Description

(Figures above in CAD, figures below in USD, including share prices.)  There is still more upside to come with Epsilon Energy.  Previously written up by utah1009 on 7/16/10 and aagold in 12/19/13, this stock worked out well both times.  Since then, EURs have improved and management has proven their skill at capital allocation.  From here, I see upside ranging from 38-114% with a couple of good catalysts on the horizon.  More importantly, I see very little downside, due to:

-  Good to great rock

-  Great management with aligned incentives (CEO comes from 15% owner JVL partners and takes no comp from Epsilon!  The head of JVL is Chairman of the Board)

-  Gas prices are not frothy, and wellhead prices in NE PA are downright depressed (but this should improve)

-  Stable and rising cash flows from a midstream asset

-  Solid balance sheet: ~0.6x net debt/EBITDA, positive working capital, large FCF after all capex

Epsilon has a 50/50 JV with operator Chesapeake in the NE Marcellus – probably the best dry gas play in the world right now.  Almost all the drilling/production right now is in/from the Lower Marcellus formation.  Half of their P+P reserves (195 bcf in total) in the Lower Marcellus are “core” (good), and half are “core-of-the-core” (great).  Additionally, Epsilon has 240 bcf of contingent reserves in the Upper Marcellus, which is an interesting free call option (more on this below).

Epsilon was rescued from mis-management in mid-2013 by veteran E&P investor John Lovoi (JVL Advisors) in conjunction with Advisory Research.  They replaced management and sold off everything but the NE Marcellus dry gas asset.  Since then, management has continued to make all the right moves:

a)  Cut all the fat out of G&A

b)  Bought back ~1.3 million shares from Sept’13 – Sept’14 and just announced a new buyback for more shares as well as for the convertible bonds (strike = $4.45)

c)  Put the brakes on new drilling now that their acreage is all HBP, in response to current lousy wellhead prices.  Waiting for new pipelines to improve basis.

d)  Shifted current capex to their high-return midstream project (the Auburn Gas Gathering System (GGS) – which takes gas from their wells as well as adjacent areas into the local interstate pipeline.  Epsilon owns a 35% stake in this JV)

The only thing not to like about this story is the lousy wellhead price they're getting right now.  Pipeline takeaway capacity has been playing catch-up to surging production in the NE Marcellus.  Epsilon’s realized price/mmcfe has ranged from about $2.50 to $3.50 in recent quarters vs NYMEX of ~$4.00+.  Admittedly, this stinks.  But relief is on the horizon.  There are 5 pipelines slated to take gas out of Epsilon’s neck of the woods:

So the Constitution pipeline is the near-term catalyst.  FERC has scheduled release of the EIS for October 24^th.  State level approvals from the NY DEC and PA DEP are coming along as well.  Management seems to be expecting the Constitution to significantly improve the basis issue, as well they should.  To give you an idea, 650 mmcf/d is equivalent to about 40% of Cabot’s current production in the NE Marcellus, where it’s the 800lb gorilla (much larger than Epsilon, which currently does ~45 mmcf/d).

The next catalyst is further ramping of the Auburn GGS, which is being expanded right now and should reach max throughput in 2015.

After that, the Empire Northern Access pipeline should bring more relief when it goes into service around 4Q16.

Following that, additional pipelines like the Atlantic Sunrise project, the PennEast and the NED will help, but I suspect management will have sold the company by then.  So there’s your final catalyst.  Management has clearly stated their intention to sell the company in a tax-efficient way once the Auburn GGS has fully ramped and the basis problem has subsided (more on this below). 

Valuation:  

There are basically four components of value: the Auburn GGS, the Lower Marcellus, the Upper Marcellus, and everything else. 

Let’s start with “everything else” – this is includes working capital, debt, cash from exercise of options, decommissioning liabilities, and corporate overhead.  These basically net to zero.  Note that my assumptions here are conservative:  100% of options get exercised, 2 more years of overhead until a sale in 4Q16, all of the converts get converted (i.e. they don’t buy back a single bond), no further share repurchases.

