In general I would put E&P (exploration and production) oil and gas companies in the “too hard” pile. They usually trade at a multiple that reflects people’s hope for what they might find in the future, and what that might be worth. You have multiple variables to predict – the size of the holdings they find, the cost of extraction, flow rates (a dollar today is worth more than a dollar 5 years from now), and future commodity prices. In short, what some people call prediction I call guessing or making things up. Too hard.
However, recent market events have placed the prices of these companies well below their NAV – the calculated worth of oil&gas they have already discovered and have a way to extract. More on how those calculations are done later We have a special situation here; companies are being priced at a fraction of the proven worth of their assets in the ground. This gives us a huge margin of safety, as we are buying assets at a fraction of their value, and valuing everything else at $0 – i.e. all future earnings, all new finds, all infrastructure - $0.
ATP is a small oil and gas company working in the GOM (gulf of Mexico) and the North Sea. They are not a pure E&P company – they are not exploring new ground. Instead, they buy leases with reserves from companies that don’t want them for one reason or another (need to raise cash, shifting operations to another area, whatever). They have a 98% success rate at turning these leases into producing fields, which is unheard of in this business. They achieve this largely by having a very focused business model. 22% of the company is owned by senior executives – they are eating their own cooking, and have a very vested interest in making the company succeed.
They start by acquiring properties from other companies. For example, they acquired their Telemark property from a company that acquired Spiniker. The company had no use for the Telemark company, and sold it to ATP. It’s not that the field has no value, it’s that it was not part of the strategic vision of the company. So a change of ownership, a shift of strategy, etc., all brings valuable blocks to market for ATP to bid on.
ATP buys blocks close to each other, developing “hubs”. This is a key part of their strategy, at it keeps costs very low. Deepwater reserves are very expensive to produce and then transport. Having a bunch of small blocks strewn all over the place would be very expensive to produce and deliver. If you look at a chart of ATP’s properties, you will see they are clustered. ATP then develops the infrastructure to deliver these reserves to market. Then, any new acquisition can be delivered to market for the incremental cost of drilling and pumping, keeping costs very low. For example, when they purchased Canyon Express they got a 62 mile pipeline with a capacity of half a billion cubic feet per day. In a sense, they got that pipeline for free since they bought the property for the reserves, and they carry it on the books at $0. However, this pipeline is the closest interconnect point for all the properties they bought in 2008. This pipeline, valued at $0 with GAAP accounting, is adding tremendous value to the company by minimizing costs. Any other company buying blocks in that area either has to create/buy their own infrastructure, or lease the pipe from ATP. And, because ATP has hubs in these locations, the blocks are less valuable to their competitors.
The next part of their strategy is to maintain production control over all their properties. As they grow, they sell developed assets to generate cash for new acquisitions. This often leads to ATP owning part of a property, and another company owning the rest. By retaining control of operation, ATP can ramp up/down production in response to commodity costs and need for capital to develop other areas. This gives them nearly complete control over their Capex, and allows them to operate profitably with oil at $20.
The final part of their strategy was alluded to in the last paragraph. While they get their cash flows from producing and delivering reserves, they will also bring a property to producing status and then sell it to produce cash for new acquisitions.
E&P companies have stringent standards for terms such as “proved reserves”, “probable reserves”, etc. They are industry standards, audited by outside companies, and used to establish sale prices of assets and companies. Proved reserves means what it sounds like – oil or gas that has been proven to be in the ground and recoverable (it does us no good if you can’t get it out). Probable is the next step out – not as solidly proven, but the seismic, geology, etc., are there. A buyer has to decide how much to write that down to value it. These get packaged together into a number called the PV-10 value, which means present value minus 10%. The estimate is beyond the scope of this, but it looks at current oil/gas prices, figures out how much it will cost to get the assets out of the ground, how long (a dollar today is worth more than a dollar 3 years from now), discounts those future cash flows by 10% back to the present. A standard DCF, in other words, all to an industry standard for the field. It doesn’t mean that the assets are worth that exact amount today; after all, oil could go up or down, but it does reflect about what another company will pay for the assets. They have the same knowledge about future gas prices as anyone else, after all.
Almost every year ATP has improved their proven reserves (all # in Bcfe unless stated otherwise)
2000: 116
2001: 235
2002: 230
2003: 303
2004: 275
2005: 527
2006: 637
2007: 716
They are adding new blocks in 2008, which we will get to soon.
Right now they have 468 proved undeveloped, 248 proved developed, 119 probable developed, and 256 probable undeveloped. By 2012, they expect to have 95% of the undeveloped to developed. Note that the 98% success rate mentioned earlier refers to this – okay, we have it in the ground, can we successfully develop it? If you look at their history in creating developed reserves, they have increased it by 310% from 2004 to the end of 2007.
The recently calculated PV-10 value of the proven and probable reserves is $7.2 Billion. Remember that these numbers are produced by independent third parties, not ATP. You can buy the company today (market cap) for $266 million. That estimate was done on June 30th, with oil at $100 and gas at $7.5MCF. As we know oil is down, but gas is not too far from that price. I’m not going to tell you what value to give oil going forward, but I think you can see we can cut oil prices a lot and still be waaay undervalued here, assuming there aren’t other problems.
