PED - Pedevco Trades For Current Production But Can Grow A Lot More

2023-03-14 03:59:58 ET

Summary

• PEDEVCO is an O&G E&P company with assets in the Permian and the D-J basins. The company is financing horizontal well development with cash flows from vertical wells.
• The company has a history of losses and value destruction, but most of it comes from legacy business. The company's new owners and managers initiated a different strategy in 2018.
• The new strategy has proven profitable and conservative. I also like high insider ownership, low managerial compensation, and SG&A cost containment.
• Considering the company's expected production for FY23 and oil prices between $75 and $80, PED can generate a 7.5% to 12.5% earnings yield on its current market cap.
• Profits can then be reinvested in its properties, with good future prospects as reflected in the company's PV-10 calculations.

PEDEVCO ( PED ) is an asset owner of oil properties in New Mexico and Colorado.

The company's current CEO purchased more than half of the company's shares in 2018 and started a strategic shift that implies financing investment in horizontal developments with cash flow from vertical wells.

This year, the company has increased profits substantially, helped by higher oil prices and increased production. With production concentrated in oil, the company is relatively protected from the more volatile natural gas prices.

The company's current production offers an earnings yield that ranges between 7.5% and 12.5% at current oil prices, compared to the company's market cap of $80 million.

Further, the company promises future developments (as materialized in its PV-10 reports), with undiscounted after-tax profits ranging between $190 and $450 million, depending on tax prices.

Although PV-10 forecasts are very uncertain in nature, I like that the company is currently profitable and offering an interesting yield. Further, the company's management has shown several quality characteristics: high insider ownership, low managerial compensation, cost containment, countercyclical capital allocation, and patience to self-finance.

For these reasons, I believe PED is an opportunity at these prices.

Note: Unless otherwise stated, all information has been obtained from PED's filings with the SEC .

Business description

Previous business : PED is a ticker and a company that has operated as many different businesses. The company operated in entertainment, satellite services, O&G services, and finally, O&G property management. The stock chart reveals a tragic history.

However, PED's current history (including the new ticker) starts in 2012 as a reverse merger with Pacific Energy Development Corporation, which sold all of its assets to the company (then named Blast Energy Services) in exchange for 95% of the company's stock.

The original PED did not do much, generating very little revenue and no profits from 2012 until 2018. The properties in Colorado (more below) come from this reverse merger.

In 2018, the company's current CEO, Simon Kukes, purchased a 50% participation in PED . That participation grew to 65% today.

Between 2018 and 2019, PED acquired properties in the Permian Basin that were already productive with vertical wells and started increasing production and profits. The company maintained properties in Colorado, a legacy from the old PED, but did not exploit them until 2021 (more on this later).

Since 2018, particularly in 2022, the company has increased its production, leading to improved profitability, aided by better hydrocarbon prices.

Asset owner : PED does not exploit any of the properties directly. It is a manager that hires contractors to operate the fields or participates in fields exploited by others. The company only had 14 employees as of December 2021 .

Properties : The company has two property areas.

The D-J basin properties in Colorado are composed of sparse licenses that are relatively uneconomical to exploit in isolation because they are noncontiguous and require joining with partners. These are assets received from the previous PED. The company has sold some of them and has 24 net wells in the area (16 operated, the rest participation). Still, this will be the main development area for the company in the future, contingent on finding partners to operate the wells and join properties.

The company's core production area is in the Permian basin, specifically in the San Andreas Fault, where it owns 300 net wells, but only 35 are productive. These are vertical wells that provide cash flow to sustain horizontal drilling in the area and the D-J basin.

Production and costs : The company has sustained production in the realm of 250 thousand boe per year for 2019, 2020, and 2021. The depreciation, lease, and operating costs have been nearly $50 per barrel.

Unfortunately, these costs may not be extremely representative given that they come from exploitations in the Permian basin from vertical wells, while the company is expected to develop horizontal wells in both Permian and D-J basins.

In FY22, the company increased production substantially, 40% on a YoY as of 3Q22 . Yearly production could very well end at 400 thousand boe. The elevated hydrocarbon prices of 2022 generated the profits the company is now enjoying.

