Description

Obsidian Energy (figures in C$)

Like many of VIC, I am finding value in the energy space. Specifically, I think OBE is by far the best actionable risk/reward name I found this year. My investment thesis is as follows:

1. Starting with the downside, OBE is trading at a healthy discount to its 2P Reserves PV 10% of  C$1.7 bln. With OBE suggesting banks are likely willing to lend up to 60% of 2P Reserves, this implies C$1.2 per share in equity value. Being more draconian and going with the actual syndicated reserve-based credit facility (undrawn) availability of C$440 mln, I get a downside of C$0.9 per share (as of June 4th this has changed as OBE announced they drew on the facility recently)

2. There is a lot of uncertainty how this plays out with lots of moving parts: status quo, asset sales, realization of tax loss carryforward value, potential deal with China Investment Corporation (CIC), etc. However, uncertainty isn’t risk because as a base case (meaning status quo and grow production modestly) I get a DCF value of $3+ per share. That value becomes significantly higher if the tax losses can be realized earlier and/or the CIC JV is worth anywhere near what CIC put in to have a 45% interest – which would alone cover OBE’s enterprise value in theory.

3. Opportunity exists because OBE was formerly Penn West, a higher dividend paying energy company with a debt-fueled grow at any cost strategy. With dividend cut to zero, a multi-year decline in production due to asset sales to stave off bankruptcy, and a current hedge book limiting OBE’s “torque” to oil prices, I contend there is a limited number of buyers of OBE given many major Canadian asset managers had been burnt on the name.

4. OBE has the bonus of adult supervision in the form of activist investors involvement, including one that pushed OBE to commit to asset sales and use proceeds to buyback stock.

Background – Unsustainable Debt Fueled Growth

Obsidian (OBE) was formerly known as Penn West Petroleum Ltd. – an oil and gas producer based in Alberta Canada founded in 1979. For those familiar with the MLP structure in the US, Canada had a similar structure on steroids back in the 2000’s where a company can convert to an income trust (or specifically Canadian royalty trust), pay out its earnings in dividends and avoid paying federal income taxes.

Not surprisingly, Penn West joined the party in 2005 by converting into the trust and embarked on a journey of growth at any cost via debt fueled acquisitions and generous monthly dividend payments. Ending the tax free bonanza, the Canadian government cracked down on income trusts in 2011 effectively forcing Penn West to convert back to a regular corporation. Even then, Penn West continued paying its generous dividend and growing its production, hitting just over 160,000 boe/d in production in 2012. Back then, there were already signs Penn West’s asset quality was questionable as management had to reiterate on the 3Q12 call that they aim to “ensure consistency” in the dividend even in softer portions of the energy cycle – this is referring to the WTI vs. Western Canadian Select spreads widening to C$25/bbl in a > US$100/bbl WTI environment! This was compounded by the fact Penn West had trouble hitting its production guidance.

Even before the downturn in oil, Penn West had to begin selling some assets and production already retreated to ~ 140,000 boe/d in 2013 – and the > $3 bln debt on its balance sheet was increasingly a concern.

Heading into late 2014 when oil prices fell sharply, both Penn West’s dividend and ability to stay on-side regarding its debt covenants were questioned. For whatever reason, Penn West’s debt had a 3x senior debt to EBITDA covenant instead of some conventional energy debt that was based on reserve values with periodic redeterminations (debt to EBITDA covenants are more easily breached when it comes to commodity volatility). Also, from an operations perspective, some assets such as Slate wells were disclosed as “would not work at < US$70 oil”. In early 2015, there were serious question marks around the management team, specifically when they provided the following remarks in the CIBC conference:

"I focused on a couple things, its not my job to do whatever it takes. So I can survive through this, me personally. My job is to make sure that we continue on the path that we think is value created for our shareholders"

It is simply unbelievable a public company management team would speak to investing public stating that management will be fine regardless (no skin in the game) and they don’t need to do whatever it takes to fix the company!

In 2015, Penn West did get covenant amendments, sell assets, reduce debt by just over $1 bln. However, production continued to drop to sub ~ 100,000 boe/d while negative FCF resulted in a complete dividend cut.

