Description

Executive Summary - Delta Petroleum (DPTR) Long 7% Senior Notes, Short Common Equity

• Delta Petroleum is a Rockies-focused E&P company that was forced by its lenders to recapitalize due to waning asset value, suffering liquidity, and poor management. The company is 34% owned by Kerk Kerkorian's Tracinda. A Tracinda representative serves as Chairman of the Board

• Delta's capital structure has two significantly different views reflected in its 7% Senior Notes versus its equity market capitalization. Despite a $250mm equity issuance in May 2009, the bonds are offered at 48.5 (24% YTM, 14% CY) versus an equity market cap of $660mm. The enterprise value is $1bn

• A valuation using $6/Mcfe gas prices yields a NAV of $460MM, which results in the full recovery on Delta's liabilities, but leaves just cents per share for the company's shareholders

• The appeal of the investment is the fact that the equity has been neutered, while the company is effectively being run to protect the interests of creditors. The reduction in the volatility of the enterprise improves the risk / return of the capital structure arbitrage. Safety to the investment is aided by ongoing support by Tracinda, which lends more room for error when considering whether the bonds will be repaid when due

• The company's May 2009 recapitalization resulted in a massive 170% increase in the share count, a significant hedging program that took away Delta's upside exposure to gas prices, and a halt to Delta's exploration program. Cash may only be spent on Delta's low-risk development assets to strengthen the company's borrowing base

• Delta's fanciful exploration plans had previously underpinned spurious 'option' value in the stock. This risk is now gone, leaving Delta as an orphaned equity that pales in comparison to its better-run peers

• The banks should continue to punish the company's equity and share count, as needed, to protect outstanding debt. Lead agent J.P. Morgan will continue to underwrite punitive equity issuances for the company since proceeds will go directly back to J.P. Morgan through the repayment of Delta's revolving credit facility. This price insensitivity was reflected in Delta's May 2009 equity issuance which saw the deal price some 50% below the stock price when the deal was announced

• Tracinda appears willing to protect its investment and has recently fronted over $100mm to the company. Since DPTR is ensnarled in a liquidity trap, Tracinda will be forced to continue in the recapitalization of the company to protect its $800MM investment and repay liabilities as they come due. Tracinda is not necessarily acting irrationally, but rather just "expensively" in its decisions to pump additional capital into DPTR, despite the fact that Tracinda made a clear miscalculation with regard to the quality of DPTR's former management team and operating strategy

Investment Thesis

DPTR's Senior Notes are attractively valued on an absolute basis, but also appear significantly disconnected from the rich equity market capitalization of the company.  DPTR's $150MM 7% Senior Notes due in 2015 present a YTM of 24% and a Current Yield of 14%.  The bonds sit behind a $225MM senior secured revolving credit facility and rank pari passu with DPTR's $115MM of 3.75% Senior Convertible Notes due in 2012.  The bonds currently trade at a significant discount to the bonds of its competitors, who themselves have experienced liquidity problems in recent months.  The thesis contemplates the bonds are money-good based on the reserves.  While gas prices can affect the strict solvency of DPTR (as evidenced in DTPR's 2008 YE 10K), the company has remained liquid, and is expected to remain liquid for reasons that will be discussed. 

The equity has been stripped of several of the key drivers that could impose losses on equity short - namely, the company's exposure to gas prices, inability to generate windfall cash flows, and the lack of any exploration prospects to sell to prospective investors.  An analysis of NAV reveals a value per share of between $0.00 per share at $5.00 gas and $2.00 per share at $9.00 gas.  The obvious issue is the assertion that the equity has no value.  While a strict NAV model yields this conclusion, the equity markets and E&P investors have historically given the manufacturing-type E&P companies significant leeway in terms of including Probable and Possible Reserves in a valuation.  The crux of the arbitrage is that DPTR's equity has been constrained by the hedges, limited CAPEX budget, and restrictions by the banks.  These actions serve to dampen the volatility of the enterprise and minimize the risk of the hedged trade. 

Since the equity issuance took place, DPTR's bonds have appreciated, but the company's 7% bonds still sport a low dollar price and attractive YTM.  The company's nearer term maturity converts have a similar YTM, but a much higher dollar price and lower current yield.  The convertible bonds mature earlier.  Depending on one's view about the implied Tracinda backstop, the value of the earlier maturity when weighed against the risk of a higher priced pari passu claim in an unexpected bankruptcy can be debated.  Companies such as Denbury Resources, Encore Acquisitions, Forest Oil, Petrohawk, Linn Energy, and Mariner have debt that trades with yields ranging from 8% - 12%.  The price of risk for moderately stable E&P companies is far lower than the risk reflected in DPTR's bonds.  While DPTR is certainly still a risky credit, the fact that the equity market capitalization is substantially disconnected from the pricing of the company's bonds presents an opportunity to profit on both sides of the trade. 

