Epsilon Energy (OTC:EPSEF)(TSX: EPS) is a Canadian E&P with its principle asset in the United States. Epsilon was managed by what I would qualify as "run of the mill" E&P executives, who spent money drilling left and right without too much success.
Earlier in 2013 John Lovoi, managing partner of the energy focused advisory firm JVL Advisors (and ex-head of Morgan Stanley Oil and Gas investment banking), along with the $10 billion asset manager Advisory Research acquired a 30% ownership stake in the company (at prices ranging from $3 to $4 a share). Epsilon management responded to JVL and Advisory Research position by initiating a strategic review. The review however failed to produce tangible results; in consequence the stock tumbled and JVL took control of Epsilon. Upon taking control of the company, the new board and management issued the following comments on July 16th:
"The Board intends to continue to encourage the development of Epsilon's non-operated position in the heart of the Marcellus Shale. As this valuable asset matures, the Board will explore opportunities to return the free cash flow from the Marcellus to shareholders in the most tax efficient manner possible, on a time frame to be determined depending on a number of factors, including the operator's pace of development at the field level."
Epsilon has operations both in Canada and the United States; the Canadian operations are of negligible value and they have been auctioned and discontinued. The company's crown jewel is its minority interest in its upstream and midstream assets in the Marcellus shale gas field in Pennsylvania.
Epsilon upstream assets:
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The company retains 5750 net acres (11500 gross) in Susquehanna County, the most prolific shale gas producing county in the Marcellus field. The company's acreage is located mainly in the township of Rush immediately adjacent to Dimock and Springville townships where Cabot Oil and Gas (COG) has achieved its best well results at 20 Bcf in EUR. Epsilon's acreage is operated by Chesapeake (CHK).
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(Source: Cabot Investor presentation - Epsilon green area added)
(SA contributor Richard Zeits at Zeits Energy Analytics provides an excellent overview of well productivity in the area adjacent to Epsilon's position. Epsilon is not mentioned in the article, but its acreage is located within Chesapeake's "core of the core" acreage, which is referenced in the article.)
Based on the company 2012 reserves report, Epsilon 2P reserves (87.2% 1P) stand at 167.7 Bcf valued at $190.7m or $3.81 per share. The reserves are valued using the following assumptions:
NG NYMEX strip prices at December 31st 2012 for 2 years followed by an escalation of 2.5% per year thereafter (operating costs are estimated to inflate at the same rate):
(Source Epsilon reserve report)
According to management, Epsilon reserves will likely be revised higher due to improved completion and well design by the operator. This improvement should be reflected in the next annual reserve update. As indicated in the release of the company Q3 results on November 5th:
"We have engaged third party engineers to help forecast the long term value of the upstream reserves. . Furthermore, we have met with the upstream operator and conducted our own analysis of Epsilon's reserves. Our preliminary conclusions are that the current reserves bookings are conservative and that the overall practices of the operator are supportive of maximizing gas recoveries. We will have more definitive comments regarding this in conjunction with our year end reserve disclosures during the 1st quarter of 2014."
It is worth noting that the Canadian reserve valuation methodology does not use flat pricing when estimating reserves (unlike their US peers). The value of Epsilon reserves could be materially different under a flat pricing estimate; however since the bulk of Marcellus shale wells reserves are produced in the first few years applying the Canadian method is reasonable. Especially when considering that the projected prices are capped under $5 Mcf until 2019.
In addition to the 2P reserves, Epsilon has a potential contingent resource estimated at 240 Bcf in the upper Marcellus; this potential resource is not included in the reserve report. It is unclear when or if this resource will be developed, but Cabot has been producing from the upper Marcellus and Epsilon's CEO highlighted in his August 2013 Enercom presentation that a one well test in the upper Marcellus has shown that production from this Marcellus layer on the company acreage is economic.
Epsilon is currently producing 38 Mcf and is expected to exit the year at 45 to 50 Mcf in production. The increase in production will be due to the additional completion of 4 wells (0.99 net to Epsilon) in the 4th quarter and the introduction of compression which will increase volumes by 10 to 15%.
Epsilon Midstream assets
Epsilon has a 35% ownership in the Auburn Gathering System (partners are Chesapeake and Statoil). The gathering system is operated by Access Midstream (ACMP) and is currently flowing at 150 Mmcf to 200 Mmcf for an estimated EBITDA (net to Epsilon) at $6.5m per year. The system current compression capacity stands at 300-330 Mmcf and its gross gathering capacity stand at 550 Mmcf.
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Based on my recent discussions with Epsilon's management, it was indicated that the company has received expressions of interest for a total gathering volume of up to 500 Mmcf. Any increase in volume beyond 330 Mmcf would require an additional investment in the gathering system, while the investment amount was not quantified, it was indicated that it could be fully funded from annual cash flows. At its maximum upgraded 500 Mmcf gathering capacity this midstream asset would generate $23m in annual EBITDA (as shown in the table above). The gathering system volume should ramp up to 300 Mmcf within 2014 ($13.5m EBITDA) followed by an eventual increase to 500 Mmcf in 2015 (23m EBITDA). At an 8 times cash flow multiple this asset could be worth $108m to $184m, or $2.16 to $3.68 per share depending on the expected volume.
