Penn West Energy Trust (PWE) Q2 Earnings Update

2008 Q2 highlights (all figures C$ unless otherwise noted):

  • Due to the acquisitions, YOY comparisons may be misleading so I will be focusing on changes from Q1 2008. Keep in mind the big spike in oil prices during the quarter (and the big drop since).
  • Operating cash flow improved markedly in Q2 2008 to $671M, up 83% from Q1 2008. Free cash flow was up as well to $440M in the quarter, besting Q1’s $85M. I didn’t put together any pro forma numbers (and neither did the company) but to get a handle on YOY operating performance, we can take dilution into account. On a per share basis, OCF and FCF was $2.82 and $1.43 per share for the 6 months, up 9% and 20% respectively from last year. FCF covered 131% of cash distributions in Q2 and 84% of distributions YTD, both solid improvements over 2007. The lowered level of capex was peculiar, at 59% of depletion, depreciation & amortization (DD&A). For reference, capex to DD&A was 78% in 2007, 87% in 2006. For a company with trouble growing reserves organically, this trend might lead to trouble down the line but the main takeaway is that high energy prices are helping PWE increase their cash flows to sustainable levels.
  • The company’s balance sheet held steady for the most part. Despite all the talk about debt reduction during the conference call, debt ratios showed a slight uptick as the debt/equity ratio increased to 0.49 from 0.45 last quarter (0.43 YE 2007, 0.25 YE 2006).
  • The company showed a loss in Q2 due to paper hedging losses but ex-hedges, the company’s margins are stronger YOY. Operating expenses increased only 1% in Q2 from Q1 while revenues more than doubled so COO Murray Nunns’ focus on tightening operations may be paying off.

Other items of note:

  • For the quarter, production came in 190,515 boe per day (boepd) down 1% on an absolute basis from Q1. This is worse than it seems as Q2 was a full quarter with the Canetic/Vault assets and Q1 pro forma production was 201,800 boepd. Management attributed this slippage “primarily to maintenance and turnaround outages” but reiterated previous guidance of 195k - 205k boepd for the full year.
  • Management raised funds flow 2008 guidance to $2.8B - $3B, due to higher energy prices.
  • Subsequent to Q2 2008, Penn West replaced some bank debt and closed a £57 offering of 10-year notes @ 7.78% interest. This rate looks notably higher than previous offerings.
  • PWE has filed a shelf registration for an additional sale of up to 20M units (5% of units currently outstanding).
  • Penn West estimates its maximum exposure to SemGroup to be $16M.

The conference call was mostly a waste of time, with individual investors focused on the big (paper) hedging loss but there were a few tidbits. Management plans debt reduction of about $400M - $500M if oil stays above $105. Their timeline for this would be around Q1/Q2 2009 and beyond that, unitholders should expect either increased capex or a distribution increase; unit buybacks or further debt reduction are less likely. They also confirmed their commitment to remain a trust until their tax loss shields are expended (2013 was the date thrown out there). The company’s hedged production numbers stand at 40% for the rest of 2008, 25% of 2009 and 10% of 2010.

While I’ve been critical of management in the past, the conference call was silly, with investors attacking management for their hedges. Some hedging is probably the appropriate strategy especially since unitholders demand higher cash payouts but the overarching theme seemed to be one of frustration at the stagnant stock price/distributions despite record energy prices. One caller even took issue with the small percentage of executive holdings in the stock (1%).

But it is still evident that PWE could improve investor relations. For a company bent on doubling its size and using its units as currency, it would probably behoove them to make that a priority.

The spike in energy prices helped dull some of the questions I had regarding the company last quarter but those concerns still remain. Even with the robust levels in cash flow, debt levels (and dilution to raise capital) are still increasing. For YTD 2008, the company realized net prices of $70.02 per BOE ($75 in Q2), which was insufficient to cover distributions and capex from operating cash flows. Theoretically, as the hedges roll off, the realized price will move up but there’s no guarantee that energy prices will remain at high levels (though I expect them to do so and eventually move higher). I have not done a comparison with other energy trusts but $75 oil as a threshold for sustainability seems high (of course, cutting the distribution would alleviate some of this pressure). My sense is that Murray Nunns was brought in to address this issue (hence the de-emphasizing of high-cost/low-payout plays like Peace River). It’s probably not too risky to wait to see how he does with unit prices at these levels (US$27-$28) and the distribution safe as long as oil is in triple digits. As I’ve stated previously, the biggest risk with PWE is opportunity loss as PWE has badly lagged the run in energy commodities.