The uncertainty on how the banks and equity markets would respond to a recapitalization of the company has been removed.  If and when DPTR repeats this process, the likely outcome is another painful equity issuance.  In the unexpected event of a reorganization, the company could carry significant debt upon exit, whereby substantially all of the equity would be owned by the unsecured creditors.  In a moderately healthy gas market, the assets will have meaningful value to creditors.  The gas forward curve would lead to an outcome whereby unsecured creditors walked away with the company.  Refer to the Energy Partners Ltd. plan of reorganization for what could be expected if DPTR were to file. 

It is believed that the banks have no desire to force DPTR into bankruptcy or a forced sale.  In a forced sale, DPTR would not realize much, if any, value for its 2P and 3P reserves, nor would any value be ascribed to DPTR's exploration prospects.  Furthermore, given the state of the market and poor gas prices, demand for DPTR's core assets would be anemic, leading to an expected discount on DPTR's 1P reserves (which are largely PUDs).  As it were, there is a substantial price that equity holders are willing to pay for "potential" that a bank auction of DPTR's assets would not realize. 

The most difficult judgment is the appropriate delta on the stock short.  To the extent the market extrapolates 2P and 3P reserves, the value grows and is compounded if the market assumes even faster rates of drilling to bring value forward.  As it stands, DPTR has no ability to ramp its CAPEX levels, which mutes this risk.  However, it is worth noting that it is far too easy to be carelessly pessimistic in a bear market when assessing the future impact of 3P reserves for resources such as the Piceance.  When sentiment improves, analysts will value DPTR on a 2P reserves basis, with a risked assessment of 3P reserves.  For this reason, the actions taken by the banks that limit DPTR's ability to increase its drilling program add significant safety to the equity short, all else equal. 

Introduction & Company Description

Delta Petroleum ("DPTR") is a classic example of an E&P company that hung the promise of immense reserves and fantastic exploration prospects to inflate its equity price and terrify short-sellers, but the company seldom delivered bankable results.  DPTR could not resist the temptation to be in a hot exploration play rather than focus on a specific basin to achieve competitive economics.  DPTR has been continually saved by generous capital markets and Kirk Kerkorian's Tracinda, which has adopted DPTR as its vehicle to express its view that there is "significant value in the oil and gas industry." 

DPTR's key asset is a large Rocky Mountain acreage package in the Piceance Basin.  While proved reserves are 880Bcfe, the company touts significantly more "probable" and "possible" reserves.  To reconcile the difference in reserve numbers, one must look at DPTR's 25,000 net Piceance acres.  While DPTR is currently drilling wells on 20 and 40-acre spacing, DPTR alludes to its competitors' success drilling on 10-acre spacing.  The spacing adjustment yields 2,500 locations, rather than 625 -1,250 locations.  While DPTR has typically drilled 1.2Bcfe wells, they point to new wells tracking at 1.4 Bcfe.  Thus, DPTR takes 2,500 locations x 1.4 Bcfe, the product of which is 3.5 Tcfe.  Tracinda underpins its support for the company on this math.  DPTR cannot yet take these reserves to the bank for the purpose of improving its borrowing base.  Furthermore, there are significant issues that must be resolved before "possible" reserves find their way onto the "proved" books.  The issue of having sufficient capital looms the largest with respect to DPTR converting more of its non-booked reserves to proved reserves.  Reserves are only "proved" to the extent an oil company has the means to extract the hydrocarbons, including but not limited to the company's financial means and whether or not those reserves are economic based on prevailing commodity prices and service costs. 

Piceance wells are reasonably robust, but are currently suffering in the current gas price environment and the poor differentials in the Rockies.  DPTR claims that most of its acreage is held by production, and thus not subject to relinquishment if drilling activity slows.  While well economics are difficult to estimate, a fair estimate of a 1.4Bcfe well that costs $1.9MM to drill would see a 25% IRR at $6 Rockies gas and a 5% IRR at $5 Rockies gas.  This does not include corporate SG&A, which companies are prone to exclude from numbers presented to investors.  Good "objective" well economics can be gleaned from better operators, such as Williams and Bill Barrett. 

In recent years, DPTR generated significant excitement through its exploration projects in the Columbia River Basin in Washington State, as well as its structural plays in the Central Utah Hingeline.  The anxiety built up over these exploration projects reached feverish levels in 2007 as buyside investors went so far as to buy operating interests in wells to get advance information.  The market's extrapolation of reserve potential reached immense levels, only to be dispelled as the lead partner in the project, EnCana, shelved its efforts and abandoned the play.  DPTR's other exploration projects have either resulted in dry holes (Utah), or uneconomic results (Paradox Basin).  Delta has expensed $540MM since 2006 on Dry Hole expense.  Against $1.4bn of paid-in capital, this is a significant hit against the company's equity.

