Description
Evolution Petroleum is a small cap, independent oil and gas exploration and production company that is trading for less than 50% of its intrinsic value. EPM has no debt and $27.8 million in cash. According to their most recent press release, they have 1.7 million barrels of oil equivalents with a PV-10 of $33 million. EPM’s most important asset is its 7.5% net revenue interest and it’s 25% reversionary interest in the Delhi Field, which is estimated to have 11.5-16 million barrels of oil, net to EPM. EPM current stock price reflects barely more than the value of its current proved reserves plus cash. A buyer today is getting a cheap option on 11.5-16 million barrel of probable reserves net to EPM, which, as I will show, are highly probable .
Background: EPM began as Natural Gas Systems. The name change was in part related to their change in focus from natural gas to oil and gas. According to their 10-K:
“Natural Gas Systems is a development stage company that seeks to acquire majority working interests of oil and gas resources in established fields and redevelop those fields through the application of capital and technology to convert the oil and gas resources into producing reserves. We focus on established fields with long-lived production from shallow reservoirs, particularly those reservoirs with low permeability. We believe this provides us with the following advantages:
• By limiting our focus to established fields, we believe we are likely to incur less exposure to the risk of whether resources are present. We also reduce the amount of capital expenditures necessary for infrastructure, such as roads, water handling facilities and pipelines.
• We prefer to acquire long-lived properties in order to reduce risk from short-term oil and gas price volatility.
• We focus on shallow reservoirs in order to reduce technical and operational risks associated with higher pressures, temperatures and their attenuate costs on deeper wells. “
EPM began in 2003 as Natural Gas Systems (NGS). With some seed capital and some debt they acquired two of their primary properties namely the Delhi Field and the Tullos Field. These two fields had a combined total of reserves of approximately 330,000 BOE equivalent with a present value of future cash flows discounted at 10% of approximately $8 million in 2003.
Properties:
Delhi Field: This has been EPM’s greatest success to date and has the most visible potential.
In 2003, EPM acquired an 80% net revenue interest in the Delhi Field for $2.8 million. After expenditures of $2.5 million, they increased production in the Delhi Field from near zero to 145 BOE per day. In 2006, they acquired an additional 7.4% revenue interest in the field for $1.5 million.
The Delhi Field in Louisiana has been in production for decades. The original oil in place has been estimated at 400 million barrels. 190 million barrels have been produced to date. Sun Oil was a large operator here and EPM has extensive logs. EPM also has the results of an early trial of CO2 injection by Sun which according to directors of EPM was highly successful. These earlier trials of CO2 injection were from the 80’s, and oil prices then would not support a profitable CO2 injection program, Hence, the CO2 program was abandoned.
CO2 injection is a well accepted and successful method for increasing production from old oil fields that have been produced with primary and secondary recovery. Primary recovery is when you drill a hole in the ground and oil flows to the surface. Secondary recovery is typically accomplished with water flooding, where water is pumped into the reservoir and additional oil is recovered. Tertiary recovery is accomplished by additional methods, CO2 injection in this case. CO2 injected under high pressure makes the remaining oil in the ground less viscous and permits it to flow to the surface. Denbury Resources (symbol = DNR) is one of the better known companies to employ CO2 injection largely because they own one of the largest sources of underground CO2 in the USA. Denbury is engaged in a major tertiary oil recovery program in Louisiana and Texas. They have an established track record and have excellent presentations on their web site. According to Denbury, they expect to recover between 15%-20% of the original oil in place with CO2 injection. Denbury states that in similar fields in nearby Mississippi, with similar geology, they expect 17-20% recovery of the original oil in place.
Although EPM owned most of the interests in the Delhi Field, they lacked the capital to develop a CO2 program which has been estimated by Denbury to cost approximately $200 million in the case of the Delhi Field. About $75 million will be spent on the CO2 pipeline, which is bigger than needed.
EPM decided that their best option would be to partner with Denbury. The deal was a win-win for both parties. Denbury in 2006 paid EPM $50 million in cash. (Remember, EPM’s invested capital into Delhi was only $5 million). In addition to the $50 million, EPM retained an overriding 7.5% royalty interest and also a 25% reversionary working interest once Denbury had recouped its $200 million of development expenses. Directors at EPM have told me that they expect the field will need to be in production for about 5 years before Denbury will recoup their $200 million investment. If Denbury fails to invest at least $200 million in the Delhi Field, they will have to pay EPM up to an additional $50 million.
Denbury refers to the Delhi Field in their presentation slides and SEC documents. They are currently building the CO2 pipeline and anticipate injecting CO2 in the 3rd quarter of 2008. They expect production in the Delhi Field to be 1,500 barrels of oil/day in 2009, 4,000/day in 2010, 6,000/day in 2011, 8,000/day in 2012 and 10,000/day in 2013. Their projections do not go past 2013. At a 15% recovery factor, the Delhi Field should produce an additional 60 million barrels of oil.
