BATL - Battalion Oil: Ramping Up Oil Production

Summary

• Battalion Oil reported that its first five wells from its 2022 development program exceeded expectations for initial production rates.
• Battalion is attempting to grow oil production so that it has more unhedged barrels.
• Hedges are a major negative for Battalion, but it can partially mitigate this through increasing production in 2H 2022 and 2023.
• Battalion appears to be trading at a fair discount to PDP PV-10, even if one assumes lower prices than strip and factors in Battalion's negative hedging value.

Battalion Oil ( BATL ) is aiming to ramp up production in the second half of 2022 as more of its 2022 development program wells come online. It noted that the first five wells of its 2022 development program had average initial production rates that exceeded expectations.

Battalion is still trying to navigate its way through its debt issues, but I believe it offers a decent risk to reward ratio at its current share price. Battalion also should see an improved cost structure in 2023 as its acid gas treatment JV project becomes operational .

If its new well outperformance continues, Battalion should be able to significantly increase production in 2H 2022, giving it the ability to benefit from strong oil prices. In the first half of 2022, Battalion's hedges basically meant that it received minimal benefit from strong oil prices.

Increasing Production

Battalion delivered increased sequential production in Q2 2022, as it averaged 15,044 BOEPD (49% oil) in the quarter, compared to 14,767 BOEPD (50% oil) in Q1 2022. This is an approximately 2% increase in total production, although average daily oil production decreased slightly by 0.5%.

Battalion had mentioned that it expected Q2 2022 production volumes to "remain in line with" Q1 2022 volumes, and then ramp up during the remainder of the year. It did a bit better than expected though, as the first five wells it completed averaged higher initial production rates than planned. This offset some weather related impacts and third-party curtailments that affected June volumes.

Monument Draw is accounting for a higher percentage of Battalion's total production as its production grows, while Hackberry Draw and West Quito volumes decline. Monument Draw accounted for 57% of Battalion's production in Q1 2022, rising to 60% in Q2 2022.

Hedges

Battalion's hedges remain a significant negative for the company. At current strip prices its remaining hedges (from 2H 2022 onward) have a total estimated value of negative $174 million.

Battalion will need to continue growing its production in 2H 2022 and 2023 to give itself more unhedged barrels. At current production levels (it averaged around 7,400 barrels of oil production in Q2 2022), rising oil prices may be a net negative for Battalion.

At 7,400 barrels of oil production per day, Battalion is around 93% hedged on oil for the second half of 2022. Production taxes are around 5% to 6%, so at 7,400 barrels of oil production per day it would receive nearly no net benefit from higher oil prices before factoring in D&C cost inflation. After D&C cost inflation, Battalion may see net negative near-term impacts from high oil prices.

As Battalion's oil production increases though, it will see more benefits from high oil and gas prices. At the midpoint of Battalion's full-year guidance, it could average around 10,000 barrels of oil production during the second half of the year. Battalion has completed five wells so far in 2022, expects to complete another three wells in Q3 2022 and is aiming for 8 to 12 total wells for the full year.

Notes On Valuation

At $13.30 per share, Battalion has an enterprise value of approximately $395 million (based on Q2 2022 net debt). This seems relatively low given that its year-end 2021 PDP PV-10 was approximately $558 million at SEC prices of $66.55 WTI oil and $3.60 Henry Hub gas.

Battalion's remaining hedges have around negative $23 million in value at those commodity prices. If that $23 million is added to Battalion's enterprise value, then it would be currently valued at around 0.75x PDP PV-10 at SEC prices.

At $70 WTI oil and $4 Henry Hub natural gas instead, Battalion's PDP PV-10 may be around $625 million, updated for reserves as of mid-2022. At those commodity prices, Battalion's remaining hedges would have around negative $53 million in value. Thus, Battalion may be only valued at around 0.72x PDP PV-10 at $70 WTI oil and $4 Henry Hub gas, including the effect of its hedges.

Battalion also has the ability to further increase its PDP value through its development program and the cost reduction effects of its acid gas treatment JV project.

Conclusion

Battalion appears to have decent upside with its stock at $13.30 per share. Its 2022 wells have performed better than expected so far, and it is poised to noticeably increase oil production in the second half of the year.

Battalion's hedges have a high amount of negative value, but the increasing production should at least give it more unhedged barrels that can take advantage of good commodity prices.

Assuming that Battalion continues to deliver good well-level results while managing its liquidity, Battalion may be worth in the high-teens in a long-term $70 WTI oil scenario.

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