ATP is estimating what they think they will actually produce based on new blocks that they have added to their operation. This is an estimate, but the last time they published an estimate they met that estimate and then some. They estimate that there is an additional 76MMBoe of recoverable oil and gas. When you add this to the analyst’s estimate, you get 7 barrels/share. If you take the analyst’s words for it, you get 5 barrels/share. In that case, you are paying from $1 to $1.5/barrel at current share prices. I can afford that, can you? Of course, ATP has to pay to extract and transport the oil, but their costs for this are very low, as I’ll discuss soon. In short, they can easily make money with oil at $20/barrel. And remember, this places the value of everything else at $0 – pipelines, drilling platforms, future discoveries and cash flows resulting from them.
Two things to look at left: 1) should we believe these prices, and 2) is ATP healthy? A no to either one would have us not buying the stock no matter what the possible reward. Rule 1 – don’t lose money, which means don’t take risks.
Should we believe these prices? The market does. ATP is carrying more debt than they should (which I will address in the second point, are they healthy), and introduced a program to pay it down by $600M. This payback is part of the debt covenant they have with their lender. The company even initiated a competition: if they achieve this in 2008 (and I believe they will), they will pay the mortgage of all the employees for a year! To do this, they have to monetize their assets, i.e. sell off some of their drilling leases. The downside to that is of course they don’t get the future profits, but they will be in a very strong situation from a credit point of view.
To this end they recently sold a block for $82M ($102/bbl and $9/Mcf). This block was 0.8% of their proved reserves and 0.5% of their proved and probable. This suggests that the company as a whole was worth $10 Billion dollars, if we assume that none of the probable reserves work out. This ignores the extra 40% that ATP estimates that they will produce. $10Billion on proved reserves alone, vs a market price of $266 million. This is not my estimate. This is not an analyst’s estimate. This is what a competitor paid ATP for their proved reserves. As a side note, and this is way beyond the scope of this post, the price paid was completely in line with other sales by the industry. No one got ripped off here. And, if anything, this suggests that the PV-10 calculations were pretty conservative, which put it at $7.2 Billion. Or, decide the PV-10 is correct. Your choice. Companies usually trade at a small multiple of the PV-10, say 1.3x or so, because after all these are E&P companies, and we should expect them to discover more reserves in the future. Recall that ATP just buys reserves that already have been proven, so “discover” is misapplied in this case. But I’m not going to go down that road, I think you can see a bit of a margin of safety in these numbers.
In October they announced a deal with EDF. They sold 80% of 2 fields for $416MM, and have an option in place to sell the last 20% by the end of the year, which would add to the $600MM required by the debt agreement. The purchase has been approved, and final signatures are expected to happen between Dec 10th and 20th, though there is a small possibility of missing that date. This sale does not make a significant impact on the 7 barrels/share that ATP owns (or 5 barrels if you want to stick with the Jan 2008 numbers), yet the sale price was 1.5x the market cap for the entire company. A sliver of the company for 1.5x what you can buy the entire thing for on the open market. So, a second competitor that values ATP at an extreme multiple over the current stock price.
There debt agreement requires them to put at least 75% of the monetization proceeds towards debt reduction. ATP has announced plans to buy back stock with the rest of the money as soon as the debt is paid. They also have stated that they should have further asset sales to announce sometime soon after the new year. I will show some computations on the effect of share buybacks on shareholder value in a bit.
Is ATP healthy? That is the big question. As noted above, they are carrying debt . I am going to skim a bit over the numbers – you must read the recent report and the last several presentations by ATP (aug 11, Oct 7, and Oct 10th, here: http://phx.corporate-ir.net/staging/phoenix.zhtml?c=123846&p=irol-presentations). Briefly, right now ATP has the capacity for 95 M Bbls/d and 250 MMcf/d. From that you can calculate cash flow. Useful life for the facilities runs from 20 years to 50 years. They are located in hubs to reduce costs. Their reserve replacement ratio has been 223%; the last 3 years was 438%. Their success rate in developing their assets has been 98%. They have a huge inventory of undeveloped reserves to drive growth in 2008-2012. They recognized that the debt was a bad idea, and are deleveraging. 22% of ATP is owned by senior management. Year to date cash flow from Gomez alone is $219M (compared to the company selling for $266M), with net revenue of $236M. You can add up the rest: we are trading for under 1X 2008 cash flow. This is not a cash flow story, as the cash flow will be used to purchase new leases and convert undeveloped into developed, but it shows that the money is there and coming in fast. Furthermore, they plan to reduce Capex by $200M next year, and increase production flows.
In the end, you have to decide how you feel about that debt. Certainly the turmoil in the market could make it hard to sell things off quickly, but remember the pressure is coming from within – management – not without – the banks. So ask yourself: what is the risk of cash flows stopping to an extent that ATP cannot service their debt? Given how fungible their reserves are, and that they have $278M in cash on the books as of 6/30/2008, it would either require a catastrophe at a major hub coupled with a financial market where they could not sell off any of their leases, or oil dropping to a few bucks.
