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Penn West Energy Trust: My $50 Price Target

by: Jack Yetiv May 22, 2008 | about stocks: PWE    

Jack Yetiv

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Folks who have read my articles on this site know that I don’t usually set price targets on stocks that I like. However, the current circumstances pertaining to Penn West (PWE) requires that an exception be made to this rule.

PWE is a Canadian Royalty trust (“Canroy”) about which I wrote an article three weeks ago. This follow-up article will build on what I said in the previous article, so I will assume you have read that article before proceeding to read this one. The reason for writing this update is that oil and gas have increased significantly since I wrote my article three weeks ago, essentially guaranteeing an outrageous earnings report when PWE reports its second quarter in a little over two months.

As we all know, oil has been hovering in the $120s the past couple of weeks, and broke decisively into the $130s this week, hitting an unprecedented high of $134 yesterday (5-21-08), as (I wrote this article). And PWE has risen more than 10% since I recommended it at $31 three weeks ago. However, what the market has failed to appreciate is that given the recent rise in oil and gas prices, PWE’s projections of a few weeks ago are very likely to be surpassed by a substantial margin.Speaking very simplistically, the metric most commonly used to value the Canroys is the “funds flow” (“FF”). FF is used by a Canroy for three general purposes: (1) to pay large dividends (PWE’s dividend yield is about 11.7% at yesterday’s closing price of $34.82), (2) to fund capital expenditures, and (3) other things are done with any FF left over.

Traditionally, not much is usually left over after dividends and capex are paid out of FF. Indeed, in 2007, several of the Canroys had to cut dividends because the FF barely even covered the dividends alone. A second issue for Canroys is that even if FF fully covers dividends, often the Canroys have to do equity offerings in order to fund their capex, which of course dilutes the metric of FF per share (which are called “units.”)

In contrast to the “normal” situation (eg. 2007), here is what PWE projected for 2008 when it announced earnings three weeks ago: FF of $2.7 to $2.9 billion, minus around $1 billion in capex and around $1.4 billion in dividend payments. These numbers would therefore leave $500 million in category (3) monies in 2008--monies that have never been available at these levels before. Because PWE had substantial debt as a result of some recent acquisitions, PWE announced that they would use these monies to retire debt and strengthen their balance sheet.

The above numbers were sufficiently compelling for me to suggest, in my previous article, that a 30-40% appreciation rate in this calendar year (ie. in 8 months) was a very reasonable expectation, with relatively little downside risk (unless one believed in early May that $80 oil and $7 gas was just around the corner, in which case PWE would be a terrible investment). But, as we all know, oil has not gone to $80 nor gas to $7.

So the question now is, what has changed that has prompted me to now call for a target of $50, which represents a further appreciation exceeding 50% (in you include the dividend) from yesterday’s close?

What has changed is that oil and gas prices have continued to increase, and although the debate continues as to what the “correct” price for oil and gas should be, very few people have made a compelling case that oil will ever go below $100 or gas below $9 (my short answer to this - OPEC will never allow oil to go below $100, and OPEC can easily prevent $100 oil simply by trimming production by 2-3%). In fact, more experts now believe that oil is more likely to see $150 this year than $100.

Although I’m far less convinced than others that we will see oil averaging $150 this year, I highly doubt we’ll see $100 oil because OPEC won’t allow it.

And here is where the recent change in oil and gas prices is critical to the evaluation of PWE: When PWE projected funds flow of $2.7 to $2.9 billion this year, it did so based on the assumption that oil would average $107 and gas would average $8.50 this year. If you believe, as I do, that these numbers are conservative, the upside to cash flow is substantial. For example, if oil averages $120 (it’s $134 yesterday) and gas averages $10 (closed at $11.72 yesterday) in 2008, my back-of-the-napkin calculations suggest that funds flow will be closer to $3.2 billion than $2.8 billion.

After deducting $1 billion in capex, that will leave $2.2 billion that can essentially be considered the equivalent of “earnings” (this is not strictly true, but will do for our purposes). If PWE were a normal corporation, this would translate into a PE of about 5. To look at it a different way, if PWE were to distribute all of these “earnings” as dividends, the dividend yield would exceed 20%. To look at it a third way, PWE’s “net profit margin” (or operating margin) would be in excess of 20%, and not too many companies can claim that level of profitability.