Oil concentration: PED's production is 90% concentrated in crude oil. The company also produces natural gas, which is mostly a by-product of oil production. This is convenient because oil prices have been much less volatile than natural gas prices. Natural gas is difficult to store, making its markets more volatile.

Strong owner-manager : As mentioned, 65% of the company's stock is controlled by the company's CEO. I like companies with owner-managers because they show greater alignment between shareholder and managerial interests. Managerial compensation is low as well, with $500 thousand for the CEO in FY21.

Relatively tax-protected : PED has some $116 million in federal carryforward tax losses that could protect several years of production from federal income taxation. At the state level, Colorado has a 4.5% corporate income tax rate, while New Mexico has a 5.9% rate .

Financially strong : After share issuance in 2021, the company holds no debts and has $27 million in cash that can be used to sustain most of 2023's planned capital expenses.

Valuation

PV-10 based : O&G companies present PV-10 estimates of the economic value of reserves. Specialized oil service companies develop the estimations, and PED provides the data.

The PV-10 calculation is an approximation to the discounted value of the reserves underground after subtracting all exploitation costs and ad-valorem taxes but before federal and state income taxes. The operating income generated is discounted at a 10% rate.

The company's latest reserve report, from December 2022, estimates a future undiscounted net operating income of $747 million. Discounted at a 10% rate, it yields $375 million. Several things are worth noticing from this.

First, from the relation of discounted and undiscounted values, and the discount rate, we can estimate that the average extraction period of the reserves is seven and a half years (747/375 ~ 2, and 1.1^7.5 ~ 2). For example, this indicates undiscounted profits of $48 million for 16 years.

Second, the estimation above was made with oil at $90 a barrel. The same calculation for December 2021 , with an oil price of $66, yielded $365 million undiscounted operating income, half of the December 2022 value. This indicates a profit of ~$24 million for 16 years.

The PV-10 calculations do not include SG&A costs because they are done at the well level. From the two calculations (oil at $90 and oil at $66), the same level of SG&A should be subtracted, given that SG&A does not depend on oil prices.

Today the company sustains $5 million in SG&A expenses yearly. However, to produce a level of profitability consistent with the estimates, the company should more than double its production (from $30 million annualized revenue from 3Q22, at prices substantially similar to those in the December 2022 calculations, to at least $80 million required to produce the $1.3 billion in reserves in 16 years). Assuming double SG&A costs are not much compared to other E&P companies with similar revenues.

This yields $10 million in SG&A expenses and puts our undiscounted estimates at $14/38 million for 16 years.

We assume the company does not require external financing to sustain the CAPEX required to increase production to the desired level. Although financing will probably be required initially, the company already has production and cash. It only requires production to reach a plateau, after which depreciation should approximately match CAPEX.

Finally, we need to remove income taxes. We do not apply federal income taxes for the first $116 million in pre-tax profits because the company has NOLs. At the state level, we use the mix of 5% between the corporate income taxes in Colorado and Texas.

In the low end of profitability, the company generates $224 million in profits in 16 years (undiscounted), which end up as $190 million after taxes. For the higher end, the company generates $600 million in profits, which end at $475 million after taxes. These figures are undiscounted.

When considering SG&A expenses of $10 million, the company's breakeven oil price is $50 per barrel (obtained by adding $160 million in SG&A expenses to all the operating expenses listed in the report and dividing that by 14 million barrels equivalents in reserves).

The company's current $80 million market cap significantly discounts the profitability expected from PV-10 calculations. To convert $80 million into $190 million, you need nine years of 10% compounding. To get to $475 million, you need nineteen years.

PV-10 to reality, the role of management : PV-10 calculations above are based on the assumption that the company can double its production rate and consistently keep it at that level for 16 years. Further, prices remain consistent throughout the period. There are many ways in which the company can fail to realize that value.

One is for SG&A costs to be higher than forecast in relation to production levels. That would permanently reduce profitability. The second one is for production to be increased significantly above the forecast in a period where prices are depressed or, conversely, for production to be below forecast when prices are high. A third one is for the company to pay high interest rates on the capital required to increase production, only to find out that the profitability from that production is impaired as prices decrease. A fourth one is for the company not to return the extra profitability to shareholders but rather to spend it on expensive new properties that change the ROIC profile of the company. The list could go on.

