Penn West Energy: More Questions Than Answers After Q1 2008 Earnings

2008 Q1 highlights (all figures C$ unless otherwise noted):

  • Operating cash flow came in at $367M vs. $296M YOY. However, taking into account the Vault and Canetic acquisitions (and the 51% share dilution accompanying them), OCF per share came in @ $1.02, down 18% from last year. Free cash flow (FCF) fell 42% from a year ago to $0.24 per share. With declared dividends of $1.02, PWE’s “standardized distributable cash payout ratio”, aka dividend/FCF ratio, was 4.5. Inverted and translated, this means the company’s available cash after capital expenditure necessary to keep the company running as a going concern covers only 24% of declared dividends.
  • The company’s balance sheet deteriorated slightly in Q1. Goodwill jumped to $2B (13% of total assets) as a result the aforementioned acquisitions. The current ratio slid from 0.62 to 0.58 and long-term debt ballooned to $3.6B from $2B YOY. Total liabilities as a percentage of tangible assets came in at 121%. Subsequent to Q1, the company issued an additional ~$510M of notes to pay off bank debt so I’d expect to see little net debt added as a result of this transaction.
  • Revenues more than doubled to $982M. Net income decreased to $78M, down 19% YOY. Earnings per share was 46% lower at $0.22. The company’s hedges really weighed down results on the income statement. PWE registered netback margins of 59.4%, up imperceptibly from 58.9% & 58.7% margins of YOY and from Q4 2007 respectively. This is despite a 37% increase in aggregate sales price and the hedges in place do not account for all of the gap.
  • Management raised funds flow 2008 guidance to $2.7B – $2.9B, due solely to raising the baseline prices for oil & gas.

In my last posting on PWE, I put the company on notice, so to speak. The company’s Q1 report did little to ease my concerns.

Operationally, the company experienced some setbacks with a worker death and a pipeline leak during the quarter. While I don’t think they are in danger of becoming the next BP, these incidents, in conjunction with some of the issues they had last year (such as the Wildboy plant fire), suggest management needs to tighten the ship a little on operations.

The company’s free cash flow is trending the wrong way. I am not sure if there are seasonal factors affecting FCF but the company is well off historical ratios of revenue-to-cash-flow conversion. The company has begun emphasizing “funds flow”, which adds back asset retirement obligations and non-cash working capital, over OCF/FCF. Unless the company also pays “non-cash” distributions and capital expenditures, color me skeptical of this measure. I asked investor relations for some color on the usefulness of this measure as opposed to measuring cash and received a cut-and-paste response from their quarterly report. Adding to my doubts, I scanned through previous earnings releases for funds flow and could not find that term (“funds flow”) in any reports until Q3 2007. I admit some slack on my part for not noticing it at the time (actually, I mistook “funds flow” as synonymous with OCF, much like their “standardized distributable cash” term is basically FCF), but at this point, I’m dubious about using this figure to assess the stock.

Daily production of 192k BOE per day came in below pro forma guidance of 195k – 205k BOEpd but I would expect this number to gradually ramp up as the new acquisitions are fully integrated.

COO Murray Nunns joined in his first conference call and de-emphasized the Seal/Peace River plays, though he did set preliminary projections of 10k – 15k bpd in select Seal locations with the potential for 40k bpd over 5 years using low-intensity steam injection. He reeled off a whole slew of new plays which had not been previously discussed but unfortunately, did not give any substantive details (such as projected reserve potential, timelines, etc.).

This highlights an increasing frustration for me as a unitholder: the company’s investor communications are poor. The company regularly mentions their millions of unexplored acres, growth prospects, etc. but rarely mentions what their organic reserve replacement ratio is, possible resource figures at these millions of acres, i.e. the true nitty-gritty of resource investing. Management spends much of their time talking about their money-losing hedges but little time talking about their crystallized growth opportunities (maybe they don’t have any?). They’ve diluted unitholders by 51% from last year to acquire Canetic and Vault but haven’t told unitholders why they did it. What properties were they so excited to get their hands on? Where is the potential for value creation that justified these transactions, especially as they’ve admitted that synergy/consolidation potential is limited? When can unitholders expect to see resource conversion on this acreage and at what rate? These are the things I feel management should be talking about.

Unfortunately, investor relations did not provide any clarity on these issues. Apparently, the new plays mentioned by Nunns are already accounted for in current proved reserves (571 mmboe). I guess it is a question of how efficiently the company will be able to exploit these resources.

