Equal Energy: Compelling Investment Opportunity at Today's Market Price

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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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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing

Referenced Stocks: EQU , NAV , NG , NGL

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