The recent buyout of Reece Energy (RXR-TSX) by PennWest is a good example of the issues facing junior producers of oil AND gas right now.

Reece had great exploration success, started slow, built up production and showed they were good operators as well as explorationists…kept their share structure clean, were able to raise money at successively higher prices, the stock jumped from $1-$5 last year…and they still had to sell out to an energy trust at a price where almost no investors made money.

Their mistake, as I see it, was overextending themselves in Q4 2008 when they already had a lot of debt, but they were very good explorationists and operators.  Plus they were not able to get some new production online in time to meet their 2008 goal of 2500 bopd by Dec. 31 – delaying much needed cash flow.

Reece caught my attention last October because of its high  rate of drilling success.  I almost wrote about it then but debt levels and high valuation made me reconsider.  It was one of the examples I mentioned in my last post where I had done all the research and wrote the article, and would now share those with readers.  Then came the buyout. Get me rewrite!

In the junior space, Reece’s competitive edge was its horizontal drilling expertise, and management’s ability to use it in areas that other people ignored – like the Viking formation in western Saskatchewan. They assembled a large land package very cheap, and it turned out to be a big winner for them.

They began having success using horizontal drilling (HD) at their Dodsland play in west central Saskatchewan near Kindersley.  I spoke to Chairman Lorne Swalm last fall, who grew up in the area and worked the pay zone there – the Viking formation – right out of school in the 1970s.

He said he saw the success HD was having in SE Saskatchewan in the high profile Bakken play, and knew where it would work – and not work – in the Viking formation near Kindersley.  The formation was well known but not economic until HD and Multi-Stage Fracing (MSF) was perfected recently.

(For new readers, HD & MSF are used on oil reservoirs which lay horizontal deep – as most do – under the surface.  You drill down to the oil producing horizon (the pay zone) and then turn the drill in a curve at the right depth (the kicking point) and hit the pay zone when the hole is horizontal. You drive the horizontal hole along the pay zone as far as you can. Then you force down a liquid with sand in it at very high pressure to bust open the pores in the pay zone – called fracing – and allow the fluid to reach the horizontal well bore.  MSF is then performed section by section along the pay zone.)

The HD wells cost up to 4-5x more than drilling a simple vertical well (the HD wells cost ~ $1.3 million), but the increased production out of these wells is worth it.  With Reece, a horizontal well in the Viking formation produces about 50-60 barrels of oil per day (BOPD), vs. roughly 5 BOPD for a vertical well.  

The Viking play near Kindersley was the growth engine for the company.  They levered their HD experience to farm into another HD play in the southwest corner of Saskatchewan – the Lower Shaunavon.  Swalm was excited about this play as he said it has similar characteristics as the Viking but triple the pay zone, adding other companies are getting 150 bopd from the Lower Shaunavon with long life reserves (which is what the hungry energy trusts want to buy).

The only well they reported from this formation was 50 bopd – clearly a disappointment and possibly one of the reasons they had to sell the company.

FINANCES

Back in November the company estimated 2008 cash flow at $28 million and net debt at year end of $26 million. Net debt in reality ended up at $40 million. Reece drilled more wells than anticipated in Q4 because their much larger joint venture partners had the cash flow to drill them, and chose to do so. 

So when Reece got the cash call in Q4 from these partners to drill the wells, Reece answered yes and paid. Maybe they should have passed? Who knows.  But having to drill 4-8 wells more than anticipated was unexpected, and for a company already near the ceiling of their debt facility, a difficult situation.  (Some of these wells hit, but haven’t been fractured yet – had MSF applied – more cash flow waiting to go online.) At the same time, cash flow was being crimped because of low commodity prices.

Reece was actually a low cost producer, with costs at about CAD$32/barrel. That left them with roughly CAD$25/barrel profit (the industry calls that the “netback”). Had they averaged 2200 barrels a day this quarter, that’s $55K cash flow a day or annualized cash flow of $20 million – 2x debt to cash flow.

That’s not huge, but their bank had already moved up Reece’s lending from $13 – $33 – $39 million through 2008 – the last move coming late in the year when really, I doubt very few bankers wanted to raise any energy company’s debt capacity.

And so, despite doing a lot of things right, management sold the company for $1.39/share plus $40 million debt – a price where few shareholders made money.  It was a combination of some wells not coming in as strongly as had been hoped, high debt, and being over-extended with commitments in a low commodity price environment that caused them to sell the company.

The PennWest deal – Take the Money!

Shareholders should remember this is a stock only deal – no cash. If I owned the stock, I would not tender to PennWest.  I would just sell the Reece stock in the market.  PennWest itself has a lot of debt – the most of any trust I could find research on, at $3.8 billion.  According to brokerage firm Peters & Co. February 6 2009 update, PennWest’s current payout ratio is 100%, which means it pays out to investors the sum total of its net cash flow (I did not see what energy prices they were using to derive that percentage).

 Therefore a cut to their monthly distribution to investors is likely, (because they need money to spend in the ground to grow the business, and pay salaries etc) which would cause the stock to drop further.

 When a company the size of PennWest must cut their own capital program by the amount of debt it takes on – when it’s a paltry $40 million – not even a drop in the ocean for them – I would suggest that could mean THEIR banker is watching them closely.  I could be wrong, but for them to make that comment on such a small amount, that really surprised me. 

I would not be a PennWest shareholder at this time.