EP - Empire Petroleum: Growth Plans Become More Challenging With $70s Oil

Summary

• Empire Petroleum's margins are contracting due to lower commodity prices.
• It has high costs per BOE, so its 2023 margins per BOE may decrease by 50% compared to Q2 2022 based on current strip.
• This makes it challenging for Empire to grow production significantly while spending within cash flow.
• Thus it may need to take on more debt and/or issue equity to fund growth capex plans.

I've mentioned before that Empire Petroleum ( EP ) needed to significantly increase its production to become more competitive since increased production would help reduce some of its per BOE costs.

Weaker commodity strip prices for 2023 may hamper Empire's ability to increase its production while spending within cash flow. Empire's costs are currently quite high on a per BOE basis (mid-to-high $40s per BOE) in Q2 2022 and Q3 2022, and at current $74 WTI strip for 2023, it is likely to realize under $60 per BOE for its production.

This leaves Empire's margins (per BOE) relatively constrained, giving it a limited amount of cash flow to reinvest for growing production. Thus it may need to take on more debt and/or issue equity to help grow production.

Production Levels

Empire's Q3 2022 production averaged 2,232 BOEPD, which was a 3% increase in total production compared to Q2 2022, when it averaged 2,158 BOEPD. Empire's oil cut went down from 62% in Q2 2022 to 60% in Q3 2022 though, resulting in its average oil production going down modestly by 1% quarter-over-quarter.

Empire's production should increase during 2023 though, as it completes its Starbuck Field Enhancement Program. That program is aiming to increase production by over 500 barrels of oil per day.

Shrinking Margins

Empire's costs per BOE are quite high, with production costs, production and ad valorem taxes and cash G&A adding up to the mid-to-high $40s per BOE in Q2 2022 and Q3 2022. Empire's cash G&A per BOE decreased significantly from Q2 to Q3, but its production costs per BOE increased significantly during the same period.

Oil and gas prices were relatively high in those periods, leading to a realized price of $84.33 per BOE in Q2 2022 and $71.30 per BOE in Q3 2022 and acceptable margins per BOE.

However, at 2023 strip prices ($74 WTI oil and $3.70 NYMEX gas), Empire's realized price would go down to around $54 per BOE with Q3 2022's production mix and production levels.

Even with a reduction in cost per BOE (to the low-$40s), Empire's margins in this example would be only $13 per BOE, down 64% from Q2 2022 levels.

The added oil production from Starbuck should increase Empire's oil cut for 2023, as well as reduce its per BOE costs. Thus I'd expect Empire's margins to be more in the mid-to-high teens per BOE range with $74 WTI oil in 2023.

This would still be around half of its margins from Q2 2022 though, slowing down its ability to grow production while spending within cash flow.

Notes On Hedges

Empire has WTI put options as hedges for 2023. These allow it to have upside if oil prices get stronger again. However, it also has relatively few hedges after Q1 2023, potentially covering less than 10% of its total oil production once its Starbuck production increases. As well, its hedges from Q2 2023 to Q4 2023 have a relatively low floor (at $50 to $60 oil). If oil prices get that low ($50 to $60), Empire is probably in trouble since its realized price per BOE would end up in the $40s, similar to its total costs (excluding capex) per BOE.

Estimated Value

I had previously modeled a scenario where Empire reached 4,300 BOEPD in production without taking on much additional debt. In that scenario, I estimated Empire's value at around $8 to $9 per share at long-term (after 2023) $75 WTI oil.

Weaker commodity prices make it less likely that Empire can scale up production to that level anytime soon without taking on a significant amount of debt or issuing equity. As a result of that issue, I am reducing my estimate of Empire's value to $7 per share in a long-term $75 WTI oil environment.

Conclusion

Empire has high costs (production and G&A) per BOE, making its margins sensitive to changes in oil and gas prices. Despite the projected increased oil production from its Starbuck field, Empire's margins per BOE in 2023 at current strip may be around half of what it realized in Q2 2022.

Empire is trying to increase production, but that task is made more difficult when its cash flow from operations contracts significantly due to the lower margins. Empire's hedges also provide limited protection since it has few hedges after Q1 2023, and those hedges from Q2 2023 to Q4 2023 have a floor between $50 and $60 per barrel.

A $90s WTI oil environment works well for Empire, but a $70s WTI oil environment poses challenges to its ability to reach the scale of production it needs without taking on more debt or issuing equity.

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