Description

Evolution Petroleum

Summary

Evolution Petroleum (“EPM”) is an Oil and Gas Exploration and Production (“E&P”) company that is primarily focused on generating a solid return on invested capital and returning money to shareholders via its dividend program. EPM is unusual for an E&P company in that it does not own or operate its own assets. Rather it holds a minority interest in producing fields that are operated by various majority owners. This allows the relatively small company to hold a diversified portfolio of assets and to have a very lean staff.

EPM’s share price was especially hard hit during the pandemic and, unlike many other E&P companies it has not yet recovered to anywhere near its pre-pandemic levels.

The share price’s sharp decline was caused by:

·         Operating issues at its primary asset, the Delhi Field in Louisiana,

·         Lack of capital available for maintenance capex at the Delhi Field,

·         No hedges going into the pandemic, resulting in a hard hit to earnings when commodity prices collapsed,

·         A sharp cut in its dividend to preserve cash.

 I believe the share price will recover in the near future due to:

 ·         Improved operations at Delhi,

·         Implementation of a new capital expenditure program for well workovers at Delhi which should lead to higher production levels,

·         The absence of hedges which will now allow EPM benefit fully from the recent increase in the price of oil, natural gas, and natural gas liquids,

·         EPM has just closed on a highly accretive acquisition (the Barnett Shale Acquisition) which will put its cash hoard to work and still leave the company with effectively zero net debt.

I believe that these factors will combine to allow EPM to (at a minimum) restore its quarterly dividend to pre-pandemic levels of $0.10 from the current $0.05 and this will provide the catalyst for the stock to appreciate about 167% to $9.50/share.

Oil and Gas Properties prior to 5/7/2021 acquisition

EPM currently holds interests in two operating properties: the Delhi Field in Louisiana and the Hamilton Dome Field in Wyoming.

The Delhi Field interest is by far the larger of the two accounting for about 75% of EPM’s current revenues. It was acquired in 2003 and has been the backbone of the company’s strategy ever since. Delhi generates about 85% crude oil and 15% natural gas liquids and is connected by pipeline to the oil & gas markets. Historically, Delhi had a very low decline rate as its CO2 flood (the mechanism used to keep pressure high in the well) and consistent well workovers (capex spend to optimize well flow) kept production levels high.

However, since late 2019 Delhi has been beset by two major adverse events. First, the pipeline that feeds the CO2 flood was damaged resulting in about 24% less CO2 being delivered to the field which in turn resulted in lower production output starting in 2020. 

Photo of Delhi Field NGL plant, source EPM

The second event was the bankruptcy of the site majority owner and operator, Denbury Resources. Following the collapse of oil prices during the pandemic in early 2020, Denbury filed for bankruptcy on July 31, 2020. Denbury completed its restructuring and emerged from bankruptcy on 9-18-2020 via a pre-packaged deal. During the time leading up to, and during, its bankruptcy Denbury curtailed virtually all capital expenditure activities, including the regular workovers at Delhi. This resulted in further production declines during 2020.

While these events were bad for existing holders of EPM, they combine to create a very interesting investment opportunity for new holders. The CO2 flood pipeline has been repaired and as pressure is restored, production steadily increases. Also, Denbury was able to shed about $2B of debt via the bankruptcy process and is now in strong fiscal shape, allowing it to again start up capex programs leading to further production gains.

The Hamilton Dome Field interest was acquired in November 2019, for $9.5 million (“mm”). It is 100% oil producing and as a mature property has a very low decline rate. In fact, for the past 3 years its production decline rate has been less than 1% per annum.  The field is operated by Merit Energy. The wells at Hamilton Dome are water injection wells and have operated smoothly throughout the pandemic, though a small number were taken offline due to the low commodity prices in the middle part of 2020.

Barnett Shale Acquisition

On March 30, 2020, EPM announced the acquisition of a package of Barnett Shale properties from Tokyo Gas for the stated price of $23.25mm. The acquisition closed on May 7th, 2021 for $18.2 net of purchase price adjustments (discussed below) and less a very few disputed leases. These Texas properties produce 70% natural gas and 30% natural gas liquids. Following the close of the acquisition in April, I expect EPM’s revenue stream to be more diversified at about 55% crude oil, 30% natural gas, and 15% natural gas liquids (of course the exact mix will fluctuate with the respective commodity prices).

In addition to the increased diversification, the multiple paid makes this acquisition very attractive. I estimate that EPM paid just over 5x EBITDA for the assets. However, the acquisition has an effective date of January 1st, 2021 even though it did not close until this month (May 2021). This means that the cash flow from the first 4 months of 2021 will accrue to EPM in the form of a purchase price reduction bringing the actual price to about 4.6x EBITDA.

