Description

Thesis:

Synergy Resources (SYRG) is painfully overvalued.  Despite a tremendous valuation, an eroding balance sheet and some of the worst realized crude pricing in the United States the company’s stock remains within ~5% of its 52 week high.  Synergy represents an attractive outright short opportunity or the perfect hedge for those wishing to put on a pair trade within the oil and gas space.  Given the relative outperformance of the company’s stock coupled with the significant slowdown of operational momentum at the company, Synergy represents one of the last highly compelling oil and gas shorts that we can find in the market today. 

Company Background:

The company’s asset footprint is concentrated in the Wattenberg Field of the DJ-Basin just north of Denver.  The company has additional assets located in Nebraska and eastern Colorado.  From an acreage perspective, Synergy controls ~36K net acres in the core of the Wattenberg in Weld County, CO, ~28K net acres northeast of the core in an extension area, ~184K acres in western Nebraska and ~63K net acres in eastern Colorado.  Nearly all of the company’s production and planned 2015 capital expenditures are centered on the company’s ~36K core Wattenberg acres.  Over the last year production at Synergy has grown from ~3,200 boe/d during the first quarter of 2014 to ~8,300 boe/d during the first quarter of 2015.  During this period the breakdown of production has remained relatively constant at 62% crude and 38% natural gas and natural gas liquids.  This production growth has been driven primarily by the company’s horizontal campaign across its core Wattenberg acreage which is for the most part held by production.  Outside of the company’s core Wattenberg acreage block, very little of the company’s acreage is held by production, significant chunks of this acreage will require lease renewals and extensions in 2015 and 2016 should the company decide to hold onto this acreage.  As a result, most of the company’s current valuation can be attributed to the company’s core Wattenberg position.  At current strip pricing the company’s core acreage in the Wattenberg will likely be the company’s only drillable asset for the foreseeable future.   

Current Valuation:

Pro forma for a recent acquisition, Synergy has ~84.8M diluted shares outstanding and net debt of ~$105M.  Given the company’s current share price of ~$13.20 Synergy has a market cap of ~$1.1B and an enterprise value of ~$1.2B.  This valuation equates to $144K per flowing boe/d given the company’s Q1 2015 production.  On an EBITDA basis Synergy is trading at roughly 12x TTM EBITDA, 9x Q1 2015 (which ended in November for the company) annualized EBITDA and roughly 16x the company’s FTM EBITDA excluding hedges.  As of 11/30/14 the company’s hedges had a value of ~$25M, the company’s oil hedges amounted to approximately ~35% of the company’s expected FY 2015 oil production.  Between 11/30/14 and the company’s most recent quarterly report earlier this week the company hedged an additional 45% of its expected production.  While it’s not clear at what price these hedges were put on given limited disclosure by the company these hedges most likely do not add significant value unless oil prices were to fall significantly further.  When thinking about the valuation of the company, I have chosen to back the hedges out of EBITDA and include them in the enterprise value to gain a better view of the profitability of the company’s assets.

The company’s valuation sticks out as excessive in a landscape where many E&Ps are down in excess of 50%.  In looking across a basket of 26 small and mid cap oil and gas companies, the valuation of Synergy compares as follows:  On a price per flowing boe/d basis Synergy’s $144K per flowing boe/d compares to an average of under $70K for the basket.  The company’s Q1 2015 (which compares to Q3 2014 for the comp set) annualized EBITDA to EV multiple of 9x compares to ~5x for the comp set whereas the company’s 16x multiple to FTM EBITDA compares to a multiple of ~10x for the comps – this assumes a 50% decline in EBITDA for the companies in my comp set as compared to the EBITDA levels that many of these firms were annualizing at in Q3 of 2014. 

Valuing Synergy on my comp set produces the following per share values: At $70K per flowing boe/d of production, the company’s stock is worth ~$6.  When using an EBITDA based approach, valuing the company at 5x its Q1 2015 “peak” EBITDA yields a per share value of ~$7 whereas at 10x my estimate of the company’s FTM EBITDA yields a per share value of ~$8.  All three are clearly substantially below the company’s current stock price of ~$13.20 and show how overvalued Synergy is when compared to the E&P universe. 

Perhaps the most telling fact set in regards to Synergy can be seen in how the company’s management team valued a tuck in acquisition that the firm recently executed.  Just prior to the collapse of the price of oil the firm purchased for $125M 5,792 net acres supporting 1,240 boe/d of production froma private operator.  This acreage is highly reflective of the company’s core Wattenberg position in Weld County, CO.  Management stated that in valuing the transaction they valued the production at $60K per flowing boe/d and the acreage at approximately $6K per acre.  Using a similar framework for looking at Synergy as a whole yields a per share equity value of ~$7.50. 

