Evolution Petroleum: Strategic Administration, Low-cost Belongings, Recovering Fuel Costs (NYSE:EPM)

Evolution Petroleum Company (NYSE:EPM) is an power small-cap centered on onshore oil and gasoline in the US. Its technique is to construct a portfolio of diversified belongings by creating and buying non-operating pursuits in a number of fields throughout the USA. Within the first quarter of 2024, EPM had a mean every day manufacturing (BOEPD) of seven,209. Nonetheless, whereas manufacturing has been up 1.7% since final 12 months, costs weighted per unit have been truly down 39.3%, destroying margins (2024Q3 MD&A, web page 33).

After just lately transitioning in the direction of extra oil fields, its reserves are cut up as follows: 49% pure gasoline, 32% oil, and 19% NGL (pure gasoline conversion ratio of 6:1). Evolution’s massive gasoline manufacturing means it profited closely on the spike in gasoline costs but additionally obtained damage by the next crash. Evolution tends to make use of little hedges, leaving a big upside when gasoline costs finally get better.

Evolution’s technique is to purchase counter-cyclical belongings, sharply priced by the low commodity costs. Their current SCOOP/STACK and Chaveroo acquisitions present they’re now evolving in the direction of long-life manufacturing, making them extra resilient to commodity value downswings.

Administration’s efficient technique, together with their nice set of diversified belongings at ridiculously low costs, makes it a transparent, sturdy purchase for my part.

Asset Overview

From October 2019 by means of February 2024, Evolution has participated in six main transactions, placing over $119 million to work for our shareholders. Throughout that point, we have paid down over $41 million of borrowings, whereas our share depend has remained just about unchanged. (2024Q3 Earnings Name).

Beginning in 2023, Evolution has taken a brand new course with the Chaveroo and SCOOP/STACK acquisitions. Evolution used to buy mature wells, late within the stage of manufacturing, that means small depletion charges, however little resiliency to low commodity costs. Now, with gasoline costs hitting lows of $1.53/MMBtu in 2023, administration had alternatives to purchase counter-cyclical belongings at depressed costs, explaining the $42.5M improve in debt.

Earlier than the acquisitions, the Delhi Area was once Evolution’s important asset. Final quarter, it produced 1,022 BOEPD, comprising 71% oil and 29% pure gasoline liquids (NGL). Despite the fact that it is certainly one of Evolution’s legacy belongings, its working accomplice continues to be increasing the sphere. Evolution diversifies by constantly proudly owning small working pursuits (principally) in massive quantities of wells in several fields.

Let’s concentrate on the efficiency of their current acquisitions, beginning with their earliest.

Hamilton Dome/Williston

Evolution acquired the complete oil Hamilton Dome area for $9.5M in November 2019. Since then, manufacturing has been fairly constant, in addition to the COVID disruptions. The depletion charge has been slowing down and is now at 0.8% yearly since 2016. Their funding has accomplished magnificently, and I calculated a 21% inner charge of return with the next standards.

Final quarter’s manufacturing sat at 385 BOEPD, offered at oil costs of $61.21/bbl for the previous 91 days. This resulted in $1.56M of revenues, and $578K of pre-tax quarterly revenue, excluding administrative prices. And bear in mind, these numbers are barely impacted by workover initiatives at first of the quarter. Yearly, this transfers to $2.3M of working money move.

For the IRR calculation, assume a 2% annual decline charge. And calculate it over the subsequent 15 years as a result of Hamilton Dome’s present Internet PDP Reserves/ Internet Manufacturing sits at 16 years. At its manufacturing value of $9.5M, the inner charge of return sits at 21%, conservatively calculated, which is noteworthy.

Equally to Hamilton Dome, the Williston area is basically an oil area (74%). With 462 BOEPD, it provides one other layer of diversification and publicity to grease for Evolution.

Jonah Area/Barnett Shale

Realized pure gasoline costs decreased 71.7% from the prior 12 months interval, which was the most important portion of the driving force of the lower in revenues. This was partially attributed to the prior 12 months interval advantage of sturdy pure gasoline value differentials obtained on the Jonah Area the place we realized a mean pure gasoline value of $20.31 per MCF within the prior 12 months interval in comparison with $3.94 per MCF within the present 12 months quarter. (MD&A 2024).

The Jonah Area was bought for $27.5MM and closed on April 1, 2022. Its commodity cut up appears as follows: 88% pure gasoline, 7% NGL, and 5% oil. It produces 10.4 MMCFEPD, which equates to 1,736 BOEPD with a 6:1 conversion ratio. Based mostly on present costs, that ratio is definitely nearer to 40:1, so do not put an excessive amount of belief within the weighted BOEPD numbers. The Jonah Area considerably profited from the spike in gasoline costs, repaying the funding in two years.

