Description

We wrote up Gulfport Energy (Ticker: GPOR) in December of 2006 when the stock was $13.50.  Our conclusions on value were either 1. Correct – since the stock went above $24.00 just ten months later or, 2. Incorrect – since the stock now rests at $10.50.  In fact, we think the recent dramatic move down is mostly a function of GPOR moving from more of a growth story to a value story.  We believe that once again GPOR represents very compelling value with 50% to 100% upside in 2008. 

The Quick Version

The Story Behind the Weakness

Management recently reined in production guidance for 2008 which has taken some growth element out of the stock at least for 2008.  And, GPOR decided to allocate this year’s Capex differently than investors had originally assumed.  This has caused investors to worry about the areas to which GPOR is allocating less capital.  Are the returns there as good as everyone has always assumed?  As well, a recent acquisition (Permian deal) made in late 2007 had the appearance of performing very poorly – there are reasons for this that are quite easy to understand but the optics were terrible.  While investor concerns are somewhat justified we believe the valuation more than accounts for recent challenges.

Capitalization

Market Cap = $450mm ($10.50 x 42.9mm shares out)

Net Debt of ~$65mm

Enterprise Value = $515mm

How to Value

Asset Valuation Method of Core U.S. Assets:  The 12/31/07 NAV of GPOR’s producing assets = $820mm (per 10k).  NAV is a pretty simply notion – it basically asks:  What do I know I have in the ground (proved reserves)?  How much can I sell it for once I extract it?  How long will it take and how much will it cost to get it out of the ground?  What is the net of all that worth today?  (Technically NAV is based on the PV-10 value which is discussed later in further depth - but basically it is the pre-tax NPV accounting for revenues, development costs, and abandonment cost all discounted to present at 10% and based on constant energy prices.  The energy prices at 12/31/07 were $92.50 per barrel for oil and $6.80 per Mcf of gas).  If one prefers to use a more conservative price deck – say $70.00 oil and $6.00 gas and then GPOR’s PV-10 would equal roughly $550mm.  This ‘asset valuation’ derives a low case and the high case for our valuation of GPOR’s producing properties equating to $11.30 to $17.60 per share. 

Multiples Valuation Method of Core U.S. Assets:  Alternatively one can value GPOR’s producing properties using multiples on 2009 Cash Flow per Share (I use 2009 because 2008 is a bit of transition year).  Comps trade in range of 3x to 9x 2009 CF / share.  Companies with a similar mix of oil vs. gas, low exploration risk, and growth seem to garner 4.5x to 6.0x multiples.    There are only two 2009 estimates for CF / share both about $3.25.  This would suggest a value of GPOR’s producing assets of $14.65 per share to $19.50 per share.  (Note – analyst estimates for the comp set and GPOR are not based on current energy prices of $100+ crude and $8.50+ gas.  Rather, most use a more conservative price deck of $70 to $80 oil and $6.00 to $7.50 gas.)

Value of Oil Sands Investment:  GPOR owns 25% of Grizzly Oil Sands – a major lease holder in the Canadian oil sands.  This holding will be described at length later.  For the time being, it is worth noting that Grizzly is likely to sell a small portion of the company this year – probably ~10%.  This will provide greater clarity to investors as to what GPOR’s 25% ownership is worth.  The more conservative analysts suggest Grizzly is worth $5.00 per share to GPOR whereas others use as much as $9.00 per share.  Comments from management would indicate somewhere in the middle of that range.  Trading and transaction comparables (none of which are perfect) give a value of $4.00 at a minimum to $10.00 or higher.  For purposes here we use $5 to $7 per share and will validate that value later in this write-up.

Value of GPOR’s Other Holdings:  These other holdings (Thailand, Bakken Shale, others) will be detailed later.  But, suffice to say they are worth $0.00 to $0.75 per share.

