Pinecrest Energy is a junior oil & gas company that generates the highest netbacks in Canada.  It currently trades at just over 1x 2014 cash flow and proved developed producing reserve value.  After raising money at $3.25 per share in February 2012, the stock now trades at $0.70.  So, what happened?

As far as we can tell, it is a classic case of a fallen market darling.  After being heavily marketed in 2011 and 2012 with substantial sell side sponsorship, drilling results did not live up to the hype.  Specifically, wells that were supposed to generate 30-40% IRRs only generated marginal returns, based on our analysis of individual well data.  Unrealistic growth expectations did not materialize and momentum/growth investors began to sell en masse.  A failed merger late in 2012 only intensified the selling pressure.  Skepticism over the profitability of its drilling prospects, funding concerns and management credibility issues have kept even brave prospective value investors away.  We believe that the stock is near a floor and trades at a very compelling valuation in terms of EV/EBITDA, price/cash flow, EV/flowing barrel, EV/proved + probable reserves.  Further, we expect that many the reasons investors have sold the stock will be remedied in the coming months.  Principally among these are 1) the company will demonstrate that it can successfully waterflood its properties and bring well costs down, 2) net debt has peaked and will remain low relative to EBITDA, 3) the company will begin to generate free cash flow mid next year.

 

Background

To provide general background, Pincrest was started as a private company in 2006 by several founding members of Crescent Point Energy and Peerless Energy including Wade Becker (CEO), Dan Toews (CFO), and Bill Turko (COO).  Crescent Point is now a $14 billion market cap energy company.  Peerless was sold in February 2008 for $334 million to Petrobank.  Management built Peerless from zero production to 5,800 boe/d in less than three years.  Production at Peerless was primarily oil from the Bakken, which provided management with the unconventional oil multistage fracturing experience needed to run a company like PRY.  Though management has developed a credibility issue at PRY, the management team/board and their former companies are widely respected in Canada. 

PRY is a one asset company; PRY owns 176 thousand net acres in Alberta prospective for Slave Point light oil.  This management team first acquired acreage in the area with Peerless.  Upon selling Peerless, management bought back PRY’s original acreage from Petrobank with $20 million of management capital.  Subsequent to management’s original capital contribution, the company has completed six share offerings to expand its acreage position and fund drilling.  Except for the IPO in October 2006 at $0.20, all of the share offerings were completed above $1.00 per share.

 

Capital Structure 

PRY had 214.3 million basic shares outstanding at the end of the first quarter.  Dilutive securities consist of 28.8 million warrants struck at $0.50, which are owned by management, and 15.5 million options with an average strike price of $1.77. 

Net debt of $95 million is drawn on a credit facility with a borrowing base of $165 million.  Including its net working capital deficit, net debt was $131.6 million at the end of the first quarter. 

 

Slave Point Light Oil at Red Earth

Production from the Slave Point is 99% light oil.  Management estimates oil in place per section of 5 to 10 million barrels with an expected recovery ratio of approximately 10% on primary recovery.  PRY has drilled approximately 70 horizontal wells to date and is currently producing around 4,000 barrels of oil per day.  Several hundred horizontal wells have been drilled by industry in the area.  Other companies active in the play are Penn West Energy (PWT CN), Baytex Energy (BTE CN), Lone Pine Resources (LPR) and Enerplus (ERF CN).  Penn West claims that this is their best play.  LPR is a distressed company and will likely monetize its Slave Point assets this year.

Pinecrest hired Sproule Associates to conduct a resource study on their Slave Point project in early 2012.  Sproule estimated that PRY’s lands held 67.5 million barrels of mid case contingent resources, based on primary recovery from four wells per section.  This compares to the 8 million barrels PRY had booked as proved reserves at the end of 2012.

PRY originally estimated that its single well IRRs would range between 40 and 60%.  Our analysis of publicly available individual well data leads us to believe that the company’s average well generates approximately a 15% IRR, which we view to be marginally commercial.  Including G&A and acreage costs, the play is sub-commercial at current oil prices, using well costs to date and previous completion techniques.  Like any unconventional play, well results get better with time and much of the initial capital goes to figuring out the right drilling and completion recipe.  Clearly, based on the capex/cash flow table below, the company did not generate a 30%+ rate of return on its wells to date.  The question is what will the rate of return be on the wells going forward?  In the first quarter, the company began to change the way it drilled and completed its wells in an effort to cut costs.  It shorted its lateral length, reduced the number of frac stages, and switched to an open hole completion instead of a cemented liner.  Without getting too technical, the idea was to spend 60% of the capital and recover 80% of previous well reserves.  It is still too early to draw any conclusions, but management seems pleased with the results to date.  In its latest operational update, PRY claims its most recent wells using an open hole completion technique will generate an average IRR of 52% on primary recovery, paying out it 1.5 years.  We have yet to see an oil company that understates its type curve well returns, but the progress is encouraging. 

