Description
EGSR is currently trading as "EGSRE" due to a late quarterly filing (caused by a change in auditors, which was necessitated by the fact that the company's prior auditors were disciplined and forced to stop auditing public companies.) This is a very temporary situation, which doesn't alter my opinion that EGSR presents an exceptional investment opportunity.
Company Overview
I believe that EGSR offers a very high probability of a 100% return over the next year, with significant potential for much greater appreciation over a 2-4 year time horizon. I also believe that the long-term risk in this name is minimal considering the challenges they have already faced and overcome in the last 6 months, along with what appears to be a low risk drilling plan for their main natural gas production field.
EGSR is an OTC microcap drilling and production growth company that is developing its main Kentucky properties to help fuel a run to AMEX in first or second Q 2005. In addition to its primary fields in Kentucky, EGSR currently has commercial oil and gas production in Oklahoma, Wyoming and Kansas. These locations vary from proven producing offset drilling locations at conventional depths to shallow shale NG wells that have long life reserves. EGSR appears to have hundreds of millions of dollars, if not billions of dollars, worth of BTU's under their land holdings versus a 35 million dollar market cap. And as the company's cash flow ramps up throughout 2005, with significant production increases expected in every quarter going forward, the present value of cash flows also brings us to a value many times that of today's market cap.
EGSR began drilling their Kentucky wells in October of 2003. Drilling results have been very encouraging- 32 out of 33 wells drilled thus far have been successfully completed, thus giving me a high level of confidence with respect to the drilling risk at their main field. One well was temporarily abandoned during mid drilling due to a rig break down, but that well is expected to be finished successfully.
The company appears to be on its way to quick profitability. However, production, revenues and profits have been elusive thus far. The culprits have included lack of compressors, improper size of piping and the firing of their original drilling contractor. These problems have contributed to the undervaluation of EGSR, but have recently been resolved, and the company should be currently cash flow positive even before the bulk of drilling projects start commercial oil and gas production.
EGSR PRODUCTION AND RESERVES
Pulaski County, Kentucky- EGSR currently holds the land rights to 20,000 acres in this field, with 60 active wells. EGSR owns 100% of the reserves and production from 29 wells that it bought and 13 wells it drilled itself. EGSR owns half of the 20 "Bluegrass" wells that were financed through their partner, Double G, with 80% of cash flow from those wells going to Double G until their drilling costs are recouped and half of the net production (which excludes a 12.5% leasehold interest) for these wells accruing to EGSR thereafter. EGSR's Bluegrass arrangement with Double G applies only to the first 50 wells drilled.
EGSR just recently installed a new booster station in the middle of the field to help raise line pressure and add gas that is currently behind pipe to production.
The total net production from this field is currently about 500 MCFPD, but should equal at least 2000 MCFPD as soon as the gas stuck behind pipe is added to production (which should happen within a couple of weeks).
This production could increase significantly, as roughly half of the 60 working NG shale wells at the field will be reentered and deepened to hit the gas zones that have been found under other wells in the field (the majority of the wells to be reworked are solely owned by EGSR.) They are also in the process of a frac stimulation program, which could likewise increase production.
EGSR currently has about 500 PUDs in Pulaski County. Having the land rights to drill a total of about 500 wells in this field is central to the value here and our cash flow estimates in coming years. And that number may increase. I believe, because of the success of the drilling in KY to date, that the company is maintaining a low profile and attempting to acquire more property in the area before the headline success is common knowledge to competitors and local land owners.
EGSR has a rig on site that will be staying with the company for at least a year. That rig can drill at least one new well per week. If new wells average 70 MCFPD before stimulation (which I feel is a reasonable projection based on press releases in the last year and discussions with management), they should be able to be put on production at closer to 100 MCFPD, on average. If the rig drills 60 wells per year, that will add 6000 MCFPD (roughly 1000 BOE) in new production per year. I expect that as cash flows start to ramp up at the end of 2005, the company will start to bring on additional drilling rigs to complete the field development in a more timely fashion.
Whitley County, Kentucky- EGSR has 8000 acres of Dovian Shale acreage in Whitley County, with 5 active wells currently on production. Those wells are doing 280-300 MCFPD, with 200+ MCFPD still behind pipe in one of the wells. The extra production behind pipe should bring Whitley County up to 500 MCFPD, or about $270K per Q at $6.00 NG prices, once it is brought into production. EGSR expects to frac the wells in this field in the spring to further boost production. The company also plans to drill some additional wells, once cash flow picks up. These wells are more prolific and more expensive to drill than the Pulaski County wells.
EGSR currently has about 100 additional PUDs for this field. This field is a quiet ace in the hole as it is currently contributing only 300 MCFPD, but could provide large upside to future reserve growth if/when the company starts to drill new wells here.