With cash costs of $2.30 per Mcfe and finding costs of roughly $3.00 per Mcfe, DPTR's efficiency is poor, but should improve now that the banks and Tracinda are running the company and must focus on sensible development assets instead of high-impact exploration projects.  For reference, a good Piceance operator should have operating costs of under $2.00 per Mcfe and finding costs of under $2.00.  Thus, DPTR operates with more than a $1.00 per Mcfe disadvantage relative to its peers.  An improvement in DPTR's operations will benefit creditors, but at the current stock price, it is unclear if the equity market has not already fully valued a "return to normalcy" for the company. 

In late 2008 and early 2009, DPTR's liquidity position suffered immensely due to low gas prices and the resultant fall in the company's cash flow and NAV.  In March 2009, DPTR's banks re-determined the company's borrowing base and forced the company to raise capital to fund the deficiency.  DPTR's banks, led by JP Morgan, recently underwrote the $250MM recapitalization of the company.  In conjunction with a forbearance agreement, the banks also forced DPTR to adopt a hedging strategy and cease exploration spending.  Given DPTR's difficulties in managing its capital structure, the only catalyst that had existed for the stock - exploration - is gone.  The actions of the banks significantly improved the prospects for DPTR's credit - secured and unsecured alike - while significantly impairing the upside of the common equity.  DPTR recently replaced its CEO and it is expected that the company becomes refocused entirely on the Piceance and is no longer run without regard for investor's capital.  Tracinda took hold of the board after the recapitalization. 

Recapitalization of May 2009 and Financial Position

On May 15, 2009, DPTR completed its capital raise through the issuance of 172.5MM shares of common stock, which was priced at $1.50.  Net proceeds were $247MM.  The deal represents significant dilution to shareholders; before the offering, DPTR had 103MM shares outstanding.  Thus, existing shareholders suffered 167% dilution.   Tracinda purchased 53.3MM shares at the $1.50 price, bringing its stake to 93.8MM shares, or roughly 34.1% of the company.  The incremental $80MM investment underscores Tracinda's commitment to the company, which generates a significant amount of moral hazard vis-à-vis an investment in DPTR's bonds; it appears highly unlikely that the company will be forced into bankruptcy since its key shareholder will keep the company liquid and pay down liabilities as they come due. 

As part of the agreement with the banks, DPTR was required to hedge a substantial amount of its production.  70% of 2010 production was hedged, and 50% of 2011 production was hedged.  These forced hedges appear to be a mixed blessing as 2010 hedges were put on at $4.10 per Mcfe at the CIG point of sale.  2011 hedges were put on at roughly $5.15 at the CIG point of sale.  Thus, DPTR has significantly muted its upside exposure to commodity prices over the next two years.    

Of the $250MM raised through the equity issuance, $70MM will first go toward paying down the revolver to the $225MM level.  After that, it is estimated that roughly $140MM will go to paying down the company's large working capital deficit.  It is unclear why more capital is not going toward the repayment of the secured debt, but this was the response from the company.  Q2 financial statements should clarify if this was in fact the case. 

DPTR will undergo an additional borrowing base re-determination in September 2009, at which point additional cash might be required to pay down the revolver if required by the banks; absent a dramatic increase in commodity prices, it is assumed that the banks will require additional cash from DPTR and undertake an additional equity raise.  All told, even though the amount raised was substantial, it is unclear if DPTR is entirely out of the woods.  The company could very well come to the equity markets again in 2010 as it struggles to right itself.  A sources and uses analysis is presented below.  The key assumptions are the allocation of the recent $250MM of proceeds.  A further reduction in liquidity could hit in September 2009 if the banks demand further repayment under the revolving credit facility. 

Valuation

The value of DPTR's assets remains strained in light of the company's liabilities.   As a result of massive dilution, the equity value is further eroded, although the 'event' of bankruptcy has effectively been realized, removing a key catalyst to the short thesis.  That said, with 170% more shares outstanding, DPTR's market capitalization is still very high relative to the NAV.  Without the ability to generate 'buzz' around exploration, DPTR is now just a high-cost operator in a low gas price environment.  DPTR has one remaining exploration well in the Columbia River Basin.  A success of this well is arguably not meaningful given current low gas prices and the very high costs of drilling in that specific basin (relating to significant layers of hard volcanic rock that must be bypassed).  This is not to ignore the fact that any success could receive undo attention in a frothy market. 

