Epsilon Energy is in a strange position.  There is no other E&P company that I am aware of that can confidently state the following about their business over the next year:

1) Their F&D cost will be $0

2) Their production/reserves will increase by 500%

3) The stock will have a 20% FCF yield

4) They will buyback stock

5) They have no debt and excess cash

So what in the world is going on here, why are we so lucky to be able to buy it at today’s low price?

Company

Epsilon went public in 2007 at $4.00.  The company has been a failure, having gotten involved with a dozen plays that are zeroes or are on their way to zeroes.  Without any thought to a strategy for the company, Epsilon acquired acreage in Oman, Ethiopia, New York, Ohio, Quebec, Saskatchewan, and maybe even a couple other duds I’m mercifully omitting.  Darts and a map might have been involved.  The company produces exactly no hydrocarbons from any of these plays.  They have 50m shares outstanding and a $125m market cap.

Before you put in your order to short a few thousand shares, I should probably tell you about the 11,500 acres they happened to acquire in Pennsylvania during their blind spending spree.  Management employed the throw-spaghetti-at-a-wall strategy and incredibly, there was one strand that actually stuck.  You see, Epsilon picked up their Marcellus acreage in the sweetest of sweet spots for just $200/acre.  Their acreage lies in the southwest corner of Susquehana County and is mostly surrounded by Cabot Oil & Gas and my old buddy, the master of value creation himself, Aubrey McClendon (CHK).  Epsilon’s acreage is pure, Cabot and Chesapeake are drilling their best Marcellus wells in the areas that offset Epsilon’s acreage.  This stuff is profitable at $3-4 gas. 

Marcellus JV

In late 2009, Chesapeake approached Epsilon about doing a JV on Epsilon’s acreage.  This was highly unusual for two reasons.  First, Aubrey will tell you he has 1.5 million acres of Marcellus shale, which is more than he could ever drill in his lifetime, a problem he is accustomed to having.  The guy has got Marcellus shale coming out his ears, so why should he care about little ol’ Epsilon and their 11,500 acres?  This the equivalent of Kobe Bryant asking Adam Morrison to give him some pointers on his jump shot.  Second, Aubrey has been the one to farm out his acreage, not farm in on deals.  Frankly, I think that Aubrey did it just so he could use these wells in their operations updates which highlight the best IP rates.

In January 2010, Epsilon announced the JV agreement.  Aubrey paid Epsilon the equivalent of $17.5k/acre for a 50/50 JV, easily making it the most expensive Marcellus deal to date.  The terms called for Chesapeake to make a $5m upfront cash payment and a $195m drill carry for a 50% working interest in Epsilon’s acreage.  Importantly, Chesapeake agreed to pay all of Epsilon’s share of costs up to $195m, whereas most drill carries call for the company who is farming in to pay for say, 50% of the costs while receiving a 25% working interest until the carry is spent.  It’s rare to see a company agree to pay all of the costs.  After the $195m has been spent, Epsilon is on the hook for 50% of the bills going forward.  Essentially, Chesapeake paid $100m for 5,750 acres, which means that before a single well was drilled, Epsilon’s acreage in the Marcellus was worth $4/share (= $100 / 50% wi / 50m shares)

Modeling

I’m making the following assumptions, all of which are reasonable, if not conservative: Chesapeake runs 3 rigs most of the time, 14 wells are drilled by the end of 2010, gas price averages $4.20, wells cost $6.7m on average all-in after allocating expenses for seismic and infrastructure, wells take 35 days to drill, $1.00/mmcfe production cost, and a 12.5% royalty.  The 1^st year decline curve with gross production is posted below.

Using this well profile, the production of the JV (after royalties, but before the 50/50 split) will therefore look something like this:

The drill carry will be exhausted by the end of May 2011, or right around the end of Q2.  Epsilon will be producing 35 mmcfe/d from the JV and from that point forward will be responsible for paying their 50% share of the bills.  Total company production will actually be closer to 42 mmcfe/d, because they’ve got 8.5 mmcfe/d of production today that I assume will be producing at 5.5 mmcfe/d a year from now, and Epsilon should also get a couple mmcfe/d extra from an additional clause in the JV which lets them collect 100% of the production through the first $50m that gets spent.  I realize there are a few moving parts here, but I’ve been in contact with other shareholders, and we all come up with the same numbers using independent analysis.

