Sunday, April 10, 2011

PetroBakken - 2010 Annual Review


In the oil and gas industry it seems that many companies love to sell potential investors on huge production growth stories.  However, when the smoke clears and some basic analysis is performed you realize that they are talking gross numbers not per share numbers adjusted for debt and equity required to achieve the growth.  I have even seen this on Seeking Alpha, as some writers are just cut and paste what is stated in press releases. 

Management can and should communicate candidly with the owners of the business.  The best example would be Warren Buffett's annual letter to shareholders.  Shareholders shouldn't have to dig a mile deep to determine if they are getting a fair deal.  Now investors must, and I repeat must, calculate returns on a per share basis.  If you do not know how to do this find someone you trust to perform the analysis for you. 

Now many investors seem to be perplexed about the downward price action of PetroBakken, but perhaps I can shed some light.  The company is majority owned by Petrobank, who spun out the company in 2009.  I want to give as many facts as possible and some limited discussion on their results.  We will turn over a few stones and examine them carefully. 

Now that the company has filed its Annual Information Form (AIF) and 2010 financial statements we can examine the yearly progress.  Year-end equity quotations were used in all calculations.  The headline on their reserve report reads, "PetroBakken replaces 274% of production and increases reserves 18% in 2010"

Performance Measures

Production Q4 2010/Q4 2009 was down 9%
Production per share (debt adjusted (DA)) Q4 2010/Q4 2009 was down 29%.

Proved Developed Producing (PDP) reserves were up 10%, year over year (YOY).
PDP reserves per share (DA) were down 14%, YOY.

Total Proved (1P) reserves were up 14%, YOY.
1P reserves per share (DA) were down 10%, YOY. 

Proved plus Probable (2P) reserves were up 18%, YOY.
2P reserves per share (DA) were down 7%, YOY.

Net Asset Value per share is defined as the reserve value, discounting cash flows at 10%, less net debt plus the cash proceeds from the exercise of options, incentive shares and deferred shares divided by the fully diluted shares outstanding. 

On a PDP basis NAV fell 9% per share YOY, from $6.46/shr to $5.87/shr.

On a 1P basis NAV fell 3% per share YOY, from $9.47/shr to $9.17/shr.

On a 2P basis NAV fell 6% per share YOY, from $16.18/shr to $15.19/shr.

Investor Discussion and Analysis

After reading through the 2010 results I can't help but notice a few issues that potential investors might want to consider.  I will cover these in point form.
  1. Net income for the year came in at $48.0 million.  Stock based compensation expense for the year totaled $22.9 million.  Stock based compensation was 22% of earnings before taxes. 
  2. The net book value of the company's oil and gas assets totaled $4.1 billion at year-end.  They also have $1.5 billion of goodwill assets recorded on the balance sheet.  The total cost of their oil and gas asset, as carried on the balance sheet, is then $5.6 billion.  Now the estimated undiscounted future net cash flow of the proved reserves totaled $4.8 billion.  This is all of the estimated future revenue less royalties and operational costs between now and the next 30 years.  Now they do have some undeveloped land, which they valued at $0.48 billion (acquired in 2010).  That gives a total value of proved properties and undeveloped land of $5.2 billion. 
  3. Now I am not a financial expert but under the full cost method of accounting (Canadian GAAP), there is a ceiling on the amount of property and equipment that can be carried on the balance sheet.  A write down exists if the undiscounted future net cash flows from proved properties at future commodity prices plus the cost of undeveloped properties are less than value the capitalized assets on the balance sheet.  In plain English the this means all future net cash from the proved reserves plus the cost of undeveloped land must be greater than the assets recorded on the balance sheet.  From what I see, they have proved properties and undeveloped land of $5.2 billion (from what is disclosed) carried on the balance sheet for $5.6 billion.  Clearly they must have more undeveloped properties to justify the assets carried on the balance sheet.
  4. Under IFRS accounting, the company no longer can use undiscounted cash flow in determining asset impairment.  Beyond this they will have to calculate impairment at a much lower operating level than Canadian GAAP (it uses the country level).  I'm not sure what discount rate companies have to use but it will be interesting to see how this changes things.  As seen above the asset value is approximately equal to cost using non-discounted cash flows, any discount rate will further exacerbate this problem.  PBN has noted that it will have to take a $50 million adjustment to retained earnings, as some assets they currently have for sale are impaired under IFRS.  The cost exceeds the fair value less cost to sell.  Considering that the net present value of the undiscounted proven cash flow is approximately equal to cost, I would expect more impairment in the future.  Using a 5% discount rate reduces the net present value of the future cash flows by 25%. 
  5. Now I found the exchange rate used by the company to be quite interesting also.  They used a $US/$CAN exchange rate of 0.93 disclosed on p.10 of the financials and in the AIF.  Now that exchange rate seems quite aggressive in my opinion.  I'm not sure why the reserve auditor, Sproule, would choose such an aggressive exchange rate.  Most other reserve evaluators are using an exchange rate of 0.98, at least in the next few years.   The average exchange rate year to date is 0.983 $US/$CAN, and it appear the lowest exchange rate ever recorded since 1949 is 0.9215 according to the bank of Canada's website (Click here).  Some might not consider this to be that big of a deal, but using 0.98 vs. 0.93 exchange rate will increase estimated future revenue by approximately 5%.  Myself, as an investor, would naturally give the asset values another 5% haircut after seeing this. 
  6. Now I have already commented on how I feel the incentive shares and the deferred common shares are a total rip off to investors but let's discuss options.  In September 2010 the company modified certain non-executive stock options that resulted in the exercise price of 2,275,688 options to be reduced from a weighted average price of $32.48/shr to $23.12/shr.  Why not lower the bar, it's easier to jump over?  If anyone says this is common practice and thus not a big deal needs to give his or her head a shake.  The stock market is not some mysterious fountain of money. 
Undeveloped Land - An asset or liability?