Kansas- EGSR has a 13% net interest in the two wells drilled thus far in the first Kansas field (the main location), where it owns the land rights to 2750 acres. Those two wells are currently producing about 275 MCFPD net oil and gas to the company.
EGSR is currently drilling at 160 acre offsets to better define the field characteristics. The company can drill for natural gas at 80 acre spacing and oil wells at 40 acre spacing. Now that EGSR has found both oil and gas at this field, it should offer them the chance to drill out 12 - 20 wells in Kansas.
There also is a second field in Kansas, about which the company has conveyed no specifics.
Wyoming- EGSR's two Wyoming wells are currently producing about 50 MCFPD net to the company. They also have two more prospects in Wyoming. The first to be drilled was brought to the company by the former engineer of Kerr Magee. I believe that they own about 2500 acres in Wyoming, but the specifics regarding these two prospects are currently unknown.
EGSR has spudded the first well; however, work on that well was halted due to the end of the BLM property drilling season. They will return to the site and finish the well in spring of 2005. The well is a wildcat crude oil prospect with a vast majority of the drilling carry cost covered by outside investors.
Oklahoma- EGSR has two Oklahoma wells, currently flowing at about 100 MCFPD net to the company. Additional details are unknown.
In summary, even if EGSR doesn't drill another well this year, the company is looking at a January 2005 production run rate of at least 2000 MCFPD, which is equal to about 320 BOEPD. That compares favorably against the 30 - 40 BOE rate in January 2004. I expect that they will exit 1Q with close to 500 BOEPD. With production at that level, they should be able to expand their production with internal funding as the wells in the Pulaski County field only cost $40K to $50K each in capex.
RESERVE PROJECTIONS
EGSR should be able to book 250 to 300 MMCF in proven producing reserves for each well drilled in KY this year. With 30 new wells drilled, they will have added 6.6 BCF of proven producing reserves (assuming current market rates of $2.31 million dollars per flowing billion cubic feet)- $15 million dollars in just the KY field. Assuming continued drilling success, each subsequent year should show massive increases in proven producing reserves.
They also own 30 additional wells that should each have 100-250 MMCF of reserves associated with them. Once they have re-drilled those wells to the deeper zones, they may yield reserves at a comparable rate to the 30 newer wells. That should lift the Kentucky fields to at least 10 BCF in proven producing reserves just from the 60 wells currently in production.
They should be able to book about 4 BCF in Kansas by year end, with a new well to be spudded in the first week or so of the new year. That is worth $9.25 million in flowing reserve value currently, with additional reserves to be developed as the field drilling schedule expands next year.
The above are new reserves generated this year. So, based on current market conditions, the value added to their reserve bottom line this year alone nearly equals their market cap. There is also every reason to believe that next year's drilling should blow the lid off these reserves and easily make these numbers seem small once multiple fields are developed at the same time.
FINANCIAL PROJECTIONS
Not only does this company have a very impressive base of assets by which to grow production, it also has a low-risk, high return on capital drilling plan in place that will provide the company with an impressive level of cash flow in coming years. The Kentucky fields will be the main driver of production and cash flows. In 2004 the company has drilled 33 new wells on these properties with a success rate of nearly 100%. Current KY land holdings (or lease rights) are estimated to be enough property to drill nearly 500 wells in total. So let's start by illustrating the return on capital provided by just one shallow well in KY:
The cost of each well is around $40K to $50K, but let’s say $50K CAPEX per well to be conservative. I estimate, based on press releases and management's comments, that each well will come online at approximately 100 MCFPD on average after stimulation. I assume well production drops off at 15 MCFPD each year and stabilizes at 30 MCFPD indefinitely (traditional gas pockets won't last forever, but the residual shale production has an extremely long life- pure shale production generally lasts over 100 years).
Average commercial production of 100 MCFPD leads to a 100% return on invested capital in about 90 days of production for each well. The net present value of the first three years of cash flow for each well, discounted at 10%, is approximately $460K based on $6 gas prices.
Yes, you read that right...the present value of cash flows for only the first three years of the well's production is worth $460K after having invested $50K per well. Each well will pay for itself 10 times over within approximately 4 years. And each well, after being on production for just a very short time period, also will provide enough cash flow to fund additional wells with internally generated cash flows. Accordingly, while the cost of each well is certainly a big factor, I do not believe that the company will have to go to the capital markets to fund the cost of the actual wells.
Total CAPEX to build the gas pipeline and collection system to fully develop the KY field is estimated at $2.5 to $3 million (this doesn't include the cost of individual wells, only the pipeline and collection infrastructure). The company has warrants outstanding from the early 2004 private placement that was used to originally fund the initial development of the KY properties.
When EGSR's stock trades at or above $.85 for a period of at least 5 days, the company can require the warrant holders to exercise these $.50 per share warrants. This will allow Energas to raise roughly $2.5 million. Therefore, I don't anticipate that the company will access the capital markets for anything that would make a material difference to the current capital structure (until such time as they decide to pursue production expansion opportunities outside of current land holdings). I believe that there will be no more than 50 million shares outstanding even when the KY field is fully developed, and the company should be essentially debt free considering that today's balance sheet is mostly debt free.