Total Valuation

Core U.S. Assets                     $11.30             $19.50

Oil Sands (Grizzly)                      $5.00               $7.00

Other                                          $0.00               $0.75

Total                                         $16.30             $27.25

Premium to Current                   55%               160%

Catalysts in 2008

• Grizzly selling 10% of itself to raise capital – will make value clearer to shareholders
• Seeing the underlying growth in the Permian become apparent (explained more later)
• Seeing continued success in land wells at Hackberry (explained more later)
• Return of WCBB well metrics (explained more later)
• New core data from Grizzly’s winter 2007/2008 drilling program

Risks and Concerns

• Luckily – there’s not much exploratory or geology risk to GPOR – this is not about trying to find the next big well.  Rather, it is about pulling out little bits of oil from lots of small wells with a success rate close to 90%
• Energy Prices:  GPOR stock will no doubt struggle if oil moves sharply to $60.  If that is one’s belief about the near-term direction of energy prices then there is probably not a single E&P stock worth owning for the time being.  Otherwise this risk can be mitigated through position sizing or hedging (for those that do)
• The growth trajectory of the Core U.S. Assets appears slower than once thought – growth investors may rotate out of the stock (or already have)
• Issues that might delay a partial sale of Grizzly (regulatory changes in Alberta, inactive cap markets, economic uncertainty)
• Hurricanes in the late summer and fall.  A lot of GPOR’s assets are coastal Louisiana (Rita was a big hit to GPOR a few years back)

The information given above is the quick story and investment thesis.  Below we provide more color/detail and attempt to validate our assumptions.

The Longer Version 

Organized as Follows

1. Understanding and Valuing WCBB (source of recent disappointment)
2. Understanding and Valuating Hackberry (source of recent disappointment)
3. Understanding and Valuing the Permian Acquisition and Properties (source of decent growth story)
4. Understanding the how the confluence of A, B, and C impacted guidance and expectations
5. Understanding and Valuing  the Oil Sands (Grizzly)
6. Understanding and Valuing GPOR’s Other Properties / Holdings
7. Discussion of PV-10 Valuation Methodology
8. Understanding GPOR’s Ownership Structure / Dynamic (Important)
9. Conclusion / Final Thoughts

1. West Cote Blanch Bay (WCBB – 61% of proved reserves):  This field consists of lots of little hydrocarbon traps in between 2k and 10k feet of depth in Lake Calcasieu in Coastal Louisiana.  GPOR has been reworking this field for a number of years.  The field is characterized by a large number of Proven Undeveloped (PUD) locations.  This basically means that these locations are validated both through seismic data and through evidence from known/understood offsetting geology.  They are typically audited by both internal and by external auditors.  At WCBB the company has a success rate of about 90% on these wells.  Given this inventory of PUDs GPOR has years of drilling prospects and will be able to offset natural declines in the producing wells.  In addition they have many additional unbooked prospects to drill in areas in which they have not reworked all the seismic or in cases that they have not submitted data to their reserve auditor.  This will allow them to book additional locations at WCBB to which reserve value is not currently ascribed.  This will happen only at a measured pace in the near term as they are more focused on converting PUDs to Proved Developed Producing rather than just proving up more PUDs.

At WCBB GPOR drilled 26 wells in 2007 and 27 in 2006.   Analysts figured GPOR would drill roughly the same number of wells in 2008 as they had in previous years.  But, management surprised the Street when they recently said the company will only drill 8 to 10 wells in WCBB in 2008 while reallocating capital to other areas.  They claimed they’d had a few disappointments with some of the wells in 2007 and felt like they were pushing the drilling too hard.  Management basically said that they believe they can drill a smaller number of really high quality wells per year but drilling too aggressively will lead to declining success rates and lower well quality.   This really caught investors by surprise – some raised concerns whether GPOR had ‘picked all the low hanging fruit’ at WCBB and that in reality the well quality/returns were declining.  Comments from management suggest the last four or five wells at WCBB have been quite solid.

