November 02, 2011 - 8:05pm EST by
2011 2012
Price: 18.30 EPS $0.00 $0.00
Shares Out. (in M): 467 P/E 0.0x 0.0x
Market Cap (in $M): 8,591 P/FCF 0.0x 0.0x
Net Debt (in $M): 2,815 EBIT 0 0
TEV ($): 11,406 TEV/EBIT 0.0x 0.0x

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Oil/Gas: 65/35

Proved + Probable: 660mm boe



Overall, I believe Penn West is an over-capitalized E&P asset that has as deep and rich an inventory of light oil and natural gas assets as any of its relative size. There are three natural arbitrages here:


  • Capital Structure: the ~$500mm dividend that Penn West pays out of cash flow has a huge opportunity cost at $80 oil and $5 gas in terms of returns available from drilling its 10,000 locations with represent a 20+ year inventory at current drilling run-rates. There are 2 ways to look at this.  First, the $500mm dividend is equivalent to the debt service on a $10bln plus loan. Alternatively, the $500mm allocated to capex would like to 25mm BOEs of reserves per year (5 points of incremental growth per year on the company’s existing proved reserve base) or 10 points of incremental production growth.
  • Operations: Until early this year, Penn West was a trust, managed to keep production flat and drive high dividend payouts; as such, a deeper, more strategic approach with global operational and execution expertise will allow the company to leverage its considerable asset and infrastructure base (Penn West is home to one of Canada’s largest and most valuable midstream businesses with 32,000 km of pipelines and 1,300 crude oil batteries and satellites)
  • Value: Penn West offers significant value even at current drilling rates as it trades at a steep discount to its NAV which on a heavily risked basis, at $80/$4 easily is in the 30s.  Alternatively, the stock is implying oil prices sub $60.

 3 years ago Penn West was a high dividend paying income trust in Canada whose assets didn’t bear reinvestment because they were high cost and so the corporate structure was designed to keep production flat and pay out high levels of dividends for income-oriented investors. With the technological renaissance related to horizontal drilling and hydraulic fracturing, the 7-8mm acres that Penn West owns in the western sedimentary basin in Canada have serendipitously turned into huge optionality that we are seeing the first hints of.


I believe we are in the very early innings of appraising and developing one of North America’s most under-appreciated asset bases.  The company has begun a transformation that will lead to significantly higher earnings power over time via higher production growth rates, advantaged royalty costs, higher operating margins on product produced, tax advantages based on structural issues with the corporate status change, and a reallocation/redeployment of capital to high return drilling opportunities.


In the hands of a world class operator with a strong and diversified capital base, I believe this transformation will happen more quickly, more efficiently, less costly, and with less growing pain which is why I think this is a M&A target and Sinopec’s recent acquisition of Daylight clearly puts Canadian assets in play.


Asset Base:

Penn West has a strong base of conventional oil and natural gas production (19%-20% decline rate) that provides a strong source of cash flow that can provide over $1.5bln of operating cash flow @ $80 oil to drill a deep, valuable asset base that has been revitalized by new drilling and completion techniques.  What was a high cost, boring asset base has now turned into a wealth of opportunity spanning from primary drilling in mutli-zone fields with significant ultimate EOR potential given the nature of the rocks on over 7mm acres in Western Canada.


Acreage math works out to less than $2,000 per acre for the enterprise without stripping out their 170k boe/d of production.


  • Key features:
    • Lower decline rate than most of its peers
    • Much more inventory; 10,000+ inventory with good oil and gas optionality
    • Tremendous excess capital via free cash flow and dividend
    • 100bln barrels of OIP in the Western Canadian Sedimentary Basin with only 20% recovered to date
    • Mainly tight sandstone and carbonate type plays
    • F&D likely to drop at least 20% from historical mid-20s range
    • Good optionality for LNG type opportunities as evidence by JV with Mitsubishi in Cordova gas play
    • Known unknown plays within its 7mm acres

 Capital uses:

  • 4 light oil plays: Cardium, Colorado Group, Carbonates, Waskada. see below
  •  Heavy oil project in the Peace River in a JV with China Investment Corp.
    • 170,000 acres carried largely by CIC
  • Shale gas play recently JV’d with Mitsubishi in Cordova Embayment
    • 175,000 acres carried largely by Mitsubishi
    • Nice LNG potential
  • Deep basin wet gas
  • Exploration: largely in their backyard given the revolution in technology and the geological features of the area (also significant multi-zone type optoinality
  • Current and future EOR opportunity is big source of value that is not included in any numbers
  • Dividend: waste of money in my opinion given avenues for potential investment


More detail:

  • Cardium: Tight sand, average frac: 20 stages
    • 665,000 acres, 2500 locations
    • F&D $15-18
    • Very good well control and infrastructure in place
    • Consistently improving results
  • Coloardo Group: multi-zone potential, tight stand, 14 stage fracs
    • 750,000 acres, 1000 oil locations, 1500 gas locations
    • F&D $16-18
  • Carbonates: Cargonate, 15 stage fracs
    • 200,000 acres
    • 500 locations
    • F&D $15-$20
    • 15 stage fracs
  • Spearfish: tight sand, average frac: 20 stages
    • 75,000 acres, 1500 locations
    • F&D $15-$17
    • Very predictable and consistent results
    • Boring but very economic


Unlike most US E&Ps who spend in excess of cash, this company generates free cash and pays a 6.5% dividend with that free cash.  This is the first company I've looked at where I would urge them to cut the dividend and accelerate investment.  Here is where I believe a very simply arbitrage can be head.