What does this translate into revenue for EPM? It’s important to note that EPM’s 7.5% overriding royalty interest starts with the first barrel of oil and is not subject to production expenses. The 25% reversionary interest likely kicks in 2014. Denbury is charging EPM a market rate for CO2 which works out to about $.75/MCF. It takes 6-10MCF of CO2 injection to produce 1 barrel of oil. EPM estimates that their share of expenses will run about $15/barrel of oil ($7.50 for CO2 costs and $7.50 of other expenses). Long term estimates for WTI are currently near $70/barrel. Delhi field oil trades at a 6% discount to WTI. For the following figures, I use $60 oil for Delhi production (roughly $63 WTI minus 5%). The following data lists the year, the total revenue to EPM and the revenue discounted at 10% per year. I assume peak production at 10,000 barrels of oil per day decreasing at 20% per year once 30 million barrels have been produced. I also assume that of the 25% reversionary interest, EPM nets only ½ that amount.
|
Year |
Revenue |
Discounted 10% |
|
2008 |
$0 |
$0 |
|
2009 |
$2,268,000 |
$1,837,080 |
|
2010 |
$6,480,000 |
$4,723,920 |
|
2011 |
$9,720,000 |
$6,377,292 |
|
2012 |
$12,960,000 |
$7,652,750 |
|
2013 |
$16,200,000 |
$8,609,344 |
|
2014 |
$52,925,000 |
$25,313,863 |
|
2015 |
$52,925,000 |
$22,782,477 |
|
2016 |
$52,925,000 |
$20,504,229 |
|
2017 |
$52,925,000 |
$18,453,800 |
|
2018 |
$52,925,000 |
$16,608,425 |
|
2019 |
$52,925,000 |
$14,947,583 |
|
2019 |
$47,632,500 |
$13,452,824 |
|
Beyond |
|
$30,000,000 |
|
Total |
|
$191,263,587 |
NPV/10 of the Delhi Field, before taxes, is $190,000,000. Assuming a 35% tax rate then the net present value after taxes, discounted at 10% would be $123 million. $123 million divided by 27 million shares is $4.55/share. Adding $1.03/share of cash, net of income tax payable, yields a current value per share of $5.58, without any value for their other properties or proven reserves. $5.58 is more than double the current share price.
Tullos Field and others: EPM reported on 9/13/2007 that as of 6/30/2007 their proven reserves equaled 1.7 million barrels of oil equivalent with a current PV-10 of $33 million. In the past year, EPM has increased reserves in the Tullos Field by 1 million barrels. They are near cash flow even with this production. They currently have high expenses due to startup costs and costs of new leases. Beginning in 2009, they will have plenty of cash to fund ongoing project, increase production and increase reserves.
60% of shares are held by management and non management directors. Employees own 15% of EPM shares and every employee owns shares. Management salaries are very reasonable. Management’s salaries are conservative. Their interests are closely aligned with shareholders.
Management has an excellent track record of increasing shareholder value and is actively investing cash in ongoing projects. Management is reluctant to give details of ongoing purchases because leasing of land is highly competitive and disclosing information in too much detail could have an adverse effect on current negotiations.
Excluding the Delhi Field, current reserves are reported for 3,449 acres. In their most recent press release, they report leases on 8,000 acres, so additional reserve additions are highly likely.
Risks:
1. Oil prices could collapse. While $80 dollar oil may not hold, excess world oil production capacity remains near historic lows. With the USA, Mexico, the North Sea and other major areas in decline and with OPEC limiting production in order to maintain prices, an oil price collapse may not be imminent. The cheap oil of the past is history. There is a lot of oil in the ground, but it is getting more expensive to produce.
2. Tertiary recovery with CO2 may not work in the Delhi Field. This seems unlikely given that one of the world’s experts, namely Denbury Resources, has already paid $50 million for the field and has committed $200 million more to go forward with the project. Rather than not working at all, it is certainly possible that the Delhi Field will produce less than expected. Even if it produces only 10% of the original oil in place, EPM should do well.
3. Management will squander the revenue from the Delhi Field. But why would they? They are large shareholders with conservative salaries. So far they are doing a terrific job. They turned a $5 million investment in the Delhi Field into $50 million with huge upside. I don’t think that all their projects will be as successful, but so far they are doing well by shareholders.
4. The whole world will go green, give up their SUV’s, ride bicycles to work, and we will go back to wood burning stoves. Sounds great! I’ll meet y’all back at Woodstock for the umpteenth reunion!!
Catalyst
1. Reserve additions are likely to be supportive of the stock price. EPM rose 20% with the report of 1.3 million barrels of oil in reserve additions.
2. Ramp up of production will increase revenue and cash flow.
3. Progress on tertiary oil recovery in the Delhi Field.
4. Investors becoming aware of managements ability to increase shareholder value.