Obviously, this whole analysis depends on oil averaging at least $107 and gas at $8.50 this year. If you believe these are not realistic assumptions, you should avoid this stock and almost any stock in the oil and gas fields. If you believe, however, that oil is likely to average in excess of $110 and gas at least $9 this year, then you should load up the boat on this one. In addition to the risk of lower oil and gas prices, there is always risk of new taxes being passed, but this is a wild card that I can’t really properly value.

For various reasons, however, I think it is unlikely that the Canadian govt will pass additional onerous taxes given that it has recently already done so.It should be noted that there are several other Canroys I like, including Provident Energy Trust (PVX) and Advantage Energy Income Fund (AAV), but PWE is the most compelling of the group.

One final thought: Unless oil crashed to $100 and gas went to $8 tomorrow and stayed there until the end of the second quarter (and I consider this rather unlikely), PWE is just about guaranteed to announce a blowout second quarter in a couple of months because oil and gas have already substantially exceeded the $107/$8.50 averages in PWE’s projections, and because we are almost 2/3rds of the way through the second quarter. It seems to me this provides substantial downside risk protection for PWE and most of the other Canroys.

Disclosure: As you may have guessed, I am long PWE.

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This article has 48 comments:

  •  
    May 22 08:29 AM
    While I think AAV may rise to $18, my feeling is that they have hedged away a substantial portion of their upside. I own PWE by proxy. Petrofund and Canetic died to leave me with this piece of Blank. They lied regarding the PetroFund distribution, they hide assets, other people think its great. So I still hold it but will dump it in favor of Pengrowth.

    I am also long PVX from $8.50, already paid for itself, long life plus pipeline and GTL. And Harvest at an average of about $25 more than half paid for...Try Replacing that refinery of theirs.

    I like the CanRoys but Pwe is definitely on my sell list, my Target was $48 but $50 is a little bit better, still will unload in low forty's if PGH is still alive.
    Reply
  •  
    May 22 08:46 AM
    Very informative article, I believe you are right on this stock as royalty trusts seem to have legs going forward and should continue to over the rest of 2008. I believe this whole sector is headed for multiyear highs as most charts are looking very bullish. The double top breakout as of May 19th, points to a bullish trend target of $58. Thank you for all of the information.
    Reply
  •  
    May 22 08:48 AM
    Jack,

    I have enjoyed reading your articles, which my brother recently tuned me on to.

    If you don't mind a basic question, I was wondering if you could explain the relationship between the funds flow and the reported earnings per share number of $0.22, which appears to have been $.32 below the single analyst estimate for the first quarter. I'm sure a basic question some would have would simply be, how could the first quarter news be very good, and yet be significantly below the estimated EPS.

    Reply
  •  
    May 22 08:49 AM
    Jack - what do you think of the prospect of PWE or PGH being likely buyout candidates by the major integrated? I wasn't too surprised when Conococo-Phillips bought Burlington Resources, however I was surprised at the premium they paid.

    ( Conococo - I type poorly, but it sounds great, I think I'll just start calling them that from now on, it has a nice "commodity bubble" sound to it)
    Reply
  •  
    May 22 10:04 AM
    I have owned several canroys for the past 3 years.............they dont owe me a thing. I do not understand your issue with PWE as it has gone from the lows of the Halloween Massacre to its current price and with a bit more time may yet hit that $50 mark...........They aint making any more or oil!.....................
    Reply
  •  
    May 22 10:05 AM
    Jack, a question for you. PWE has cited under their new CEO that all their CO2 enhancement projects would depend on a single supplier, not a multiple supplier scenario as previously thought.

    Also, the new CEO talks up exploration of all the new and old lands alot more than the older management team.

    The question is: Is this a shift away from Pembina and Swan Hills tertiary programns and is management hinting at switching capex to a good old fashion explore and drill for conventional oil and gas? Good Lord knows they have the land to do it.
    Reply
  •  
    May 22 10:08 AM
    PWE would be an excellent acquisition. I conservatively value 200mb/d at $15B, just about their EV. Plus they have $5B in tax pools which, for the right Canadian company, could be as good as cash. Plus loads of undeveloped land and an oilsands play. However, there are few Canadian companies that big.