Admittedly, I am less familiar with the valuation of midstream assets; the CEO has advanced an 8 multiple in August as a reasonable multiple to use, but I have seen cash flow multiples as high as 11 times proposed for this asset (Jennings Capital December 2011). Management has indicated that they expect the system to run at full capacity for at least 5 years, followed by a gradual decline over the 25 years contractual relationship. (I would welcome informed readers' comments on the valuation for this asset).
The company's CEO Mr. Michael Raleigh has affirmed publicly in a November 20th press release that Epsilon's Midstream volume is expected to grow materially next year:
Increased demand for throughput capacity of the Midstream assets have firmed in recent months as area operators seek attractive market outlets for their Marcellus gas production. Based on current expressions of interest from third parties, we anticipate throughput volumes to grow meaningfully through 2014.
Corporate Strategy
What makes Epsilon unique is the fact that this is an asset managed by shareholders for shareholders; the CEO, Chairman and most board members are major shareholders. Mr. Raleigh does not collect a cash salary; his compensation is entirely based on the appreciation in the stock price or the return of value to shareholders. As a result of a number of cash saving initiatives, the new management has already slashed G&A by 33%. Epsilon is managed with the singular focus of maximizing shareholder returns.
In line with its newly adopted shareholder centric approach, Epsilon has initiated a buyback program on September 16th with the goal of acquiring and canceling 5% of its outstanding shares. Already 447,400 shares have been acquired and cancelled under the program. Management has affirmed its intention to continue its buybacks going forward or initiate a dividend in the future. The management has expressed openness to consider a transaction once the upstream and midstream assets are fully optimized, as indicated in the Q3 earnings report (and affirmed to me personally by the CEO):
"In our opinion, the optimal time to approach the divestiture market is when both the upstream and midstream assets have been optimized. We will continue to pursue a monetization strategy that is accretive to shareholders for the foreseeable future."
Management has also indicated an interest in an alternate option to enhance shareholder value, consisting of the creation of a Trust once the assets are optimized.
Another macro factor of interest is the expected narrowing of differentials between the regionally produced Marcellus gas and NYMEX. The differential currently stands at 70c to 80c discount to NYMEX. As new take away capacity comes online this differential is expected to half in the next 18 months, thus adding meaningfully to cash flows. Epsilon management shares the same outlook, from Q3 earnings report:
"the price differential (the difference between price paid to Epsilon and NYMEX) for our operating region remains stubbornly high due to infrastructure constraints and the productive nature of the sub-surface rock. We believe the current differential will narrow significantly in coming quarters as new infrastructure projects become operational. In the longer term, we believe gas will trade between $3.50 - $4.50/mcf.In this environment, our two assets will generate attractive levels of cash flow which will provide management the opportunity to repurchase additional shares or pay dividends to shareholders."".
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(Source: Cabot Oil & Gas - Bentek)
Valuation & Risks
At $3 per share, Epsilon's current enterprise value of $190m (inclusive of $40m in convertible debt) is at best only valuing the company's upstream assets and attributing no value to the company's mid-stream assets. Even at today's reduced gathering volume those assets are worth an additional $1.6 per share (200 Mmcf in volume at $10m EBITDA - 8 times multiple); and should we value the midstream assets at their potential 2014/2015 mid-range valuation of $146m, this would give us a stock price of $5.92 per share or almost 100% upside from current levels.
Achieving a doubling in the valuation is of course dependent on the company delivering on its optimization plan for the upstream and midstream assets; the path to that deliverability is subject to a number of risks:
Minority interest: As indicated by Epsilon's management, the company does not control the pace of development, thus a decision by its partners to slow down drilling or slow down the development of the mid-stream asset could prove detrimental to Epsilon. While Epsilon's partners have not expressed a wish to slow down development, this is still an ongoing risk. Under a development slow down scenario, management's best option would be to plow cash flows into buybacks until development is resumed.
Undeveloped reserves: 57% of the company P1 reserves are PUDs (Proven Undeveloped); while management believes that those PUDs are conservatively booked, execution to produce and fully prove those reserves remains a risk. Adverse changes in commodity prices could further hamper the developments of the undeveloped reserves.
Liquidity: Epsilon is a highly neglected stock. Being a junior Canadian TSX listed company with US based assets, few investors have shown interest in the stock and to my knowledge there is no current brokerage coverage. While this could be a signal of market inefficiency, and thus offer an opportunity, it does limit the stock's liquidity and increases its volatility.
Commodity risk: Natural gas prices may weaken further in the coming years, or the Marcellus regional market prices may continue to be depressed due to continued rising production and a failure for the upcoming take away capacity to relief the bottleneck. Severely depressed natural gas prices could impair the value of the producing reserves and render undeveloped reserves uneconomic to develop.
In summary, weighting the pros and cons, I still believe that Epsilon offers a compelling opportunity to invest in an undervalued asset along a uniquely aligned board and management team with the singular objective of increasing and unlocking shareholder value.
Disclosure: I am long OTC:EPSEF. 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. (More...)
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