Finally, the company will mostly use cash on hand to pay for the acquisition. This means that cash which was generating virtually no return will be put to work at what the company estimates to be a +20% IRR.

The Dividend

The founder of EPM, Robert Herlin, remains the chairman of the board and is a +5% owner. He is fiercely committed to the dividend which, until the pandemic, was providing him over $700k in annual income. During the pandemic, EPM cut its dividend from $0.10 per quarter to $0.025 and the stock fell from a price of $6-8 pre-pandemic range to a low of $2.12 per share. EPM has already begun to increase the dividend.  In the first quarter of 2021 it brought it up to $0.03 and earlier this month announced another increase to $0.05 which provides a 5.61% yield at current prices. In conversations with management, it is abundantly clear that the Company intends to return its dividend to previous levels as cash flow permits. I would expect it to be back to the $0.10 quarterly level within 12 months with upside above that due to the cash flow generated from the recent acquisition.  As will be discussed later, dividend increases will be the driver of higher share prices.

Forecast

The table below provides the revenue and EBITDA that I expect EPM to achieve, assuming unchanged commodity prices (natural gas has some seasonality). EPM should be able to generate better than $4.5mm per quarter in pre-dividend after Capex free cash once the Barnett Shale acquisition is fully contributing (I do not expect the company to be a cash taxpayer during this period).  A dividend of $0.10/quarter affects cash flow by a negative $3.3mm per quarter, which would be comfortably covered by free cash flow. This would also allow EPM to regrow its cash balances to finance future acquisitions and to help weather any fluctuations in commodity prices.

To put my projections in context, in the quarter ended December 31, 2018, with $59/barrel oil, EPM generated EBITDA of $6.34mm; this was prior to the Hamilton Dome acquisition and, of course, prior to the pending Barnett Shale acquisition. I offer this as a comparison point of what the Delhi Field can contribute when the CO2 flood is fully operational and when appropriate maintenance capex has been performed. While production is still ramping, I believe it will take several quarters to fully return to near 2018 production levels at this asset. 

Valuation

I realize that traditional E&P investors like to value investments on Net Present Value (“NPV”) or some multiple of Barrel of Oil Equivalent (“BOE”) per day, and this probably makes sense for companies that are operators and actively looking for new wells to drill. As EPM is a financial player in the hydrocarbon space, I think it is more appropriate to value it based on a multiple of EBITDA or the implied dividend yield.

Between fiscal 2017 and 2019 (June YE), EPM traded in a range between 9x and 13x trailing EBITDA. Once the Barnett Share acquisition is fully absorbed, the company will be on track to generate about $29mm in annual EBITDA with zero net debt. EPM has 33.5mm shares outstanding which would imply a share price in the range of $7.8 to $11.25 with a midpoint price per share of $9.50 using this method.

Between the end of 2016 and September 2019 (when the CO2 pipeline issue occurred), EPM traded in a dividend yield range of between 2.9% to 5.6% with an average of 4.3%. If EPM raises its dividend back to its pre-pandemic level of $0.10 per quarter, this would imply a share price between $6.7 and $13.8 with a midpoint price per share of $9.40 using this method.

These two methods give us a remarkably similar midpoint result and are the underpinning for my price target price of $9.50. However, I also believe that there should be some upside to the company’s results as the rate of post-pandemic economic recovery accelerates leading to an increase in demand for hydrocarbons. The current US administration’s hostility to drilling new wells on federal land will also put upward pressure on commodity prices. With a mostly fixed expense structure, price increases are extremely accretive to EPM’s earnings.

Conclusion

Due to the past operating issues and capital constraints at Delhi, as well as its lack of hedges going into the pandemic, EPM was severely penalized by the market, especially once it cut its dividend. This can be seen in the following chart when comparing EPM’s share price with the price of US West Texas Crude Oil (“USCRWTIC”).  The two tracked each other well until the CO2 problem in September 2019.  Now that oil has recovered and the CO2 problem is fixed, it would be reasonable to assume this relationship will return.

Chart comparing EPM share price in white * and USCRWTIC in orange line.

However, EPM now presents an investment opportunity as the operational and capital challenges are behind it. It is particularly well positioned to benefit from the higher commodity prices that are likely to continue, or increase, during the post pandemic recovery and, finally, EPM has just closed on an accretive acquisition. These events will allow it to steadily increase its dividend to pre pandemic levels, providing a catalyst for a 167% increase in share price.

Catalyst

1. Dividend Increase

2. Oil remaining above $50 per barrel for West Texas Intermediate Crude.

3. Acquisition by larger E&P company

4. Additional acquistions of free cash flow generating E&P revenue streams.