    Could a US company use the tax pools?
    Reply
  •  
    May 22 10:17 AM
    PWE stirs more blog interest than almost any single issue. Question for everybody: Did anyone out there buy PWE when it hit its lows of 23 and change to 28.oo per unit early this year?
    Anybody double down at those prices?
    Reply
  •  
    May 22 11:02 AM
    Your article may be a little misleading as PWE hedges a lot of ther production at a much lower price than the spot price for oil. As such they do not benefit much from the high oil price.
    Reply
  •  
    May 22 11:10 AM
    PWE looks good it may need some time though for consolidation, as far as picking up a long... I'd wait for the $32 range

    www.investorslive.com/...
    Reply
  •  
    May 22 11:16 AM
    Yes, lots of mid twenties, and some as low as 13.40 . No one mentioned the compounding of their drip program. My wife wants the divi's, I want the compoundig drip!
    Reply
  •  
    May 22 11:18 AM
    I believe they are about half hedged. They have some oil sands production and possible exposure to the Bakken shale. However, the distribution after the trust tax goes into effect in 2011 will be more like conventional oil cos.
    Reply
  •  
    May 22 11:47 AM
    Thanks Jack.
    PBT & PVX treating me well.
    AAV is next and now I guess PWE.
    Reply
  •  
    May 22 12:11 PM
    I find CanRoys tricky. I bought ERF a year ago when oil was ~70 a barrel and haven't made a dime (other than the dividend which is substantial). I bought pwe more recently and have done pretty well capital gain wise. I bought pwi and the arabs bought it. It's hard to believe that operationally, erf is that different that pwe and pwi. One person above makes a good point that if nothing else, these Canroys represent a claim to a lot of oil in a country that respects the rule of law, that is important.
    Reply
  •  
    May 22 01:18 PM
    With regard to hedging, PWE has hedged 42K barrels of its daily production of 109k barrels (excluding Natural Gas) with a cap of $81 until the end of 2008. Assuming they can sell the uncapped 67K BOE at an average of $120, they should achieve an average income of $107/barrel though to December. Jack, presumably your analysis already reflects this.
    Reply
  •  
    May 22 02:56 PM
    i bot pwe at 24 and bot more at 34. they have great unexplored assets. plus oil is likely to remain high. plus a great dividend. but i laso own solar stocks.
    Reply
  •  
    May 22 03:33 PM
    Some quick answers.

    Most important, hedging, which was partially answered above. None of the Canroys are fully hedged, and as noted above, PWE is about 1/2 hedged in 2008, and even less so in 2009. When PWE made its projections based on $107 oil/$8.50 gas, IT TOOK INTO ACCOUNT the amount that was hedged that would not generate ANY increase in revenue until the hedge fell off.

    PWE presented a sensitivity analysis showing how much extra funds flow it would get for each dollar of oil about $107 and each 10 cents above $8.50. When I did my calc in early May, I concluded that if oil averaged $120 in 2008, and gas was at $9.50, their FF would increase about $400-500 million. That is a HUMONGOUS increase because after the capex and the dividends are paid, it essentially DOUBLES the amount of "leftover uncommitted" cash flow.

    And the market is giving that mathematical (almost) certainty (as long as oil and gas prices don't crash) very little credit.

    Which gets me to the next point--Canroys. They sure are weird in terms of price appreciation or lack thereof. The kind of events that should goose them by 20% maybe move them by 5%. In essence, THAT recognition is why I wrote my article.

    I do believe, however, that this is changing. Look at how BTE has moved in the past month or two, and even AAV since it announced earnings a few days ago (up about 10%). That didn't happen with PWE last quarter. I think there is a decent chance it will happen this coming quarter. THAT is also one of my messages in my article.

    More comments later.

    Jack
    Reply
  •  
    May 22 03:45 PM
    OK, as to tax pools--I have no idea if they could be sold to a US or even a Canadian company. I just don't know. What I do know is that the pools PWE will have will protect it from the SIFT tax until 2014, so I suspect they will hold onto their pools.

    Re: buyout--anything is possible, but PWE is pretty big (market cap around $16 billion I think), so it would take a big buyer. In addition, their business model as Canroys is quite different that the oil integrateds in the US, so I'm not sure there will be a good fit.

    Re: CO2, tertiary programs and normal E & P--their capex covers all of them. CO2 won't produce much in 2008 nor will their sands projects, so they have to concentrate on the bread-and-butter that pays the bills. But CO2 and sands are a large part of the future, so they are definitely putting cash into them even now.

    Earnings vs. FF: earnings don't mean anything in this business for reasons too complicated to get into. But I think funds flow minus capex compared to price is a fair substitute for PE.

    Finally, will PWE consolidate at $32? Hell, I dunno. But I know it shouldn't, for two reasons. One, PWE is ridiculously underpriced and offering a 12% dividend yield that almost 100% secure. Two, it has moved very slowly from $30 to $34--about 3 weeks. At that speed, it's sort of consolidating along the way.

