Description

We are long shares of Penn West Petroleum Ltd. (PWT CN, PWE, the “Company”).  Please note that all dollar figures are in Canadian Dollars unless otherwise noted.  Penn West is the dominant player in Canada’s Cardium play.  The Company entered the current oil downturn with too much debt and was forced to sell assets.  After selling over $2 billion in assets over the last two years, Penn West has a very manageable capital structure and is in a position to meaningfully grow reserves and production within cash flow at current oil strip prices.  Our thesis is that the market is overly discounting the stock due to historical mismanagement and high leverage.  We think the stock should trade over $3.00 per share, a 50% return over the next year and still a discount to peer multiples, as the market fully appreciates the Company’s clean balance sheet and the earnings power of its remaining assets.  Admittedly, this idea has lost some of its upside since I started writing it, but we think recent price appreciation is indicative of a warranted rerating that is underway.           

Capital Structure

Penn West had an average diluted share count of 502 million shares for the quarter ending June 30, 2016.  At a share price of $2.17, the market cap is $1.1 billion.

Debt as of June 30, 2016 was $1.5 billion, consisting of $1.2 billion of senior secured notes with various maturities and $342 million drawn on its credit facility.  The company has a secured revolving credit facility with a borrowing base of $1.2 billion and a maturity date of May 6, 2019.  The Company also had $1 billion in cash with which it expects to pay down debt in the second half of 2016.  Accounting for Q3 disposition proceeds, pro forma net debt is $491 million, including working capital deficiency.  The current enterprise value is $1.5 billion.

Background and Reason for the Opportunity

Penn West was one of the largest Canadian income trusts.  Similar to master limited partnerships in the US, energy trusts allowed companies to distribute a large portion of their cash flow to investors without paying corporate income tax.  The structure was created in 1986 and was phased out by the Canadian government beginning in 2006 as some 250 companies had converted to income trusts.  These distribution structures encourage companies to attempt to add value through paper-financed acquisitions rather than the drill bit.  Generalizing the model, the income vehicle with the lower cost of capital uses its stock as a currency to roll up peers with a higher cost of capital.  The arbitrage between the two valuations allows for an increase to the distribution at closing.  The resulting amalgamation of assets is often poorly managed, but everyone is happy as long as the distributions are flowing and growing.  This type of situation often ends in tears once the company loses its cost of capital for whatever reason and can no longer mask the results of the underlying business with acquisitions.  For Canadian income trusts, changes in tax laws took away most of their cost of capital advantage though some, including Penn West, continued to pursue an income distribution strategy in a corporation structure with limited success.  Penn West completed its conversion to a corporation in January 2011. 

For long-term holders of Penn West, the stock has been a brutal investment since the end of the income trust days.  From a peak of $28 per share in early 2011, the stock traded to a low of $0.60 in late 2015.  Poor capital efficiency, a bloated cost structure, and an unsustainable payout ratio destroyed significant value over that period.  On May 2, 2013, Penn West announced that the board of directors had commenced a renewal process, which began with the resignation of the former chairman John Brussa, who had been a director since 1995 and was one of the creators of the Canadian income trust structure.  Three days later the Company announced the appointment of Rick George as Chairman.  Rick George ran oil sands producer Suncor (SU CN) from 1991 to 2012, providing investors with a 50-bagger return over that time period.  The following month, Muray Nunns, who had been Penn West’s CEO for eight years announced his retirement and was replaced by David Roberts, then the COO of Marathon Oil Corporation (MRO).  David Roberts came with 30 years of experience, previously serving as Marathon’s SVP of Business Development and Managing Director at BG Group.  Prior to joining BG, he spent 18 years at Texaco, ultimately serving as advisor to the vice chairman of ChevronTexaco from 2001 to 2003. 

Here are a couple of articles on George / Roberts that are worth reading for management background:

http://www.albertaoilmagazine.com/2013/10/canadas-greatest-oilman-rick-george/

http://albertaventure.com/2014/09/v250_penn-west-david-roberts/

In conjunction with the renewal process announcement, the Company announced a dividend cut and the initiation of a strategic review process to maximize shareholder value.  The new board and management team established a mandate to reduce operating costs and G&A costs so as to create a step change in the efficiency of each invested dollar.  This began a cultural change across the Company.  As David Roberts said, “We have instilled a value-first culture at Penn West in which we challenge the cost/benefit of every activity we engage in and question the profitability of every barrel we produce”.  The scope of the review included a technical evaluation of the Company’s substantial producing and non-producing assets, a study of each peers operations and a benchmarking analysis for each play, and consideration of various capital structure and strategic combinations and options.  Roberts took a very practical approach to reducing costs and improving capital efficiencies.  First, he identified the best-in-class operator in each of Penn West’s operating areas and then adopted that operator’s techniques and attempted to beat them on cost, drilling time, efficiency, etc.  Apparently, shortly after Roberts stepped into the CEO role, he called his counterparts at several companies that he considered to be the leaders in the Cardium and Viking.  The conversation went something along the lines of: we are struggling, this is what we are currently doing, would you mind sharing what you are doing so we can do better?  All evidence indicates that those conversations were fruitful. 

