Description

Evolution Petroleum Corporation (“EPM”) is a misunderstood free cash flow story with an imminent catalyst.  We believe that EPM is worth approximately $13-14 per share on a standalone basis and $15-18 per share to an acquirer with a lower cost of capital (i.e. an MLP), representing 50-80% upside to fair value over an approximately one-year holding period.  This investment is in its final innings and we believe the denouement is rapidly approaching.

Company History

The predecessor entity to EPM was formed in September 2003 by CEO Bob Herlin with backing from Cagan McAfee Capital Partners.  Bob was joined in the executive suite two months later by CFO Sterling McDonald.

Bob and Sterling were each twenty-five year veterans of the oil and gas industry and – though they had not previously worked together – they shared an appreciation for the dangers of leverage in an exploration business.  In the 1980’s Sterling had served as Treasurer of Reading and Bates Corporation, a NYSE-listed E&P company, as it (successfully) danced along the edge of bankruptcy.  From 1997-2000, Bob acted as CFO, and then CEO, of Benz Energy Ltd. in an (unsuccessful) attempt to keep the company out of bankruptcy.  With the scars to show from their prior experiences, Bob and Sterling decided that – unlike most E&P companies, which have rightly earned their “wildcatter” reputations – EPM would be operated conservatively and with plenty of cash on hand.

In late-2003 the company purchased what would become its signature asset: the Delhi Holt Bryant Unit (“Delhi” or the “Delhi Field”) located on ~14,000 acres in northeastern Louisiana.  Delhi, originally discovered in 1944, had produced a staggering 192 million barrels of oil (as well as substantial natural gas) from nearly 500 wells during its sixty-year history.  At the time of EPM’s purchase, however, Delhi’s production had dwindled to a mere 18 barrels of oil per day (“BOPD”) – a fraction of its former yield – and most of its wells had been abandoned.

To extract petroleum from an oil field, energy companies generally divide the process into three stages.  In the first stage, known as primary recovery, the natural underground pressure in the reservoir is sufficient to force oil to the surface; primary recovery generally results in a recovery factor of 5-15% of the reservoir’s original oil in place (“OOIP”).  As the natural pressure in the reservoir diminishes, fluids are injected into the reservoir to maintain pressure; this is known as secondary recovery and generally results in a recovery factor of 25-35% of OOIP.  The most common fluid used in secondary recovery is water, a technique known as “waterflooding.”

In the last decade or so, tertiary recovery – also known as Enhanced Oil Recovery (“EOR”) – has become a more common practice within the oil industry.  The goal of tertiary recovery methods is to reduce the oil’s viscosity so that the oil can more easily flow to the surface.  By heating the petroleum through steam injection, or by injecting surfactants/detergents (to lower surface tension) or carbon dioxide (to increase miscibility), tertiary recovery techniques have been shown to result in a recovery factor of as much as 10-20% of OOIP.

EPM purchased Delhi for $2.8M in late-2003.  Over the next two-plus years, the company invested several million dollars to increase production to ~145 BOPD and carry out additional studies of the resource.  EPM’s analysis showed that Delhi not only had substantial remaining recoverable oil in place, but also that Delhi’s sandstone had favorable characteristics for conducting tertiary recovery via a carbon dioxide flood (“CO₂ flood”).

In late-2004, EPM began conversations with industry participants to find a suitable partner to develop the Delhi Field as a tertiary recovery project.  Rising oil prices had incentivized energy companies to invest in EOR technology, and tertiary recovery techniques had advanced by leaps and bounds in a short period of time.  After a protracted negotiation with three potential partners, EPM entered into an agreement to build out Delhi with Denbury Resources Inc. (NYSE: DNR, “Denbury”), a multi-billion-dollar energy company based in Plano, TX.

The June 2006 agreement involved the sale of EPM’s Delhi working interest to Denbury in exchange for (i) $50M in up-front cash, (ii) a commitment by Denbury to spend at least $100M to install a CO₂-EOR process in Delhi, and (iii) a 23.9% reversionary working interest in the project once cumulative project revenues less direct operating costs reached $200M.  In addition, EPM retained net royalty interests in Delhi of ~7.4%.

In the seven years since the agreement, the Delhi Field has outperformed even the most aggressive of expectations.  Denbury’s ownership of the largest naturally-occurring reserves of CO₂ in the US at Jackson Dome in Mississippi – located just 100 miles east of Delhi – provided the Delhi Field with a stable, low-cost source of CO₂.  In addition, Denbury’s expertise as the largest CO₂-EOR operator in the country as well as continued advancements in CO₂ flood techniques resulted in rapid Delhi production growth (see Exhibit A).

               Exhibit A

Source: State of Louisiana Department of Natural Resources

As of early-2013, Denbury had invested north of $400M in the Delhi CO₂-EOR project with plans to invest an additional $40M+ per year through at least 2015.  Delhi’s peak production is projected to be 12,000+ BOPD.