Second, we have the Auburn GGS.  Management has guided to $23 million of EBITDA at 500 mmcf/d of throughput.  Since then, the JV decided to expand to 550 mmcf/d … not only could Epsilon’s production increase, there is also gas coming from the adjacent Overfield GGS that needs to flow through Auburn to reach the TGP 300 interstate pipeline.  Extrapolating, I expect $25.3 million of EBITDA when maximum throughput is reached in about 2 years.  Between now and then, there’s easily $10M/year in EBITDA (using 2Q14 results at only 319 mmcf/d) and $15M of capex.  

The big question here is what EBITDA multiple they can get.  In August 2013 management suggested an 8x multiple as reasonable.  I suspect they’re being conservative, for a few reasons:

1)       the CEO owns no options and they’re trying to repurchase shares as cheaply as possible

2)      Western Gas Partners (ticker: WEP) sold a similar gathering system just west of Epsilon’s for 9.7x in February 2013

3)      A couple of small brokers who cover Epsilon have suggested 10-11x.  Normally I don’t put too much faith in sellside research, but ask yourself:  how many times have you heard of a midstream asset going for single-digit EBITDA multiples?  I can think of that WEP sale and that’s it.

At 8.0x I get a value of $172.3M, or $2.95/share on a fully-diluted share count of 58.5M shares (assuming no further buybacks and full dilution from options and the converts).  At 9.7x it’s $207.8M, or $3.55/share.  At 11x it’s $235M, or $4.02/share.

Third, we have the Lower Marcellus acreage.  I value this by making a couple adjustments to the pre-tax PV-10 at year end 2013, which incorporates the NYMEX strip and the forecast for basis.  The first adjustment is for 1H14 production, the second is for a 50% increase in EURs on new wells due to improved completion techniques by CHK, as per management’s guidance.  Note that even after this increase, CHK’s EURs still pale in comparison to those of Cabot, which operates in basically the same area and has a roughly 2 year lead on CHK in terms of understanding the geology.  So it sounds reasonable.  Net net, I get 195 bcf of P+P reserves worth $187.6M or $3.21/share.

There are a couple ways to sanity-check that number.  The first way is to use the $17,500/acre that CHK effectively paid for its 11.5k acres (=50% stake) in the JV back in January 2010.  This values the other 11.5k acres (Epsilon’s half) at $201.3M, or $3.44/share.  The second way is to look at a more recent comp: Bill Barrett sold some Uinta Basin acreage flowing 50 mmcf/d for $5,500 per mmcf/d in Oct’13.  It’s a roughly reasonable comp given that 1) it too is all dry gas, and 2) at the time of sale it was only getting a lousy $2.65/mcf at the wellhead – even lower than Epsilon.  This implies that Epsilon’s ~45 mmcf/d is worth $247.5M or $4.23/share.  Note that CHK restricts the flow of the wells to 75% of capacity in order to reduce proppant flow-back and maximize EURs.  The point being that Epsilon could be flowing a lot more than 45 mmcf/d if unrestricted.  So both of these checks come in higher than the $3.21 above.

Finally, there’s the Upper Marcellus which I value at zero to be conservative.  Why?  It’s not due to test results: plenty of operators (including CHK on the JV’s acreage) have seen very positive results on the Upper Marcellus wells they’ve drilled.  Rather, it’s because CHK says it has 8-10 years of Lower Marcellus drilling inventory in this area.  Remember, CHK is the operator and is in charge of the drilling plan, so my worry is that they don’t get around to really exploiting the Upper Marcellus for a long, long time.  That said, management thinks they could convince CHK to drill more in this formation in the near term.  With a contingent resource of 240 bcf, the upside could be large … it’s all a question of timing.

So those are the four components of value.  Now let’s consider taxes: the options for a tax-efficient sale include 1) selling the whole company to midstream MLP, which would then sell off the upstream piece (at a stepped-up tax basis), 2) converting the company into a hybrid U.S. MLP or a Canadian Foreign Asset Income Trust (FAIT), and 3) selling the whole company to a large-scale natural gas consumer.  (Note that this 3rd option limits the extent to which Epsilon is willing to enter into long term supply contracts, which is why Epsilon isn't selling more gas at NYMEX prices like Cabot does.)

I frankly don’t know how to handicap the tax issue, so I won’t try.  Instead, l give you the following table of per share valuations, which I think explains why Epsilon has paid as much as $4.79 (with an average of $3.73) to repurchase shares.  At C$4.30 the US$ price is 3.85, so upside ranges from 38% to 114%.

Catalyst