I also asked them a simple question: what was Penn West’s organic reserve replacement ratio? I found their answer unsatisfactory but reproduce it below for the reader to judge:

As an actively managed Trust we do not have a limited life. We are
naturally keen to replace oil and natural gas liquids reserves. We can
do so through: acquisition – buying companies and assimilating their
proved reserves; or organic growth – including revisions to existing
reserves estimates based on new information, extensions to existing
reserves, new discoveries and improved oil recovery rates. In terms of
Proved Reserves, as at the end of 2006 it was 379 mmboe, and as at the
end of 2007 the Proved Reserves was 561 mmboe.

I was directed to page 6 of the Q4 2007 earnings release. Excluding Canetic and Vault, Penn West registered replacement ratios 81.5% of proved and 98.5% of proved+probable reserves to production. Excluding acquisitions, these “organic” replacement ratios fall to 38% and 40.7% proved & p+p respectively. Note that “discoveries” account for only 7% of this organic p+p replacement or 1.3 mmboe of 18.5 mmboe reserves added against 2007 production of 45.5 mmboe. With figures like these, it’s no mystery why the company doesn’t go out of its way to clue investors in but frankly, it speaks negatively of management’s integrity.

At this point, while I am not selling completely out of my position, I have reduced my position by a third, registering gains of roughly 30% in little over a year. Part of the impetus for investing in oil companies is for the leverage on the oil price. PWE has badly lagged the oil bull run, remaining below its post-Halloween-massacre high around $36 even as the price of oil and gas have ran to record highs and the US dollar to record lows (which boosts the price of foreign-listed stocks).

While PWE is in little danger of going out of business, there may be better ways to play the energy market without PWE’s apparent operations and management risk. If management cannot deliver more dynamic exploration results and improve communications with the marketplace, expect this underperformance to linger and the opportunity costs of lagging in such a raging energy bull market are too high.



As I finalize this post, Penn West has announced another acquisition, this time of Endev Energy for C$125M.

5 Responses to “Penn West Energy: More Questions Than Answers After Q1 2008 Earnings”

  1. Ej Says:

    Thanks for the interesting article Davy, it was definately enlightening because I too assumed funds flow was trust talk for cash flow. Going from $650 in CF to $300 something really puts a damper on what I thought was a solid investment. Taking into account changes in working capital is accounting double speak and I am really disappointed that management has resorted to this.

    They have also closed off higher commodity prices bailing them out with the low hedges. It appears that PWE cant fund there dividend from operating CF and will have to continue to reduce working capital and sale assets till the hedges run though.

    That pretty much screws all of my calculations up and makes me question management. Reductions in working capital are not sustainable and shouldn’t be included in YOY calculations.

    I wonder how much of the 2.8 billion that they project generating is generated via operations and how much of it is asset sales and reductions in capital.

    This is really disappointing and really distorts things. Its rough because I thought this would be a good vehicle to ride out peak oil but, that does not appear to be the case.

    Management has great assets but seems content with diluting shareholders and acquiring more assets.

    What makes you hold instead of selling and redeploying into XEC, CNQ, or something else. Also what other oil and gas investments do you like.

    I also hold ESV but, am looking for other options that arent PWE. XEC is mostly natural gas and is a FCF beast, I am hoping to acquire it on the next pull back. Thanks for your comments, Ej.

  2. Davy Bui Says:

    Hey EJ,

    As of right now, I don’t have a whole lot of oil/gas prospects on-deck. Generally speaking, when everybody is talking about something, it’s best to look elsewhere. My previous investments (ESV, CHK, DVN) were made last year. The run-up in the commodities has driven up the whole sector — even old blowhards on my watchlist like Talisman (TLM) and Vaalco Energy (EGY) have run up 50%+ lately. I’m looking for a pullback but even if the peak oil train is leaving, I’m still maintaining discipline.

    Despite my belief that peak oil is correct, I try to maintain a value-investing approach in my energy investments, looking for companies at a discount to NAV or FCF. After all, there’s always a chance that we’re wrong and if so, a margin of safety will cushion the losses.

    The reasons I haven’t sold all of my PWE: 1) relatively low downside risk + lack of cheap alternative investments, 2) tax purposes — my position was built up throughout 2007 and I want to minimize short-term cap gains, 3) greed — they still have that nice oil sands position surrounded by Shell and if peak oil is correct, even PWE will benefit to some extent.

    I looked at XEC late last year — have no clue why I didn’t buy but as you saw with BAM, happens quite a bit with me.

  3. Davy Bui Says:

    Another quick comment:

    Running the numbers on Endev Energy, I show them paying $25 EV/proved BOE. For reference, my same number on Devon Energy is $16 EV/proved BOE.

    I admit my calculations are pretty rough but part of the point in my post regarding the replacement ratios and with the acquisitions is that, currently, PWE is less of an E&P and more of an A&P (Acquisition & Production).

    As everyone knows, oil prices are very high right now. And PWE is basically buying oil (via acquisitions) to replace their production.

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