Description

This is a small cap E&P company for value investors who want to catch the oil patch pullback. Since I’m not an oil and gas guy, I’ve provided an intuitive set of explanations and metrics that don’t require a reservoir engineering degree to evaluate. Oh, did I mention it trades below the NPV10 (more on this later) of its proven reserves and should gain 60% during 2005 and another 30% in 2006 even if oil trades at $37.5 (and, if oil falls to $30/bbl, you should get your money back and might make 20%). For those who are superstitious, McDermott International (one of the best VIC ideas of 2004) plays a significant role in the Callon story.

Callon is an exploration and production company that drills for oil and gas on the gulf coast. The company has been around in one way, shape or form since John S. Callon founded its predecessor in 1950. John is getting a little long in the tooth, but he still serves as Chairman of the Board. Not to worry though, since his nephew Fred joined in 1984 and assumed the CEO role in 1997. Fred’s appointment doesn’t appear to be completely driven by nepotism - he did get an M.B.A from Wharton in 1974 and then worked at KPMG before joining Uncle John’s firm.

The Callon’s embarked on a risky strategy in the later part of the last millennium (aka 1997/1998). They decided that they wanted to play in the biggest of the big leagues in the Gulf of Mexico – deep water drilling for $1 billion+ discoveries. The Callon’s, being good Mississippi oilmen, weren’t fazed by the fact that one well complex and development platform in the deep water cost multiples of their current equity market capitalization of $80 million. They signed up for working interests of 11% to 22% in three projects run by Murphy, Shell, and BP oil with an elegant plan to only fund the first project and then use the cash flow from that project to fund the second project and then finally to use the cash flow from projects one and two to fund project three.

Unfortunately, their plans didn’t accurately forecast three things: (1) the steep pullback in energy prices in 2001/2002, and (2) the fact that they had absolutely no control of the pace or timing of development since they weren’t operating these projects, and last but certainly not least that (3) McDermott International would be over one year late in delivering the Medusa Spar platform. These factors (McDermott’s delay being the largest) combined create a $300 million (peak) mountain of debt all due in less than 24 months and pushed the company to the brink of bankruptcy in 2002 - one could have purchased the stock for $3.20 at that time (Don’t stop reading yet, the story only has two or three more disappointments before it gets good).

After almost doubling the share count to avoid a default, the Callon’s plan finally began to work. First Medusa and then Habanero came on-line, and, by Q2 2004, production rates were high enough to reward tired investors after seven years of hype and promises. The company earned $0.58/share (even with below market hedges on all of the production) in that quarter. The stock moved up smartly to the $14/share range. The company issued some more shares and tamed its debt monster by prepayments and refinancing $200 million for 7 years. Commodity prices were booming. Even the “haters” began to wonder if the Callon’s luck had changed.

It hadn’t. In August, one of Habanero’s two wells began intermittent shut down due to problems on a sub-sea control valve designed to cut flow in the event of emergency. The problem worsened until the well was shutting down every five minutes. As the Callon’s luck would have it, this well accounted for 80% of Habanero field production and 30% of their total production.

Shell Oil, the well operator finally found a jack-up rig that was available to perform repairs on the well in September 2004 and commissioned the rig just in time for it to arrive on-site and be incapacitated by Hurricane Ivan. The rig returned to port for repair and is now on-site performing the repair work. Simultaneously, Murphy Oil, the operator of the Medusa field, announced on September 20, 2004 that the Hurricane had shut down its field for an estimated five weeks. Both of these production shortfalls at the same time disabled over 50% of the company’s production and resulted in a third quarter charge of $731,000 for ineffective hedges that company had to cover with cash absent oil/gas to deliver.

And finally, before we arrive at the 2005 silver lining in the Callon cloud (though cloud may be too charitable to describe the last seven years at Callon), we have to cover one more insult on top of the heap of injuries. Callon hedged over 50% of its planned 2004 production during the last half of 2003 resulting in a 2004 realized oil price to them of about $33.00/barrel of oil equivalent.

