Description

ATPG has been repriced by the market over current production run rates.  The market’s near term focus has created a tremendous value opportunity to purchase ATPG at less than 2x 2009 cash flow, or under 1.6x 2010 cash flow.

ATPG is an oil and gas development company operating in the Gulf of Mexico and North Sea.  Both areas are politically stable for oil and gas operators, negating the risks associated with more far flung companies operating in West Africa or the Middle East.  ATPG has a fairly unique business model of developing acquired assets with logged, probable, and proven reserves.  This is not a company engaged in virgin exploration, but rather a company exploiting the assets that either don’t fit a former owner’s strategic plans, or a former owner’s lack of capital resources for the development process.  As a result, ATPG has a 98% success rate in bringing its undeveloped properties to commercial production.

ATPG’s strategy is focused on a system of ‘hubs’, which bring synergies to the cost of exploiting surrounding leases.  ATPG will have its own leases around such hubs, but can also process oil and gas for third parties.

Terminology:  Mcf is 1000 cubic feet of gas.  Mcfe is the 1000 barrel of oil equivalence to 1000 cubic feet of gas…multiply the number of barrels of oil times a factor of 6 to reach an Mcfe number.  MMcfe is million cubic feet of gas equivalent.  Bcfe is billion cubic feet of gas equivalent. 

The present problem:

ATPG made a great deal of noise about achieving a daily rate of 300MMcfe/day of production by the end of 2007.  Part of this was driven by expectations of a near 60MMcfe/day run rate for the W-1 Wenlock gas well located in the North Sea.  ATPG announced the W-1 well was online as of December 6, 2007 and had tested in July at 58MMcfe/day, with production rates expected near or even above that level.  On December 13, ATPG announced the Kilmar K-3 gas well was completed and tested at 45MMcfe/day.  On December 20, ATPG announced it had reached and exceeded its company-wide goal of 300MMcfe/day production rate for yearend 2007.  The market ended the year with ATPG stock priced at $50.54/share. 

Through January 17, ATPG fell a little over 7% to $46.85, in line with overall market weakness.  On January 18, ATPG announced that it had achieved record Q4 and full year 2007 production.  It mentioned that 2008 YTD production rates were around 260MMcfe/day, and that Wenlock W-1 was running at around 40MMcfe/day due to an unknown issue.  The tone was clearly indicating run rates versus peak production, and the market was not happy with this shift, as the prior emphasis on production ‘goals’ apparently led many to assume a peak level of production equated to sustained production.  The market took ATPG down 11.5% on the 18^th alone, and it has now settled 21% lower in one week at $36.87.  On January 24, company officials in an investor presentation did not rule out a reservoir issue with the W-1 well, but believe a more likely problem is somewhere in the hole or subsea equipment.  Time is needed to further evaluate the situation, and more information will likely be available by the end of February.

Yes, one can fault the company for pushing the 300MMcfe/day figure too hard, and one can remark on the market’s foolishness of dinging the company 21% on a 13% drop in daily production.  But in its haste to punish ATPG over these near term issues, the market is ignoring the company’s understated assets and future production increases that WILL occur in the next couple of years. 

Present Undervaluation:

ATPG shares are now priced below where they were two years ago when full year 2005 results were announced.  Back then, the full year 2005 production was 19.9Bcfe of oil and gas.  For 2007, production is 63.5Bcfe.  In 2005, gas sold during the year averaged $7.46/Mcf, and oil sold during the year averaged $41.90/barrel.  Converting the barrel price to a Mcf equivalent, shows the company averaged a realized price of $7.37/Mcfe on all production in 2005.  By contrast, in 2007 the price realized per Mcfe is $9.30.  In the two year interim, ATPG went from 31.13MM fully diluted shares to 37.27MM fully diluted shares.  So, the share count is up 19%, but production is up 219%, realized revenue is up 303%, and the stock in two years is down 6.5%.

The Near Future:

So on current run rates ATPG is substantially cheaper than two years ago, but what is the future outlook?  The market was enamored with the thought of advancing production rates year over year past 2010.  The confusion appears to be over what numbers one should use for those rates.  ‘Peak’ production rates became adopted as average rates and may have led to overestimating the future.  Real world experience for ATPG includes the occasional hurricane which can temporarily curtail production, low prices in the summer for gas in Europe which can result in voluntary curtailment of North Sea gas production, suspensions of production while facilities are being upgraded, decrease in flow rates of existing wells as they age, delays in achieving production, and yes, the possibility a well won’t flow at an expected rate at a given point in time.  So the future outlook needs to use a conservative view of average daily production rates.

With respect to price, there are the opposing forces of supply and demand, global economic expansion and higher energy use, or perhaps some recessionary downside in consumption.  There is the threat of supply disruption in politically unstable Africa and the Middle East.  I can’t predict absolute prices 2 years out, but in subjectively weighing these forces, it isn’t difficult to conclude that price is more likely to run in a $60-100 price for oil, than fall back to $40, and gas is more likely to run $7-10, than fall back to $5.

ATPG hedges the cash flow from future production with substantial forward sales, and a backstop of puts for a floor on some additional production.  For 2008, based on a 250Mcfe/day average rate of production, or 91.5Bcfe for the year, ATPG has already sold 61.4Bcfe on forward contracts, at an average price of $10.03/Mcfe.  That’s 67% of probable 2008 production (using guidance from the January 24 investor presentation) locked in at a price nearly 8% higher than that realized in 2007.  So, one should expect an above average financial performance relative to the effect of conservative production volume increases.