    I bought more today in the $34.70 range. I'm looking for $50 by the end of the year--I won't worry about getting in at $34 versus $32.

    Jack
    Reply
  •  
    May 22 04:44 PM
    good article, thanks.
    Reply
  •  
    May 22 06:03 PM
    Bythe way, if you want a different view of this company, please see David Bui's article published today on SA. I think it is well-written, although the perspective is a bit from the negative side. Mine might be too positive. One should read both to get a balanced view.

    See also my questions to him to see if we can resolve our difference of opinion.

    Jack
    Reply
  •  
    May 22 06:11 PM
    SO glad I have almost all of these in one form or another... they helped me weather the financial crunch!
    Reply
  •  
    May 22 07:07 PM
    My analysis is pretty consistent with yours.

    1. Just a bit of clarity on your numbers. Right after the earnings report I came up with the $500 million in extra available cash flow after distributions & capex figure as well. However, during the conference call mgmt said that it would be "as much as" $500 million. If I remember correctly the answer they gave to the question was " 300 to as much as $500 million".

    2. You didn't work acqusitions into your mix. PWE just made a smaller one, and even though they have a lot of prior acquisitions to finish digesting, I suspect they will continue buying out smaller players whose price are not valued as high as PWE's on a $/bbl produced or $/bbl of reserves basis (pick up some additional tax pools before the new tax regime hits as well).

    Best of Luck....
    Reply
  •  
    May 22 08:21 PM
    Your analysis and David Bui's sound so diametrically opposed to one another that one has the sense that you are each writing about a different entity. Perhaps Q2 will be decisive in terms of which way the wind is blowing. You confidently maintain that a fairly spectacular quarter is in store while David continues to be sceptical of PWE's near term and long term future even as he looks at the very same data. One of you, it seems, is destined to do what people around here do all the time in the Washington,DC area: revise and extend one's remarks. I bought PWE before you came out with your original piece, Jack, and will continue to hold onto my units--at least until I can see what is behind the Q2 curtain. May the only surprises be welcome ones.
    Reply
  •  
    May 22 10:38 PM
    Well, there is one area of similarity between Bui's and my piece--I agree with him that management is not the greatest. BUT, that was the OLD management, and yet PWE is being punished for it--maybe fairly, maybe not.

    But it is that VERY punishment that makes PWE's value compelling because it gives double upside to PWE if it improves its management (the other part of the double is oil/gas prices)--with little downside risk--again due to commodity prices.

    Let me put it a more gross way--even if the management remains bad, PWE will still have a strong (probably record) second quarter if oil stays where it is right now. But if commodity prices go stronger, AND the new management improves on the old (not THAT hard a job), and the integration of Canetic and Vault goes better than expected (all plausible possibilities but no guarantees), then PWE will blow the second quarter out of the park.

    Obviously, I believe the latter scenario, and on that basis, I am calling for a $50 price target after TWO more quarters are announced. I also expect that with the November announcement, they will announce an increase in dividends (won't happen next quarter--they want to pay off some debt), and that will give the stock an extra few dollars of run.

    But even if I am wrong, I just don't see much downside risk even if management remains sub-par because commodity prices will still give them a very good quarter.

    So, if I am wrong, you will collect 12% dividends and maybe see 10% appreciation (actually, it's already gone up 10%+ frrom where I recommended it). If I am right, you'll get 50% by the end of the year. And downside risk is very limited.

    How many stocks give you that set of potential outcomes? Normally to get 20% return, you have to take on a lot of risk. In this stock, I think 20% is almost a given (barring taxation or collapse in oil/gas prices), with decent upside from there.

    Jack
    Reply
  •  
    May 23 12:30 AM
    Hi Jack

    I have an alternative energy situation that I would like to discuss with you. crcjunior@yahoo.com

    Regards
    Rick
    Reply
  •  
    May 23 11:59 AM
    "David Bui on SA" ??? Where does one find that piece?

    Wayne
    Reply
  •  
    May 23 09:56 PM
    SA--Seeking Alpha. His article appeared today, 5-23. You can search under author's name.

    It's a good article, raises some good points, and is followed with lots of good comments (and some not so good).

    Jack
    Reply
  •  
    May 24 07:46 AM
    I sold out of the last of my Penn West Friday. Actually, in all honesty, I bought it so long ago I can't remember what it was called then. I did have some Canetic. I had a company called Viking. This was when gas was Natty was $1/1000 cu ft.