The result of the strategic alternatives process was a long-term plan to focus on a small number of key plays, primarily the Cardium.  This involved significant asset rationalization to shore up the balance sheet and monetize non-core assets that would not receive substantial capital under the new plan.  Target non-core asset sales were $1.5 - $2.0 billion, and target debt to fund flows are 1.0 to 1.5x, down from over 3x at the time.  Additionally, staffing was reduced by over 50%. 

The turnaround plan seemed to be gaining traction, with significant debt and operating cost reductions realized, and then November 2014 happened.  Had the George/Roberts team not made significant progress on its plan, Penn West almost certainly would not have survived the downturn.  The survival path, however, was painful for investors and involved selling core assets, particularly the Company’s Saskatchewan Viking position.  After selling in excess of $2 billion in assets over the last two years and removing its leverage overhang, the Company can focus on growth rather than survival.  We think that the George/Roberts-led Company will create substantial value for shareholders exiting this downturn.    

Core Assets - Cardium

The Cardium trend is the largest light oil accumulation in the West Canadian Sedimentary Basin and holds Canada’s single largest conventional oil field Pembina, which has produced a cumulative 2 billion barrels since 1953.  Estimates of original oil in place are in excess of 12 billion barrels.  Industry Cardium production peaked in the 1970s at approximately 200 thousand barrels per day and was in seemingly perpetual decline into the 2000s.  Over the last decade, horizontal, multi-stage fracturing technology has expanded the footprint of the Cardium beyond its conventional core into thinner “halo” areas and locations with lower quality rock properties, reviving production growth and development activity.  A similar phenomenon has occurred in many major North American oil fields.  Penn West has a 675,000 net acre position in the Cardium trend, more than triple the size of its next largest peer and making up approximately 40% of the trend.  We consider the Cardium assets the crown jewel of the Company. 

Penn West’s historical inferior horizontal well results in the Cardium were a result of poor operations, not poor geology.  In fact, owning the heart of the conventional part of the field, Penn West arguably has some of the best rock in the play.  The Company was the last of the large Cardium players to adopt slickwater fracturing technology.  Since doing so, horizontal well results have improved dramatically.  Extending lateral lengths and optimizing frac designs have further improved results.  Looking at industry production data reported monthly, recent vintage Penn West Cardium wells now rank among the best in the play.  Along with current management’s cost savings efforts, Penn West’s Cardium economics are competitive with other top tier North American unconventional oil plays.  Importantly, Penn West had not spud a Cardium well since October 2015.  As the Company ramps its drilling program in the back half of the year, we expect further efficiencies and an even more visible benefit from modern completion techniques. 

Today the Cardium produces 18.5Mboe per day for Penn West, around 75% of pro forma Company production.  Proved and probable reserves in the Cardium are approximately 100 million boe.  Contingent resources total to greater than 650 million barrels, demonstrating the large future potential of these assets.  The Company continues to advance multiple waterflood programs in the Cardium to maximize recovery and reduce production declines.  Additionally, the Cardium is a stacked play, with further upside in the Company’s 500 sections of Belly River and Manville acreage. 

Other Core Assets

Viking

Penn West sold its core Saskatchewan Viking position earlier this year to Canadian Pension Plan-backed Teine for $975 million in cash.  At $71k per flowing barrel and around 15x cash flow, this was by far the highest recent Viking transaction comp and well above our (and we suspect the Street’s) expectations.  While this was clearly a premium asset as evidenced by its premium price, it removed the debt overhang from the stock.  At a pro forma debt to EBITDA below 2x, the Company is now in a position to grow production again as commodity prices warrant. 

The Company retained its over 100,000 acres in the Alberta Viking, which could develop into a new core area.  Currently, the Alberta Viking represents only 1M boe/d of production and a small portion of the Company’s cash flow.  The Company believes it can apply its accumulated knowledge from the Saskatchewan Viking to its Alberta Viking holdings.  Offset operator activity indicates this area is highly prospective.    