Historical Valuation:

Synergy has historically had a high valuation relative to peers industrywide as well as when compared to DJ Basin peers such as PDC Energy (PDCE) – which coincidentally is dramatically less expensive when compared to Synergy despite having a larger footprint in the core of the Wattenberg.  This premium valuation has been driven by the reputation of management as great operators who have a passion for keeping costs low and selling their companies to larger operators in the DJ Basin, something they have done three times in the past.  These factors have been reinforced by management’s ability to grow production tremendously starting in early 2013 as the company transitioned from a legacy vertical drilling program to a horizontal drilling program.  FY 2013 production averaged ~2,150 boe/d compared to ~4,280 boe/d in FY 2014 and ~8,270 in Q1 of 2015 which was reported earlier this week.  Such growth rates have at times led to high valuations in the oil and gas space, particularly for companies operating in a specific field. 

Catalysts that Ensure a Successful Trade:

Had oil prices not fallen significantly after Thanksgiving it is likely that Synergy would have been on pace to put up another successful year as the company would have been able to continue with its horizontal campaign.  Numerous sell side analysts had previously published estimates suggesting the company could see average production approaching 12K boe/d on average over FY 2015.  Such a level would likely have supported the company’s current valuation.  Given the collapse of oil prices and the resulting required pullback in the firm’s capex budget it now appears that Synergy is going to only average somewhere below 9,500 boe/d over the course of the year.  This slowdown comes as management has stated its intent to focus primarily on completing previously drilled wells which sets the stage for slower growth going forward as the company moves into 2016.  The company’s small production base, composed primarily horizontal wells that have recently been brought online suggests that production could decline quickly if the company cannot replace flush production.  As such given the current pricing outlook and the nature of horizontal wells it is likely that the company will be getting virtually zero return on the capital invested to achieve this production.

Infrastructure constraints relating to takeaway capacity out of the DJ Basin was already set to be a major issue in 2015 for companies like Synergy.  However widening differentials between local pricing and pricing in Cushing have dramatically elevated the level of pain being felt by DJ Basin producers.  Local pricing from the start of December to today has averaged $12 a barrel below Cushing, when oil was at higher levels this differential was less painful; however, at current prices this differential leads to significant EBITDA contraction.  It is important to note that companies typically cannot hedge basis differentials in places like the DJ Basin.  While pipelines are set to help relieve the bottleneck in the area management has stated that the differentials between local pricing and Cushing will average around $10 a barrel for the foreseeable future.  This differential helps bring down the average realized price for a barrel of Synergy’s production to between $32 and $36 dollars over the course of 2015 before hedges based on the current futures curve and the company's production mix.  The current spot price in the DJ Basin of $33 for a barrel of oil implies even lower realized prices for the company and should force the company to put out weak second quarter results. 

Management historically refused to run any of their prior companies with debt.  As such they have stated that they are uncomfortable running Synergy at more than 1.5x debt to EBITDA based on expected FTM EBITDA.  With the company’s current production of ~8,300 boe/d and assuming a FY 2015 average of just below 9,500 boe/d, management would likely be comfortable with its net debt load rising to no more than $130-140M.  Following the closing of the company’s most recent acquisition, I believe the company’s net debt number stands at ~$105M.  Given various capital expenditures in Q2 that number is likely higher today.  In the company’s Q1 2015 call, management stated that their credit facility with its $230M borrowing base had only $83M of availability remaining.  Based on commentary in the transcript the company’s net debt level appears to be somewhere above $110M.  Given the company’s remaining capex backlog Synergy should hit 1.5x debt to FTM EBITDA in relatively short order, particularly with current basis differentials.  With management’s conservative nature and the pride that they have historically had in having a debt free balance sheet, I would not be surprised to see the company conduct a stock offering given how well the price of the company’s stock has held up in order to repay debt.              

Key Risks:

As with any business exposed to commodity prices the primary risk to this short thesis is the price of oil moving up dramatically.  However even in that instance Synergy will move up far less when compared to other oil and gas names making it an ideal short for an oil and gas pair trade. 

Catalyst

Given wide basis differentials in the DJ Basin, Synergy should report weak results in the upcoming quarter.  These results are likely to compell management to further reduce capex/production estimates for the year, further threatening the company's momentum based bull case.