Even with all this painful medicine, Penn West was once again at risk of breaching covenants in 2016, leading to another round of capex cuts and asset sales, with production now shrinking to < 60,000 boe/d.

I am not going through the assets in detail because I don’t have a technical edge over the market in analyzing them. The bottom line is my best guess is: 1) Water flooding should work and keep declines <20% especially with David French as CEO given his experience at Bankers Petroleum, and  2) my assumed capital efficiencies seem to jive with what mgmt and the sell-side think is reasonable. I’m also skipping a long macro discussion on energy prices. Using WTI as a reference point, I think OBE’s downside is protected for an up to 20% sustained decline in prices.

Asset Sales, Deleveraging, Name Change, New CEO + Activism

Finally, near the end of 2016, a new CEO was put in and with pending asset sales, the company had 3 remaining asset plays capable of producing ~ 30,000 boe/d: Cardium, Viking and Peace River. By July 2017, the company was renamed Obsidian energy.

Strangely, FrontFour Capital, an activist fund, had a position in Penn West and could not take an active role, as the founder’s father (Rick George) was on the board (https://www.bloomberg.com/news/articles/2017-06-22/hedge-fund-pirates-ii-father-son-and-curse-of-the-black-oil).

Due to Rick George passing away (as mentioned in the 2Q17 call), FrontFour turned activist on OBE by year end demanding OBE slow down capital spend, sell off assets and return capital to shareholders.  At the same time, Edward Kernaghan also took a 5%+ position in OBE. The feedback on the street is Kernaghan is more patient with OBE and is willing wait and see them execute on their plans.

What’s the Downside?

I always like to know what my downside is in case I’m wrong. For OBE, I think the downside is protected by both its 2P reserve value and what lenders are willing to extend to OBE.

Starting with the reserve report, using the 10% 2P number gets us C$1.65 bln which is approximately $2.46 per share in equity value (realistically lower than that due to expenses not captures in the NPV reserve calculation).

Being more conservative, I have two additional ways to look at the downside:

1. OBE suggested banks are willing to lend up to 60% of their reserve value. Using the C$1.65 bln figure, that would be ~C$1 bln, or ~$583 mln, roughly C$1.2 per share

2. The latest OBE undrawn credit facility had $440 mln in availability. That equates to roughly C$0.87 per share (this has changed slightly because OBE announced they drew down on the facility since June 4th but unless the uses are strictly value destructive, the point remains the same)

I believe the supposed willingness of banks to lend up to 60% of reserve value and OBE’s current undrawn credit availability is important because: 1) the banks should be particularly conservative considering OBE’s near-death experience and EBITDA covenant breaches previously and 2) in light of this, the banks also likely have access to detailed insider information unavailable to equity holders.

Open Ended Upside

There are a number of moving parts (which I will touch on later) for OBE that makes the upside somewhat open-ended and uncertain. Assuming OBE executes on modest single digit production growth, I see OBE generating ~ $0.32 per share of FCF using maintenance capex – which is the basis of how I get to a $3+ target. Specifically my assumptions are:

• 35K boe/d production (unhedged)

• Success in waterflood in holding a corporate 18% decline rate

• US$65/WTI and US$/C$ 0.78

• Maintenance capital in the $125 mln range, implying corporate capital efficiency of $18,500/boe/d

Peace River JV with China Investment Corp

The Peace River asset produces about 5k boe/d and is currently a 55%/45% JV between OBE and CIC respectively. Due to its large potential resource base and a previously higher oil price environment, CIC initially set up the JV with Penn West (OBE predecessor) for $312 mln and subsequently spent $505 mln to earn in their current 45% interest. Perhaps CIC is way off or struck a bad deal but it would suggest the Peace River asset has more potential than the current 5K boe/d production would indicate.

Specifically, at $817 mln for 45% interest, implies $1 bln for OBE’s 55% interest – this asset responsible for ~15% of OBE’s production covers its entire current enterprise value.