While we share the concerns of other shareholders, we believe GPOR will ultimately drill and produce their existing PUD locations (albeit somewhat slower) and more locations as yet unbooked.  We also believe they will drill, book-up, and produce locations which are not in the PUD inventory – they have been doing this successfully for some time (think of it as booking and shipping something that never makes it through backlog – in this case PUDs are the backlog).  But, to be conservative at this point we only give them credit for the PUDs and currently producing reserves and not any additional unbooked locations.  Having said that, our conversations with other coastal salt dome players suggest that there are probably many prospects that GPOR will ultimately exploit at WCBB and that are not in the current reserve report. 

2. Hackberry (16% of proved reserves):  Hackberry has been billed as the next WCBB – ‘an old salt dome with lots of fractured and small complex structural hydrocarbon traps’.  The field has potential drilling location on the land and in the water.  This field was exploited many years ago and abandoned when oil was cheap and easy to find.  A few years back GPOR shot 3D seismic and has been progressing toward a meaningful program in the field.  Their confidence in their success was evidenced by the construction and installation of a large production barge that can handle 5k barrels of liquids and 30Mmcf per day (cost ~$9mm installed).  This meant that the water locations alone were thought to eventually have the potential to produce at levels not all that much lower than WCBB.  Management had a lot of confidence and we believe part of what drove the stock in 2007 was investors buying into this view (ourselves included).  Some of the early wells at Hackberry came on very strong and there was every reason to be optimistic.  Hackberry was to be the next WCBB and provide production and reserve growth for years. 

What has become clear since that time is that the wells in the water at Hackberry fell of as quickly as they came on.  It was believed that once the gas was produced off the top, behind that would be oil (typical pattern at WCBB and other successful Hackberry wells).  In fact, for the most part there was gas with little oil.  This means that the water part of the play at Hackberry may be a lot less significant than thought – it also means that the production barge may have been unnecessary (installed cost was $9mm).  GPOR drilled 9 wells in the water at Hackberry in 2007 and will only drill one in 2008.

Interestingly – the land wells at Hackberry have been better.  3 wells were drilled on land in 2007 (2 successfully) and 4 to 6 will be drilled on land in 2008.  The land wells at Hackberry were pretty decent and the company hopes to repeat that success on the part of the structure that underlies the land.  We should hear about two of the new land wells at Hackberry by mid-summer.  Given these wells’ proximity offsetting other successful wells in the area and the fact they are drilling into sands known to be productive, there is a reasonable expectation of success.  Evidence of this should restore faith that Hackberry will be a nice growth driver although not likely at the levels once hoped for.  A total of 17 wells are in the permitting process with the State of Louisiana on the land at Hackberry.  This gives GPOR a nice inventory of drilling locations for at least this year and 2009. 

3. Permian Basin (West Texas – 23% of proved reserves – Operated by Windsor – Windsor owned 50% by Wexford which is discussed later):  This was an acquisition that GPOR made in late 2007.  It is pretty simple geology and wells are done on 40 acre spacing.  The art is not in finding the oil rather it is in drilling the wells economically and producing them effectively.  More than 1/3 of GPOR’s 2008 Capex will go to the Permian and it really represents the best near-term growth driver.

Despite the fact the Permian will by definition grow meaningfully in 2008 (if you Capex – it will grow) this asset gave investors a big scare around the time of the 4Q call.  This was due to management’s admission that their Permian assets will produce roughly 550 barrels / day in the first quarter of 2008.  This seems pretty terrible since when they bought this asset in late 2007 it was producing 800 barrels / day.  Rightly so, this struck people as a meaningful decline and created concerns over management’s understanding of what they’d bought.

