Description

(Note: all numbers in USD so the stock should be approx $51 CAD when it trades in Canada)

Pacific Exploration and Production (Pacific) is a Canadian-listed E&P company which operates in Colombia.  It emerged from bankruptcy today and will be listed on the TSX under the symbol PEN beginning tomorrow.  While it has a storied and somewhat checkered past, we believe that its future should be straightforward and that it represents a highly compelling turnaround investment opportunity.

As with many post-restructuring equity opportunities, Pacific’s valuation is very low, market awareness is scant and current commentary from the Company has been quite limited.  In contrast with some other restructurings, we believe fixing Pacific is not simply a balance sheet exercise – rather the realization of the Company’s full value will require significant improvements in corporate culture, capital allocation and cost structure as well as the completion of certain important strategic initiatives.  While a number of these self-help programs have already been initiated and we expect their impact to become visible over time, we believe that the current valuation reflects little to no awareness of this potential.

For those who believe that the price of oil will move higher over time, Pacific represents an attractive long-dated call option as it has high operational leverage and no financial leverage.

Extreme Makeover – Pacific Exploration Edition

No meaningful analysis of Pacific (formerly Pacific Rubiales) would be complete without first examining its history, even if only briefly.  Pacific’s great accomplishment was the successful development of the Rubiales heavy oil field which reached peak net production of over 70 Mboe/d (200Mboe/d gross) in 2013.  The success of this exceptionally complex project was a surprise to many as prior operators had failed to reach commercial viability.  It also provided a great financial windfall which was driven, in part, by Pacific’s very low cost of entry.  Unfortunately, much of the resulting cash flow was squandered on far-flung exploration projects (e.g., Papua New Guinea Gas, offshore Brazil, etc.), challenging development projects (e.g. CPE-6, Rio Ariari) and failed technology projects (e.g., STAR).  Furthermore, the company began a debt-financed acquisition spree in order to diversify production ahead of the expiration of the Rubiales concession, which occurred on June 30, 2016. This resulted in an unsustainable debt load of over $5.4B with the path to bankruptcy then hastened by the collapse in oil prices.

We believe that Pacific’s demise was driven by hubris, lack of capital discipline, a bloated and entitled cost structure (with significant self-dealing by the founders[i]) and a focus on production growth rather than returns.  With this as a starting point, the restructuring process for Pacific represents an extreme makeover.  In the following sections, we will address a number of these historic flaws and how we believe they are to be addressed going forward.

Balance Sheet

Prior issues with Pacific’s balance sheet have been definitively addressed through the bankruptcy process.   Pacific entered into bankruptcy with $1.2B of bank claims, $4.3B of bondholder claims and an accounts payable line that had ballooned.  It is exiting bankruptcy with $250M in total debt, a small LC facility, approximately $556M in cash and significantly reduced payables.  The process of creating this strong and simple balance sheet benefited from the fact that the bank and bond claims were pari passu and have all been converted to equity.  Pre-petition shareholders (including those who had created a lot of corporate drama) were massively diluted through the restructuring process and now hold less than 1 basis point of the new shares (in aggregate).

The Company’s cash position benefited from $500M of DIP funding. Half of this cash came from Catalyst Capital Group, a Toronto-based private equity shop that focuses on distressed and turnaround opportunities.  Catalyst’s DIP note was converted to equity on exit.  The remaining $250M of the DIP funding came from bondholders and was converted into a 5-year exit note which will represent the Company’s only debt post-emergence.

Since all of the pre-petition creditors (excluding local trade claims) and the plan sponsor received equity, it is very clear where the focus will be with regard to creating future value.  Finally, it is worth noting that it is rare for an E&P company to have a large net cash position at this point in the commodity cycle and those that do are highly valued.

Governance

Prior to restructuring, Pacific had a weak and dysfunctional 12-member board – which included two members from a 20% stakeholder that attempted and failed to purchase the company in 2015, two members of a syndicate of Venezuelans who stymied that bid as well as the two co-founders who served as executive co-chairman and had a penchant for self-interested transactions, which are extensively disclosed in the company’s quarterly Management Discussion and Analysis as filed on SEDAR.  The new board has 7 members with Gabriel de Alba from Catalyst serving as Chairman.  None of the new board members have any prior connection to the Company and together they bring significant oil & gas operating, turnaround, and financial experience as well as significant relationships and experience in Colombia. 

Management & Strategy

As discussed above, Pacific has suffered from poor management and corporate strategy.  That said, we believe it is important to separate technical competence from strategic competence.  Regarding the former, we believe that Pacific has largely distinguished itself in a positive fashion for its ability to successfully develop and manage highly complex, large-scale fields and related infrastructure in a challenging environment and also for its exploration success.  Regarding its corporate strategy, we are expecting dramatic changes that we believe will result in significant value creation for shareholders.

We believe that a significant upgrade to Pacific’s management team has begun.  The search for a new CEO appears to be in the late stages and a new CFO has already been hired.  We believe that the management upgrade will extend well beyond these two positions and draw our confidence from the governance provisions of the restructuring agreement.  These provisions  require a 3^rd party consultant to review all senior managers with the retention of the most senior personnel requiring super majority approval by the new board and a simple majority for the remainder.  We believe that the strength of Pacific’s balance sheet and its significant scale in a very interesting oil & gas region will help it attract new talent while retaining the most capable members of the current team.