Jonah Area sits at 21% of Evolution’s complete reserves, and Barnett Shale sits at 40%. These percentages are possible overstated as a result of they use the 6:1 pure gasoline conversion ratio. Nonetheless, when gasoline costs revert to their imply, this leaves a big upside for Evolution.

SCOOP/STACK and Chaveroo

The addition of Chaveroo and SCOOP/STACK are good suits for our evolving technique of each including long-life manufacturing throughout commodity value downswings and including undeveloped areas by making acquisitions by means of the drill bit. (Q3 Earnings Name).

For his or her new acquisitions, SCOOP/STACK reaches round 1,550 BOEPD at a 6:1 pure gasoline conversion ratio, comprising 40% oil, 13% NGL, and 47% pure gasoline. For $40.5M, Evolution purchased a ~3% working curiosity in 247 lively wells, with the potential for cooperating on 300+ extra with its operators. This makes it extremely diversified, however troublesome to promote within the occasion of a liquidation. The low liquidity on these small pursuits creates shopping for alternatives for administration.

SCOOP/STACK receives the very best gross sales costs of all Evolution’s fields. Simply assuming steady manufacturing with steady costs at a 30% netback margin results in $3.2M of funds from operations (FFO) for a single quarter. For less than $40.5M!

Chaveroo is one other welcome addition to Evolution, particularly including to its oil publicity. There are at the moment three wells in manufacturing, with a 41% NRI. Moreover, in keeping with their Q3 Earnings Name: Along with the operator, we’re planning to drill the subsequent 4 wells starting in September 2024, adopted by one other six wells starting in April 2025.

These are wells paying again in 16 months! After every pays itself again, assume a long-term, slowly reducing manufacturing of round 50 BOEPD. Yearly, at a $40/bbl netback at a 41% NRI, this provides an additional $300K of yearly money move per properly.

Heightened Leverage

The current SCOOP/STACK acquisitions have been funded by taking out $42.5M in borrowings underneath the Senior Secured Credit score Facility. This doesn’t but replicate the impression of web money Evolution expects to obtain for the ultimate buy of the acquisitions. Administration goals to maintain their web debt to professional forma EBITDA ratio under 1x. This implies administration is devoted to shortly paying down debt. Nonetheless, they did state that this should not be a motive to move on another enticing offers coming their method.

As may be seen by Evolution’s historic web debt ranges, it is rather uncommon for administration to take out such a big debt place, this heightens the danger of default within the case of sustained decrease costs. Then again, this implies administration’s confidence in greater costs going ahead and the enticing value of its current acquisitions. As will likely be mentioned later, this danger is balanced out by them promoting gasoline futures, which stand considerably greater trying a 12 months later.

In keeping with their 10-Q (Observe 5. Senior Secured Credit score Facility):

On Could 5, 2023, Evolution prolonged the maturity of its debt contract to April 9, 2026. They’re borrowing on the Secured In a single day Financing Fee (I:SOFR) plus 2.80%, with a minimal of 0.50%, or on the Prime Fee plus 1.00%. Concurrently, the worth of the belongings backing the mortgage was elevated to $95 million. Their renewed contract now permits for extra versatile hedges.

Their present rate of interest quantities to eight.12% (5.32% + 2.80%). Assuming they do not lengthen the maturity date, they usually pay down the debt in three years, they’d begin off paying $3.45M in curiosity, taking place shortly afterward as they pay down 14.2M of the principal yearly over three years. This excludes the online money they already obtained after the completion of the acquisition.

Fuel Costs

Evolution’s Proved Reserves are made up of 49% Pure Fuel and 19% NGL. Its 2024Q3 income consisted of 63% of oil, nevertheless, as gasoline costs have been hitting lows, down 85% from their 2022 peak. The inherent cyclic nature of the gasoline market makes for some nice counter-cyclical buys, now EPM is down 45% in virtually a 12 months.

Whereas the gasoline business will proceed to slowly develop at the very least over the subsequent 15 years, it is going to lose market share to renewables. Nonetheless, gasoline will stay an integral a part of the worldwide power market. Because the world appears to be destroying its power infrastructure, pure gasoline will likely be there to again up the failures of unreliable renewables. In keeping with the EIA, in 2023, 33% of U.S. power consumption nonetheless got here from pure gasoline.

I believe this quote sums it up fairly properly: Coal is just too soiled. Oil is just too messy. And renewables are too intermittent. However pure gasoline is excellent. -Chris Tomlinson

The largest motive this chance exists is due to worry round future gasoline costs. However, gasoline futures, greater costs appear to be partially sure. Particularly contemplating what Evolution introduced of their Q3 earnings name:

We additionally hedged pure gasoline past the required 12-month interval to capitalize on the excessive costs obtainable within the calendar 12 months 2025 and past.