I also took my modeling one step further and tried to do a rough estimate of what this company will look like once they fully develop the KY property with 500+ wells. The following assumptions were used to build long term cash flow projections:
1) Starting very soon (likely within the next month), an average of 5 wells per month are drilled in KY (they have at least one drilling rig secured full time for the next year). In December 2005 they will have the resources to add a second rig and drill 10 wells per month. In December 2006 they will have the resources to add a third rig and drill 15 wells per month.
2) Starting in the quarter beginning Feb 2005, one well per quarter will be added to the Kansas property (this will be funded mainly by partners).
3) I estimate that Kansas wells will come online initially at 150 BOEPD (20 net to EGSR) and total well production will decline 15 BOEPD each year.
4) Kansas land holdings allow for 11 total wells in time.
5) The company will maintain EBITD margins of 65%. This ratio appears appropriate based on EBITD margins of others in the sector (with heavy NG interests) including APA, APC, BR, DVN, EOG, and EPEX as examples. The simple average EBITD margin for these six companies in the trailing 12 months, as reported by Reuters, is 67%.
6) Operating expenses (35% of revenue) were calculated using total revenue with $35 oil and $5 gas commodity price assumptions. This should be closer to the commodity price average TTM and allows for commodity price changes in the model (different commodity prices should not materially affect operating expenses).
Using these assumptions I modeled both the monthly and the quarterly results for the company. I determined that it will take approximately 3.5 years to fully develop the Kentucky and Kansas properties. More importantly, the projected operating cash flow from these properties, once fully developed, is what we want to know.
Assuming $40 oil prices and $6 gas prices (slightly lower than today's commodity prices), this model shows that the company will have a run rate of roughly $88 million in revenues and $62 million in annual EBITD approximately 3.5 years from today. With only 50 million shares outstanding, a multiple of just 5 times EBITD suggests that the stock could have a fair value of roughly $6 per share in as little as 3-4 years. Here is our projected run rate for revenue / EBITD for the following time periods without the company adding additional land assets:
Annual revenue run rate (millions):
1-31-06 $ 19.3
1-31-07 $ 45.0
1-31-08 $ 77.6
Annual EBITD run rate (millions):
1-31-06 $ 13.6
1-31-07 $ 31.9
1-31-08 $ 55.0
While I believe that we are in an energy bull market, sustained high oil and gas prices are not necessary for EGSR to be a successful investment. I modified the model to determine how $30 oil and $4.50 gas prices affected the projections. This scenario still yields an annual EBITD run rate of $40.5 million once Kentucky and Kansas are fully developed. Again at just 5 times EBITD, this suggests a fair value for the stock of nearly $4 per share in 3-4 years even if oil and gas commodity prices revert to relatively cheap levels. I will let you make your own decisions as to where you see oil and gas prices going in the future. But, for reference, in 2003 NYMEX natural gas prices averaged a record $5.50 per MCF and have averaged $5.84 per MCF to date in 2004 according to FirstEnergy Capital Corp. And short-term contracts have recently been trading hands well north of $7 per MCF.
Essentially, I am saying that higher gas prices would merely be icing on the cake, and not a factor crucial to the investment thesis here. The main risk I see with this company would be complications with building out the gas collection and pipeline infrastructure and availability or increasing costs of drilling rigs. Of course, when drilling for oil and gas you are never guaranteed to be 100% successful. However, the type of shallow drilling EGSR is pursuing in KY along with a 2004 drilling success rate of nearly 100% on 33 new wells leads me to conclude that this is a low risk, high reward long-term investment.
Catalyst
1) Eye-catching operational improvement is expected in every successive quarter for at least the next 3 to 4 years. The company (having mostly resolved its many production issues) should ramp production impressively, and become increasingly profitable and cash flow positive.
2) Additional reporting of production rates, both in total and on individual new wells now that Kansas and Kentucky drilling is set to begin again.
3) Releasing reserve estimates for the KY field, which should be somewhere between very impressive and astounding due to the shale deposits the company owns. Once those reserves estimates are calculated and released (sometime in February, most likely), it will be obvious that EGSR is trading at a fraction of its true value.
4) Moving to AMEX, which will bring EGSR into the mainstream and allow it to follow in the footsteps of other quality small cap O&G stocks (TGA/ TMXN/MSSN/CNR/FPPC/TRGL/EGY/ASPN, etc) that have blown up over the last year. EGSR is one of the few small cap O&G "sleepers" left, and the stock should be bid up aggressively as the EGSR story becomes better known and institutions/hedge funds get into the action. AMEX listing requirements are met (pursuant to rule three) at a stock price just above one dollar.
5) Possible acquisition of additional acreage.