Description

Background

QEP has undergone significant re-organization and simplified into a two-basin shale producer with a new management team. Despite the restructuring, QEP’s producing assets have limited inventory and most recent wells are underperforming because of spacing issues that have plagued the shale industry in the last two years. 

Assets aside, QEP has a very challenging debt maturity schedule that would require extraordinary measures to refinance in its entirety and I think the 4Q result will shine the spotlight on QEP’s lack of options to repay the debt maturities. The 2019 reserves report will also show how less cushion relative to outstanding debt, and trigger a debt covenant.

QEP has outperformed the XOP by 16% after announcing 3Q19 results and three recent sell-side upgrades have skewed sentiment and positioning much more positive than before. Energy risk-on into year-end has also added to the positive skew.

Thesis

After a better than expected 3Q19 update, street expectations for 2020+ production are too optimistic, including 4Q19 expectations. Consensus expectations for 4Q19 and 2020 production have moved up 3% and 1% respectively since the end of 3Q19 results and I see 2-3% downside to 2020 oil production estimates.

More importantly, the equity and debt markets appear complacent about QEP’s ability to repay $2.1bn of debt with $1.6bn in maturities due between 2021 and 2023 and neither the debt or equity are trading with any inkling of distress even though QEP does not have the cumulative FCF to repay or proved reserves to support the debt.

Furthremore, if my view of 2019 proved reserves is correct, it would be the catalyst to crystalize the debt issues at QEP because it would trip the 1.5x net funded debt to proved reserve covenant and it would also highlight the over-valuation of QEP’s equity relative to the amount of debt.

Lastly, QEP recently tried and failed to get bondholder consent on December 13th to be able to repay more than $500m of unsecured debt with secured debt, which reduces the options on the table to repay the unsecured notes. 

Detailing the Thesis Points

Thesis Point #1. At the current forward strip, QEP is expected to generate $580m in cumulative FCF over the next 5 years, which is insufficient to cover the $1.6bn in maturities between 2021-2023. The following table lays out QEP’s expected FCF at strip vs the annual debt maturities. QEP currently has $92m of cash on hand.

Furthermore, at the forward strip, my expectation of QEP’s proved reserves only covers net funded debt by 1.3x, below the 1.5x covenant. It also implies $1.60/sh of equity value per share (1P/2P valuation of $1.28 / $2.56 per share, 75%/25% weighted).

At the current strip, QEP will generate $220m of FCF over the next 15 months, which is insufficient to fully repay the $398m notes due in Mar 2021. QEP will need to partially fund the maturity with the revolver, which will increase focus on the $500m 2022 maturity and $650m 2023 maturity. 

QEP is looking to monetize their water assets, but even at a 7x multiple, it would be insufficient to cover the 2022 maturity while selling free cash flow. Once equity holders realizes that QEP will have to refinance unsecured debt with the revolver and a $500m secured debt constraint, I think the equity and debt will begin to price at more distressed levels.

Thesis Point #2. I think QEP’s 2019 proved reserve report will surprise to the downside. QEP’s 2018 proved reserve estimate of $5.0bn incorporates a $65/bbl WTI price deck vs $57/bbl in 2019 and the forward strip at $52-$55/bbl. Furthermore, it appears that QEP over-booked 2018 PUD reserves relative to the current commodity environment – based on QEP’s $600m expected annual capex it implies $3bn over the next 5-years vs 2018’s 5-year plan of $4.4bn, according to the SEC 5-year PUD booking rule.

Based on the current go forward capex of about $600m per year, I expect that QEP will disclose PDP and PUD reserves of around 316mmboe in 2019 vs 658mboe in 2018 which implies a proved NAV of $2.3bn at current strip pricing. If this materializes, it would imply a 1P value of $1.28/sh based on proved reserves and it would also trip the 1.5x proved reserves to net funded debt covenant.

The combination of weaker FCF generation and lower proved reserves is likely to prompt credit and equity markets to value QEP with a degree of distress.

Path to Thesis Playing Out

The thesis will play out with QEP’s 4Q19 results where QEP will announce their 2020 guidance in February 2020 and publish their 2019 reserve report.

Together with QEP’s 2020 guidance, QEP is expected to announce their annual proved reserves which will determine how much PDP and PUD cushion there is to their debt schedule. I expect their proved value to fall below the 1.5x proved reserve to net funded debt covenant and reveal no PDP cushion relative to debt.

Besides downside to production and proved reserves, QEP’s $398m of notes due March 2021 will become current in 1Q20, which should highlight QEP’s credit issues, as it did with WLL during 2Q19. 

Valuation and Comparables

Based on my current assessment of QEP’s reserves and a blended value of 1P/2P estimates, I arrive at a fair value of $1.60/sh and a risk-downside to the short of $5.00/sh. The short carries a 3-to-1 risk-reward factor. 

QEP trades inline with the comp group but given the leverage profile and debt maturity issues, it should trade at a discount, closer to WLL.

Macro Considerations

As a levered small-cap E&P company, QEP is highly sensitive to inflections to the crude macro environment. Crude optimism has improved significantly off the bottom helped by the year-end risk on rally (WTI $58/bbl vs $50/bbl in early October). Time-spreads are still deeply backwardated and recent negative DOE reports have tempered my bullish expectations near-term as well.

In summary, my crude macro view is neutral to negative after rallying hard off the bottom and has met technical resistance in breaking out. However, any positive change to crude macro or energy sentiment would pose challenges to the short. I think the XOP or a more beta-levered small-cap oil name like CDEV or SM would be an appropriate hedge. 

Risks to the Thesis and Mitigating Considerations

A risk to the short thesis is oil prices and even when paired with a similar small cap E&P, there can be significant mis-matches of single-day stock performance relative to hedges given the high beta and volatility of the stock.

The possibility of a sale of the water business above market expectations to meaningfully de-lever the company is a risk, however midstream valuations with significant single-company and parent-sponsor risks have not garnered significant interest. For example, OMP, the midstream MLP for OAS has not received suitable bids and WES/NBLX, larger midstream companies with better capitalized large-cap sponsors have also failed to receive acceptable bids. The risk of above market expectations for midstream valuations are low.

The risk of a takeout is low, because management has recently concluded a strategic review and recommended the best course of action is to operate as a standalone, which I think implies that there were no meaningful bids to QEP. Furthermore, recent M&A deals have transacted with lower premiums - PE acquisition of JAG was for a 11% premium and CPE lowered the CRZO to 7% to get shareholder approval. Lastly, most buyers had a negative day-one reaction, which lessens the risk of a large one-day move in the event of a takeout.

Catalyst

4Q19 results and associated reserve reports.