"When I buy a stock I understand that no matter what it can go to zero."
The above statement is no different from this statement:
"When I date a girl, I understand no matter what she is going to die."
Both of these statements are correct, however what matters is the probability of either event taking place and not the possibility of it taking place. I have mentioned before that assertions such as this stock will go to zero or win big are not accurate. The action taken by Penn West yesterday is an example of steps undertaken to prevent a zero outcome, while limiting the upside outcome. The reality always present itself in shades of grey, there is no black or white. As things stand today Penn West core asset base is simply in "care and maintenance mode" the company has fenced the core asset base and will only develop those within the limits of cash flow, thus not adding to debt anymore even if oil languishes in the low $40s. It is much easier to maintain flat production on 54K core barrels by replacing core declines only than keeping total production flat at 90K barrels by replacing core and non-core declines. Beside safeguarding the core, the company is putting on the table every other asset they have in their possession, exactly the right move in my book.
In light of the above, this is what is going to happen over the next few quarters based on recent developments:
- Core production will remain flat (as long as oil is above above $40 and below $58WTI).
- The best non-core assets will be liquidated at 30% discount to what they were worth in 2014 (Weyburn, Swan Hills.)
- The remaining non-sold non-core assets will be utilized as a depleting cash cow to fund development/maintenance of the core until the market improves, and what remains of those assets production is sold.
In case it was missed, Penn West board and management declared defeat yesterday. There is no 5 year plan, and they are not going to build a new large Canadian E&P. What they are going to do is save the company core assets and so until the oil market re-balances in the latter part of 2016/early 2017. The fact that covenant rope is tightening around their neck, they have no choice but to accept what the market offers for their non-core assets. The quality and the extent of their non-core assets will insure that enough will be liquidated to materially change the debt dynamics, meanwhile their extremely depressed valuation will likely make the least attractive non-core divestitures supportive to their valuation. It will be a race between a debt ticking clock, volatile oil prices and their brokers ability to secure deals for various assets in time. It will be tight, but the outlook for oil in Q4 and 2016 looks much healthier than the last 12 months and thus this should facilitate the asset sale process. Of course a second covenant relaxation is always possible if they can show lenders traction on the asset sales front.
As I indicated yesterday, by the time this is set and done, Penn West will emerge as a Viking, Cardium and Slave Point focused mid-size player with low debt and very attractive IRRs even in a long term $60 to $70 WTI oil world. This smaller, less indebted player will be worth substantially more than where we are trading today (mid to high single digits) but it will also be no where close to where a bigger PWT could have been in 2017 without the oil collapse. It is also likely that as the core is steadily worked off that a larger player will bid for the total company in order to lock in their valuable core, if that offers succeed of course would depend on what we are offered.
My investment in Penn West was always underpinned by two key factors: Penn West large and valuable asset base and the quality of their Board and management team, ultimately it is those two factors that will save the company from this oil Armageddon, while many others will cease to exist.