DEN - Evolution Petroleum Is Going Conventional

2023-09-14 11:42:35 ET

Summary

• Evolution Petroleum Corporation's conservative management has displayed excellent timing in past acquisitions, indicating a positive outlook for oil and natural gas prices.
• Despite a disappointing quarter, the company's generous dividend is supported by a strong balance sheet and cash flow.
• The joint venture with PEDEVCO allows Evolution Petroleum to further diversify into traditional upstream business and access low-cost production and growth.
• Evolution has a decent cash balance and no long-term debt.
• Evolution is gaining an operating size to the point where it can participate in projects where it has more say in operations.

Evolution Petroleum Corporation ( EPM ) is a small company that has been very conservatively managed for as long as I can remember. A no debt balance sheet has been a priority until a spate of acquisitions in the recent past. They actually happened just before natural gas and oil prices headed skyward. The prices of fiscal year 2022 allowed for a very fast debt repayment back to a no debt balance sheet. Today's announcement of a joint venture with Pedevco Corp. ( PED ) should have investors thinking about the excellent timing this management has displayed in the past as a statement about oil and natural gas prices in the future.

Earnings Disappointment

Earnings obviously disappointed the market. But the company listed weather-related and maintenance-related issues that are part of the business. Nothing listed in the earnings report accounts for the market reaction to the news. The next quarter should be back to normal and the stock price will likely respond accordingly. Yes, the items listed affected production. Since this is a small producer, the production levels materially dropped. From the market reaction, one would think these one-time items were a fatal blow.

Dividend

Instead, the market should have concentrated on the rather generous dividend that is supported by an extremely strong balance sheet. That $.12 per share quarterly dividend provides a yield that most investors report on average for a full year return on investments.

Even in a disappointing quarter like the current one, cash flow more than supports the dividend. Note that accounts payable changes soaked up a lot of cash flow. That is a timing issue rather than a permanent cash flow decline. It does not, as a rule, represent a lessening ability to support that dividend.

But this little operator has $11 million of cash and basically no long-term debt. Not only does the dividend support the stock price long-term, but the debt free balance sheet gives management considerable flexibility in the future to go after bargains, as it has in the past.

Cash Flow

The paydown of liabilities used about $7 million of cash flow in the current quarter. That kind of thing will happen with small companies. Even with that event (which is likely a timing issue), the company still reported a decent cash balance.

Furthermore, the cash flow reported for the fiscal year was a generous (approximately) $50 million. This shows that the diversification program begun a few years ago is successful in lessening the dependence on the Denbury ( DEN ) joint venture. Investors have to keep in mind that a small company like this will have lumpy cash flow because expenditures can be rather large for the small company.

Since Denbury is going to be acquired by Exxon Mobil ( XOM ), the immediate future is filled with far more reliability than the Denbury bankruptcy was. Exxon Mobil is a renowned operator with a far better reputation than Denbury ever had as a small operator (let alone a small one that went bankrupt). As management has noted several times, Denbury was clearly cash constrained. That will not be the case for Exxon Mobil.

Probably the main danger of the Exxon Mobil acquisition is that this joint venture is considered a high-cost secondary recovery operation. Exxon Mobil is likely to review it for cost improvements and if none are available, Exxon Mobil management has a long history of selling interests in high-cost operators and reinvesting the cash in low-cost operations. So, this main source of a decent amount of cash flow may be facing a period of uncertainty.

Much of the conventional assumption is that Exxon Mobil wants the carbon dioxide business of Denbury. Therefore, that same thought process assumes the secondary recovery business will be sold at some point due to the high costs of the business.

PEDEVCO

Evolution management announced a joint venture with Pedevco. This is a conventional opportunity similar to the business run by Ring Energy ( REI ). This will take the Evolution Petroleum management further into more traditional upstream business while continuing to diversify away from higher cost secondary recovery business.

Pedevco is a conservatively run company that was hurt badly by the events of fiscal year 2020. The reason was that the company had not finished transitioning to an operating mode from a concept company that was acquiring leases with the idea of developing them. This is similar to the Ring Energy story I have covered many times, except Ring Energy had more production going into fiscal year 2020.

That still did not stop fiscal year 2020 from setting a lot of companies back. The market changed overnight from relatively friendly to demanding return of capital, while becoming very hostile to production growth. Since both companies (Pedevco and Evolution) are financially strong, the change in the debt market requirements did not affect either that much.

On the other hand, finding capital to funding the growth of Pedevco became a real challenge. Now, this joint venture benefits both companies. Evolution is finally getting large enough to have access to low-cost production and growth it can control. Most of the acquisitions before this made it a partner in a situation with a well-established operator, where the operator controlled the partnership growth.

The other advantage of this partnership is that the wells drilled in this conventional opportunity are either very cheap vertical wells or fairly cheap horizontal wells. Because this is a conventional opportunity that uses "modern completion techniques, the decline rate will be slower than is the case for unconventional. Therefore, the cash needed to maintain established production will likely be lower as well.

Barnett Shale

There has been a lot of talk about how declining natural gas prices have affected the total company results. The Barnett Shale purchase was established production that really has had no recent drilling. Older production is often high-cost production.

But this part of the portfolio had an outsized impact on company earnings when natural gas prices soared last year. That opportunity may again arise in fiscal year 2025 when a considerable amount of export ability becomes available. It is very possible that the North American natural gas market will join the far stronger world market as North America heads from oversupplied to a larger natural gas exporter.

Key Ideas

Evolution Petroleum maintains a very strong balance sheet to offset the high cost of secondary recovery and the passive investment position in the partnerships. A lot of operators essentially control the pace of operations, including proposing capital expenditures and new wells. That has made this company consider a strong balance sheet as mandatory.

The debt-free balance sheet considerably lowers the risk of investing in a small company. Likewise, the stock price downturn on the earnings report sharply lowers the risk of long-term investing principal loss. Management has long emphasized cash flow. So, this company tends to generate a lot of cash for its size. This company is a strong buy consideration with experienced management and conservative financial strategies, considerably lowering the risk of an upstream play (particularly a high-cost producer like this one) far below the risk of many larger competitors.

Recent acquisitions have diversified the company away from the first and still major partnership with Denbury Resources. That partnership is likely in for a period of uncertainty once Denbury is acquired by Exxon Mobil. But then again, the company has other revenue sources.

Management has, in the latest conference call, backed the recent dividend. The debt free balance sheet allows maintenance of that dividend for as long as the company chooses. However, should a deal float by, this upstream company, like many before it, could elect to use that dividend money for further growth and stability in the future.

Upstream company distributions are not the same as utility company distributions. Investors need to remember that this company is upstream and highly dependent upon commodity prices when setting a dividend. The balance sheet is always the priority here. A big consideration of the balance sheet is to fund partnership requirements as needed.

Still, that dividend has financial backing that is much better than many larger competitors. This little operator is a strong buy consideration on a stock price rout that really went overboard from the start of the announcement.

The cash flow even in lean times is generous enough to pay the dividend and fund growth projects because this management prioritized "lots of cash flow" far in excess of capital requirements. That is unlikely to change in the future. Investors are generously paid with that dividend while waiting for more deals that will fund further growth. That strong balance sheet and the dividend protect against long-term capital loss. But small company stocks are very volatile, as today showed. Investors that consider this company for investing need to be aware of that.

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