ATP Oil & Gas Corporation (Ticker: ATPG)

For those who believe in buying when there’s blood in the streets, few areas today would seem to be “bloodier” than businesses associated with deepwater drilling in the Gulf of Mexico. We think one opportunity that has arisen from the carnage is that of ATP Oil and Gas Co. (ATPG), whose stock we believe is worth $20-$40 per share (2x-4x the current price) despite its 60% plunge over the past two months.

In our opinion, ATPG’s current share price values all of the company’s proven and probable Gulf of Mexico (GOM) deepwater reserves at a 65% haircut assuming $70 oil and $5 natural gas. These draconian assumptions needed to justify the currently depressed stock price indicate that the downside in ATPG shares is well protected no matter how long the GOM deepwater drilling moratorium lasts, and it is important to note that the company has net assets other than those specific deepwater GOM reserves.

Since ¼ of U.S. oil production comes from deepwater GOM, we firmly believe the necessity of tapping domestic oil resources will eventually open deepwater GOM for drilling again, thereby not permanently impairing a significant amount of the $4 billion of ATPG’s pre-tax proven and probable oil and gas reserves in the area. In the meantime, we estimate ATPG is currently break-even and has over $350 million in cash and available credit with no major debt maturities until 2015. In the event the deepwater GOM drilling moratorium is lifted, the potential upside in ATPG shares is extraordinary.

Company Overview

ATPG is an oil and gas development and production company (rarely does exploration) that utilizes a hub model to gain economies of scale for its own leases and those of third parties nearby. As such, ATPG invests major capex into a central infrastructure (including platform) near a cluster of its own leases and then proceeds to buy or develop other attractive reserves in the same vicinity at attractive prices. The company has a consistent history of growing proven and probable reserves (at a 20% CAGR over the past five years). ATPG operates 99% of all of its proven reserves (on a PV-10 basis) which allows the company control of development timing and correlated costs.

ATPG owns two re-usable floating platforms worth approximately $984 million ($834 million net of GE Finance’s 49% SPV ownership): ATP Innovator is currently used at the Gomez Hub and ATP Titan is currently used at the Telemark Hub (both in the GOM). A third platform called Octabuoy will have a total installed cost of $600 million ($150 million already invested with $99 million deferred), is nearly 60% complete, and is intended for placement at the Cheviot Hub (North Sea) in 2012. These floating platforms are re-usable and have useful lives exceeding 40 years in water depths from 300’ to 9,500’. As an example, ATPG estimates that only 30% of the useful life of the ATP Titan platform would be used under its current plans in the GOM.

Why is ATPG so Cheap?

We think it is fairly obvious that the unmitigated disaster that is the BP oil spill and the desperate moratorium imposed by scrambling politicians have led to excessive pessimism priced into ATPG’s shares. We think a temporary moratorium to ensure safety makes sense, but the market seems to be worried (in ATPG’s case at least) that there is an extremely high likelihood that deepwater Gulf of Mexico drilling is forever banned. This pessimism is compounded by somewhat misleading trailing financial statements (due to a recent doubling of production and major debt refinancing), $16+ million in insider sales around $20 per share (before the BP spill), and a spotty record of operational disappointments and equity dilution over the past few years (please see two previous VIC write ups).

As a result of the GOM deep water moratorium, ATPG must delay three wells slated for the second half of 2010 (MC941#4, MC942#2, MC305#2) while it can continue completion of two wells (MC941#3, MC754#1). Thus, April’s daily production of 27k BOEPD (double 4Q09 production) should be relatively stable for the remainder of the year (achieving 9+ million BOE in total production).

We think Mr. Market’s pessimism is entirely overblown since 1/3 of the nation’s domestic oil production is from the GOM and 80% of that GOM production is from deepwater GOM activities. Ultimately, we believe it is a question of “when?” rather than “if?” drilling is allowed to proceed in the deepwater to stabilize and/or grow what is currently ¼ of total U.S. oil production. That said, however, deepwater GOM drilling being allowed again is NOT necessary to have ample downside protection in the stock at this price.

Valuation using NAV

ATPG has 212 million BOE (58% oil) of proven and probable reserves (62% in deepwater GOM, 32% in North Sea, and 6% in GOM shelf) valued at a pre-tax PV-10 of $4.4 billion at $70 oil and $5 natural gas. These proven and probable reserves have been growing at a 20% CAGR over the past five years and we expect them to continue growing (although we assume no additions to 2P reserves for the valuation below). In addition, ATPG owns three floating platforms and related infrastructure worth approximately $1 billion net of GE’s $150mm minority interest. The company’s total long-term obligations (net of cash) are approximately $1.95 billion (after adjusting for the April financing). There are 51 million shares outstanding (and an additional 6.3 million shares in dilution if the $140 million preferred is converted at $22 per share). ATPG’s current after-tax NAV including proven and possible reserves at $70 oil and $5 natural gas is approximately $36 per share:

The valuation assuming $70 oil and $5 natural gas is rather conservative since futures prices are still well above that level (and ATPG hedges a lot of its annual production). Prices for oil and gas are off about 4%-7% from the YE 2009 price deck, but using those prices, the after-tax 2P values would go to $4.5 billion (for a total NAV of $60+ per share), and values are presently closer to that than $70/$5. Slide 12 of the Company’s April presentation has these numbers.