Dangers

Whereas hedging future commodity costs takes away a big chunk of potential dangers, their heightened leverage makes them extra prone to different dangers. Evolution owns small working pursuits in fields it does not function. Operators might make Evolution contribute capital expenditures when it’s already tight on money. Moreover, its area operators’ self-interest could not at all times be aligned with that of Evolution.

Evolution’s operations could encounter extra workover than anticipated. Their legacy belongings particularly, since these shallow reserves require dearer drilling. Most essential of all, is its commodity pricing danger. If oil costs fall and gasoline costs keep low or go even decrease, they will wrestle to pay down debt, and it might get ugly, even with hedges in place.

Valuation And Dividend

Evolution has been paying out $4 million in quarterly dividends for the final 7 quarters. Here is a mannequin breaking down their last-quarter manufacturing and costs. I added a piece declaring what would occur if gasoline costs have been to normalize, which they’ve already partially capitalized on with future contracts.

2024Q3 Nat Fuel (MBBL) LNG (MMCF) Oil (MBBL) Whole Whole Manufacturing 2,115 104 199 Present Worth $2.77/MCF $25.26/bbl $73.06/bbl Revenues $5.9M $2.6M $14.5M $23M Potential Worth $5.00/MCF $30.00/bbl $70.00/bbl New Revenues $10.58M $3.1M $13.9M $27.6M Click on to enlarge

The important thing assumption right here is that pure gasoline costs have been to go to $5.00/MCF. And if gasoline costs have been to return to $7.50/MCF, that will add one other $5M+ to revenues.

Bills

Let’s deduct all of their bills: $10M for LOE, $1.5M for CO2 prices, $2M for G&A, together with stock-based compensation, and $2.5M for elevated curiosity bills. And eventually, assume $2M tax prices, closely depending on income. This totals $18M in complete prices, which seems barely conservative, contemplating Funds From Operations was $8.64M in 2024Q3.

Lease Working Bills CO2 Prices G&A Curiosity Bills Taxes $10M $1.5M $2M $2.5M $2M Click on to enlarge

Dividend

Evolution is dedicated to persevering with their capital spending even throughout low commodity costs. Administration does not present any steering for capital expenditures going ahead. It should largely rely upon how a lot free money move Evolution can generate after paying down debt and the bottom dividend.

Assuming costs restore to the “Potential” value I wrote above, we might see round 10M of FFO, after which we’ll see a couple of million of capital expenditures, $3M would maintain operations and fortunately assist the drilling of recent wells in SCOOP/STACK and Chaveroo. Now, with $7M of FCF, we nonetheless want the debt principal repayments of $3.5M per quarter. This leaves us with $3.5M for the dividend, simply in need of the $4M quarterly funds. Contemplating they’ve $11M in money, the dividend will proceed to be comfortably payable sooner or later.

Revenues on Restored Costs Whole Prices Capex Debt Compensation Dividend $28M $18M $3M $3.5M $3.5M Click on to enlarge

Personally, I am not an enormous fan of constantly paying dividends by means of downturns as they must dip into their working capital (at the moment at $7.5M). Sadly, they must please the market, and it’s comprehensible; that is how the market works. Presently, Evolution is providing an 8.80% dividend yield.

Evolution Petroleum cannot actually be valued utilizing EV/EBITDA, as a result of the current debt improve disrupts its enterprise worth, whereas manufacturing hasn’t adopted but. Here is a DCF to attempt to estimate a price for the intermediate run when costs have barely recovered, as seen above within the “Potential” value.

For its preliminary annual FCF, we multiply the quarterly $7M by 4. Assume a 3% development charge over 10 years, since they’re significantly investing in development. I used a P/FCF ratio of 5, which appears adequately conservative, traditionally.

Preliminary FCF Interval Low cost Fee Development Fee Terminal Worth (P/FCF) $28M 10 Years 10% 3% 5 Click on to enlarge

These enter variables end in an intrinsic worth of $268M, leaving a 42% upside if gasoline costs get better solely partially. That equates to $8.16 per share.

Conclusion

Think about, that each one you want is for gasoline costs to get better, which is already priced in futures contracts. After administration pays down debt over the subsequent three years, this leaves room for elevated development capex or a better dividend. Normally, Evolution goals for little hedging, leaving an enormous upside. Every thing appears to level to an ideal funding over the subsequent three years. Precisely how nice will rely upon how chilly the subsequent couple of winters will likely be and subsequent gasoline costs.