The Numbers:

I’ve spent some time on a verbal description of now versus two years ago and the coming year simply to show ATPG is cheap on previous valuations of the company.  But an investor is buying the longer term future.  That story has always been based on growing production volumes as the dominant theme.  The market seems to think the recent news throws all of those expectations in to question.  The market has it wrong.

Production volume step increases remain in the cards over the next several years.  Al Reese, the CFO, and lead person in communicating the company’s story, strongly suggested an average daily production figure of 250Mcfe/day was appropriate for 2008 in an investor presenatation on January 24^th.  ATPG has many opportunities to build on that level of production going forward.

Assuming smaller projects (like those on the continental shelf and smaller hub areas) will offset production declines from existing wells, the key areas for future production step-ups are the Telemark and Canyon Express hubs in the Gulf of Mexico, and the Cheviot field in the North sea.

Telemark will first come on line in late in 2008 or more likely early 2009 (Things happen in complex projects.)  The production facility, called a ‘MinDOC’, being installed in the northern part of this area will have an initial capacity of 25,000 barrels of oil/day and 50MMcf gas/day throughput.  I assume 50% of this capacity will be used in 2009, for an increase of 36.5Bcfe production for 2009 from this source alone.  Then by mid 2010, a second MinDOC will enable production from the southern portion of this hub in the AT63 lease block.

The timing on incremental production in the Canyon Express hub I’ve held off until 2010.  ATPG plans to have a rig onsite by 2009, but could accelerate this into 2008.  I assume no production increase until 2010.

The Cheviot Field in the North Sea will not likely come online until late 2010 or early 2011, but as this is the single largest reserve for the company it is out there as a further substantial step-up to production.

Throughout the next two years, there will be further well development in the Gulf shelf areas, as well as the Tors and Wenlock hubs in the North Sea.  Third party production will added in 2009 at the Gomez hub in the Gulf, the company’s largest current production site.  

So in modeling the next few years I use 91.5Bcfe of production in 2008 based on the numbers from the January 24 presentation, add only the 36.5Bcfe of production from Telemark to reach 128Bcfe in 2009 (351Mcfe/day), and ramp production for 2010 to 155Bcfe (425Mcfe/day) based on likely additions at Telemark, Canyon Express, and the North Sea during the year.  These rates are 15% lower than daily rates I’ve seen in the past from a variety of sources.  This reflects the reality of the business occurrences described earlier.  I’ve not incorporated any upside for recent acquisitions during 2007 lease auctions, nor do I assign any value to the likely substantial increase of proved and probable reserves (based on acquisition and development activity in 2007) to be reported for year end 2007 on February 29^th.

In modeling financial performance I use the hedged revenues reported on January 24 in the appendix of the investor presentation and make price assumptions for the unhedged production at a $9.00/Mcfe level.  (That is 10% below 2008 hedged prices.  Gas runs lower than $9.00, but this is equivalent to $54 oil.  ATPG has already hedged some 2010 and 2011 oil over $68.)  One of the underlying keys is EBITDA margin.  As production volume and price have both increased, and volume will continue to increase, I expect EBITDA margin, which likely hit 73.8% for all of 2007, to move to the upper 70s in the years ahead.  This is critical as essentially I’m modeling to determine cash flow.  Management has indicated the strong possibility of placing some of the floating production infrastructure into an MLP or similar deal that would free up capital.  I don’t explicitly utilize such an event, but I do believe it is reasonable to believe that along with cash generation from operations, this event would provide a cushion to suggest no additional debt is likely to be added.  This stabilizes cash interest expense in the model.  Cash taxes are a challenge.  ATPG has NOLs both here and in Britain, and with the vagaries of oil industy taxation may continue to be a deferred tax payer in the US.  I include some modest cash tax payments in 2009 and 2010.

The results of this approach shows ATPG generating EBITDA of $634MM, 934MM, and 1098MM in 2008-2010.  Cash flow from operations (ex working capital changes) of $522MM, 718MM and 870MM is realized in 2008-2010.  This is $13.99, $19.28, and $23.35 per fully diluted share in each of those years.

This is not a free cash flow story as development costs are substantial likely ranging from 600MM to 775MM in each of the three years.  Still, ATPG should likely reach positive after tax free cash flow by 2010 on this very conservative set of assumptions.  In the meantime, cash balances will fluctuate, but debt should be stable.  I reiterate, the stock presently prices at less than 2.0x 2009 cash flow. 

Stock Valuation and Return:

If one uses a cautious 4.5x EV/EBITDA valuation on the above generated EBITDA numbers, then EV in 2008-2010 will be $3076MM, $4189MM, and $4941MM respectively.  Net debt varies, but clusters around 1300MM.  The actual market caps produced from specific net debt levels each year are 1765MM, 2829MM, and 3686MM.  On a fully diluted share base of 37.27MM, we get a share price of $47.37 for 2008, $75.90 for 2009, and $98.90 for 2010.  The stock closed at $36.97 on January 25.

The market is focused on a near term ‘disappointment’ on production rates.  But as is so often the case, this permits those with a long term view to profit handsomely when Mr. Market regains his senses.

Disclosure:  the author may buy, sell, or hold securities in ATPG at any time.

Catalyst

Near Term: February 29 report and CC on full 2007 results, update on proved and probable reserves, and more detail on production increase plans and update on Wenlock W-1 issues.
Long Term: Further development of existing oil and gas assets for significant increases in production.