So where do our intrepid Callons go in 2005? Qualitatively, they go from:

- Two major fields (Medusa & Habanero) finish repairs and increase production above Q2 2004 levels when the company earned $0.58/share (hedged below market),
- Below market hedges rolling of to a hedged position that is neutral at $37.50/bbl with significant uncapped floor protection at $35/bbl,
- An exploration and development budget that allows for a tripling of exploration expense now that large development costs on Medusa and Habanero are behind company allowing company to reverse likely 2004 reserve declines,
- A new major field (Entrada) with proven reserves that will likely come on line in 2006 with likely flow of 50mmcfe/day to Callon more than replacing declines at Medusa and Habanero,
- 18 good quality exploration prospects for 2005 that allow for a real portfolio approach to risk management rather than relying on “grand slams”


Quantitatively, with oil at $37.50/bbl, the stock price doubles over the next two years as production volumes increase over 50% from 2004 levels…if oil stays above $40/bbl it gets even better…


The trajectory looks something like this (hopefully):

2003 2004 2005 2006 2007
Production (mmcfe) 13,923 21,024 27,375 31,755 34,675
- Average daily (mmcfe) 38.1 57.6 75 87 95
- Strip price per mcfe $6.25 $6.25 $6.25
- Differential $0.33 $0.33 $0.33
- Callon price per mcfe $5.29 $5.50 $5.92 $5.92 $5.92
- Callon price per boe $31.7 $33.0 $35.5 $35.5 $35.5

Revenue ($ mm) $73.7 $115.6 $162.0 $187.9 $205.2
- Lease Operating+Taxes $11.3 $18.9 $26.0 $30.2 $32.9
- G&A $4.0 $6.0 $7.1 $8.3 $9.0
EBITDA $58.4 $90.7 $128.8 $149.5 $163.2
- Depreciation $51.0 $71.2 $76.2 $78.0
- Debt Interest costs: $21.3 $19.0 $16.2 $12.9
-Taxes: $ - $ - $10.0 $25.3
Earnings: $18.4 $38.7 $47.1 $47.0
Shares 18.0 18.0 18.0 18.0 18.0
EPS $1.02 $2.15 $2.62 $2.61

Development CAPX $50 $43 $20 $40 $45
Exploration CAPX $10 $22 $60 $59 $63
Total CAPX $60 $65 $80 $99 $108

Depletion per mcfe $2.09 $2.43 $2.60 $2.40 $2.25

12/31 Reserves 217 203 226 237 249
Additions ? 15 50 43 47
Cost/addition ? $4.33 $1.60 $2.30 $2.30

Cash generated/(used) $4.4 $29.8 $34.7 $42.6
Debt $225 $200 $200 $170 $136

Equity Valuation at:
10x EPS $10.23 $21.48 $26.16 $26.11
4x EBITDA $9.05 $17.52 $23.76 $28.74
5x EBITDA $14.09 $24.68 $32.06 $37.81
$2.68/mmcfe reserves $19.81 $19.11 $22.48 $25.80 $29.53 NPV10 at $32oil
$3.25/mmcfe reserves $25.54 $29.63 $33.30 $37.42 NPV10 at $38oil

Note: 1) $6.0mm G&A 2004 is net of $2.3mm loss on debt extinguishment.
2) 2004 reserves are after an 8mmcfe deduction for royalty relief since oil above $34/bbl.
3) 2005 gas at $6.33 and oil at $38 they are neutral. At $30 and $5 they are at $33.43 and $5.25.
4) No cash taxes in 2005, 17.5% effective rate in 2006, full rate in 2007 forward.
5) $2.68/mmcfe reserve valuation based on fast depletion deep water wells at $32/bbl oil from 12/31/03 annual report.
6) $3.25/mmcfe reserve valuation my estimate based on $37.5/bbl oil.

Then again, if oil falls to $29/bbl, you should barely escape with your initial investment. Thus, goes the oil patch…

Catalyst

1) Medusa & Habanero Field Production above Q2 2004 levels by Q1 2005
2) 2005 exploration year budget allows reserve build
3) Late '05 begin development of Entrada prospect (80% production increase)
4) North Bob prospect - The last grand slam I didn't even need to mention..