Conversely, things could go better than expected (lower SG&A, accretive acquisitions, countercyclical capital allocation). The decisions that differentiate the PV-10 ideal company from the real company to be seen in the future are taken by management. I believe PED's management has shown several desirable characteristics.

One reassuring aspect in this respect is the high insider ownership, and low managerial compensation, as mentioned above. A second one is managerial experience. The company's CEO, Simon Kukes, owner of 65% of the company's shares, has helmed some of the most important Russian oil companies (names like Yukos, TNK, and Samara-Nafta). Two of those commands ended up in very profitable sales of those companies to larger companies, TNK in 2003, and Samara-Nafta in 2013.

Regarding capital allocation, the company acquired the Permian basin assets during the relatively low price period of 2018/19. The company has not made substantial acquisitions during the high-price period of 2021/22. It indicates countercyclical capital allocation because assets should be purchased during market downturns rather than upturns.

PED did not invest significant capital outside of the property purchases during the 2018/2021 period, concentrating on cleaning the balance sheet. This indicates that the company was not concentrated on increasing production at any cost but rather on waiting for opportunities to sell production at attractive prices and, most importantly, financing the expenses with self-generated funds.

Regarding cost containment, SG&A expenses have decreased compared to production between 2020 and 2022. As mentioned in the PV-10 section, containing SG&A costs is an important part of generating a profit from the company's operations.

Present and future: PED offers an interesting discount on PV-10 profitability under two different price scenarios ($65 and $90 a barrel). Further, the company's management passes several tests that lead us to think it can conduct the company to good outcomes: high insider ownership, low compensation, countercyclical capital allocation, self-funding CAPEX, controlled SG&A expenses, and previous successful experience in much bigger operations.

However, it is also important to consider how much is being paid for the company's current production. Future promises are great, but the investor should be grounded in the present.

For 9M22, the company has averaged 95 thousand barrels per quarter at a cost per barrel of $50. These prices represent a mix of vertical well production in the Permian basin and horizontal wells in DJ and Permian. This is because most of the FY22 increase in volume (one-third of production) comes from horizontal wells.

The WTI has ranged between $75 and $80 for several months. Considering these prices, the company generates between $25 and $30 per barrel in gross profits. This adds to between $10 and $12 million in gross profits yearly (400 thousand barrels, without new production).

As seen above, SG&A expenses run at $6 million TTM, decreasing to a $5 million annualized rate in the 9M22 period. Considering the $5 million scenario, we arrive at between $5 and $7 million in pre-tax profits, currently affected only by 5% state income taxes (NOLs cover federal taxes).

For the beginning of FY23, the company expects increased production from 2.5 net wells (35% participation in six gross wells, 5% in another eight) in the DJ basin that started production in December 2022. Considering that each net well can increase production by 100 barrels a day during its initial operation ( see Niobrara type curve ), we can consider an additional 100 thousand barrels in yearly production from these two wells. Our above calculations with 500 thousand barrels instead of 400 thousand barrels yield a net income between $7.5 and $10 million.

The company does not plan on investing significantly more in 1H23. After that, the investment will go first to non-operated wells in DJ, then operated wells in DJ, and finally to operated wells in Permian (but only in FY24). This again signals the willingness of the company to wait until CAPEX can be self-financed rather than rush to invest using debt or share dilution.

With a market cap of $80 million, PED offers an expected earnings yield of between 6.25% and 8.75%, with earnings of between $5 and $7 million based on FY22 production and oil prices between $75 and $80. If production is increased to include already operating DJ developments, the yield figure climbs to 8.75% and 12.5%.

For a negative scenario, the company's accrual break-even would be around $60 per barrel ($5 million in gross profits from 500 thousand barrels and $10 profit per barrel).

Conclusions

In terms of the present, PED offers an earnings yield of around 10% using production already in place and current oil prices. Its break-even price is relatively low, at $60 per barrel.

Regarding quality, the company has no debt, and a management that has been conservative in allocating capital, is cost-conscious, and has a significant stake in the company.

Further, the company has several positive opportunities in the future, as evaluated from the company's PV-10 report. The discount to undiscounted PV-10 profits is significant. Using a range of oil prices, the company's current market cap to PV-10 profit relation is similar to investing 10%, compounded by nine and nineteen years.

For these reasons, I believe PED stock is an opportunity at these prices.

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