The last thing buyers of North American assets need is a $500mm dividend.  And while this dividend was suitable for Penn West 3 years ago, it simply no longer is.  This transition of moving away from the dividend will be a very difficult process in the public markets.  As such, I believe this company is a sitting duck.  There are two ways to look at this:


  • For some, a $500mm after tax dividend can be a funding vehicle for the acquisition.  For example, let’s say an NOC or an IOC or a large E&P has a pre-tax cost of debt of 4%.  In this scenario, a $500mm dividend is akin to interest and amortization of a $12bln loan.  The company’s enterprise value is just over $10bln…
  • For others that themselves are adequately or over-capitalized, the goal would be to re-deploy that capital into the drill-bit.  Again, some quick math: the company’s has stated that to generate 1 boe/d of production it costs $25,000-$30,000 across its 4 light-oil plays.  So assuming that over-time the $500mm of dividends can be reinvested at these capital efficiencies, this would be an additional 15,000-17,000 boe/d of production per year with that incremental 10% growth to current levels of production. In other words, the growth rate would go from 5% to 15%...within cash flow.
    • Looking at capital efficiency from an F&D perspective, $500mm times a $17 F&D would be 30mm barrels a year of incremental reserves on top of what they are already adding.
    • At $2bln of capex, you’d be able to add 120 million boe of reserves per year.
  • The numbers on accretion to earnings can get very high if you assume a $45-$50/boe incremental net back which is what you have at $80 oil. I’m happy to give more color to those with interest.  Sufficed to say that this company is massively under-earnings what its asset base and capital structure can bear.


  • I build up value in 3 steps:


1.      What is this worth on a no growth trajectory? In other words, if this were treated like a big major oil company or a dividend payer with flat production, what would the appropriate yield be?  (Note that this would be yield to equity.)  The following is with oil around $85-90. The $900mm of capex is what you’d need to keep flat.  Arguably this comes down over time as the conventional decline rate plateaus.


Flat Production Case  
  2011 Est
Cash from Ops          1,700
Maintenance Capex             900
 Free Cash             800
Implied Value at 4% yield         20,000
Implied Value at 5% yield         16,000
Implied Value at 6% yield         13,333


2.      What is value on the current trajectory that the company is on? Assume $90 oil and $5 gas.


Cash from Ops          1,700       2,000       2,200
Capex          1,200       1,500       1,700
 Free Cash             500         500         500
 Dividend             500         500         500
 Balance               -              -              -  
2011 Production Exit       168,000   175,155   187,154
 Decline Rate 18.50% 19.50% 19.50%
 Decline Amount        (31,080)    (34,155)    (36,495)
 Capex          1,300       1,500       1,700
 Capital Efficiency         34,000     32,500     31,000
 Gross Production Adds         38,235     46,154     54,839
2011 Production Exit       175,155   187,154   205,498
 Exit to Exit Growth 4.3% 6.9% 9.8%




3.      What does Penn West look like with the excess capital (i.e. dividend) invested into the ground to generate the cash flow and production growth that the assets and company are capable of?


Invest Excess Capital Case        
  2011 Est 2012 Est 2013 Est 2014 Est 2014 Est
Cash from Ops          1,700       2,100       2,500       2,900      3,300
Capex          1,300       1,750       2,200       2,500      2,500
 Free Cash             400         350         300         400         800
 Dividend             500         250            -              -             -  
 Balance            (100)         100         300         400         800
Prior year Production Exit       168,000   175,155   194,846   225,870   262,054
 Decline Rate 18.50% 19.50% 20.50% 21.50% 21.50%
 Decline Amount        (31,080)    (34,155)    (39,943)    (48,562)    (56,342)
 Capex          1,300       1,750       2,200       2,500      2,500
 Capital Efficiency         34,000     32,500     31,000     29,500     28,000
 Gross Production Adds         38,235     53,846     70,968     84,746     89,286
2011 Production Exit       175,155   194,846   225,870   262,054   294,998
 Exit to Exit Growth 4.3% 11.2% 15.9% 16.0% 12.6%
Cash from Ops          1,700       2,100       2,500       2,900      3,300
 Maintenance Capex             900         975       1,100       1,200      1,200
Free Cash             800       1,125       1,400       1,700      2,100




Assuming $90/$5 after 2011, in this case, you phase out the dividend over 3 years and drive the capex higher as you eat into the inventory of wells.  By 2014, the company will again be generating excess free cash but you have production (before royalties) of close to 260,000 boe/d with 75% from liquids. 



A full blown NAV of the company get you easily to $30+ share price and based on 2012 production exit of 185k boe/d @ $120k per flowing boe, I think it's worth $35 (I use 85% NRI on the 185k boe/d production rate to get that number).


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