In Part One of this series I introduced readers to “Kurt’s Bible” a great piece of energy stock investing wisdom written by Canadian energy analyst Kurt Molnar of Raymond James.
In Part Two here, I want to warn energy stock investors of a huge risk that they are taking if they rely on the proved and probable reserve data being published by energy producers today.
Molnar raises the issue eloquently in his report and I think every energy stock investor needs to know about it.
This risk has been created by the horizontal drilling and multi-stage fracturing revolution—which has completely changed the energy game.
What horizontal drilling and fracking has done is turn what was an exploration and production business into a manufacturing operation. Prior to the horizontal revolution, exploration a was lot more hit-and-miss. Especially for smaller and midsize producers, production growth was hard to see until a well hit.
Tight oil or shale plays are generally much more consistent over a larger area, and it’s now common for an energy producer to have a decade of horizontal development drilling locations.
The “E” from E&P–exploration and production–business is pretty much gone. Today it is more about “D”–development.
This new long-term visibility on future production is great for the companies and their investors—years of low-risk drilling is good! But it means a very large number of future drilling locations can be included by reserve engineers in proved and probable (2P) reserve numbers.
This is where A Big Problem is being created for investors relying on these numbers.
The Problem isn’t that the future drilling locations aren’t real. The oil is there and the companies know how to get it out.
The Problem is that while these drilling locations are included in the reserve report, producers don’t need to have the financial means to fund the development of these locations.
It is important to note that in a reserve report, only the proved producing reserves—what the industry calls 1P–are guaranteed to be fully funded.
But for 2P reserves—Proven AND probable—a producer might have to issue a huge amount of equity—or take on massive debt–in order to actually fund the development of those reserves. Both these options greatly increase theEnterprise Value (EV) of a company. (EV=market cap + debt or – cash.)
The independent engineering company prepares the reserve report. They always estimates (and discloses) the amount of development capital required to develop the proved and probable reserves.
But the underlying E&P company is under no obligation to explain to investors where that development capital is going to come from.
These next three paragraphs are really important for investors to understand:
Many companies like to present to investors just how “cheap” their stock is by comparing their proved and probable net asset value, or 2P numbers (reserve value less total net debt divided by shares outstanding) to the current share price.
You see, great companies trade at 2x NAV. Good companies trade at 1.5x NAV. Average companies trade at 1x NAV. Explorers trade 0.3-0.8 NAV
What these companies often leave out is that it may require a huge increase in the current share count or total debt in order to raise the necessary development capital to generate the production assumed in that reserve report.
If that share count or debt increase were to be factored in the true net asset value per share may not look cheap at all relative to the current share price. In fact the same company might actually look quite expensive.
An extreme real life example can help illustrate this issue (and honestly, if you’re not an accountant it’s still pretty vague):
Arcan Resources (TSX:ARN) is a company that on a net asset value basis could look extraordinarily tempting to investors.
According to its independent reserve engineers Arcan has a proved and probable present reserve value (discounted at 10%) of $582.8 million.
Source of image: Arcan Resources April 2014 presentation
In its April 2, 2014 press release Arcan reports its net asset value per share using this estimate of reserve value to be $2.53. Meanwhile the recent share price for Arcan has been trading around $0.30.
Wow, Arcan’s net asset value is eight times more than the current share price. Most decent producers trade at a slight premium or slight discount to their NAV. Is this a huge opportunity or is there more to the story?
The answer lies in the development capital assumptions included in Arcan’s third party engineering report (below).
To realize the $582.8 million of reserve value and $5.32 of net asset value, Arcan is going to need to spend $69 million in 2014, $104 million in 2015 and $75 million in 2016 developing its property.
Meanwhile, for 2014 Arcan is estimating that it will have only $41 million of cash flow in 2014 with production shrinking slightly over the course of the year.
Over the next three years Arcan is likely going to generate less than $120 million in cash flow while the engineering report is assuming that Arcan will spend $246 million.
There is a big ($126 million) hole here that needs to be filled.
The obvious question then becomes how does Arcan fund the $246 million of capital spending assumed in the reserve report over the next three years when it is only likely to have at best $120 million of cash flow? Every option available for Arcan is going to create significant dilution in the net asset value per share.
To raise the almost $126 million it needs to meet the development capital assumed in the reserve report Arcan would have to issue 420 million shares. That would quintuple the current share count at current prices.
Other alternatives would be asset sales or additional debt both of which would again significantly alter the net asset value figure provided by Arcan.
To put it bluntly, Arcan’s net asset value is virtually meaningless in relation to the real world situation the company finds itself in.
Arcan is an extreme example because the company is in considerable financial distress with its overleveraged balance sheet. But the issue is very real across the entire industry, and investors need to be aware of it.
The net asset value figures provided by companies should be taken with more than a single grain of salt.
In the Arcan instance and the others across the industry this isn’t a case of the engineering companies or the E&P companies themselves violating any reporting standards.
No, it’s more of a case in the industry where management decides what information to publish prominently to put their best foot forward–and what information to bury in the financial notes. And I would suggest that the more an E&P company’s net asset value is impacted by this the less likely it will be to make mention of it.
Molnar suggests, and I certainly agree, that there is nothing wrong with an E&P company showcasing it theoretical equity value by referencing the engineering report. However, he says it’s important for investors to understand the potential impact on dilution; the number of shares or amount of debt that will be required.