Valuation on a Stand-Alone Basis

From an original $8.3M total common equity investment in the company, we believe Bob and Sterling have built EPM into an enterprise worth approximately $450M on a stand-alone basis.  EPM’s fully-diluted share count is ~33.4M, so this equates to a stand-alone valuation of $13-14 per share.

EPM’s assets can be divided into four buckets:

1.    Delhi.  The Delhi Field is EPM’s crown jewel asset.  According to the most recent reserve report prepared by independent petroleum engineering firm DeGolyer and MacNaughton (“D&M”), as of June 30, 2012, EPM’s net proved and probable reserves totaled 16.8 million barrels of oil with a present value using a 10% discount rate (“PV10”) of more than $500M.  According to analysis released by EPM and corroborated by Denbury, we believe EPM’s 23.9% working interest will revert to the company in the fall of 2013 – and most likely in September or October of this year (i.e., in 4-5 months).  At the time of the conversion, our calculations indicate that the PV10 of Delhi will be just shy of $600M, or approximately $400M on a fully-taxed basis.  On 33.4M fully-diluted shares, this represents value of ~$12 per share.

2.    Cash and Assets to be Monetized.  As of December 31, 2012, EPM had $18M of cash and zero debt.  In addition, EPM is in the process of monetizing non-core oil and gas assets in the Giddings Field and Lopez Field in Texas and in the Woodford Shale in Oklahoma.  Between the additional cash from operations generated in 2013 and the sale of these assets, we believe this adds $1+ per share to EPM’s value.

3.    Mississippi Lime.  In April 2012, EPM acquired a working interest via a joint venture in the Mississippi Lime formation in Kay County, Oklahoma, on the east side of the Nemaha Ridge.  Initial drilling results from the project have been mixed.  We ascribe minimal value to this asset.

4.    GARP.  In 2011, EPM received a patent on an internally-developed Gas Assisted Rod Pump (“GARP”) technology that can meaningfully increase the economic life of horizontal wells and lead to an additional 10-30% of cumulative recovery at low cost (less than $10 per barrel of oil equivalent).  EPM has successfully tested its GARP technology on a number of wells, and while we are optimistic about the technology, we ascribe minimal value to it due to an unclear path to commercialization.

From our initial valuation of $13-14 per share, we note two potential sources of delta to our figures.

The first is the price of oil.  EPM does not sell forward or hedge out its oil production, so an increase or decrease in the price of oil can have a meaningful effect on the value of EPM.  Not all oil, however, is created equal.  EPM’s Delhi production is “light crude oil” which trades at a premium to “heavy crude oil” because it has a lower viscosity and produces a higher percentage of diesel fuel and gasoline when processed by an oil refinery.  Specifically, oil from Delhi is priced at Louisiana Light Sweet (“LLS”) crude prices, which have traded at a $10-25 per barrel premium to the US-benchmark West Texas Intermediate (“WTI”) crude over the last few years and close to European-benchmark Brent crude prices (LLS, WTI, and Brent are all “light crudes”).  LLS currently sells for ~$107 per barrel, an ~$11 premium to WTI.  The D&M reserve report used an LLS price of $113.52 per barrel; at a $107 LLS price, we believe EPM’s stand-alone value would be reduced by approximately $0.50 per share.

The second is the Delhi reserve report.  Production from Delhi since the D&M reserve report has significantly exceeded expectations, implying that the recovery factor from Delhi may be higher than previously believed.  In particular, D&M used an expected recovery factor from CO₂-EOR of 13% on proved reserves and 4% on probable reserves.  Given recent production data and an accelerated production timeline, we think (i) the recovery factor on proved reserves may be raised to 15-20%, and (ii) a portion of probable reserves could be re-classed as proved reserves with a higher recovery factor.  In addition, Denbury is in the process of re-mapping the Delhi Field using 3-D seismic technology with the expectation that past estimates of OOIP may be low.  Should D&M raise its recovery factor assumptions, re-class probable reserves to proven reserves, or determine that OOIP is higher than previously believed, Delhi’s PV10 could increase materially.

Valuation to an Acquirer

We value EPM at $13-14 per share on a stand-alone basis.  However, we believe this is an incorrect approach for thinking about EPM’s value.  In our view, EPM is far more valuable to an acquirer than it is continuing on its own.

Since the 2008 financial crisis, master limited partnerships (“MLP’s”) have become a popular vehicle for investors seeking yield in a low-return market environment.  An MLP is a publicly-traded limited partnership: it has the twin benefit of (i) greater liquidity as its shares float freely on an exchange and (ii) an advantaged tax status as it is structured as a pass-through entity for tax purposes.  To be considered an MLP, the entity must generate 90% or more of its income from “qualifying sources” as defined by the US Internal Revenue Service.  These qualifying sources generally relate to the use of natural resources, and in particular oil and gas assets. 