Here are the performance measurements going forward:

  • Hit guidance:
    • 195k - 205k boepd production for 2008
    • $2.8B - $3B FY 2008 funds flow ($7.40 - $7.90 per unit basic)
    • $1B capex
  • Organic growth in reserves. The company has been acquiring reserves but it needs to start converting acreage into reserves. Murray Nunns talked about this a little during the call but was not ready to talk about anything yet.
  • Execute their debt management program. Previously, the company announced plans to sell $200M - $300M in assets to pay down debt as well as terming out an additional $500M. While they have been rolling into long-term debt, I haven’t seen any asset sales. In any case, management stated a goal of $400M - $500M debt reduction (if oil is over $105/bbl).
  • Increased netback margins as hedges roll off their book.
  • Maintain sustainable operating levels, i.e. fund capex and distributions from operating cash flow. These days, management emphasizes funds flow (which adds back changes in working capital and ARO) but investors will better served to use OCF. Otherwise as management puts it, “Over the medium term, additional borrowings and equity issues may be required from time to time to fund a portion of our distributions or maintain or increase our productive capacity.”

4 Responses to “Penn West Energy Trust (PWE) Q2 Earnings Update”

  1. Mikey Says:

    My confusion is this — PWE ’s payout ratio is 52%. That means they are making so much money from operations that dividend / cash flow = 52% leaving 48% for running the business. That is a good thing. However, based their quarterly report, their fund’s flow is 753M and net loss is 323M. That means they have to borrow money to pay the dividend. That’s a bad thing. One of my assumptions is incorrect. Can you explain what I am missing.I am also hazy on something else. Hedges are necessary to ensure that the company makes a profit if oil falls below a certain level. It should not cause a company to lose money when it goes ABOVE a certain level. My assumption is that PWE hedged by buying Puts. That is a fixed cost. The higher oil goes, the more money the company should make.

    Could it be that PWE has losses because of acquisition costs from Canetic and Endev? Isn’t it normal to have to borrow money to buy companies in order to grow? Profits from operations of Canetic and Endev should amply cover the interest costs, but only part of the principal cost. If PWE is showing a loss because of that, I don’t see why investors should be concerned. Moreover, will these “losses” show up as tax pools post 2011?

  2. Davy Bui Says:

    Hi Mike,

    It’s important to be precise in discussing the results and not mix/match (as I did with OCF and funds flow previously). As a general rule of thumb, assessing resource companies based on their income statement bottom-line (i.e. earnings) isn’t the best way to evaluate them, especially if hedges are involved.

    The earnings loss that companies like PWE and CHK are showing are accounting losses — THEY ARE NOT ACTUAL CASH LOSSES. These losses simply represent the money these companies could have made if they had not hedged their production when prices were at $145/bbl.

    My analogy would be to imagine that you make $50k at some job but that you could have been a lawyer and made $100k. And every year, when filing your taxes, you were required to show not only the $50k in cash that you received but also the money you could have received as a lawyer (I don’t know, maybe your mom makes you do this to rub it in). Your taxes would show that you earned no money the whole year, even as you cashed $50k into your bank account.

    That is why, if you read my quarterly updates, I always start with the cash statement, then the balance sheet and last & least, the income statement. At the end of the day, cash is the only thing that matters.

    BTW, much of these paper losses will show as gains in the next quarter if prices remain at these levels.

    As for borrowing money, my take is that they borrow money because, unless oil is over $100/bbl, they can’t pay for distributions and running the business out of cash flow. Check my other posts on PWE for more info.

  3. StopPigeons Says:

    I’m sorry for asking what is probably a very basic question but how do you come up with the 440M FCF number? If FCF=(Cash Flow from Operating)-(Cash Flow from Investing) the number is different.
    “Standardized distributable cash” was indeed 440M in Q2 and 85M in Q1. Is this the equivalent of FCF for energy trusts?
    …I wish I had more knowledge of accounting (sigh!)

  4. Davy Bui Says:

    Usually FCF is

    OCF - Maintenance CapEx = FCF

    which seems to be synonymous with “standardized distributable cash”, i.e. cash left over after spending the money needed to keep the business going.

    Hope that helps.

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