Evolution Petroleum (EPM) has long had a pristine balance sheet and an excellent growth record. But the stock has rarely been valued in accordance with that record. The reason is that Denbury Resources (DNR) has had financial challenges for a very long time. Denbury is unfortunately, the operator of the most significant asset of Evolution Petroleum.
Partnerships are generally only as strong as the weakest link. In this case, Denbury, the weakest link by far, is now facing its greatest challenges. Denbury Resources has now announced that it is skipping the second bond payment that is now due. Short of a highly unusual agreement outside of a formal reorganization, a bankruptcy filing in the near future would be a reasonable expectation by the market.
For Evolution, highly probable reorganization puts agreements with Denbury into uncertain territory. The bankruptcy court has the right to review any and all agreements. Management stated in the conference call for the latest quarter that they would not “speculate” on the actions (or strategy) of Denbury Resources. In defense of that statement, management could well be in a tight spot between legal requirements and shareholders right to know. Therefore, it could be best not to go there for the time being.
Once Denbury does the most likely action and files for reorganization, then the situation changes enough that management will probably be able to talk to a greater extent about the action. Hopefully, once the situation clears up enough, management will have a conference call about this very material situation for shareholders.
It is very possible that the contracts with Denbury Resources do not change or that Denbury Resources management negotiates a “pre-pack” that quickly resolves all uncertainties. Then the next market concern would actually be the operations of the main Evolution Petroleum asset.
Management did mention on the conference call that this secondary recovery at Delhi had the lowest lifting costs in the Denbury portfolio. However, secondary recovery by itself is extremely expensive compared to unconventional or even conventional. Therefore that assurance is not very assuring during a time of low oil prices. There is still a risk of a court ordered shutdown of the operation or the sale of the operation to another partner not of the choosing of the management of Evolution Petroleum.
Evolution Petroleum management therefore needed to cut the dividend not only because prices are lower but because legal expenses will most likely climb in the future. Mr. Market has never liked the uncertainty involved in a reorganization no matter how certain an individual investor may feel about the outcome.
Anytime a partner in the partnership has financial troubles, that partner is unlikely to approve capital expenditures for growth. Probably only the bare maintenance expenses will be approved. Those types of actions can really “tie up the partnership” and keep it from realizing the full potential envisioned when the partnership was formed.
Source: Evolution Petroleum June 2020, Investor Presentation
That means that the growth shown above will come to a temporary end until the financial challenges of Denbury Resources get resolved. Note that Evolution Petroleum has dealt with the lower profitability of secondary recovery by maintaining a no debt balance sheet. That has enabled Evolution Petroleum to “sail through” the current situation. A longer recovery poses no threat to the company whatsoever due to the lack of debt.
However, the current possibility of a reorganization by Denbury Resources also means that there will be a very different view of required maintenance activities until that reorganization is completed. Most likely production will decline and anything that the court views as remotely unnecessary will be deferred until after reorganization. Therefore, investors can expect low expenses during the reorganization followed by a period of “catch-up” expenses afterwards.
Probably the best that Evolution Petroleum shareholders can hope for is a pre-packed reorganization announced by the management of Denbury Resources. That type of reorganization would remove a lot of uncertainty while hopefully providing a basis for re-evaluating the current price by Mr. Market. It would also provide management with a solid basis for evaluating the current dividend going forward.
The outlook for Delhi appears pretty bright, once the current situation gets resolved.
Source: Evolution Petroleum June 2020, Investor Presentation.
The Delhi Field produces oil and the more valuable part of natural gas liquids. Therefore the margins appear to be excellent. The catch with any secondary recovery has always been the amount of capital needed to produce those great margins. Usually that capital needed is fairly high by industry standards. The result is that secondary recovery is rarely as profitable as either conventional or unconventional. Not many secondary projects will therefore survive the current climate of “lower for longer”. This project does appear to be one that will survive the current industry climate.
Management has long recognized the need for diversification. But this management has some fairly strict requirements about considering diversification prospects.
Generally, this management will not operate the project. Therefore, the operator that comes along with the proposed purchase is an important consideration.
Secondly, profitability is a very high consideration. But profitable secondary recovery projects meeting the criteria of this management are not that easy to come by. The current climate may offer those possibilities. It may also offer management the chance to diversify into either unconventional projects or even conventional projects where the company does not have to operate the leases.
Source: Evolution Petroleum June 2020, Investor Presentation
The company has finally begun the diversification process. This company is small enough that growth will not be smooth because larger companies often have several projects that can smooth the growth curve. What has been needed here for some time is far less dependence on a project run by Denbury Resources.
Normally a company like Evolution Petroleum with its pristine balance sheet and growth record would be an excellent candidate for consideration by most investors. However, the upcoming reorganization of Denbury Resources makes this investment a specialty investment for consideration by investors knowledgeable about the process that will unfold.
Now should Denbury either reorganize outside of bankruptcy or file for bankruptcy with a prepackaged reorganization, then a lot of uncertainty related to the current situation will disappear.
In the meantime most risk averse and really many average investors will want to wait until much of the uncertainty related to the current situation disappears. Evolution Petroleum is well managed and has excellent prospects. However, the prospects of the partner in Delhi are likely to “steal the show” for the foreseeable future. This company probably bears watching though for a decent entry point as it is at bargain price levels (though for a good reason unfortunately).
Additional disclosure: Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company’s filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.
Source: Seeking Alpha