil and gas prices. Note that the below PDP value does not account for proved undeveloped reserve value, which would require new drilling capital: Based on the above, the return scenarios have an attractive risk/reward profile: 

Sum of the Parts Valuation - NO NEW DRILLING 

OIL PRICE

30 35 40 45 50 55

2.00 -0.56 0.42 1.62 3.23 4.67 7.99

2.25 0.39 1.37 2.57 4.18 5.62 8.94

2.50 1.34 2.32 3.52 5.13 6.57 9.89

NATURAL GAS 2.75 2.29 3.27 4.47 6.08 7.52 10.84

3 3.24 4.22 5.32 7.03 8.47 11.79

3.25 4.19 5.17 6.37 7.98 9.42 12.74

3.50 5.14 6.12 7.32 8.93 10.37 13.69

Current and Future Strategy

The current strategy for the company is focusing on generating cash and retiring debt. There will be no new drilling until oil and/or natural gas wellhead pricing satisfies a level where the returns on drilling would be unquestionably higher than the foregone free cash flow yield to the equity (via deleveraging). The required hurdle rate for any new projects will be high. I anticipate the only discussions surrounding new drilling would be in: 

1. The 100%-oil Beta field (federal waters offshore California), which offered extremely high IRRs on wells drilled as recently as 2015. Regulatory hurdles are formidable, but the company has spent extensive time and effort to obtain permits for this area 

2. The natural gas-weighted assets in East Texas, which offer compelling returns at $3 pricing.

(Above $3 natural gas the company can profitably maintain current levels of gas productions for many years to come given PUDs in East Texas and the Miss Lime which turn profitable at $3 gas).

Balance Sheet

Amplify’s debt consists entirely of a reserve-based credit facility (RBL). At the beginning of 2020, Amplify’s RBL balance (and net debt) was $285mm. In the face of this spring’s COVID-driven crash in oil prices, management agreed to an acceptable borrowing base reduction and amortization schedule. Amplify’s RBL borrowing base was reset at $285mm on June 12, 2020, with an agreement to be amortized by $5mm per month until it hits $260mm by November 1  

Amplify had its November 2020 amortization requirement covered by July 31, with additional deleveraging to occur into year-end 2020 

As of July 31, 2020, the company’s net debt was $259mm. By year-end 2020, I estimate that the company will have $229mm drawn on its RBL. The next RBL borrowing base determination will occur in November, and I expect use of free cash flow for debt retirement to be the priority for the foreseeable future. At current strip pricing, by year-end 2022 I project that the RBL balance will be reduced to $168mm. At that time 80% of the current proved developed (PD) reserve base will remain in place, and thus the company will have many productive years of life remaining even assuming no drilling of proven, undeveloped reserves 

Assuming $35 oil, Amplify’s two natural gas-weighted properties alone cover their debt at $2.75 for natural gas. Based on my estimates of the PV-10 of Amplify’s PD reserves for year-end 2020, and assuming $35 oil, the below table values the company’s East TX and Mississippi Lime assets at varying natural gas pricing levels:  That leaves a 10 year call options struckat $35 for the remaining assets.  At $40 and above the equity value absent the debt in the event of asset sales is $3.

Natural Gas Gas Basin

Price Value ($mm)

$2.00 $130

 2.25 166

 2.50 202

 2.75 238

 3.00 274

 3.25 310

RRC sold its East Texas/LA gas assets for $245M plus Contingent Value Payments two months ago when the gas strip was considerably lower.  Based on that sale AMPY’s properties would be worth $100M or so assuming similar price per BOE.  According to management at $3 gas the AMPY E TX/LA implied value would be closer to $150M.  A sale of those assets could allow the company to pay down debt to less than $100M while only reducing production by BOE by 35% but only 15% be revenue given ratio of oil to gas price being more than 12x vs. 6x implied by BOE conversion.

Bear Case/Risks

1.Sustained pricing below $35 for oil and $2 for gas would result in further distress.

Below these levels for say, six months, could result in a restructuring. This is an undesirable outcome for bank lenders as in a pricing environment like that, selling assets for more than they are owed could be difficult and of course banks are not set up to run the assets longer term.  In addition, unlike most energy bankruptcies, Amplify does not have any bonds to equitize and more importantly no cash flow is flowing to bond holders in form of coupon payments that could go to senior bank lenders.

 2. US shale oil will roar back at north of $50 per barrel 

Given the lack of external capital available to the energy industry and investors’ demand that US shale drill within internally generated cash flow, I do not believe that this is likely in the $50s for oil. However in this higher oil price scenario, AMPY would hedge many years of oil production at those levels and achieve an extremely attractive outcome. The company’s oil production carries a sub-10% decline rate and it has 14 years’ worth of PD oil reserves. This compares favorably to the very best shale oil names, which I estimate hold 5-7 years of PD oil reserves.

