|Shares Out. (in M):||30||P/E||0||0|
|Market Cap (in $M):||303||P/FCF||0||0|
|Net Debt (in $M):||41||EBIT||0||0|
|Borrow Cost:||Available 0-15% cost|
Having watched with amazement as Torchlight has defied gravity after a brief near death experience, we looked for other small cap E&P companies with similarly buoyant stock prices. While we haven't found anything as egregious as Torchlight, we did notice that Torchlight's JV partner, Ring Energy, happens to be a good short candidate because:
1) Questionable assets that may not be economic
2) Running out of debt capacity, will need to raise equity to grow
3) Valuation is absurd based on reserves and recent acquisition
4) Projections for 2016 are way too high - $27mm of EBITDA impossible without massive dilution
While Ring doesn't have the same kind of questionable auditors, management, reserve engineers, and so on as Torchlight, it does have a similar carefully curated investor relations approach. Information shared with shareholders is limited and heavily controlled. Missing information includes well type curves, detailed acreage location and maps, details about asset status before acquisition, and go forward development plans. What is always there, in every presentaition, is a chart of management's prior company's stock price performance and prior company production growth. This is a red flag and in this case we think that this will wear thin as over inflated expectations are confronted with reality in 2016.
1) Questionable assets
Ring owns two oil fields, both in the Permian basin. One is in the Central Basin Platform, an area that has been extensively vertically developed, and that is seeing almost no current drilling activity in the low oil price environment. The other is in the Delaware basin, in Reeves and Culberson counties, an area where horizontal drilling activity has sustained as well results have been sufficiently strong to justify drilling with oil below $50. Assets that have little economic drilling potential at current commodity prices are typically valued for their existing production only. And Delaware basin asset value and prospectivity are very location specific, calling into question Ring's choice to not disclose acreage location. And Ring's recent acqusition of those assets gives a recent mark-to-market value for the assets - they are unlikely to have appreciated materially in the 6 months since the acquisition, particularly considering the 25% decline in the price of oil since then.
We think Ring's assets have questionable economics because 1) there is virtually no drilling activity in the entire Central Basin area of the Permian, 2) Ring has slowed down drilling in that area and made a large acquisition outside of the area and 3) Ring's new area will likely be the focus of Ring's capital spend going forward, but was bought for a fraction of Ring's enterprise value and 4) Ring doesn't provide enough detail for outside investors to independently assess the quality of the new area drilling prospects
2) Limited liquidity
Along with its $75 million Delaware basin acquisition, Ring recently increased its borrowing base from $40 million to $100 million, and drew $41 million on its revolver. However, Ring only generated $11 million in EBITDA in the first 9 months of 2015, and only $3 million in the 3rd quarter. $41 million is a stretch for a $12 million a year EBITDA oil company, and is close to Ring's 4x leverage covenant. Absent a much higher oil price, Ring cannot draw much more debt without violating that covenant, threatening its ability to grow without issuing equity.
3) Nosebleed valuation
Ring has $41 million of debt and a $303 million market cap, for a total enterprise value of $344 million. This compares unfavorably to multiple potential valuation measures for its assets. One measure is based on production - Ring recently paid $75 million for 1,300 BOEPD of production plus more than 10,000 net acres in the Delaware basin. Ring has 2,275 BOEPD of production, as of the end of September. Valuing the whole company at that $58,000 per BOEPD metric yields a value of $132 million, or $2.99 per share net of debt. And Ring's Proved Developed reserves were estimated by the company to be worth $141 million as of June 30th, assuming $55 oil. The forward 12 month price for oil is $45, so the current Proved Developed value is likely lower, consistent with a sub $3 per share value for Ring's assets. This compares unfavorably with Ring's current share price of just under $10 per share.
4) Impossibly high analyst estimates for 2016
What makes this a compelling and timely short is how high analyst expectations are for Ring, and by how much Ring is going to miss those expectations unless oil prices go way higher. Analyst consensus for Ring's 2016 EBITDA is $27 million. Compared to Ring's most recent $3 million EBITDA from Q3, this expectation seems way too high.
Another problem Ring has that will make this even more unachievable is that its existing production is declining rapidly. Production in the Central Basin area has already declined, despite tens of millions of dollars of capital expenditure this year and even more expenditure last year. To hit $27 million of EBITDA, Ring would have to more than double production. But if Ring were to spend all its cash flow and borrow all the money it could get while staying under the 4x leverage covenant, it would struggle to replace production declines. In fact, despite $100 million in capital expenditure in the first 9 months of 2015, Ring's production was only up 50% in Q3 2015 versus Q3 2014. Ring might need to spend 10x its current available liquidity to get to $27 million in EBITDA, which would necessitate a wash-out equity raise. And absent that, Ring is very likely to miss consensus by a wide margin. This big miss could reset analyst and market expectations lower, bringing the company valuation back down and the stock price closer to a more reasonable value of $3 per share.
1) The price of oil could recover, sending Ring stock higher. REI is already pricing in a much higher oil price, providing some cushion.
2) Ring's Delaware Basin asset could outperform. Despite lower oil prices and a recent private market transaction mark, Ring could have gotten an exceptionally good deal. There is limited public information about this asset, and Ring could drill wells that exceed expectations. It would need to drill many such wells to grow into its current valuation, but it is possible.
Miss analyst expectations in 2016
Failure to grow production in line with high-growth valuation
Sustained low oil price