But, there was a good explanation for the decline although this was not fully communicated to the Street.  The basic explanation is this:  A well in the Permian is first drilled (~20 days), then fractured (pump a bunch of fluid into the formation to fracture it - ~14 days), then when production comes on you must first produce all the frac fluid mixed with some oil (another 90 days).  Thus, it takes a while to get a well drilled and on line and at peak performance – typically at a level of about 100 barrels / day.  This rate declines relatively quickly and eventually more or less flat-lines for a long period of time at roughly 30 barrels / day.  These early declines mean that if you stop drilling wells for a period you’ll see some steep declines in the overall field.  GPOR (really Windsor) did just this during the final month of the deal and for two months after (Nov, Dec, Jan).  Not drilling and fracing new wells meant that the field showed meaningful declines.  I imagine the decision seemed rational to management at the time.  They wanted to buy the asset and at the same time slow things down for a short period to assess how they were going to Capex the field.  This may have been a good decision operationally but it created terrible optics and made investors rather nervous. 

We are still not sure if the Street really understands how this will change over the course of the year.  GPOR is quickly ramping up drilling at Permian and they will move from one rig currently to three rigs by May.  Exit production rates at Permian should be close to 1300 to 1400 Boepd up from a low of 525 Boepd in January.  Expect 35 to 45 new wells in 2008.

4. The Confluence of A+B+C:  The three above factors were enough to scare the heck out of the market – in part rightly so.  Production estimates came in by 20% and 2008 CF/share estimates were reduced by more than that.  Street analysts slashed price targets from $25-$30 down to $19-$25.  The stock in turn responded by moving from $14.00 to $10.50.  The YTD decline is 42% and the stock is close to 60% below the mid-October 2007 high.  Over this same period energy prices have continued to move up considerably.      

In our view the stock price reaction is well overdone.  The valuation has moved down to levels where GPOR is trading at a significant discount to the value of the known hydrocarbons in the ground (ignoring upside from other things like unbooked reserves and Grizzly).

5. Grizzly Oil Sands:  Underlying a remote region of Alberta Canada lies what is perhaps the world last great reserve of oil (or something close to oil).   At varying depths and in varying thicknesses these reserves (based on current recoverability factors) are second only to Saudi Arabia’s.  Not only that but this resource is in peaceful Canada – most of the other large undeveloped energy reserves are in riskier / less stable areas (West Africa) or in countries with the nasty habit of repatriating their resources (Venezuela, Russia).

Yes – the oil sands are dirty, hard to extract, require lots of infrastructure and energy, etc, etc, etc.  But, seeing as this is one of the last great reserves people are now scrambling to get their hands on acreage.  Recent oil sands buyers include not only large independents like Conoco Phillips and Marathon but also national oil companies such as Statoil and CNOOC (China National Offshore Oil Corporation).  The great demand for these prospects is just becoming apparent in the last few years.  Many oil sands projects probably would not be a profitable at sub $50 oil.  For this reason, much of the reserves in the ground were ignored by the larger players for many years.  This left the leases to be snatched up by small players willing to effectively speculate that one day the price of oil or new extraction technologies would make oil sands more than just marginally profitable.  It did not take long for this to bear out. 

Before these properties became as coveted little Grizzly Oil Sands was actively leasing up acreage.  The company was funded 25% by GPOR and 75% by Wexford private equity funds (the relationship between these two parties will be explained more later).  By now, Grizzly is the #2 holder of land among independent development stage oil sands companies – they hold over 500k acres.

They have good data from their 2006/2007 winter drilling campaign (2007/2008 winter data is not quite available yet).  This data only accounts for about 1/3 of their acreage.  But, in this acreage alone they have ~12bn barrels of Original Bitumen in Place (OBIP).  (As measured by bitumen that is over 10 meters thick – this is the current cut-off for economic recoverability.)  Current estimates suggest about a 1/3 recoverability factor which means that over a very long period of time Grizzly could extract 4bn barrels of bitumen. 

I know, I know – that’s a lot of bitumen.  Wait – what the heck is bitumen?  If light sweet crude oil is a cup of coffee, bitumen is the wet grounds discarded at the bottom of the trash can.  It takes a lot of energy, processing, and miles of transportation to turn bitumen into oil or other refined products but with much effort the coffee grounds can produce quality coffee.  

