EPSN - Epsilon Energy: Diversification Just In Time

2023-09-01 05:55:57 ET

Summary

• Epsilon Energy is a small player in the oversupplied Marcellus Basin and needs to diversify to access better markets.
• The company's presence in the midstream business provides a steady cash flow buffer compared to total upstream players.
• Management is using cash earned in the Marcellus to invest in other basins and offset the oversupply situation that results in weak natural gas prices.
• The Permian diversification will result in oil becoming a more significant part of the business.
• The cash and short-term investments combined with the share repurchases decrease the downside potential of the shares.

Epsilon Energy (EPSN) has been a debt free company that hit the cash bonanza last year when natural gas prices climbed in tandem with oil prices. But this is a very small player in the Marcellus Basin. The Marcellus Basin is oversupplied with natural gas. Therefore, a logical step for a company of this size is to diversify as it is probably not yet large enough to get its production to better markets.

Chesapeake (CHK) is the operator of these wells and even the operator does not do much with maximizing natural gas sales. That means that a small partner like Epsilon has few to no options to improve the selling price of the production. Hedging will help somewhat during periods of weak pricing. What would help a lot more is an operator of the wells with access to premium priced markets. But that day appears to be a long way off (if it ever comes).

In the meantime, the company does have a significant presence in the midstream business of the Marcellus. This provides a cash flow buffer because the midstream business is typically a steady business throughout the upstream business cycle. Therefore, the profit fluctuations here will be less than is the case with a total upstream player.

Diversification

Management is taking the cash earned in the Marcellus and using it to get earnings in other basins. This would offset the oversupply situation in the Marcellus that leads to "lower lows".

Management is diversifying into the liquids business to offset the dry gas business in the Marcellus. Liquids pricing generally holds up better (especially light oil) than does gas pricing in an oversupplied basin like the Marcellus.

Management can easily hedge their share of the production if the payback of the well is at all threatened by oil price declines. Right now, that does not appear to be at all likely.

The company recently reported a loss before hedging because of low natural gas prices. Oil prices, on the other hand, are nothing close to a loss right now.

The location shown above is some of the better acreage around. Therefore, paybacks should be short in the current environment and cash flow a little better during any downturn.

This management generally finds capable operators for its acreage. So, the administrative costs are kept low with this strategy.

Overall Business

There is one other location in Oklahoma where the company also has a significant presence.

The other diversification move has been into the Anadarko Basin in Oklahoma. This diversification move, like the one in the Permian was designed to lessen the dependence upon the Marcellus business.

The Anadarko is still an emerging basin. It does complete to some extent with the Permian and Eagle Ford production. Therefore, the gas production does not contribute to profits as it would even in an oversupplied basin like the Marcellus.

The closer you get to Texas, the more likely drilling decisions are based upon the liquids' production with natural gas being an "extra". The Anadarko wells may therefore have similar challenges to the Marcellus basin (in terms of profitability) due to the closeness of Texas production.

Finances

The company had a record year in fiscal year 2022. But this fiscal year is proving to be as challenging as many years were in the past. Therefore, management is looking to profitably invest its cash hoard earned last fiscal year into places that may provide a little more earnings stability than is the case with the oversupplied Marcellus.

Much of the cash is currently in short-term investments. The balance sheet remains essentially debt free with an unused line of credit just in case a real bargain appears.

The strong balance sheet allows this company to participate with the operators in drilling wells when industry conditions are favorable as they are now. This company may not be large enough to compete for the best acreage. But it certainly can find decent acreage and deals in what is largely perceived to be a seller's market.

Investors can expect management to keep a fair amount of cash on hand to maintain financial flexibility. The company does not control the development of its acreage (although in some cases there are contractual requirements). Therefore, keeping enough cash on hand to meet the requirements of the various operators is probably essential to continued conservative balance sheet management.

Shareholder Returns

The company pays a quarterly dividend of $.0625 per share. Given the strong finances, this dividend can be maintained for quite a long time even if natural gas prices are very low.

In addition to the dividend, management has been steadily repurchasing shares opportunistically. This is likely to continue especially during a time of weak commodity prices.

One of the things that management mentioned is the strong balance sheet enables management to be flexible about hedging future production. This management is generally opportunistic about that.

To the extent that hedging generates extra cash, there is more cash to purchase shares during times of weak natural gas prices (like the present time). Management is also in no rush to spend the cash earned in the last fiscal year.

Key Takeaways

The cash and short term investments total about $37 million. That is very roughly $1.50 per share. This cash provides considerable downside protection in the event of unfavorable news. The share purchase program provides still more downside protection.

The dividend provides an above average yield of nearly 5% while investors wait for better pricing and for the cash to be suitably invested in the business.

The results of the recent diversification should become more apparent as the fiscal year continues to unfold. The most likely outcome is that oil will become significantly more important to the business. Most dry gas producers eventually diversify into liquids and oil. So, this company is heading down a well-worn pathway.

The CEO is relatively new. But the board has been around a long time and that board has a lot of experience with the company. Therefore, I would expect continued conservative management of the balance sheet with well-chosen diversification moves in the future.

This is a company that will take quite a bit of patience as it needs to grow quite a bit to attract more institutional attention. But it is very well run. The conservative balance sheet and well-supported dividend make this a fairly safe investment despite the small size of the company. It is a strong buy consideration for investors that have the patience to allow this small company to continue to grow.

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