When the facts change: Getting back into Equal Energy

I have been inching my way back into a position in Equal Energy over the last week and a half.  On Thursday, with the stock dropping back to $3.40 (on the Canadian exchange) I increased my position significantly.

Of course I sold Equal at an even lower price.  I began selling in May with a third of my position at $3.35, another third at $3.20, and the rest at $2.85.

So why by back now?

Well, some of the facts have changed.

Three key events have occurred that have changed my opinion on Equal Energy

1. I read the SeekingAlpha posts on Equal by Nawar Alsaadi
2. Drilling of the Mississippian has begun
3. Central banks around the world are easing

Nawar posted a number of really excellent articles on Seeking Alpha describing each of Equal’s assets in detail.  I found his article on the Lochend Cardium sweet spot particularly useful.

I hadn’t looked at Equal since I sold back in May, so I was not aware that they had such a success at Lochend.  They announced, along with their second quarter results, that they had drilled a well that had tested at over 800 boe/d.  Nawar’s analysis of the Lochend area, leveraging off of the presentations of NAL and Pengrowth, suggested that this well was not a fluke, and that Equal’s land was within an area of higher production that was benefiting from the use of slick water frac’s.

Nearly a full quarter of production from this well (which I would imagine should be somewhere in the neighbourhood of 200-300 bbl/d over the 3 month period) along with a second well that the company expects to begin producing in August, will lead to higher oil production, higher corporate netbacks, and higher cash flow in the third quarter.

With their 3rd quarter update the company should also have results from at least two Mississippian wells that were drilled in the second quarter.  I’m really interested in seeing the results from these wells.  If successful, they could create interest in the stock.

At the macro-level, I am not fighting the Federal Reserve and the other central banks that have decided to quantitatively ease in unison.  If the central banks were not easing I would remain hesitant to invest in Equal.  The environment would remain as it has been for the last year and a half; one where only stocks with the strongest of outlooks do well.

Equal does not have the strongest outlook.  Natural gas and natural gas liquid prices remain depressed; a look at ethane and propane prices at the Conway hub (where most of Equal’s NGL production is priced) shows that prices are still struggling.  Another Seeking Alpha piece by Nawar addressed the outlook for NGL prices at Conway, but most of the catalysts for higher prices won’t begin to be see until next year at the earliest.   The result is that a significant amount of Equal’s production is only marginally profitable (witnessed by  the declining corporate netbacks in the chart below).

The company also has a significant debt load that it carries on its balance sheet.

During times when the market is focused on the negatives, these points carry a much greater burden.  However, they are the sort of concerns that get discounted as the market looks positively at the future, as I suspect is beginning to happen now.   An upbeat market will tend to focus on the fact that Equal is cheap, and that it is having success in its core areas.

Another event that could give some much needed exposure to one of Equal’s core areas is the IPO of ICON, an oil and gas focused trust that has set its sights on the Hunton formation.

ICON Oil and Gas Fund

I read through the prospectus of ICON. According to the filing:

The partnership anticipates entering into Participation Agreements with Special Energy Corporation (“Special Energy”) with respect to certain prospects in the Hunton limestone formation and other formations similar in profile, as well as conventional oil and liquids-rich natural gas plays, in the Mid-Continent region of the United States.

ICON is trying to raise $200 million in its IPO.  Based on the prospectus, I wouldn’t expect that ICON would be a bidder on Equal’s assets, simply because they seem to have a relationship with Special Energy, another producer that is focused on the Hunton.  However ICON does appear to be looking for joint ventures.

With respect to each Project, the partnership will partner with one or more oil and gas operators, in each case, subject to a participation agreement (including, in each case, an attached operating agreement) (each, a “Participation Agreement”). Each Participation Agreement generally provides that the related operator will conduct and direct, and have full control of, all operations with respect to specified oil and natural gas prospects within one or more Projects.

The IPO suggests interest in the Hunton from outside investors, and perhaps we will get a transaction that will help put some numbers to Equal’s Hunton land.

The Strategic Review

I have very little in the way of insights.  It’s a wildcard and I don’t know how it plays out.   However, to speak more generally, I am both more confident in a positive conclusion to the review and less concerned about the fall out of a fruitless conclusion now then I was back in May.  Money has begun to flow back into the resource market.   You can see it in the stock prices of speculative issues and I have had heard it from a number of sources in the industry.  A thaw is occurring.  Assuming this continues, investments will no longer be valued only on the basis of what they could immediately fetch in sale and sales will be more readily found.

Spending within cash

The last point I want to make on Equal is that they are within a rare breed of oil and gas juniors that is mostly spending within their cash flow.   I’ve spoke about it before; too many juniors outspend their cash flow (sometimes by multiples) and end up with huge debts that can’t be repaid without significant dilution.  When I look around the junior universe I see many companies following the same path that Arcan Resources did; trying to build production by raising debt, and at some point I expect these companies to hit the same debt wall that Arcan did.

Equal, on the other hand, has been conservatively managing its cash flow.  While not perfect, they have been doing an admirable job of limiting expenditures to be mostly in line with cash generation, and this in a declining commodity price environment.  I’ll leave you with a simple chart of cash in and cash out.