DPTR's year end PV-10 value underscores the extent to which DPTR's equity is overvalued and also explains the urgency with which DPTR's lenders pushed such a large equity deal for the company; the banks wanted out.  DPTR's 2008 10K shows a PV-10 value of just $159MM for the company's reserves.  This valuation was determined on a $4 price deck.  At a $5 future commodity price, DPTR's PV-10 is estimated at $325MM.  To be generous, a PV-10 will be run at $6 realized gas prices (keep in mind DPTR has already hedged a substantial amount of its production at levels below this), and employed the 10K's generous operating assumptions.  It is difficult to be precise with a pro-forma PV-10 model, but the results are more or less representative of the NAV.  Under these assumptions, DPTR's NAV is $460MM.  After subtracting $150-225MM of Senior Secured Debt (depending on if WC was paid down) and $265MM of Senior Unsecured debt, there is little value left for shareholders.  This valuation does exclude value for 2P and 3P reserves.  However, given DPTR's massive backlog of PUDs, the company's existing inventory adequately reflects a large future program that would not be significantly impacted by additional reserves being booked, holding constant the current level of CAPEX.  For instance, DPTR's inventory of booked wells would take 10-20 years to drill.  The additional impact of reserves in the out years does not affect the NPV of the company.  By extension, the key driver - absent gas prices - is the level at which DPTR spends money to bring forward the time value of reserves.  Given its continuing struggles with its banks and inability to generate cash flow from operations due to low gas prices and hedges, DPTR's ability to ramp spending is significantly impaired. 

While it is difficult to convey the workings of an NAV model, DPTR's cash flow generation highlights the difficult situation of the company.  DPTR generated $85MM of LTM EBITDA from E&P activities (stripping out the non-recourse drilling rig business that is worth zero).  In Q1 2009, DPTR generated ($5MM) of negative EBITDA.  2009E and 2010E expected EBITDA is just $38MM if $6.00 Henry Hub gas is assumed, along with Colorado differentials.  Clearly the creditworthiness of DPTR in a low gas price environment is not attractive when ignoring the willingness of equity investors to fund 2P and 3P reserves.  But again, the disconnect between the views expressed through DPTR's bonds and equity prices appears too large given the circumstances. 

A simplistic way to frame the investment is the $ / Mcfe of reserves through the face value of the debt, relative to the Enterprise Value per Mcfe of reserves.  DPTR is valued at $0.48 per Mcfe through its debt, and $1.23 per Mcfe through its equity.  For comparison, Bill Barrett Group is valued at $2.34 per Mcfe.  Two important distinctions must be made, though.  First, DPTR has aggressively booked reserves in its Proved Undeveloped category, which Bill Barrett could easily have booked had it felt so compelled.  80% of DPTR's reserves are undeveloped, while 47% of Barrett's reserves are undeveloped.  Secondly, DPTR has roughly a $1 per Mcfe cost disadvantage relative to Bill Barrett, which affects the value of the relative reserves possessed by each company.  That said, the value of the reserves through the debt provide substantial comfort, while all previous issues surrounding the equity serve to greatly dampen enthusiasm for the stock. 

Accounting Red Flags

DPTR continues to be a company that generates significant 'red flags.'  DPTR's booking of Proved Undeveloped Reserves skyrocketed in FY 2008.  A dose of cynicism could point to DPTR's valiant effort to pad its borrowing base and stave off a default by way of boosting its PV-10 value, and thus, the asset value that provides a backstop for DPTR's secured loans.  While DPTR did make a large acquisition of acreage from EnCana in 2008, DPTR's reserve numbers simply bear notice.  In fairness, the Piceance basis is very low risk, but such accounting is aggressive and likely used for the reason stated above. 

The warning signs step from the high level of PUDs, reflected by 700Bcf of PUDs relative to just 181Bcf of PD reserves.  The next warning sign is the significant increase in Reserves Added per well drilled.  This spiked from 1.3Bcf/well to 3.1Bcf/well.  This occurs because DPTR effectively booked 'offset' wells for each direct well that was drilled.  This is shown by proxy from the change in PUDs relative to wells drilled.  That 4.3Bcf of PUDs were booked per drilled well relative to 700MMcfe in 2007 and 820MMcf in 2006 serves as a warning sign that DPTR books almost 5-6x as many PUD wells per actual drilled well than it had done in 2006 and 2007.  This aggressive booking puts downward pressure on DPTR's 2008 F&D cost, as significant reserves were added without the commensurate capital having been spent.  This eventually is reflected in the F&D costs; in future years, CAPEX spent to develop those previously booked PUDs will add money to the numerator, but no new reserves will be added in the denominator. 

Catalyst

• Bank borrowing-base redetermination in September 2009
• Awareness of recapitalization through Q2 financial filings
• General inconsistency of high-yielding bonds against equity value that far exceeds PV-10 estimates of value
• Natural gas market worries