I believe Equal Energy (
EQU
) equity represents a compelling investment opportunity at
today's market price. At $2.93/share, EQU shares can be purchased
at a 61% discount to a conservative estimate of their liquidation
value. Furthermore, there is a growing group of activist
investors who are agitating for change. Nawaar Alsaadi is
currently leading this group, and he has recently increased his
stake in the company to 4.6% of the outstanding shares. He's
prepared to further increase his stake, to pressure management
into taking whatever action is necessary to close the gap between
the stock's liquidation value and its current market price. The
upcoming annual shareholder's meeting on May 11th provides a very
near-term catalyst for this investment opportunity.
Between his own stake and those of other major shareholders
aligned with him, Mr. Alsaadi now has about 20% of the
outstanding shares as a voting block, and apparently at least one
additional large hedge fund has taken an interest and is actively
working with him. If that fund ends up taking a major position in
EQU, his liquidation plan will very likely be implemented.
Neither EQU executive management nor its board of directors
controls a significant percentage of the outstanding shares, and
it appears that management has minimal to no support from the
shareholder base. It's also helpful that Canadian law allows any
person or group that controls at least 5% of the outstanding
shares to request a special shareholders meeting in order to vote
a new resolution or nominate new directors.
EQU was written up once before on GuruFocus. Please see the
previous writeup for some more background, but basically EQU is a
junior oil/gas E&P company with operations split between
Canada and the US. Its shares trade both on the TSX in Canada and
on the NYSE in the US. Corporate headquarters is in Canada, and
prior to 2011 they reported their results in accordance with
Canadian GAAP. In 2011 they switched over to IFRS. EQU's market
cap is around $100M, with ~$340K worth of shares traded per day.
FY2011 revenue was ~$160M.
The liquidation analysis is pretty straightforward. Canadian
E&P companies file an "Annual Information Form" (AIF) every
year, which contains all key information necessary to ascertain
the value of the company's Proved and Probable oil/gas reserves.
Importantly, this AIF must be certified by a qualified 3rd party
(Haas Petroleum Engineering Services for US assets and McDaniel
and Associates for Canadian assets, in this case). What follows
is the key data from their 2011 AIF, and how it can be used to
conservatively estimate the company's liquidation value.
The value of any oil/gas company's reserves is highly dependent
upon present and future commodity prices. In this analysis, I've
used somewhat lower commodity price assumptions than those used
in the AIF. I think continued weakness in Natural Gas (
NG
) and Natural Gas Liquids (
NGL
) pricing, and a possible long-term change in the historical
relationship between NGL and crude oil pricing, warrants these
more conservative assumptions. So I've assumed $95/bbl WTI oil,
NGL pricing at 40% of WTI (EQU historical pricing has averaged
around 53% WTI, but pricing has been much weaker lately), and NG
pricing (Henry Hub) of $3.50/MMbtu. The assumed (constant) NG
price is consistent with average futures-market pricing for 2013.
To derive the adjusted NPV10 (Net Present Value at 10% discount
rate, pretax) value, I've assumed that operating expenses are
approximately proportional to revenue, which implies that the
NPV10 values for Oil, NGL, and NG scale proportionally with the
corresponding commodity price. In an attempt to err on the side
of conservatism, I'm only giving them credit for their Proved
Producing reserves; i.e., I'm completely ignoring their
"Probable" Reserves. I'm using pretax NPV10 values rather than
after-tax values because EQU has $432M in tax pools available to
offset future profits.
The rest of the liquidation analysis is as follows. The NPV of
the "Decomissioning Provision" comes straight out of the Annual
Report. The Mississipian undeveloped land is valued at the price
Atlas Resource Partners just paid for their recently announced
50% joint venture with EQU. The Cardium and Viking undeveloped
land is valued at a rather draconian 75% discount to the NPV10
per well location claimed in the 2012 Investor Presentation
posted on their website. This discount is in line with the price
Atlas was willing to pay for their 50% stake in the Mississipian
(the $18M paid by Atlas represents a ~73% discount to claimed NPV
per well), so I think it's a reasonable estimate. I'm also being
very conservative by estimating the value of their Hunton
undeveloped land at $0. Clearly $0 is an unrealistically low
estimate, but for reasons that will become clear later, I don't
know whether or not new drilling for NGL/NG in the Hunton is
economic given the current outlook for NGL/NG pricing, and I
don't know how to estimate its "option value" (since obviously NG
and NGL prices could rise in the future). So I'm just assuming $0
for now. Total debt, including net working capital, is $147M. So,
putting all the pieces together yields a Liquidation Net Asset
Value (
NAV
) of $253.2M, or $7.23/share.
Unfortunately, EQU's valuation as a going concern yields a very
different answer. To be honest, I'm not sure exactly what the
problem is. I've tried on several occasions to engage EQU
management in a discussion of my analysis and the conclusions
I've drawn from it, but at this point it appears they've stopped
responding to my queries. For whatever reason, it simply seems to
cost them too much in annual capex to maintain flat production.
The details of this flat-production analysis are given below.
Note: doesn't include Maintenance Capex for items such as major
well workovers, pipeline, or processing facilities. Could be
another ~$4.5M in annual Capex required for flat production.
As indicated in the table above, this analysis is based on the
2012 Investor Presentation posted on EQU's website. On Slide 18
they give various estimates, including 2012E cash flow of
$60M-$65M. Taking the midpoint of that range, I'm assuming $62.5M
in 2012 cash flow from operations. Adding back the $8M in
estimated cash interest charges yields a "Debt Adjusted Cash
Flow" (DACF) of $70.5M per year. Using the cash flow
sensitivities given on this same slide, it's simple to estimate
annual DACF using my commodity price assumptions, which I believe
are more realistic given current circumstances. Note: these are
the same pricing assumptions as those used in the previous
liquidation analysis. The only additional information required is
the annual capex required to maintain current oil/gas production
at current levels. EQU management has previously indicated that
they estimate it would cost them about $47M per year in new
capital spending to maintain flat production (i.e., to compensate
for natural depletion of existing wells). And that's the whole
problem. There's simply not enough DACF left over for equity and
debt holders to make this capital spending economic. The NPV10 of
the excess cash flow is only about $135M, and after you subtract
debt and the decomissioning NPV the equity actually has a
*negative* value! Furthermore, this $47M number is actually too
optimistic because it ignores ancillary maintenance capex items
such as major well workovers, pipelines, and processing
facilities.
As I said before, I'm not quite sure why it seems to cost them so
much to maintain flat production, but one possibility is that new
drilling for NGL and NG in the Hunton is simply uneconomic given
current NGL/NG pricing. But really I'm speculating here, I just
don't know. What I *do* know, however, is that EQU's liquidation
value is far, far higher than both its current market price and
its value as a going concern (with its current drilling plans and
corporate strategy) given the information EQU management has
released to date. So it should be clear that EQU as an investment
opportunity is highly dependent upon the shareholders being
successful in their attempts to force management to make serious
changes in their current plans, perhaps going so far as to
liquidate the entire company.
Please don't hesitate to ask any questions you may have.
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