We also draw confidence from the involvement of Catalyst who has an exceptional track record for distressed and turnaround investing.  While not energy specialists, we believe they bring the necessary skills to change the culture and cost structure of the Company.  We are also encouraged that Catalyst has chosen to take 100% of their investment in the new equity of the Company – fully aligning their interest with that of other shareholders.

G&A Cost

We believe that the cost structure for Pacific is set to improve as the Company’s far-flung and bloated organization is rationalized by the new team.   As of year-end, the Company had over 2,500 employees and offices in Toronto, Calgary, Houston, Peru, Switzerland, Spain, Mexico and Panama in addition to its offices in Colombia. In 2014, total compensation for the CEO, CFO, President and the two Co-Chairman totaled nearly C$40M plus an additional C$21M of long-term incentives.  While we do not believe that Pacific has disclosed a detailed organizational chart, it is our understanding that Pacific has over 30 highly-compensated VPs.  As an example of the high SG&A at Pacific, Bloomberg lists 22 executives for Pacific while its peers, Canacol Energy, Parex Resources and Gran Tierra Energy, in aggregate, have only 23 listed.  While these costs cannot be shed instantly, we believe that there is a great deal of low hanging fruit as well as longer-term opportunities to reduce overhead expenses.  Pursuing these opportunities will be a key priority for the new team.

Operating Cost

Pacific’s operating costs are more difficult to forecast as the Company has not discussed how its unit costs for the now-terminated Rubiales concession compared with the remainder of their production.  While the cost structure at Rubiales’s benefitted from scale, it was also compromised by its very high water cut.  As such we are anticipating that, after some initial noise, unit cost will be fairly similar.  In general, we have not yet incorporated any additional efficiencies related to greater management discipline.

One cost that we do expect to be addressed over time is that of transportation.   Specifically, we see some potential for a reduction in pipeline tariffs as Colombia needs to encourage greater investment in order to stem production declines.  We also believe that Pacific’s new team will seek to address fees paid on one of its pipelines for periods in which the pipeline is out of service.  These issues are important for both Pacific and Ecopetrol, Colombia’s national oil company, and we are hopeful that some progress can be made.

We would also expect to see Pacific adopt a more disciplined and transparent procurement process for goods and field services and we believe that such improvements will yield significant savings over time.

Capital Allocation

A look at Pacific’s past would suggest that the prevailing mindset with regard to capital was that it was unlimited.  Pacific’s former managers invested in gas exploration ventures in Papua New Guinea, offshore oil exploration in Brazil, among others; they built ports, pipelines, electrical transmission systems and invested in a floating LNG project.  It is also clear that their investment process prioritized production growth over return on invested capital.   Pacific’s new Chairman has stated that going forward, these priorities will be reversed. As with much of the industry, we expect Pacific’s capital efficiency to be improved, its capital allocation to be far more selective and its geographic footprint to become more focused.

Valuation

Pacific’s valuation is currently rather opaque but it should come into focus over the next few months.  Among other things, the current opacity is related to (1) the lack of company guidance or commentary during the restructuring process and (2) the loss of the Rubiales field at the end of Q2.  That said, and allowing for a wider than typical confidence interval, we believe that Pacific’s valuation is very low.

In the table below we have used 2017 consensus EBITDA and production estimates for Pacific’s Canadian-listed, Colombian-focused peers (Gran Tierra Energy, Parex Resources and Canacol Energy).  For Pacific, we have used our 2017 EBITDA and production estimates of $410MM and 72 Mboepd, respectively. With regard to Pacific’s reserves, we have used 2015 year-end values excluding the Rubiales Field. In the case of Gran Tierra’s reserves, we have used pro forma figures to take into account a recent acquisition and related financing.  

Based on the quoted price of Pacific’s Bonds, Pacific’s new shares have an implied price of approximately $37.90.  Based on our EBITDA estimate for 2017, the shares are 20% cheap to the median of the peer group.  Our estimates incorporate some improvement in G&A but no other operating improvements.  We have not included estimated one-time charges associated with cost reduction programs but suspect that much of this would occur in 2016.  If instead, we view valuation from the perspective of reserves and production, the shares have between 62% and 95% upside.  While these latter measures ignore Pacific’s poor historic management, we believe they highlight the Company’s potential should the new owners improve operations to be in-line with the peer group.

With regard to the prospects for an improved oil price environment, we believe that a $10 increase in Brent would result in a 2017 EBITDA of approximately $625M – an increase of over 50%.

Conclusion

Turnaround investing requires patience and an ability to recognize the latent potential of poorly-performing assets or businesses. The most compelling opportunities combine significant latent potential, a motivated, talented and empowered agent of change and, ideally, a favorable trend for the industry.  We believe that Pacific has all of these characteristics.    While there will likely be some noise and volatility along the path, we believe that the risk-reward is highly compelling and that the margin of safety is significant.

Catalyst

Post reorg equity