|Shares Out. (in M):||504||P/E||0||0|
|Market Cap (in $M):||726||P/FCF||0||0|
|Net Debt (in $M):||407||EBIT||0||0|
Obsidian Energy (figures in C$)
Like many of VIC, I am finding value in the energy space. Specifically, I think OBE is by far the best actionable risk/reward name I found this year. My investment thesis is as follows:
Starting with the downside, OBE is trading at a healthy discount to its 2P Reserves PV 10% of C$1.7 bln. With OBE suggesting banks are likely willing to lend up to 60% of 2P Reserves, this implies C$1.2 per share in equity value. Being more draconian and going with the actual syndicated reserve-based credit facility (undrawn) availability of C$440 mln, I get a downside of C$0.9 per share (as of June 4th this has changed as OBE announced they drew on the facility recently)
There is a lot of uncertainty how this plays out with lots of moving parts: status quo, asset sales, realization of tax loss carryforward value, potential deal with China Investment Corporation (CIC), etc. However, uncertainty isn’t risk because as a base case (meaning status quo and grow production modestly) I get a DCF value of $3+ per share. That value becomes significantly higher if the tax losses can be realized earlier and/or the CIC JV is worth anywhere near what CIC put in to have a 45% interest – which would alone cover OBE’s enterprise value in theory.
Opportunity exists because OBE was formerly Penn West, a higher dividend paying energy company with a debt-fueled grow at any cost strategy. With dividend cut to zero, a multi-year decline in production due to asset sales to stave off bankruptcy, and a current hedge book limiting OBE’s “torque” to oil prices, I contend there is a limited number of buyers of OBE given many major Canadian asset managers had been burnt on the name.
OBE has the bonus of adult supervision in the form of activist investors involvement, including one that pushed OBE to commit to asset sales and use proceeds to buyback stock.
Background – Unsustainable Debt Fueled Growth
Obsidian (OBE) was formerly known as Penn West Petroleum Ltd. – an oil and gas producer based in Alberta Canada founded in 1979. For those familiar with the MLP structure in the US, Canada had a similar structure on steroids back in the 2000’s where a company can convert to an income trust (or specifically Canadian royalty trust), pay out its earnings in dividends and avoid paying federal income taxes.
Not surprisingly, Penn West joined the party in 2005 by converting into the trust and embarked on a journey of growth at any cost via debt fueled acquisitions and generous monthly dividend payments. Ending the tax free bonanza, the Canadian government cracked down on income trusts in 2011 effectively forcing Penn West to convert back to a regular corporation. Even then, Penn West continued paying its generous dividend and growing its production, hitting just over 160,000 boe/d in production in 2012. Back then, there were already signs Penn West’s asset quality was questionable as management had to reiterate on the 3Q12 call that they aim to “ensure consistency” in the dividend even in softer portions of the energy cycle – this is referring to the WTI vs. Western Canadian Select spreads widening to C$25/bbl in a > US$100/bbl WTI environment! This was compounded by the fact Penn West had trouble hitting its production guidance.
Even before the downturn in oil, Penn West had to begin selling some assets and production already retreated to ~ 140,000 boe/d in 2013 – and the > $3 bln debt on its balance sheet was increasingly a concern.
Heading into late 2014 when oil prices fell sharply, both Penn West’s dividend and ability to stay on-side regarding its debt covenants were questioned. For whatever reason, Penn West’s debt had a 3x senior debt to EBITDA covenant instead of some conventional energy debt that was based on reserve values with periodic redeterminations (debt to EBITDA covenants are more easily breached when it comes to commodity volatility). Also, from an operations perspective, some assets such as Slate wells were disclosed as “would not work at < US$70 oil”. In early 2015, there were serious question marks around the management team, specifically when they provided the following remarks in the CIBC conference:
"I focused on a couple things, its not my job to do whatever it takes. So I can survive through this, me personally. My job is to make sure that we continue on the path that we think is value created for our shareholders"
It is simply unbelievable a public company management team would speak to investing public stating that management will be fine regardless (no skin in the game) and they don’t need to do whatever it takes to fix the company!
In 2015, Penn West did get covenant amendments, sell assets, reduce debt by just over $1 bln. However, production continued to drop to sub ~ 100,000 boe/d while negative FCF resulted in a complete dividend cut.
Even with all this painful medicine, Penn West was once again at risk of breaching covenants in 2016, leading to another round of capex cuts and asset sales, with production now shrinking to < 60,000 boe/d.
I am not going through the assets in detail because I don’t have a technical edge over the market in analyzing them. The bottom line is my best guess is: 1) Water flooding should work and keep declines <20% especially with David French as CEO given his experience at Bankers Petroleum, and 2) my assumed capital efficiencies seem to jive with what mgmt and the sell-side think is reasonable. I’m also skipping a long macro discussion on energy prices. Using WTI as a reference point, I think OBE’s downside is protected for an up to 20% sustained decline in prices.
Asset Sales, Deleveraging, Name Change, New CEO + Activism
Finally, near the end of 2016, a new CEO was put in and with pending asset sales, the company had 3 remaining asset plays capable of producing ~ 30,000 boe/d: Cardium, Viking and Peace River. By July 2017, the company was renamed Obsidian energy.
Strangely, FrontFour Capital, an activist fund, had a position in Penn West and could not take an active role, as the founder’s father (Rick George) was on the board (https://www.bloomberg.com/news/articles/2017-06-22/hedge-fund-pirates-ii-father-son-and-curse-of-the-black-oil).
Due to Rick George passing away (as mentioned in the 2Q17 call), FrontFour turned activist on OBE by year end demanding OBE slow down capital spend, sell off assets and return capital to shareholders. At the same time, Edward Kernaghan also took a 5%+ position in OBE. The feedback on the street is Kernaghan is more patient with OBE and is willing wait and see them execute on their plans.
What’s the Downside?
I always like to know what my downside is in case I’m wrong. For OBE, I think the downside is protected by both its 2P reserve value and what lenders are willing to extend to OBE.