BATL - Battalion: Even With Risks The New Joint Venture Implies Higher Price

Summary

• Battalion Oil Corporation develops oil and gas assets in the United States.
• I believe that most financial advisors only assessed the valuation of future production of oil and gas, and forgot to check the joint venture.
• I also assumed improvements in drilling and fracking efficiency, beneficial market hedges, and substantial growth in production from 2022.

Battalion Oil Corporation ( BATL ) will likely benefit from the recent increase in the price of oil and gas. However, the recent joint venture signed may also improve productivity and efficiency, and push the free cash flow up. In my view, most investors are not taking into account the recent increase in reserves and the joint venture to assess Battalion Oil’s valuation. Even considering dramatic consequences from the company’s geographic concentration risk, inflation, and supply chain issues, I believe that the current stock price is too low.

Battalion Oil: The New Joint Venture May Enhance Future Production

Incorporated in Delaware, Battalion Oil Corporation develops oil and gas assets in the United States. Already selling and producing oil and gas, the company reports close to 96,000 million barrels of oil equivalent , and recently signed new agreements, which may enhance future oil and gas production.

The most interesting thing about Battalion Oil appears to be the recent joint venture signed to build an acid gas treatment facility. I believe that most financial advisors only assessed the valuation of future production of oil and gas, and forgot to check the joint venture.

In May 2022, we entered into a joint venture agreement with Caracara Services, LLC to develop a strategic acid gas treatment and carbon sequestration facility in Winkler County, Texas. The joint venture, operating as Brazos Amine Treater, LLC, has also entered into a Gas Treating Agreement with us for gas production from our Monument Draw area. In exchange for contributing to the joint venture a wellbore with an approved permit for the injection of acid gas and surface land, we retained a 5% equity interest in BAT, an unconsolidated subsidiary. Source: 10-Q

Thanks to the new facility, the company expects to reduce opex, and perhaps unlock new reserves. Management provided further information in a recent presentation to investors.

Battalion Oil Corporation is really doing a good job by drilling and developing new reserves. Since 2019, the number of proved reserves has increased by more than 11%. Besides, proved undeveloped reserves increased from 24.1 million Boe in 2019 to 53 million Boe in 2021. Further increase in the amount of reserves thanks to new joint venture will likely enhance future free cash flow.

Balance Sheet

As of June 30, 2022, Battalion Oil Corporation reported $43 million in cash, net oil and gas properties worth $334 million, and $449 million in total assets. With a significant number of proven reserves and already producing oil and gas, Battalion Oil also reports a healthy balance sheet.

The company does report some debt. However, in my view, the company’s future production appears sufficiently foreseeable to have the current amount of debt. Long-term debt stands at close to $189 million, and net debt would be $177 million.

Base Case Scenario Would Include Productivity Improvements, New Business Combinations, Stable Commodity Prices, And Drilling And Fracking Efficiency

Under this scenario, I would be expecting first of all more joint venture agreements with other operators and perhaps new M&A operations. In my view, as the net leverage decreases, and free cash flow grows, financial institutions may be willing to hear M&A propositions from Battalion Oil. Inorganic growth will most likely bring the company’s valuation up.

Under my base scenario, I assumed improvements in drilling and fracking efficiency, beneficial market hedges, and substantial growth in production from 2022. Besides, I also assumed that eventual increases in EBIT will likely lower net leverage. As a result, the company’s interest expenses will likely decline, which would enhance future free cash flow, and may push the company’s cost of equity down.

I used the most recent figures delivered by Battalion Oil Corporation to assess the valuation of the company’s oil and gas production. I used a price close to $73.99 per Boe or barrel of oil equivalent, which was reported in the last quarterly release.

Besides, I assumed constant production close to 5.92 million barrels of oil equivalent per year, which is close to the figure released for the year ended December 31, 2021.

Putting everything together, with declining price per Boe and total reserves of approximately 95.8k million Boe, I obtained a revenue stream of around $400-$420 million. Also assuming a declining EBIT margin from 40% in 2023 to -20% in 2034-2035, 2023 NOPAT would stand at $131.1 million. I tried to be as conservative as possible by using an effective tax of 22% for the calculation of the NOPAT.

With changes in working capital close to $2 million and D&A close to $151 million, I obtained free cash flow of around $137 million in 2023 and -$8 million in 20235. I believe that my figures are quite conservative.

Assuming a discount of 8%, the net present value of future free cash flow would stand at $460.7 million. By subtracting the net debt, and dividing by the total amount of shares outstanding, the fair price would be $17 per share.

My Bearish Case Scenario Would Imply $10 Per Share

Battalion Oil Corporation mainly produces oil and gas in the Delaware Basin in West Texas, which represents significant geographic concentration risk. Higher salaries, supply chain issues, and new governmental regulation could bring the company’s free cash flow margins down. As a result, I think that the company’s fair valuation would decrease. The stock price could fall:

We are a pure-play, single-basin operator in the Delaware Basin in West Texas. As a consequence of this geographical concentration, we may have greater exposure to the impact of regional supply and demand factors, delays or interruptions in production from governmental regulation, processing or transportation capacity constraints, market limitations, water shortages, or other conditions adversely impacting our ability to produce or market our production. Such events could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Source: 10-k

Geologists may fail to forecast future reserves, or may not find what they expected. As a result, management would report lower production and lower free cash flow. Once journalists notice, I believe that new reports could push the company’s valuation down. The company disclosed these risks in its documentation given to investors:

Exploration, development, drilling and production activities are subject to many risks, including the risk that commercially productive reservoirs will not be discovered. We invest in property, including undeveloped leasehold acreage, which we believe will result in projects that will add value over time. Source: 10-k

Finally, Battalion Oil could suffer increases in the cost of electricity and materials, which may also affect production and perhaps revenue growth. In the worst case scenario, the company’s future production may not become profitable, and management may decide to stop its operations.

Cost increases may also result from a variety of factors beyond our control, such as increases in the cost of electricity, steel and other materials that we and our vendors rely upon and increases in the cost of services to process, treat and transport our production. Any escalation or expansion of tariffs could result in higher costs and affect a greater range of materials we rely upon in our business. Source: 10-k

Under very dramatic conditions, I assumed that future production would be lower than expected. I obtained a total production of 81 million Boe. With a declining price per Boe of $71-$37, revenue would lower from $420 million in 2023 to around $250 million in 2035. Also, with a declining EBIT margin between 30% and -25%, 2025 NOPAT would stand at close to $105 million.

Now, with a discount of 9.5%, the net present value of future free cash flow would stand at almost $335 million. If we also subtract net debt of $177 million, and divide by around 16.3 million shares, the implied share price would be $10 per share.

My Takeaway

Considering the current price of oil and gas and future conservative projections, Battalion Oil Corporation could be worth much more than $17 per share. The fact that management recently signed a new joint venture, which may enhance future production, was not assessed sufficiently. I also believe that new joint ventures and acquisitions could occur once the net leverage lowers as promised by management. Even considering a bearish case scenario with inflation, supply chain risks, and failed geological models, in my view, the upside potential appears more significant than the downside risk. I certainly find more catalysts to justify a long position in the stock.

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