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Canceled Sale Of Non-Core Asset Is A Negative Development For Obsidian Energy Given Upcoming Debt Wall – Obsidian Energy Ltd. (NYSE:OBE)

By August 30, 2019 No Comments

The termination of the agreement to proceed with the sale of its PROP (Peace River Oil Partnership) assets announced yesterday is bad news for Obsidian Energy (OBE). In a previous article, I discussed this transaction was needed – but not enough – for the company to face its debt wall.

Management was also looking to sell some other assets. But, in the current challenging oil and gas environment in Canada, no other transaction was announced.

Now, the company is back to square one with its legacy assets. So, let’s have a look at the Q2 results to assess the urgency of the situation.

oil and gas rig

Image source: Anita_starzycka via Pixabay

Note: All the numbers in the article are in Canadian dollars unless otherwise noted.

Q2 results

As previously communicated, the company focused on its Cardium assets. Management is looking to sell any – or all – of the other assets.

Obsidian Energy Q2 earnings: production by assets

Source: Q2 2019 MD&A

Due to the production curtailment in Alberta and because of the shut-in of legacy assets, production dropped 3% year-over-year.Obsidian Energy Q2 earnings: production by product

Source: Q2 2019 MD&A

But management confirmed the full-year production guidance in the range of 26,750 boe/d to 27,750 boe/d.

Thanks to stable costs and a higher realized price compared to the previous quarter, the company realized a positive total netback of C$5.27/boe, before unfavorable hedges.

Obsidian Energy Q2 earnings: costs and netbacks

Source: Author, based on company reports

I detailed in a previous article my calculation of the replacement costs of C$12.06/boe. As management didn’t change its guidance, my estimation remains valid.

Adjusted funds flow amounted to C$41 million. But it excludes about C$7 million of restructuring charges and legal expenses.

And thanks to a limited capital program of C$8 million, net debt decreased from C$497 million at the end of the previous quarter to C$478 million.

The urgency to sell assets

Despite the decrease in the net debt and the record adjusted funds flow since 2017, the net debt to annualized adjusted funds flow ratio is still high at 2.91x.

And if we take into account the last 12 months, the net debt to TTM adjusted funds flow ratio increases to 4.93x.

Besides the high leverage, the structure of the debt is an extra risk. The company described the terms of the updated credit facility:

Subsequent to June 30, 2019, the Company reached an agreement with its lenders whereby the underlying borrowing base of the syndicated credit facility and the amount available to be drawn under the syndicated credit facility remain at $550 million and $460 million, respectively. The revolving period ends on February 28, 2020 with revolving period reconfirmation dates on November 19, 2019 and January 20, 2020. Under the agreement the term-out period ends November 30, 2020.” – Source: Q2 2019 MD&A

With C$417 million drawn from its credit facility and a portion of expiring notes in the short term, the company is facing a debt wall of C$451 million by next year.

Obsidian Energy Q2 earnings: liabilities

Source: Q2 2019 MD&A

If Q2 oil prices hold, free cash flow will stay positive and refinancing the debt at acceptable conditions is a likely outcome.

But the company is exposed to a short period of low oil prices over the next few quarters. Because of the depressed Canadian oil prices during Q4 2018, the debt covenants were already relaxed as per the table below.

Obsidian Energy Q2 earnings: debt covenants

Source: Q2 2019 MD&A

The debt to adjusted EBITDA limit will decrease again to 3:1 at the beginning of next year.

Thus, realizing an asset sale at a fair price before next year was important to reduce risks of refinancing the debt at a high cost.

Yet, the communication around the cancellation of the C$97 million PROP deal was minimal. The press release stated:

In order for the sale to proceed, the consent to the transfer of our Partnership units and the transfer of operatorship of the Partnership was required, however, the consents for these transfers were not obtained and the agreement was terminated. We intend to pursue all other viable alternatives for the disposition of our interest in the Partnership and continue to focus on our high-quality, light oil Cardium asset.”

The reasons for the cancellation of the transaction are not clear. My interpretation is the JV partner that owns 45% in the PROP asset somehow opposed this deal.

In any case, this development isn’t going to encourage other potential buyers.

Attractive free cash flow yield at Q2 oil prices

Production during Q2 is equivalent to the forecasted full-year production. Thus, assuming Q2 adjusted funds flow stays constant at C$41 million (excluding the restructuring and legal costs), the annualized adjusted funds flow will reach C$164 million.

Given the sustaining capital program of about C$120 million, the company will generate a free cash flow of C$44 million. The stock price at C$1.3 corresponds to a huge free cash flow yield of about 46%.

As highlighted, the short-term debt is the main risk. But it also inflates free cash flow. The company reported the weighted average interest rate amounted to 5.7% during Q2.

Obsidian Energy Q2 earnings: interest rates

Source: Q2 2019 MD&A

A longer maturity, which corresponds to a less risky capital structure, would increase the interest rate. An average interest rate 2% higher than during Q2 would impact free cash flow by about C$9.5 million. But even with a free cash flow of C$35.4 million, the free cash flow yield would still exceed 37%.

Also, this valuation assumes the WTI price of US$59.81/bbl during Q2 stays constant. But the WTI spot price is now closer to US$55/bbl. With the sensitivity table management provided, the corresponding cash flow would drop by C$25 million, and the free cash flow yield would be 20%.

In any case, with a WTI price above $US55/bbl, the free cash flow yield is attractive. But the main risk remains the debt load in the short term.

Conclusion

Despite good Q2 results, Obsidian Energy is still exposed to a debt wall over the short term. The sale of the PROP assets at an acceptable price in the current challenging Canadian environment was a positive development to reduce risks.

But with the deal being canceled, the company is back to square one. Management must still sell its non-Cardium assets to avoid refinancing its debt at unfavorable conditions.

Given oil prices during Q2, the free cash flow yield is important. But the WTI prices are now lower and the main risk is still the debt load. Thus, given the high risks and disappointing execution, I still prefer to stay on the sidelines.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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