Tax Shield

When a company goes from 160,000 boe/d to 30,000 boe/d and almost went bankrupt during this process, the only silver lining is OBE has a ton of tax pools (i.e. tax loss carry forwards that US investors familiar with). In fact, OBE is unlikely to pay income taxes for 20+ years given $2.4 bln in tax pools. While my FCF estimate doesn’t assume cash taxes, there is a potential for a transaction for another entity to use up and bring its value forward on (from an NPV perspective).

Over generalizing and assuming a 25% effective tax rate, OBE tax pools would be worth ~$600 mln or $1.2 per share.

Cost Structure – Especially G&A

OBE is currently guiding to $2-$2.5/boe in G&A costs. This works out to $20-$25 mln at 30,000 boe/d production run rate and is apparently a high number. Similar sized companies are running at much lower G&A $ levels such as Raging River at ~$9 mln, Crew Energy at ~$13 mln and TORC Oil and Gas at ~$10 mln. While OBE has cut a lot of costs during the downturn, I suspect some of the G&A still reflects a much larger Penn West legacy footprint. As a thought exercise, an incremental $10 mln in sustainable G&A savings at this production level and giving it a 15x multiple would result in $150 mln in value or ~$0.30 per share.

Activists Likely to Ensure Proceeds Not Squandered

Likely bowing to FrontFour’s activist pressure, OBE is using RBC to run a sale process for its Viking and Peace River asset (although as we just learned this week the Viking asset sale will not proceed). It is very interesting OBE laid out so explicitly that they would use some of the proceeds to buy back shares (likely “encouraged” by the activists to put in that language). With my base case fair value estimate of $3+, it is quite likely that share buybacks would be quite accretive to shareholders.

https://www.obsidianenergy.com/press-releases/obsidian-energy-announces-strategic-actions-to-unlock-shareholder-value/

Planned Use of Proceeds
The Board will determine the right balance of accelerated Cardium growth, debt repayment and share buybacks based on changes in the Company’s borrowing base as a result of any production being sold, and Obsidian Energy’s share price at the time of any such sale. The Company intends to apply for a Notice of Intention to Make a Normal Course Issuer Bid (the “Bid“) with the Toronto Stock Exchange (the “TSX“) upon closing of the potential transaction. The Bid will be subject to the approval of the TSX and the Company’s lenders. Obsidian Energy intends to repurchase shares on both the TSX and New York Stock Exchange (the “NYSE“) and/or alternative Canadian trading systems.

Why Does This Opportunity Exist?

Too Many Canadian Asset Managers and Sell Side Burnt on Penn West

Penn West was widely owned by large Canadian asset managers (including all the bank owned ones) all the way up to its peak production period in 2012. With a drop in oil prices, dividend cuts and an over levered balance sheet, predictably these large fund managers sold out as Penn West became “uninvestable”. I would speculate many large Canadian fund managers would not touch Penn West again given the history – maybe partly while OBE went through a name change. I believe we are seeing the same dynamic with the sell-side as many analysts covered Penn West and got the call wrong. Now the sell-side mostly has “HOLD” ratings on OBE

No Dividend

Compared other small/mid cap Canadian energy names, OBE still does not pay a dividend, leaving OBE investable to a very small subset of investors: value investors and activists.

High Uncertainty and Perceived Lack of Growth

I suspect the market is mispricing OBE because of the significant uncertainty on what path it will take. Similarly, I have outlined several things OBE could do to unlock value including asset sales, specifically its JV with CIC, surfacing value on its giant tax pools and growing and managing its decline rate with waterflooding. I concede I don’t know which of these scenarios will play out but I’m totally ok with situations with limited downside and open-ended upside.

Also, looking at the rear-view mirror, OBE’s production obviously looks terrible, going from 120,000 boe/d to 30,000 boe/d. I happen to think some of the better assets remain and mid-single digit production growth appears reasonable.

Bottom Line - $0.40 downside and $1.80 upside looks very attractive to me.

Catalyst

- CIC buys out OBE's 55% stake in Peace River for anywhere close to what they put in

- Execution

- Dividend reinstatement + share buybacks