Peace River Oil Joint Venture (PROP)

On May 13, 2010, Penn West announced that it and China Investment Corporation (CIC) would form a joint venture to develop Penn West’s “world-class resource” bitumen assets in the Peace River area of Alberta.  Under the terms of the agreement, Penn West contributed assets valued at $1.8 billion in exchange for a 55% interest in the JV.  The $1.8 billion of assets included approximately 237,000 net acres of oil sands leases and 2,700 boe of daily production.  In exchange for a 45% interest in the JV, CIC agreed to invest $817 million, $312 million of which was due to Penn West at closing, and $505 million in a carry.  In conjunction with the deal, CIC purchased 23.5 million units of the Company at a price of $18.51 per unit, which was approximately 5% of the company at the time.  The purpose of the transaction was to accelerate development of the asset and reduce debt.  Penn West had $112 million of deferred fund assets related to this project at the end of the second quarter.  A contingent resource study done by AJM Deloitte estimated this project held 473 million barrels of bitumen net to Penn West’s interest.  The Company is currently running a two rig program here, where CIC is paying 90% of the cost until 2018.  Current production net to Penn West’s interest is approximately 5 Mboe/d.  Proved and probable reserves here are 37 million boe.  We think economics at current prices are challenged in this play on a gross basis.  However, since CIC is essentially funding the drilling, it makes sense for the Company to continue investing here.  At current oil prices, PROP generates around $30 million in stable cash flow for the Company.  At modestly higher oil prices, we could see this play being worth a very significant portion of the current enterprise value. 

Remaining Assets to be Sold

The Company is targeting an additional 10-20Mboe/d of asset sales, of which $75 million / 6Mboe/d was announced in the second quarter earnings release.   Importantly, these assets have very high operating costs and significant abandonment liabilities.  As such, the Company is guiding to only $100-200 million in proceeds for these assets.  We see upside to this target given management’s historical conservatism in divestiture proceeds targets.  Divesting of these assets will allow operating costs to go from a current run rate of approximately $15/boe to $10-12/boe.   

We also speculate that what remains of the Company could be a tempting acquisition target given its low base production decline rate, manageable debt / abandonment liabilities and leading position in the Cardium.

Phase 2 – The New Penn West

The new Penn West looks vastly different than the bloated company producing close to 200Mboe/d just a few years ago.  Pro forma of the final asset sales, Penn West will be a growing Cardium-focused company producing approximately 25Mboe/d with a clean balance sheet and a competitive cost structure.  Operating costs will continue to trend down with asset sales and cost cutting measures to around $10-12 per boe.  Netbacks at current commodity prices will be a top tier $20+.  The PROP and the Alberta Viking will continue to see additional capital allocation due to the partner carry and exploration upside, respectively.  For 2017, the Company expects to grow production by at least 10% within cash flow.  The preliminary 2017 budget is $150 million. 

At current commodity prices, we estimate the pro forma entity will generate around $200 million in EBITDA in 2017.  Penn West is highly leveraged to oil prices.  At USD 60 WTI, we estimate that EBITDA would grow to in excess of $300 million.  The Company maintains it could grow production at a 15% CAGR while continuing to pay down debt at that oil price.

Valuation

We look at the valuation for Penn West and other E&P companies in several ways, including NAV, EV/PV10 (proved, proved + probable) and EV/EBITDA.  Inputs like reserve life, dividend yield, payout ratio, capital efficiency, recycle ratios, production growth and capital spend are important when considering the appropriate multiple for each metric.  We see Penn West as compellingly valued on all of these metrics.  The Company estimates its base decline rate is 19%, which would be among the lowest in Canadian E&P.  Given that the Company’s reserve report is quite stale after all of the asset sales, we are using a sum-of-the-parts valuation on the Company’s remaining core areas.  Our net debt assumes the Company is successful in hitting its final asset disposition target of $200 million.  We are also only including production and cash flow from the remaining core areas.

We value the Cardium at a reserve multiple discount to where the Company sold its Viking assets.  Given the size and quality of the Cardium position, we think this is fairly conservative.  It also equates to a flowing barrel multiple of $74k, which we also view as appropriate.

We value the PROP on a cash flow multiple plus the remaining carry value given the stable nature of this cash flow stream.

The Alberta Viking value is somewhat arbitrary.  As mentioned above, with any exploration success, this area would be worth significantly more.

Comparables

We chose comparables from oil-weighted juniors and intermediate producers.  While not a perfect metric, dollars per flowing barrel multiple is a common metric for comparing producer valuations.  We think Penn West should trade at the average production multiple for this peer group or higher given its asset quality, high netback and low decline rate.  At $80k/flowing boe, the stock would be $3.17.  For what it’s worth, we also think that TVE CN is a compelling Cardium story with high-quality management.

Risks

Oil price / Canadian differential risk

Inability to transact on final asset sales

Missteps in achieving cost targets

Well results underperform our expectations

Catalyst

Catalysts / Reason to Own

Leverage to oil prices – Company is unhedged in 2017.  This obviously cuts both ways.  Without getting into an oil macro debate, we view the risks as being to the upside. 

Valuation – We think a reversion to at least the peer group average is warranted.  Historically traded at a discount due to poor management, high leverage and no growth.  All of these issues have now been removed.

Rerating from improved cost structure – consensus estimates look too low and not updated for the dispositions and lower cost guidance. 

Improving well results – We expect a further improvement in Cardium results when 2H 2016 program consists of 100% modern completions.  Any success in the Alberta Viking could drive the market to incorporate that play’s upside into the valuation.