Now, many investors consider land to be a valuable asset but I am going to demonstrate how that is not always the case.  You may want to print a copy of the AIF to follow along.  First, on page 11 of the AIF, the company drilled three wells but the completion caused a breakout into an underlying formation of water.  For the fourth well the company figured out how to complete wells successfully to prevent the water influx.  I quote, "PetroBakken plans to continue drilling into the Spearfish using this technique to preserve expiring lands".  If land retention drilling drives investment decisions, is that best use of capital?  More could also be said regarding the significant risk of drilling these wells given the technical challenges found, but let's continue. 

Turning to page 12 of the AIF, we then read the following, "A third well was drilled in November 2010 as a single leg horizontal to preserve expiring land..."

I really wonder how much these types of land strategies cost the average company in terms of return on capital?  It has to be a few percentage points at a minimum, likely more.  Perhaps this would make a good research project for a young finance student. 

To further make this point let me quote Don Gray, Chairman of Peyto Exploration and Development in his 2010 letter to shareholders. 

Investors should also be wary of companies that promote large purchases of land but provide no reliable information on whether the land is truly prospective, the amount of capital required to develop reserves or whether it can even be done economically. They want investors to believe the biggest challenge is getting the land and after that it’s as easy as shooting fish in a barrel. Be equally cautious about companies that press release peak flow rates from short term production tests leaving out any meaningful information on how the well will actually perform. At times, it seems like the Wild West is alive and kicking with yahoos on every corner selling snake oil to unwitting investors. This means it is more important than ever for investors to do their homework and differentiate between the real profitable businesses and the ones who see the investor as their opportunity.

I highly recommending reading the full letter found on page 2 of Peyto's 2010 annual report (Click Here).

Conclusion

In conclusion, it is vital that potential investors calculate returns on a per share basis and avoid the headlines in most press releases.  I could have spent more time getting into how the PDP reserves (the BOE's actually on production) cost $64.47/boe to find, develop or acquire, but why bother?  The company nets around $42/boe for each barrel produced (Revenue less cash costs).  Usually you want to find the barrel of oil for less than you can sell it for.

As a potential investor we should be concerned with two things.  First is what we are paying for current reserves (assets), and secondly, how much real economic return the company can generate on invested capital.  For PBN, the current enterprise value divided by the total proved reserves is $44.34/boe.  That is what you are paying for proved reserves in the ground.  Since the company nets around $42/boe after all costs, this isn’t an overly attractive proposition.  We either have to believe that oil prices will rise (and they have since Q4), the reserves are understated (which I doubt), or we are paying up for a proven management team that can create value with the drill bit (yet to be seen).  Furthermore, the very short reserve life of 4.3 years on a PDP basis, 6.8 year proven basis puts the company on a fairly steep production treadmill. 

Last and certainly not least we must examine returns on both total capital and equity.  If we were to examine the large high quality resource companies like Talisman, Encana, or Canadian Natural Resources we would see fairly consistent returns on total capital of approximately 10% or better and return on equity of 15% or better over the last ten years.  PetroBakken, in contrast, earned 1% on total capital and 1.4% on shareholders equity in 2010.  And this was during a time of fairly robust oil prices.  If you as an investor don’t understand how important these measures are, I would take some time to educate yourself.


Best Regards,
Kevin


P.S. I will not respond to emotional responses or any arm waving.  Fact based discussion will serve everyone the best. 

3 comments:

  1. This is an emotional response so you do not need to reply but let me tell you that I immensely enjoyed reading your account and it showed me how analyzing an annual report can be an intellectually rewarding process. Please continue to publish your blog! This quality of blogs is quiet rare!

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  2. Nice write-up Kevin. They seem to be issuing debt and stock like drunken sailors for low return acquisitions. Between the dilution and the dividend payout, there's not much there for the longterm buyer. I guess it's all about the options for the exec's. I noticed that several board members don't own any stock, hmmm.

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  3. Hi Kevin, thanks for the intelligent analysis. I am a speculative investor although I have read Ben Graham's books, and just bot this at 8.41 per share (pure asset play)

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