This analysis also tells us the draconian discount currently priced into the stock: ATPG’s equity is conservatively worth over $2 billion, yet its market cap is less than $500 mm; therefore, applying the $1.5+ billion discount entirely to the after-tax deepwater GOM 2P of $2.3 billion implies a 65% discount. We believe this is far too harsh for what could very well be just a temporary delay to development plans.

While we aren’t sure how long the moratorium might last nor how much the new standards might increase costs, we are highly confident this haircut is too steep. Just as doing nothing was not politically feasible, however, it could be political suicide to either permanently ban deepwater drilling or make the process cost-prohibitive (under which scenarios they would likely need to compensate companies some value for their leases and capital investment – after all, even Venezuela compensated companies for nationalized assets). Just read these articles to see the brewing moratorium backlash:

http://www.nola.com/opinions/index.ssf/2010/06/louisiana_deserves_answers_mr.html

http://www.nytimes.com/2010/06/05/us/05gulfecon.html

Entrada

The above haircut on deepwater GOM reserves is actually understated since ATPG recently spent $0.3 million acquiring GOM leases for a project near a Conoco field whose previous operators had booked over 30 million BOE in proven reserves and over 50 million BOE in proven and probable reserves. Thus, we think this is low hanging fruit that is likely to add to ATPG’s proven and probable reserves by year-end.

Production Growth and Cash Flows

ATPG just released updated guidance for 2010 production of between 9 million and 10 million BOE, which is down from pre-moratorium guidance of 12 million BOE, but up from 5.9 million BOE in 2009. In fact, daily production as of April had already doubled from 4Q09, hitting 27k BOEPD. Before the moratorium, ATPG was guiding for daily production to hit 50k BOEPD in early 2011 and enter 2012 at around 75k BOEPD. At 75k BOEPD, we believe ATPG would be generating around $10 per share in CFO with most major capex expenditures behind it. Once ATPG’s Telemark #4 well is completed by 3Q (not subject to moratorium), this daily production number should climb even further. We believe ATPG will be profitable at these production numbers since ATPG earned $1 per share in 2007 at similar production levels (adjusted for a higher share count now).

The company also updated its capex guidance for 2010 to be around $500 +/- $25 million for the full year. It is important to note that $240 million of this was already spent in 1Q ($77 of which was non-cash vendor financing) and $140 million of the total is non-cash vendor financed. Thus, ATPG is only due to spend another $200 million in cash capex for the remainder of 2010, far below its $370 million in liquidity as of end of 1Q (when adjusting for April’s financing).

Liquidity

In a stroke of luck, the day before the BP oil disaster ATPG closed a $1.5 billion note due in 2015 at 12% interest. These funds paid off existing bank loans and provided a net $131 million in cash to the company to go along with its $140 million in cash on hand at end of 1Q (the $45 million of restricted cash was largely freed up subsequent to quarter-end, explanation is given in the Q). In addition, ATPG closed a $100 million Senior Secured First Lien revolving credit facility from which it has not drawn. Just as ATPG was able to finance half of its ATP Innovator platform, we believe it is possible they will be able to finance up to half of their ATP Titan platform, potentially freeing up to $340 million in additional cash in the next year. Our confidence is bolstered by management’s comments on the May 6^th conference call (two weeks after the spill): “We continue in negotiations with [the ATP Titan financing], and I have not heard any pushback from the entities that we are talking with on that. So it does not appear that there would be any direct or indirect impact as a result of the conditions in the Gulf…At this particular point - I do not want to count chickens before they hatch - but, as I see it, I do see it moving forward.”

In a highly unlikely worst-case scenario of a permanent deepwater moratorium in the GOM, it’s possible that ATPG could sell its partially completed Octabuoy platform and move its ATP Titan platform to its leased acreage in the North Sea (assuming current GOM production had tapered off), sell/lease its ATP Titan platform and proceed with current North Sea Octabuoy plans, or just move ATP Titan to a new hub somewhere else in the world. We have confidence these platforms have retained most of their value since GE was willing to buy 49% of ATP Innovator at cost two years after its in service date.

Insider Ownership

ATPG’s management owns 13% of the company’s shares outstanding. Management sold $16+ million worth of shares in January of this year, however. Two directors bought 2.5k shares on the open market a few days ago. To us, this respectable ownership and the large margin of safety in the share price offset management’s having been accused of over-promotion in the past.

Oil Price Risk

ATPG hedges some of its production, but you can hedge out the rest of the oil and natural gas price exposure if you wish. ATPG has crude swap contracts valued at over $400 million and natural gas swap contracts valued at over $50 million as of April, representing approximately 2/3 of 2010 production.

Disclosures: We and funds we manage own shares of ATPG and disclaim any responsibility to update our ownership status. Please do your own due diligence as we have lost money before and ATPG’s shares may lose value.

1) 2Q financials showing good liquidity and ramping revenues

2) Financing 49% of the ATP Titan for as much as $340 million

3) Entrada reserve estimates increasing 2P reserves by a double-digit percentage