So the question is what is the 4bn of recoverable bitumen worth and more specifically what is the 1bn net to GPOR worth?  It is interesting to note that all of the value we were discussing earlier relating to GPOR’s U.S. properties was based on ~30mm barrels of proved reserves.  In the case of their holding in Grizzly we are talking about 1bn barrels net to GPOR.  Of course, all of the challenges in oils sands extraction and processing mean that bitumen in the ground in Canada is worth a fraction of what oil in the ground in Louisiana is worth.

The M&A comps are a bit tricky to understand because what someone will pay per recoverable barrel of bitumen is dramatically influenced by where a company is in its development path.  An independent with very little data and no current plans for a facility might get 15 cents per estimated recoverable barrel.  A company with significant core samples and a permitted facility might receive closer to $1.00 per recoverable barrel.   Given Grizzly’s progress they are moving off the low end of this range.  Currently they are just completing their second year of core samples and are working to submit plans in 3Q 2008 to get a permit for a facility. 

Toward the end of 2007 Grizzly apparently tried to sell a small piece of the company.  They said they wanted to raise $150mm and this would account for 8% to 12% of the company (I believe it was the GPOR 3Q call that they discussed this).  The middle of this range would suggest a value of $1.5bn or about 37.5 cents per recoverable barrel.  This also foots with rumors of Grizzly targeting a valuation of 35 cents per recoverable barrel.  They did not get a deal done by the end of 2007 and scrapped the deal until 2008.  The rumor was that Wexford wanted to mark the investment to market so they could book (or at least talk about) the return to LPs – this may just be Street conjecture rather than fact.  Once it was clear that a deal was not going to get done quickly, the company figured they would simply wait.  This was primarily because they expect Grizzly to be more valuable in 2008 than late 2007 because they’ll have the results from the 2007/2008 winter drilling program.  The real key is that the owners of Grizzly would like to raise money for the entity so it can self-finance Capex rather than GPOR and Wexford having to continually fund the program.  In the near term Capex is not too meaningful but ultimately a production facility will cost around $325mm – at that point Grizzly will clearly need financing from outside equity. 

Thus, while we are unsure on timing, all indications from GPOR are that Grizzly will sell some portion of itself in 2008.  We use $0.20 per recoverable barrel at the low end of our valuation range and $0.40 for the upper end.  Quite frankly we do not think that Grizzly would take less the $0.20 since Wexford and GPOR could always fund them for another year.  And, although some people have suggested the price could go higher than $0.40 we do not think comps warrant a higher price at this time.  $0.20 per recoverable implies at $800mm value for Grizzly - $200mm net to GPOR or $4.65 per share and $0.40 per recoverable implies $1.6bn for Grizzly – $400mm net to GPOR or $9.30 per share.  (Remember – this valuation is based on core data from only 1/3 of Grizzly’s land)

As well, trading comps also validate this valuation.  They suggest values of $0.15 per recoverable barrel of bitumen for the least developed independent oil sands players.  Companies further along in their development path might fetch as much as $1.00 or more per recoverable barrel of bitumen.  (The Grizzly presentation available on their website has trading and transaction comps at the end.)   

Sanity Check:  From the 10k we know that GPOR has only put ~$30mm into the Grizzly through 12/31/07.  Doesn’t it seem like lunacy that in just a few years this could be worth ~25x this amount on the low end?  These types of return are of course very rare but not all together unheard of.  In fact, such returns are occasionally generated by E&P companies that are first to a new and significant play.  Take for example the Barnett Shale – the earliest players there could lease land at just a few cents on the dollar of what land costs today.  Another example is the case of Suncor – a Canadian oil sands player.  According to a presentation given (I think by Wexford) at the 2007 John S. Herold Pacesetter conference Suncor is trading at 45x their contributed equity.  These are just examples but suggest it is possible in this space for early movers to generate very high returns.  The oil sands set up perfectly for this and the early players are benefiting dramatically from moving first and leasing up acreage.  If you look at a map there is basically zero acreage left for lease – those who want in now have to buy their way in.     