    I just wanted to write and thank you for buying my investment from me so near the peak. It's not often that you get to thank the person who catches the last wave of the bull run and nievely buys your investments at ridiculous prices.

    So, again, thanx dude. Tell me you also bought that BHP BIlliton I shorted last week.

    Reply
  •  
    May 24 11:30 AM
    dont they hedge their production?
    If so they may not be realizing the spot prices
    Reply
  •  
    May 24 09:24 PM
    You liked Thornberg when it was over $5 a share,
    now that's it's down below a $1, do you still like it?

    How far down will you ride this one?
    Reply
  •  
    May 26 07:59 AM
    i live in edmonton alberta and ill tell you that southern alberta is sitting on hells kitchen. Everywhere they drill they hit gas and just end up capping it. At the begining of the 1900's they drilled a well and sparked a fire that burned the equivelant of 200 000 cubic meters a day....it burnt for 26 years. If natural gas keeps going the way its going look out. Just a little fact i thought id pass along.
    Reply
  •  
    May 26 07:59 AM
    i live in edmonton alberta and ill tell you that southern alberta is sitting on hells kitchen. Everywhere they drill they hit gas and just end up capping it. At the begining of the 1900's they drilled a well and sparked a fire that burned the equivelant of 200 000 cubic meters a day....it burnt for 26 years. If natural gas keeps going the way its going look out. Just a little fact i thought id pass along.
    Reply
  •  
    May 27 11:46 AM
    Hello Jack,

    A put or shut up challenge, I love it. For some reason I was unable to post on the latest Bui article on PWE. Hope you see this post.
    Reply
  •  
    May 27 11:47 AM
    Jack, give me 24 hours and I'll get back to you.
    Reply
  •  
    May 27 05:22 PM
    Steve, Jack here.

    I'm not sure what you are referring to. Please enlighten me!

    Jack
    Reply
  •  
    May 28 12:38 PM
    Jack,

    Like yourself, I have been loading up on PWE and bought another 114,000 units at 24.60 believing like you that this will be a $50 equity by the end of 2008.

    My question pertains to the unit price decline nearing the dividend date. What is your (or other members of this board) view on the relationship between dividend date and unit price. Is this a typical dip or does it have more to do with the recent volatility in oil prices?

    Is there a 52 week high barrier that we are dealing with as well?

    I'd be interested in your thoughts.

    Bob
    Reply
  •  
    May 29 05:06 PM
    Bob, I have noticed that PWE is affected by ex-dividend date of the 28th of the month. All things being equal, PWE will go up toward the 28th and down on the 29th.

    Of course, this week has been affected by profit-taking in the oil and gas complex as well as PWE going ex-dividend.

    We're now 2/3rds into this quarter and even after today's drop to $126/$11.46, there is a very good quarter baking. I would say oil has averaged close to $120 so far in the second quarter, and gas has averaged close to $10.50. PWE's very exciting projections were based on $107 and $8.50.

    EVEN if oil were to go to to $100 and gas to $8 tomorrow, this quarter would probably still carry averages over $107/$8.50, and I think PWE would still announce well, but of course the stock would go lower than where it closed today.

    As to 52-week high--I think PWE has been as high as $37 or $38, maybe 8 months ago, and there will probably be some resistance there, but I don't see that as being a big barrier if oil/gas are still at $120/$10, which I think is likely.

    Obviously, if oil/gas go below $100/8.50, all bets are off.

    Jack
    Reply
  •  
    May 30 08:43 PM
    Jack

    How does the take over of Endev effect the unit price and/or the dividend?

    Taurino
    Reply
  •  
    May 31 09:21 AM
    Jack,

    Thanks for the reply. I am staying the course with PWE.

    In an earlier post, you were strong on HTE. Have you revised your position on investing in Harvest?

    Also BPT is small but is considered to be significantly undervalued at its current price. The Street.com rates it as a BUY with an A rating. Have you looked at this Trust? What are your thoughts on a US grantor trust (besides the taxation issue)?

    Bob
    Reply
  •  
    May 31 03:32 PM
    Endev has minimal impact on PWE because it is a $170 million acquisition for a $15 billion enterprise--essentiall... 1%. PWE did buy it at a decent price, as I recall, of $49,000 per flowing barrel because I believe the deal was reached some months ago.

    HTE--I posted on this probably 2 months ago whe