BATL - Battalion Oil Issues $38 Million In Preferred Stock

2023-09-12 10:58:59 ET

Summary

• Battalion issued $38 million in Series A-1 Redeemable Convertible Preferred Stock.
• This should give it sufficient liquidity to deal with its required term loan payments for a while.
• Battalion's hedges cover most of its PDP oil production, so its free cash flow doesn't benefit much from higher oil prices.
• It may not be given permission to do additional drilling with its November 2025 term loan maturity upcoming.
• The backwardation of the oil futures curve also doesn't allow it to hedge new production at a particularly high price.

Battalion Oil (BATL) recently issued $38 million in Series A-1 Redeemable Convertible Preferred Stock to some of its largest shareholders. These additional funds should give it enough liquidity to deal with its required term loan repayments.

Oil prices have improved, but Battalion remains in a challenging position since it appears to be hedged on most of its PDP production. Unless it has the liquidity and permission (from its term loan lenders) to drill new wells, its limited amount of unhedged production means that its free cash flow won't benefit that much from higher commodity prices.

At $100 oil and $5 gas, I estimate that Battalion's free cash flow (from PDP wells) would improve by around $26 million in 2024 and 2025 combined compared to current strip (which involves an average of high-$70s WTI oil over that two-year period). That would leave Battalion with approximately $185 million ahead of the common shares in its capital structure at the end of 2025 if WTI oil averaged $100 during 2024 and 2025. At current strip instead, $211 million would be ahead of the common shares in Battalion's capital structure.

I remain neutral on Battalion's common shares since hedges limit Battalion's ability to benefit from higher oil prices without additional drilling. The November 2025 term loan maturity and the backwardation of the oil futures curve (with 2025 strip around $12 lower than spot prices) make it less likely that Battalion will be given permission to do additional drilling as well.

Series A-1 Preferred Stock

Battalion announced that it had issued $38 million in Series A-1 Redeemable Convertible Preferred Stock. The purchasers (including funds managed by Luminus Management, Oaktree Capital Management and LSP Investment Advisors) paid approximately $37.05 million for the Series A-1 Preferred Stock. Those three firms are also Battalion's largest shareholders.

The Series A-1 Preferreds are similar to the Series-A Preferreds (which had a liquidation preference of $26 million at the end of Q2 2023), with a 14.5% cash dividend rate and a 16.0% PIK dividend rate.

The initial conversion price of the Series A-1s is $7.63 compared to $9.03 for the Series As .

If the preferred share dividends keep getting paid-in-kind, around $91.7 million ($37.9 million for Series As and $53.8 million for the Series A-1s) will be outstanding by the November 2025 Term Loan maturity date.

These could also be converted into 11.2 million shares (at that time), significantly increasing Battalion's outstanding share count from its current 16.5 million total. Conversion would be a positive though, as it would reduce the continuing transfer of value away from the common shares via interest costs and preferred dividends. The conversion price of both series of preferred stock is also above Battalion's current share price.

Hedges And Free Cash Flow

Battalion has the majority of its projected oil production hedged at well below current strip prices. If it does little in the way of additional development, I estimate that it can average close to 5,500 barrels per day in oil production during 2024. For comparison, Battalion averaged around 7,000 barrels per day in oil production during Q2 2023. These oil production estimates are probably on the optimistic side in a scenario where Battalion doesn't drill new wells and relies on workovers to help stem production declines.

Based on my estimates, Battalion has around 90% of its 2024 oil production (without new wells) hedged at $63.69, which is around $17 less than current 2024 strip. Battalion is thus projected to end up with approximately $31 million in realized hedging losses in 2024 at current strip.

Battalion may be able to average 4,500 barrels per day in 2025 oil production (again without new wells). It would then have hedges covering around 76% of its 2025 oil production at an average swap price of $61.18, which is around $14 below current 2025 strip. This would then contribute to around $19 million in realized hedging losses for Battalion in 2025 at current strip.

The large amount of hedges limits Battalion's ability to benefit from increases in commodity prices. At current strip (including roughly $81 WTI oil in 2024 and $75 WTI oil in 2025), Battalion is projected (assuming no new wells) to generate $57 million in free cash flow over that two year period. This increases to $83 million at $100 WTI oil and $5 Henry Hub gas.

These free cash flow estimates don't including the increasing liquidation preference amount on the preferred shares, which could increase by around $25 million during that time frame.

Notes On Drilling Plans

Battalion may face challenges if it wants to resume drilling activities. At $80s WTI oil, Battalion's well-level economics should be solid. However, Battalion's term loan currently matures in November 2025, making any new wells uncertain to pay back by the term loan maturity.

As well, Battalion's high cost of capital (with roughly 13% term loan interest rates and 16% PIK dividend rates for its preferred shares) also slows down its ability to reach pay back.

Oil prices are also in backwardation, and Battalion would be forced to hedge much of its projected production from any new wells. Although near-term oil prices are in the high-$80s, the current strip for 2025 is only around $75.

Thus I don't believe additional drilling will help Battalion enough unless its term loan maturity was extended and its hedging requirements were relaxed (or if the futures curve flattened out so that Battalion could hedge future years in the high-$80s or better).

Notes On Valuation

At $100 WTI and $5 Henry Hub gas until the end of 2025, Battalion is projected to end 2025 with $92 million in credit facility debt (currently maturing in November 2025) and $93 million in outstanding preferred shares. This leaves $185 million ahead of the common shares in Battalion's capital structure.

At current strip instead, $211 million would be ahead of the common shares in Battalion's capital structure at the end of 2025.

It is uncertain whether Battalion will be able to get its term loan maturity extended beyond November 2025. If it does get its term loan maturity extended, it may be required to continue making payments, which would likely result in additional preferred equity raises to help pay down its term loan debt.

I remain neutral on Battalion's common shares due to the large amount of term loan debt and preferred shares ranking ahead of the common shares in the capital structure.

Due to hedges, prolonged higher oil prices won't greatly change the amount of debt and preferred shares ranking ahead of the capital structure, although it could make it easier to sell Battalion's assets for a decent amount.

The preferred equity seems likely to capture much of any upside for Battalion, with any cash redemption taking place 2+ years after the issuance date requiring a payment of 120% of the liquidation preference.

Conclusion

The infusion from Battalion's $38 million issuance of preferred shares improves its liquidity and should allow it to keep up with its required term loan payments. However, Battalion appears to have most of its PDP oil production hedged through 2026, so its free cash flow will not benefit much from higher oil prices unless it brings new wells online. Currently, I project Battalion to end 2025 with $185 million ahead of the common shares in its capital structure at $100 WTI oil and $5 Henry Hub gas over the next couple years. This is only a $26 million improvement compared to the $211 million in term loan debt and preferred shares it is projected to end 2025 with at current strip.

The November 2025 term loan maturity, its limited liquidity and the backwardation of the oil futures curve also makes it less likely that it will be given permission to drill more in the near-term.

I remain neutral on Battalion due to the high probability that the preferred shareholders will end up with most of the benefit from any further and prolonged increase in commodity prices.

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