In its last Q2 report, Eagle Energy is guiding for a sustainability ratio of 150% for 2012 due to increased spending this year. The company increased its capital program to $42 million up from $32 million on the back of higher costs at the Salt Flat field and for drilling 2 extra wells on its new Permian Basin acreage. While the total payout ratio is high, I believe it simply reflects getting the Permian Basin operationally up to speed in terms of production.
We’ve seen this movie before; when Eagle acquired its Salt Flat field it grew its oil production more than 8 times in order to bring the field’s sustainability ratio below %100. So looking at the new acquisition from the same angle, I expect EGL’s increased spending to materially grow production from its Permian Basin field over the next 12 months in order to reach the same level of sustainability. The field was acquired with about 600 boe (88% oil and liquids) of production.
Contrary to Canadian dividend paying producers, Eagle Energy does not suffer from volatile discounts to WTI in their realized price of oil. In fact, the company is realizing a premium price to WTI for its oil as it negotiated a new marketing agreement for the remainder of the year and the first 2 months of 2013. Eagle’s sales will be pegged to Louisiana Light Sweet (LLS) versus Cushing (WTI). This immediately adds an extra $5 per barrel of oil sold since LLS trades at a premium to WTI.
Better yet, the company has now completed the electrification of its Salt Flat field which shaves off $4 per boe from its operating expense by getting rid of most of its diesel generators. That’s a total of $9 per barrel going into 2013 if we assume their marketing agreement will be extended till the end of the year.
Overall, I am pleased with the Q2 report but there is one item that bothered me and that’s their hedges for 2013. Only ~12% of production is hedged for next year which leaves the trust vulnerable to the volatility in the price of oil. By next quarter, I sure hope to see a larger portion of 2013’s production hedged above $90 per barrel.
Unlike its sister Parallel Energy Trust, Eagle is not suffering from operational challenges; the trust fetches top dollars for its commodity and enjoys a solid balance sheet with debt to cash flow < 1.5x. At 150%, the total payout ratio is concerning but there is no danger at all in the short term to the distribution as I believe the spike reflects the growing pains of the new field.
Looking towards 2013, increased production will move the total payout ratio closer to the 100% mark. For our scenario, this means an average production rate of 4,200 boepd (98% oil) which is a 15% increase from the 3,600 boed level announced for H2-12.
- 2013 average production 4,200 boepd (98% liquids)
- WTI oil price of $90
- Natural gas liquids at 50% of WTI
- Natural gas price at $3.00 /mcf
Assuming a similar capital program is spent in 2013 ($42 million), the total payout ratio falls to 115% which means a deficit of $10M. The DRIP proceeds would reduce the ratio substantially below 100% and contribute towards lowering the debt.
However, the scenario assumes no further acquisitions are executed which is highly unlikely since the trust will be acquiring the remaining 6.5% working interest in the Permian by April 2013. Furthermore, capital expenditures may be higher next year since the company clearly indicated they wish to double current production in the next 18 month.
This leaves us with 2 major risks:
- Obviously, the price of oil is the first one especially with the lack of hedges for 2013.
- Meeting the longer term production profile the company is targeting.
Finally, even if the distribution is not in danger, the share price is vulnerable to market sentiment and oil price volatility. In my opinion, the risk to the downside outweighs any upside in the near term given the state of Europe and the global economy. The acquisition scenario will get repeated which means the sustainability ratio will be distorted as development of new fields gets accelerated. In the long run, I fully trust management’s ability to deliver but in the short term the growing pains might hurt the company’s share price.
What do you think of EGL.un?