Effective MLP’s are structured to have a steady stream of income that can be paid out to investors.  As a result, many MLP’s operate pipelines and other energy infrastructure assets that earn a consistent profit regardless of the price of the commodity transported.  More recently, however, some MLP’s have been structured to hold cash-flowing energy assets where the forward price of the underlying commodities can be hedged.

These energy commodity MLP’s have a significantly lower cost of capital than EPM.  In early-2012, Linn Energy LLC (NYSE: LINE) – an energy commodity MLP with an enterprise value of more than $15 billion – issued $1.8 billion of debt at a coupon of 6.25%; based on that debt’s current trading levels, we believe LINE (or a similar MLP) would likely be able to raise debt to finance an acquisition at a sub-6.00% coupon.  For every 100bps cost of capital advantage to an acquirer, we believe EPM’s value increases by approximately $1 per share.

The US oil and gas industry also benefits from significant tax advantages related to the timing of tax payments.  In particular, energy companies are allowed to immediately deduct intangible drilling costs (“IDC’s”) related to drilling oil/gas wells.  IDC’s typically make up 60-80% of the cost of a well – IDC’s include survey work, labor, fuel, repairs, supplies, essentially everything but the physical steel of the well itself – and can effectively be fully depreciated in year-one.  As a result, energy companies with significant drilling programs are able to defer cash tax payments on income-producing assets, increasing the present value of their assets’ cash flows.

Doing the math, we believe that EPM is worth an additional $1-4 per share to an acquirer with a lower cost of capital and an additional $1-3 per share to an acquirer with a significant drill program where IDC’s can be used to offset cash tax payments or where the acquirer has meaningful net operating loss carry-forwards (“NOL’s”).  As an acquirer would likely hope to keep some of that upside for itself, in our view the range of incremental value EPM can extract is $2-4 per share.  We therefore believe the value of EPM to an acquirer is ~$15-18 per share.

Investment Thesis

It’s easy to see why EPM might trade at a significant discount to intrinsic value – for at first glance, EPM appears to be an expensive stock.  In calendar years 2011 and 2012, EPM earned $0.09 per share and $0.16 per share of net income, respectively.  At ~$10 per share, EPM trades at 111x 2011 earnings and 63x 2012 earnings.

In this case, we believe trailing financials do not reflect the value of EPM’s assets.  By 2014, we estimate Delhi will be generating cash flow (after netting out all capital expenditures) of roughly $75M per year, putting the company’s shares at just above 4x pre-tax free cash flow.  Once the reversionary working interest kicks in, EPM will flip from looking “expensive” to looking “cheap” – and, we believe, will draw much more investor attention.

EPM possesses many of the characteristics we look for in a core investment.  The company has net cash and zero debt.  Management has a history of good capital allocation decisions and is well-aligned with investors: management owns 21% of the company, and Bob and Sterling have much – if not most – of their personal net worth invested in the company.  In addition, several “smart money” investors hold large positions in EPM stock including respected oil and gas investor John Lovoi (19%), Peninsula Capital (7%), and Advisory Research (7%).

Importantly, we also believe EPM is well aware that its business makes more sense in the hands of an acquirer.  In January 2013, EPM’s CEO Bob Herlin made the following statement in an interview (emphasis added):

“I’ve been very clear for many years now that Evolution is a company that has been designed and managed for the purpose of creating value for the shareholders and getting that value to the shareholders in the most efficient way possible.  We are not trying to become the next Swift or Apache or Anadarko.  We are clearly setting ourselves up to be a company that’s an acquisition target in the not terribly distant future.”  (Source: The Wall Street Transcript, Evolution Petroleum Corporation (EPM) interview dated January 7, 2013; available at www.twst.com)

In our view, once the Delhi working interest reverts to EPM, the company will become a significantly more attractive target for a large commodity energy MLP or other acquirer.  Our expectation is that EPM will be sold within 6-12 months of the reversionary interest kicking in.  With upside of 30-40% to fair value on a stand-alone basis, upside of 50-80% to fair value to an acquirer, and an expected investment time horizon of a little more than one year, we view the risk/reward in EPM shares as compelling and timely.

Risks

As with all investments, there are risks to an investment in EPM including regulatory risk, execution risk, and the risk that EPM is unable to successfully conclude a strategic alternatives process.  However, in our view the largest risk in this investment is commodity risk relating to the price of oil.  We do not have a strong lean either way on the price of oil, and this is reflected in our portfolio via substantial short exposure to equities exposed to oil prices and, at times, by shorting the commodity itself via USO US, in order to hedge out our oil price risk.

Disclaimer

NOTE (1):  DISCLAIMER.  The author of this posting and related persons or entities (“Author”) currently holds a long position in this security.  Author may buy additional shares, or sell some or all of Author’s shares, at any time.  Author has no obligation to inform anyone of any changes to Author’s view of EPM US.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in EPM US.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

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