6. Value of Other Holdings:  GPOR holds a number of other small interests which are not included in PV-10 calculation.  The most significant of these is a small piece of Tatex in Thailand and also 20% of Windsor Bakken.  Both investments were made in 2005 when such properties were riskier and energy prices were meaningfully lower.  At cost GPOR only has about $6mm in the properties.  Thus, for conservatism it is probably easier just to value them at this level or perhaps not consider them at all.  We use $0.0 contribution to share price at the low end or our range.  A more aggressive set of math would suggest that these properties could be worth at least $0.75 per share.  This is not that hard a number to get to given the dramatic increase in acreage values in the Bakken area and success in Thailand. 

7. Discussion of whether 1.0x PV-10 is a good a baseline price to pay for E&P companies:  Suppose we are comfortable that oil will stay in the $70 plus range (at least over time).  Even at that level the PV-10 value of GPOR is still higher than the current Enterprise Value (and PV-10 is just calculated on core U.S. assets).  Does that mean that by definition we are getting the stock at a good price?  Certainly it seems like a reasonable assumption since the NPV at 10% discount rate is higher than what we are paying today and incorporates all costs or development, extraction, and abandonment.  I suppose one could argue that 10% is not the right rate but it seems a decent place to start.  The one thing to remember is that PV-10 is a pre-tax number.  Standardized Measure is a GAAP NAV calculation which also account for taxes.  If you are buying stock in a company which has a very low tax basis in its assets (implying they’ll need to pay more tax due to higher profit) then there could be a meaningful difference between PV-10 value and Standardized Measure.    

In practice, when valuing E&P companies PV-10 is often seen as a base case – simply the value of what is known to be in the ground.  In some cases E&P stocks trade at meaningful multiples of their PV-10.  This is often true in the case where a lot of future reserves are as yet unbooked.  GPOR’s Louisiana and Texas properties should trade at least 1.0x PV-10.  They are very safe assets (in the U.S.), there is little to no ‘exploration risk’, and there is potential reserve growth due to drilling unreserved locations.  We believe value investors should take great comfort in buying GPOR stock at a meaningful discount to PV-10. 

8. Ownership Structure: GPOR is 36% percent owned personally by Charles Davidson who manages Wexford Capital.  As mentioned earlier, Wexford is the 75% owner of Grizzly.  As well, a number of other properties that GPOR owns or has bought into are the result of and in some cases partially owned by Charles Davidson / Wexford.  One person described GPOR to us as, “Chuck’s vehicle for investing in the energy sector”.

There is probably no person with a better understanding of the value of GPOR’s underlying assets.  It is worth noting that when GPOR raised money in Jan of 2007 Chuck bought 530k shares at $11.92.  Then in May 2007 when GPOR needed money to expand their drilling programs Chuck bought 700k shares at $16.00 – that is roughly 50% higher than today and oil was in the mid-$60 range at the time.  We suspect he has good sense of the underlying value of GPOR’s assets and we are encouraged that he was buying at meaningfully higher prices.

When the stock was in the $20s Chuck did file a registration statement for his shares.  This made some investors nervous as they thought he might become a seller.  At current prices we are not worried about this.  If the share price returned to the mid $20s we suspect he might seek partial liquidity – really just a guess. 

9. Final Thoughts / Conclusion:  GPOR is quite cheap on just the asset values of the core properties – even at $70 oil.  As well, the stock trades below the comp range on 2009 cash flow multiples.   Then, if you add in Grizzly and the other assets you have tremendous upside potential. 

The exploratory risk is relatively low and all of the assets are based in U.S. and Canada (ex very small Thailand holding) which takes out the political risk inherent in many “cheap” E&P names. 

Charles Davidson (the guy who probably understands the value best) was a buyer at meaningfully higher prices.

Finally, there are decent catalysts for 2008 with a sale of a portion of Grizzly, summer news of Hackberry land wells, evidence that the Permian will be a growth driver once the field production catches up with current Capex, and finally additional core data out of Grizzly will begin to delineate the other 2/3 of their land. 

Catalyst