EPSN - Epsilon Energy: Surviving Plunging Natural Gas Prices

2023-04-10 12:09:44 ET

Summary

• Shares of natural gas concern Epsilon Energy Ltd. have fallen 25% since the first day of December 2022 as the price of its underlying commodity has crashed ~70% since.
• Owing to its low overhead (nine employees), the company can achieve profitability with natural gas prices in the low $2 area.
• With the market in severe contango and debt-free Epsilon’s cash position equaling nearly 40% of its market cap, the recent beneficial owner buying merited a deeper dive.
• A full investment analysis follows in the paragraphs below.

There's a fine line between audacity and idiocy. ”? Jim Butcher.

Today, we take a deeper look at a small, but intriguing E&P concern that is navigating the recent plunge in natural gas prices. An analysis follows below.

Company Overview:

Epsilon Energy Ltd. ( EPSN ) is a Houston-based on-shore natural gas and oil company focused on dry gas production of the Marcellus Shale in Pennsylvania, as well as the exploitation of oil, natural gas liquids [NGLS], and natural gas resources in the Anadarko Basin of Oklahoma. As of December 31, 2021, the company held proved natural gas reserves of 110.97 billion cubic feet, 819,726 barrels [BBLS] of NGLs, and 305,052 bbls of oil and other liquids across 76,544 gross (13,176 net) acres. Epsilon was formed in Alberta, Canada in 2005 and went public on the Toronto Exchange in 2007 with its first trade transpiring at $7.42 a share, after giving effect to a 2018 1-for-2 reverse stock split. In 2019, its listing migrated to the NASDAQ, where shares of EPSN are trading near $5.50 a share, equating to an approximate market cap of $125 million.

As can be gleaned by the gross-net splits, the company is not an operator – with only nine employees – but rather an investor, looking to generate above market returns from its ownership interests in natural gas producing assets, which provided 81% of its revenue during the first nine months of 2022 (YTD22). Its net interest in Pennsylvania is 4,597 acres, which produces ~25 million cubic feet per day (MMcf/d); its net interest in Oklahoma is 8,579 acres and produces ~2.7 MMcf equivalent/d. In addition to these leasehold investments, Epsilon owns a 35% interest in the Auburn Gas Gathering System – operated by Williams Partners – into which all its Marcellus production is dedicated. Its Auburn interest provides 11% of the company’s total revenue, with oil (5%) and NGLs (3%) filling in the balance.

The obvious benefit of Epsilon’s operating model is that it incurs very low overhead costs; the downside it that it does not control the pace of field development.

Q3 2022 Earnings & Outlook

With 2022 being a banner year for natural gas prices courtesy of the conflict in Ukraine, it was not surprising to see Epsilon post a record quarter in 3Q22, in which it earned $0.41 per share and Adj. EBITDA of $16.5 million on revenue of $21.2 million as compared to $0.06 a share and Adj. EBITDA of $6.8 million on revenue of $13.1 million in 3Q21. This outcome was primarily due to robust energy complex pricing that included average pricing of $7.40 per Mcf for natural gas, $39.91 per bbl of NGL, and $102.26 per bbl of oil and condensate versus $3.46 per Mcf, $34.02 per bbl; and $70.80 per bbl in 3Q21, representing appreciations of 114%, 17%, and 44%, respectively.

The quarter was the first for new c-suite additions CEO Jason Stabell and CFO Andrew Williamson. Dropped into the middle of a great year for Epsilon – in YTD22, the company generated more Adj. EBITDA ($41.5 million) than FY20 and FY21 combined ($39.8 million) – new management (and its investor base) had good reason to believe the year would close with a bang when the company posted these quarterly results on November 10, 2022. Natural gas was trading at ~$6.25 per Mcf on the NY Mercantile, elevated by fears concerning how a frigid winter in Europe would impact a tenuous supply-demand dynamic. For the avoidance of doubt, 4Q22 was likely an excellent quarter. Natural gas traded to ~$7.00 in mid-December and shares of EPSN were trading at $7.50 on December 1, 2022. (Epsilon has yet to provide a date for its 4Q22 and FY22 earnings release.)

Analyst Commentary & Balance Sheet:

Also inspiring confidence was the company’s balance sheet , featuring cash of $40.3 million ($1.75 a share) and no debt (as of September 30, 2022), aided by free cash flow generation of $26 million in YTD22. The cash line was inclusive of Epsilon returning a quarterly dividend of $0.0625 per share (current yield of 4.4%) to shareholders and deploying an additional $6.2 million to repurchase 982,500 shares over the second and third quarters of 2022. That said, management indicated that it was concerned about the low trading volume in its stock and hinted that it was looking at strategic opportunities for the cash on the company’s balance sheet.

No one on the Street follows the low market capitalization and lightly traded Epsilon.

However, one of the reasons that the stock is thinly traded (beyond the fact that there are only 23.0 million shares outstanding as of September 30, 2022) is that the c-suite and the board own ~25% of the shares outstanding – so, it goes without saying that they are aligned with shareholders.

One of those shareholders is beneficial owner Solas Capital Management, who used the recent dip to purchase 300,000 shares at $5.45 on February 23, 2023, bringing its total ownership interest to 3.6 million shares, or 16%.

Recent Trading:

That recent dip was a function of the collapse in natural gas prices, which cratered from ~$7.00 in mid-December to (briefly) under $2.00 per Mcf on February 22, 2023. No longer convinced of a prosperous 2023, the market turned negative on the company, selling shares of EPSN down 25% from $7.50 on December 1, 2022 to $5.65 on February 24, 2023. A back-of-the-envelope calculation would suggest that after generating free cash flow of $11.2 million with $1.6 million in capex in 3Q22 and average gas price realization of $7.40 per Mcf, Epsilon should be holding cash of ~$50 million at YE22 as management indicated that it anticipated no material capital outlays in 4Q22 with its average realized gas price likely to be in the low $6 area. It did spend $1.67 million purchasing 285,400 shares in 3Q22, but only had 200,910 shares remaining on its authorization entering 4Q22.

That said, the company has likely emptied its chamber, purchasing stock at these depressed levels alongside Solas. It has not issued any press releases in 2023, likely meaning that it has not authorized another share repurchase program and it has not engaged in any acquisitions.

Verdict:

Unless its operator in Oklahoma begins to aggressively expand its oil and NGL capacity, or Epsilon acquires a more liquid asset (no pun intended), Epsilon Energy Ltd. stock is a proxy for natural gas prices. However, with its extremely low overhead, it can be mildly profitable at $2.50 natural gas and still be EBITDA positive at $2.00 natural gas, prices where some marginal producers will shut in production; thus, reducing supply and re-elevating prices. Also, gas prices should rebound as the market is in severe contango with futures one year out much higher than the current spot price.

As such, with 40% of its market cap in cash and a rebound in natural gas prices in the offing, a small watch item investment in Epsilon is recommended even though Epsilon Energy Ltd. shares are too thinly traded for any holding larger than that.

Timidity is the silent acceptance of bondage ”? Constance Friday

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