Let’s look at the enterprise value. Market cap is $266. Preferred stock is $0. Debt is $1609, cash is $278. 266+1609-278= $1.7B. ATP could be bought for $1.6B today, vs $7B if they never aquire any more reserves and do nothing but spin down the company, and just let the infrastructure rust. After the monetizations, debt should be around $1B, leading to an enterprise value of $988MM.
This is not an investment story that requires calculation of the value of the infrastructure. But, to put some color on that, consider some of their major projects. Gomez cost them $300MM, with a useful life of 20 years. Telemark I is 91% complete, has a 50 year life, and has cost $515MM to develop. The extremely valuable pipeline they own is carried on the books at $0. Cost of development and sale prices are different things, but it is trivial to see there is a lot of value being carried here that the NAV calculations are ignoring.
In short, a company with a market cap of $266 Million has been valued as having $7B in reserves by external auditors, and $10B by a competitor when oil was at $100. I call that a margin of safety, and then some.
Interest costs are around $100M a year. This will vary quarter by quarter as interest rates fluctuate, and of course will lower as they pay down the debt. The terms require that 75% of any asset sales be used to pay down debt. They refinanced in June, at LIBOR + 5.25, and this loan has several conditions relating to the asset sale, maintaining Debt/EBITDAX radios, etc. They are good terms for shareholders - as it forces the company to keep the company healthy, but of course they have to maintain cash flow. The debt agreement is in effect to 2012, which should insulate them from the current credit market. Call it luck that they did this in June if you want (Al Reese, CFO calls it that), but the result is a company insulated from the credit crisis being priced as if on the verge of bankruptcy.
On cash flow, their sales are hedged, so sales are somewhat predictable. You can get the latest information from the quarterly reports. Of course, as each quarter rolls around, the oldest hedges expire and they have to contract new hedges at current market rates, but this still provides visibility into cash flows for the near term future. The cash flow for the first 6 months of 2008 was $292M. 2009 should yield around $700M, depending on where oil/gas prices fall at the time. In 2009 new projects are coming on line which should boost production around 40%.
On the other hand, in response to the credit landscape and lower oil&gas prices, they have planned to reduce Capex in 2009 by $200M. Since their whole business is changing undeveloped proved into developed proved, they can slow down or speed up development at whatever rate they want. That’s an important point. While Capex is high for this company, they have almost total control over it. There is Capex for actually pumping and transporting from the well, but that all results in a profit. The major Capex is due to development - drilling, etc. This will result in lower cash flows in 2010 then expected. Still much higher than now, but lower than originally calculated.
Finally, let’s look at value/share. I don’t try to predict share prices, since the market is crazy, but it’s worth seeing what kind of value is locked up in the shares, and what kind of return we might expect from a share buyback.
PV-10: 5.3 Billion
Debt: 1.6B
cash: 300M
shares: 35.9M
5.3B + 300M - 1.6B / 35.9M = $111/share
Now, companies don’t trade at PV-10. A lot depends on what people think the future might be, etc. But that is a simple ballpark, and it doesn’t include the 40% extra that ATPG thinks it will recover beyond the PV-10 conducted by outside auditors, but it also doesn’t consider Capex, taxes, etc. Still, I’d be happy buying shares up to $40-50 or so.
Okay, as I noted, they will start a share buyback once the 600M debt is paid back. Of course, this requires that the prices stay this irrational while they execute the buy. But, let’s dream, shall we:
$70M buyback = 3.5 million shares $20 (> 2x current prices)
Debt: 1B (debt paid off)
Cash 230M (less 70M buyback)
PV-10: 4.7 (less the 600M sale)
Shares: 32.4
4.7B - 1B + 230 / 32.4 = $121/share
Such is the beauty of share buybacks when share prices are low.
It you want to break your heart, try making it a bigger buyback, or at a lower share price. Break it from the heart palpitations, I mean!
What are the risks? A storm would cut production. I ask myself, what will the impact be on the bottom line in 10 years? Short of the “perfect storm” which hits all their various hubs (in two entirely different places in the world, I’d say the impact would be small. Naturally, the stock price would take a great hit for awhile, but I would welcome that. Even if every well was destroyed in some kind of global capacity, their reserves would still exist, and they would just endure the incremental costs of rebuilding the infrastructure.
The real risks I see are more along an ecological disaster followed by a multibillion dollar lawsuit. That would be tough to recover from, and would permanently destroy value.
So there you are. A company trading at a huge discount to their value if they closed up shop tomorrow, with positive cash flows, and the ability to make a profit even if oil is cut in half. 22% of it is owned by company executives, and they will be announcing deals in the coming days whereby they are selling a sliver of the company for 1.5x the current market cap. The valuation of their reserves was calculated by independent third parties, and competitors have shown they support those valuations by paying hard cash for assets from ATP.