3.Overhang

Fir Tree Capital Management holds 25% of AMPY’s shares outstanding. They are willing sellers of their block and have sent that message to the market by selling bits and pieces and filling a few Form 4s after every sale. The acquisition of these shares would almost surely come with their two Board seats, which at this time constitutes 40% of the Board of Directors. Given the state of energy as an uninvestable asset from ESG perspective along with general negative sentiment on oil use due to COVID work from home, destruction of air travel etc, we have yet to see a buyer show up despite what I see as an incredible risk/reward proposition. 

Operating and Financial Projections Assumptions:

Current strip pricing for oil and natural gas and no new drilling. The company has significant hedges in place for the remainder of 2020, which locks-in operating cash flow for the year 

Note: A $5 change in oil pricing or $1 change in natural gas represents roughly $20mm of EBITDA in 2021

2H'20 2021 2022

Realized Prices

Oil $38.00 $41.00 $42.00 

Differential (4.00) (3.00) (3.00)

NGLs 11.34 15.05 15.75 

% of Oil 27% 35% 35%

Gas 2.00 2.40 2.20 

Differential 80% 80% 80%

Market Prices

Oil $42.00 $43.00 $45.00 

Gas 2.50 3.00 2.75 

Production

Oil 11,000 10,506 9,981 

NGLs 4,500 4,000 3,640 

Gas 72,000 65,000 59,150 

Total (BOE) 27,500 25,339 23,479 

% Oil -8% -7%

Revenue

Oil 76,912 157,222 153,004 

NGLs 9,390 21,973 20,925 

Gas 26,496 56,940 47,497 

Total 112,798 236,135 221,427 

Expenses

LOE 60,000 110,986 107,123 

per BOE $11.86 $12.00 $12.50 

GP&T 9,361 17,157 15,898 

per BOE $1.85 $1.85 $1.85 

 Taxes 7,896 16,529 15,500 

G & A 12,000 22,000 22,000 

EBITDA 23,541 69,462 60,906 

With minimal cap ex of $10M or less and interest at less than $7M per year the company will generate more than $50M in FCF in 2021 and $45M in 2022 at current strip. This will allow debt to come down to $165M by my calculations at the end of 2022!

NAT GAS MACRO - Why I am bullish

Demand has grown consistently in recent years and has been impressive in the face of COVID-19, declining 0.9% year-to-date and turning up recently. Switching from coal to natural gas-fired electric power has been a tailwind. On the supply side, production peaked at the very beginning of 2020.

Supply fits into three categories: Natural gas-centric shale plays (Appalachia and the Haynesville); associated gas from oil shale plays; and “Other” (conventional gas and miscellaneous). According to EIA data, they broke down as follows in 2016, 2019, and 2020 year-to-date:

Percentage of Supply Gas Shale Associated Gas Other

2016 38% 27% 34%

2019 47% 33% 20%

1H'20 49% 34% 17%

Production Growth Rates Gas Shale Associated Gas Other Total

2016 8% -1% -12% -2%

2017 10% 7% -8% 3%

2018 23% 20% -10% 12%

2019 15% 20% -11% 10%

1Q'20 8% 17% -14% 6%

2Q'20 6% 0% -18% -1%

3Q'20 Estimated 1% -6% -20% -6%

OTHER: This category has and will continue to decline under most any scenario, as these are higher-cost resources that have been depleted over decades 

OIL ASSOCIATED PRODUCTION: Predictably dependent on activity in shale oil basins - without higher oil pricing, natural gas production from these sources will continue to decline. 

GAS SHALE: Production growth from the Haynesville and in Appalachia moderated ahead of associated gas, as weak pricing drove more discipline. As with oil, shale gas operators have been pressured by investors to spend capital within internally generated cash flow. It appears that $3 per mcf is the magic number for increased drilling activity in these plays.

One final note is that as LNG exports have been a drag of late, and that has also reversed - the export arb window has reopened now that global natural gas storage has declined in Asia and Europe. While not an overwhelming factor, it is material. Given the above supply factors, it is difficult to envision a sub-$50 oil environment where gas is not at least $2.75 per mcf.

Valuation

What is the equity worth currently?  I believe $40 oil and $2.75 is the accurate valuation at this point although I do feel if crude remains at $40, natural gas will rise well above $3 for the reasons mentioned above and possibly as high as $5 given shale gas plays are maturing and can’t grow enough to offset legacy OTHER production declines as well as associated gas declines.  As such I believe the equity will be worth in excess of $5 per share in that scenario next year.

Catalyst

Asset sales

Debt deleverage

Dividend Re initiation