Obsidian Energy Stock: It’s These Leverage Levels (NYSE:OBE)
Obsidian Energy (OBE) had a long rally. the app for the company to be listed on the NYSE again represents a full circle, as the company was previously listed on the NYSE years ago when I covered the stock as Penn West Energy. The challenges of the past few years remain, as debt levels are high and the company still has a current decommissioning liability (which for many companies is a future liability). Still, the company was fortunate to survive until the current commodity price environment took over. This could finally give the company a chance to achieve the investment-grade strength that has eluded management for some time.
Management expects to report more than C$400 million in debt. In the current business environment, this debt burden can be adequately paid off and debt ratios are likely to be satisfactory for many. the credit available on the bank line of credit is now approximately 35 million Canadian dollars at the end of the financial year. This amount of credit available for the size of the company’s operations indicates some concern among lenders about the ability to repay the debt load.
The good news is that the unexpected rise in commodity prices has allowed the company must declare its cash flows over C$200 million for the year. These surprisingly strong cash flows and high commodity prices will continue to accelerate the debt reduction program. The key will be to convince the market that debt is reasonable throughout the industry cycle, not just now when commodity prices are extremely high.
Therefore, a priority will continue to be to pay down the debt. There will most likely be an informal level of leverage agreed upon by the company and lenders that would be appropriate to have during the next cyclical downturn. The current high commodity price environment may well allow for a combination of production growth and debt repayment to achieve a decent debt ratio.
The company acquired the remainder of the interest of the heavy oil project become the sole owner. The debt burden may prevent much expansion in this very profitable project located in Peace River. Currently, the project is developing the Bluesky formation with the Clearwater formation as upside potential. The industry is very interested in the Clearwater interval because it is very cost effective.
However, a conservative assessment is necessary because heavy oil is a discounted product. Often, this discount increases to erase margin during cyclical downturns. The result is that heavy oil producers often halt production pending the inevitable recovery of the industry. Shrinking margins tend to affect discount products much more than light oil products during downturns.
To combat this trend, competitors like Headwater Exploration (OTCPK: CDDRF) have long-term debt balance sheet. Headwater also maintains a decent cash balance on the balance sheet. A company with such a conservative strategy can shut down production and simply wait out a period of low prices until adequate profitability returns.
Obsidian, on the other hand, is in a position to very much want the generous cash flow that heavy oil produces for most of the industry cycle. But the balance sheet does not resist the disappearance of margins which frequently happens to heavy oil in periods of decline. So, there will likely be some kind of balanced development that allows the company to take advantage of current prices while increasing production of more desirable commodities like light oil.
The presence of heavy oil production may also mean that the lending group will have a lower acceptable debt ratio for the company than would be the case for simple light oil production. This would “hedge” the additional risk of highly volatile heavy oil production. Investors will have to see how this all plays out in the future.
Note that the management sold shares to pay for the remaining interest in the Peace River Project that the company did not own. Using shares to take stakes or acquire companies is a very good way to accelerate the process of reducing the debt ratio. The company may need to make another transaction or two like this in order to bring the debt ratio down to acceptable levels approved by the lender.
Much of the industry seems to be heading towards a debt ratio below 2.0 as calculated by their lenders. The current high price environment will likely bring debt ratios back into acceptable territory from the end of 2021. But the key will be what is acceptable for lenders as the entire industry prepares for the next cyclical downturn. . Generally, companies do not deleverage adequately without using shares for an acquisition or selling certain assets. The next downturn seems to come too quickly.
Management has provided limited insight into well profitability. But many key profitability numbers aren’t there (like ROI, IRR, and break-even). This lack of disclosure may be a sign that there is still competitive work to be done to “catch up” with industry leaders. Profitability is a combination of several factors. Thus, high or low throughput often does not equate to profitability on its own.
The other consideration is that this company retains a good deal of the older production. At times, management has virtually divested some of this older production to small operators with low overhead to reduce the decommissioning liability. Yet they still report a significant amount of teardowns each year. This means that compared to the current activity, the company has a good number of wells that have become unprofitable when the company was considerably larger. This ongoing dismantling issue may well be a consideration for the indefinite future until older production comes into balance with current activity.
This older production problem can also be reflected in operating costs. These costs remain above those of some of the best operators in the industry. So it’s harder to tell if operations are lagging competitors, or if there’s just a lot of older production left on the books (despite last years efforts) keeping average production levels high. These high production costs tend to correlate with decommissioning costs to lead to the conclusion (same conclusion as before) that decommissioning will be a problem for years to come.
In summary, Obsidian has come a very long way from where it was a few years ago. Many challenges have been overcome to get the company to the point where it can re-apply for NYSE listing that it had years ago. But some issues still seem to hamper cost competitiveness. Management must continue to overcome persistent legacy challenges while developing a better future for the company.
Currently, high commodity prices are likely to accelerate the company’s return to investment grade if they last long enough. But this industry is notoriously inconspicuous. Thus, investors should watch an investment like this very closely. Industry conditions can change to have an outsized effect on the stock price of a company like this.
Growth will likely be limited by financial strength considerations and the resulting lending group debt repayment targets. The company is clearly in better shape than it was a few years ago. However, it is obvious that there are still some problems to be solved. Hopefully the current commodity price environment remains in place long enough to resolve the debt ratio issues. This direction continues to defy the odds when it comes to the company’s survival. This should continue in the future. The benefit to shareholders of this strategy may take some time.