From the inception of the play, management was excited about the waterflood potential of the Slave Point.  In its marketing presentation, management points to several legacy analog waterfloods that have been highly successful in Slave Point vertical wells.  The company will initiate eight waterflood pilots this year.  Three are currently injecting water, all of which have already shown a production response.  Whereas before the waterflood potential was the icing on the cake, it is now critical to the commerciality of this play.  While we are not engineers and have no technical background, we expect the waterflood program to be successful.  That all of the sections on waterflood have already shown and increase in production is very encouraging.  If successful, waterflood capital is highly efficient as no drilling is required; it simply increases the recovery from existing wells.  Based on analog waterfloods, recovery factors in waterflood sections could be as high as 25%+.  PRY claims to generate returns of between 67% and 240% on waterflood sections.  Time will tell.    

Due to a prolonged spring breakup in the area, PRY is only actively drilling in the first and fourth quarters.  Minimal capital spending and drilling occurs in the second and third quarters.  Limited access to well sites also makes the production profile very choppy, with production growing rapidly through the winter and declining heavily in the spring and early summer.  Management was actively seeking another play area to diversify its asset base and smooth out its production.  After a failed merger with a peer, PRY remains a one asset company.

 

Failed Merger

On November 12, 2012 Pinecrest and Spartan Oil Corp. (STO CN) announced they would merge and convert to a dividend paying corporation.  Dividend pay corps are all the rage in Canada these days, often times traded at double the EBITDA multiple of their non-paying brethren.  STO was a well managed company with producing asset primarily in the Pembina Cardium area.  On December 10, 2012 Spartan informed Pinecrest that it had received a superior offer and would be terminating the transaction.  PRY received a $10 million break-up fee.  Since the cancellation of the merger, PRY’s stock has declined over 60%.  It is unclear how much of the decline is attributed to the deal, but it certainly has not helped investor sentiment.  PRY is actively looking at ways to add a new play to the company, but at the current stock price, almost any transaction would be highly dilutive.    

 

CAPEX and Cash Flow

To date in the play PRY has spent over $600 million in capex and generated $193 million in cash flow (includes 2013 budget).  Management guided to 2013 capex of $133 million and we estimate PRY will generate EBITDA of $90 million this year.  After several years of outspending cash flow, we expect, PRY to become free cash flow positive sometime next year.  This is heavily dependent on 1) the 2014 capex budget, which will not be released until early next year, and 2) the success of the waterflood pilots. 

 

Year	Capex	Cash Flow
2014E	$  130.00	$      120.00
2013E	$  136.00	$       90.00
2012	$  212.80	$       71.78
2011	$  164.90	$       31.17
2010 (Aug-Dec)	$    87.18	$        (0.21)
2010 (FY end Jul 31)	$    28.69	$        (0.11)
Total (2010-2013)	$  629.57	$      192.62

 

Valuation

PRY trades at a valuation that makes it one of the cheapest, if not the cheapest E&P company in Canada, on basically every metric.  This is especially surprising considering its light oil weighting, strong capital efficiencies to date, and top quartile production growth rate.

 

Share Price	$              0.70
Shares Outstanding	$           233.95
Market Capitalization	$           163.76
Net Debt	$            94.86
Enterprise Value	$           258.62
2012 EBITDA	$            66.65
1QA EBITDA	$            89.06
2013E EBITDA	$            90.00
2014E EBITDA	$           120.00
EV/2012 EBITDA	3.9x
EV/1QA EBITDA	2.9x
EV/2013E EBITDA	2.9x
EV/2014E EBITDA	2.2x
12 Avg Daily Prod. (Mboe)
2012	3.142
1Q 2013	4.315
2013E	4.500
2014E	6.500
EV/'12 Daily Prod (Boe)	$            82.31
EV/1Q13 Daily Prod	$            59.94
EV/'13E Daily Prod (Boe)	$            57.47
EV/'14E Daily Prod (Boe)	$            47.02

 

Net Reserves	MMBoe	Pre-Tax PV10	Per Share
PDP	5.575	$       228.89	$    0.57
Proved	8.086	$       253.03	$    0.68
Proved + Probable	13.380	$       352.55	$    1.10

 

Normal Course Issuer Bid

On June 5, 2013 PRY announced its intention to purchase up to 19.6mm shares (10% of basic shares) in a normal course issuer bid program.  Our conversations with management lead us to believe that, unlike many other Canadian companies, PRY will likely significantly reduce its shares outstanding if the share price does not increase dramatically.  They believe that at the current price they can buy their own barrels cheaper than they can prove up additional barrels through the drill bit.  

 

Target Price

The fair value of the stock is somewhat binary, depending on whether or not the waterflood is successful.  If unsuccessful, the stock should trade around $1/per share representing a slight discount to proved plus probable reserve value (+43% return).  We believe that at the current price, the market is more than discounting an unsuccessful waterflood program.  If successful, we peg fair value at around $2.00, equating to a 186% return.  The upside case could be in excess of $3 per share if the market considers the full development value of PRY’s acreage and that the company will have a cash flow surplus sometime next year.  The downside price could theoretically be zero if management continues to struggle with recycling cash flow into profitable projects.  We view this scenario to be highly unlikely given the recent success with new completion designs, the initial waterflood response and the fact that management has 29 million warrants struck at $0.50.
 

Catalysts

1.  Additional data confirming waterflood success
2. Confirmation that completion design changes increase commerciality
3. Share repurchase program
4. Successfully meeting guidance for the balance of the year