Forest Oil: Strategic Challenges Are Not Over

Executive summary:

• Forest Oil's (FST) stock reacted to the company's earnings release two days ago with a steep ~35% decline.


• The market's negative reaction is not surprising as Forest's report contained a series of disappointments on the operating side in the Eagle Ford, the company's core operation.


• While capital re-allocation to the company's best prospects makes sense, the measure puts the spotlight on economic returns and valuation in the Eagle Ford.

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Eagle Ford Well Results In Q4 2013 Were Weak

According to Forest's press release, 17 gross (8.5 net) wells that the company completed since its last operational update had 30-day average gross production rate of 304 Boe/d. This is substantially below the average for 2013 wells completed earlier in the year.

• Forest reported that the average 30-day rate for its 44 gross (22 net) wells drilled in 2013 had the average 30-day rate of 408 Boe/d. This implies that the average 30-day rate for the 27 wells drilled earlier in the year was 474 Boe/d.

Forest commented that 3 gross (1.5 net) wells were drilled in areas where flow rates were affected by increased faulting. According to Forest, these wells were drilled in the southern portion of the acreage in an area where the company's two 3D seismic surveys overlap and where the resolution resulted in reduced imaging of a deep-seated fault complex. These wells produced high volumes of water, which originated from the deeper formations.

Management commented:

To mitigate this risk going forward, we are in the process of merging and reprocessing these 3D surveys to more accurately image the fault patterns in this portion of the field. This data will be processed, interpreted and utilized to select drilling locations by the third quarter of 2014.

The southern area of the field is where we plan to concentrate the majority of our activity during 2014, and it is where we have the best well results amongst our total set of wells. We'll direct our first half efforts in the areas of the field where we have a high degree of confidence in our understanding of the geological, geophysical and reservoir attributes of the field.

Forest announced that during the first half of 2014, while waiting for the reprocessed seismic and continuing to evaluate well performance data, management elected to reduce and defer activity in the Eagle Ford.

EUR Estimate To Be Revised Down

During the question and answer session, management commented that the company is revising down its existing type curve in the Eagle Ford. The EUR per well are being reduced by ~30 MBoe, from 300 MBoe to 270 MBoe. While the company's booked PUD reserves contain a cushion of safety (management commented that year-end 2013 PUDs were booked using ~240 MBoe EUR assumption), the revision is very material to the calculation of expected drilling economics.

Forest has estimated its drilling returns in the Eagle Ford in the ~27% range (assuming 300 Mboe per well and $90 per barrel WTI), as illustrated on the slide below. Assuming PV-10 valuation of ~$35/Boe for producing reserves and assuming 80% average royalty rate, the 30 Mboe reduction in the EUR will reduce the PV-10 per well by ~$0.84 million per well, likely bringing expected drilling returns substantially below 20%.

(click to enlarge)

(Source: Forest Oil's December 2013 Investor Presentation)

Adjusting Operating Course

Forest reiterated its 2014 production guidance of 120-130 MMcfe/d (~35% oil and NGLs) on a $290-$310 million budget (this represents a substantial outspending of the company's estimated discretionary cash flow). The guidance equates to a 10% volume growth and a 30% growth in oil, each on a pro-forma basis. The guidance is impressive but may be a tall order given that Q1 2014 volumes are actually expected to average 105-110 MMcfe/d, a decline from 111 MMcfe/d in Q4 2013.

Forest expects to "see a notable uptick in second half volumes compared to the first half as we benefit from the increased Ark-La-Tex activity." Based on its current projections and planned 2014 activity, the company expects fourth quarter 2014 net sales volumes to average 145-150 MMcfe/d.

Forest stated with regard to its operating plans for 2014:

While the seismic is being reprocessed and optimal well design is being evaluated, Forest has elected to reduce the pace of drilling in the Eagle Ford. As such, the 2014 drilling plan will entail drilling 48 gross (24 net) wells. Forest expects that the net capital allocated to the Eagle Ford for drilling and completion activities in 2014 will total $95 million.

Based on an improving price environment, lower drilling and completion costs, and excellent well results, Forest has elected to increase activity in East Texas and recently added a second operated rig to the program. A third operated rig is expected to begin drilling during the second quarter of 2014. Forest anticipates drilling 20-25 wells in East Texas in 2014. As part of an expanded Ark-La-Tex drilling program, Forest plans to continue development of a light sweet crude oil play in East Texas where it has successfully completed three horizontal producers since initiating this program in the second half of 2012. Forest currently holds approximately 19,000 gross (14,000 net) acres within this concentrated area. The Company is currently engaged in the integration of 3D seismic data with geological and well data and expects to commence additional drilling activity in this area during the second half of 2014.

Our total capital budget remains unchanged at $300 million, at the midpoint of our guidance range, but the drilling and completion component of the capital budget is now allocated 64% to Ark-La-Tex and 36% to Eagle Ford, compared to 23% and 77% previously.

Implications For The Stock

Challenges related to the faulting in the southern portion of Forest's acreage are understandable (offset operators have also mentioned the issue). The decision to re-process seismic to obtain better subsurface imaging in the problem area is logical. However, the three wells that encountered faulting will hardly explain, in investors' eyes, the weakness of the average 30-day IP rate for the latest 17 wells.

It is important to take into consideration that by this time Forest has most likely fully utilized the drilling carries from Schlumberger (SLB) and has completed retention drilling obligations on the larger portion of its block. This might have been a factor in the company's decision to reduce the pace of drilling. Another factor may be the fact that acreage is still available in the Eagle Ford for leasing and Forest may have a choice of actively developing its existing block versus trying to put together acreage in other, potentially more promising areas of the play.

Management's decision to redirect capital to the most attractive drilling prospects is a positive development. However, the slowdown of drilling pace in the Eagle Ford does not send an optimistic signal with regard to the prospectivity of Forest's acreage. Moreover, the lack of consistent well results in the Eagle Ford after three full years of operatorship (including more than half a year of best efforts by Schlumberger who has contributed as a highly involved operating partner and the subsurface and completions expert) is certainly disappointing and reiterates concerns regarding the quality of the acreage and the JV partners' ability to deliver predictable, competitive returns operating it.

Given that the Eagle Ford has been viewed as Forest's most promising prospect, the task of demonstrating to the market that the company has an adequate, competitive asset platform for profitable growth still remains incumbent on the management team.

Despite the dramatic re-pricing in the past six months, Forest's stock (current price of $2.00 per share) still implies a premium to the company's PV-10 value. In the 10-K form filed two days ago, Forest reported that its proved reserves at the end of the year had PV-10 of ~$726 million (the computation is based on the SEC case pricing of $3.67 per MMBtu and $97.33 per barrel). Part of the PV-10 value is attributable to PUD reserves that will require $676 million of capital to be fully developed. By comparison, the company's Enterprise Value is currently ~$920 million ($240 million equity value plus $735 million of net debt at year end less assumed future receipt of the $54 million escrow deposit related to the sale of the Panhandle assets).

For the stock to move higher, the market would need to have confidence that the company's future drilling effort will create value to substantially grow the PV-10 and also cover general expenses.

While there is clearly significant value associated with Forest's acreage, both in the Ark-La-Tex region and Eagle Ford that is held by production. Forest's Panhandle transaction vividly demonstrated that the divestiture market is challenging. In its 2013 divestitures, Forest was able to receive $1.3 billion for properties that had PV-10 value of $1.1 billion. The premium to the PV-10 value was moderate, despite the high quality of Forest's core Panhandle asset.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Forest Oil: Strategic Challenges Are Not Over

Disclosure: I 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. (More...)

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