In one year’s time, there will be a couple components to the value of Epsilon.  First, there will be the value of the production/reserves from the Marcellus JV.  Second, there will be cash from the gas produced in the JV.  Third, there will be a small amount of Marcellus PUDs that they haven’t yet drilled.  Fourth, there will be some token value in these other plays.

1) $??? – Marcellus JV

2) $35m Marcellus PUDs

3) $30m Cash

4) $20m Other Plays

Valuation

Why do I have to use question marks for the Marcellus JV valuation?  The Chesapeake JV alone created $4.00 in value on the day the deal was signed, yet the stock remains mired in the $2.50 range.  Why??  Management has shown signs that they want to grow this company.  Yes, despite failing 1 out of every 12 times when it comes to new plays, they foolishly think (much like every other E&P CEO) that they have “the gift” after a lone success that had more to do with luck.  They believe, although encouragingly, not strongly, that plowing the cash flow into other projects, or perhaps more Marcellus acres, is the best use of shareholder capital.  It is not.  This is a company that needs to be sold, not try to grow.

There are three inherent issues with Epsilon, they’re not necessarily flaws, just constraints.  First, Epsilon is not an operator.  They have a small staff and have never drilled anything themselves.  They’re basically a group of landmen, so growing through the drill-bit shouldn’t be an option.  Besides, developing gas is a lousy business, all of the value creation is in land appreciation.  Second, they are a small company and drilling three $5-7m wells with a 50% working interest is simply too expensive.  If Chesapeake continues running 3 rigs in the JV, Epsilon will quickly turn into a negative FCF company.  Finally, and this is the biggie, Epsilon has no ability to produce sustainable growth.  What happens to the multiples of companies with a short shelf life?  The point is that Epsilon is clearly a case of a company that’s worth more in a sale than as a going concern.

What Epsilon Is Worth In A Sale

I am assuming the company gets sold right after the drill carry gets used up.  Prices for deals have ranged from $7,000-$13,000 per mmcfe/d.  Stocks themselves trade between $6,500-$15,000 on an ev/mmcfe/d metric.  Let’s take the low end of this range and see what Epsilon should be worth a year from now if they sold to a neighboring producer like Chesapeake or Cabot:

I should reiterate that $6,500 per mmcfe/d is a really, really low multiple.  The only companies that trade at this level are the bottom of the barrel E&P’s, mostly the coal bed methane guys.  A more reasonable multiple is about $9,000, in which case Epsilon looks something like this:

Or maybe you think it’s value should be based on reserves instead of production.  By the end of Q2 2011, Epsilon will have right around 100 Bcfe in proven developed reserves assuming 6 Bcfe wells (gross), which generally are worth $2.50.

So that’s the good news.  If management choose to do the right thing, the stock is worth 3-4x more than today…and that’s not even modeling any buybacks, of which a small 1m share buyback is currently in place.

What Epsilon Is Worth As Going Concern

This is a microcap Canadian E&P company that has no real inventory of PUDs, cant operate, and will be spending more than it makes.  That’s going to get you a low, low multiple.  How does 3x EBITDA sound?  Fair?  I dunno…there’s no comp for something like this.  I include the PUDs and other plays in this analysis, but at 3x EV/EBITDA (excluding PUDs and other stuff) the stock is worth exactly $2.50.  Could it trade lower?  I suppose, but now we'd be talking about a stock that's trading well below the value of its reserves.

Note that with no debt and no taxes, EBITDA is a proxy for cash flow as well.  This is why I think Epsilon is a great opportunity, because the valuation is such that it’s hard to lose money even if management ventures down an ill-advised path towards growth.  Further, I’ve tried blowing this company up in Excel, and it cant be done without some kind of big external event like a huge acquisition or something like that.  Justifying a price below $2.50 in 12 months with the current assets - even assuming they spend a couple million more on god knows what - is really, really hard.  In the meantime, I’ve been in constant communication with the CEO and board about my thoughts.  It’s all friendly so far, and they have been receptive to my ideas, albeit without any real action.  I feel confident that over the course of the next year you’ll see increasing pressure from several large shareholders to put the company up for sale before the drill carry expires.  Management and the board own about 25% of the stock, but I know about 25-30% of the large holders.