Torsten Asmus
Searching For Wonderful Businesses: Evolution Petroleum
Investing in the Oil & Gas sector can be challenging. There are also numerous ways to obtain exposure, such as through investment into supermajors, refiners, pipeline companies, oilfield suppliers, drillers and royalty companies. The industry is also cyclical, with the companies operating in the sector often vulnerable to excessive expansion and frequently find themselves overleveraged. The specter of regulation also looms large, particularly when a major disaster occurs.
Yet investment in the sector can also be profitable, and if timed right, immensely so. If the proper company is found, there can also be an opportunity for substantial value to be realized and compounded over a series of cycles. Due to the industry’s inherent cyclicality, significant profits can be made while sifting through the wreckage of a bust and having the conviction to invest when the sector is deeply out of favor, as these conditions are often transitory. When there is excessive supply, wells are shut in, companies go bankrupt, capital expenditures slow and new drilling grinds to a halt – which in turn creates scarcity, sowing the seeds of the next boom.
I have seen several cycles play out over my time spent observing the markets, and many companies have come and gone. The ones that have managed to survive and reward shareholders all exhibit the same characteristics: conservative balance sheets, strong management, quality assets and disciplined capital expenditure. Though these companies may be found throughout the sector, there is one subset that I believe to be particularly attractive due to the lack of capital employed and potential for growth – that of royalties.
Most companies available to investors that own Oil & Gas royalties are structured as Royalty Trusts or Master Limited Partnerships and due to these structures, they must pay out most of their earnings, leaving little room for capital reinvestment or organic growth. They may also dilute shareholders, leave them burdened with cumbersome tax filings or in the case of royalty trusts dissolve outright during periods of low commodity prices or after a predetermined length of time.
However, not all royalty companies need to be structured in this manner. One company, organized as a C Corp, is Evolution Petroleum (NYSE:EPM), a company that I believe to be a particularly attractive long term investment for investors seeking exposure to Oil & Gas as well as an interesting vehicle for speculators. The company is a small one, and after a long period of relatively little activity, it has sprung to life and has executed several well timed acquisitions that have significantly increased its earning power and left it well positioned for future earnings growth.
What Evolution Petroleum Does
Founded in 2003 and headquartered in Huston, Texas, Evolution Petroleum invests in royalty and working interests for Oil & Gas properties across the United States. The company currently has assets in the states of Texas, North Dakota, Louisiana, and Wyoming. In addition to purchasing royalty interests – giving property owners the right to royalty income, the company holds working interests – which give owners the right to further develop and exploit the properties they hold title to.
Evolution Petroleum does not directly operate any of these properties, and instead collaborates with co-owners of the underlying assets as an operating partner, leaving the company free to incrementally deploy extra capital into the asset through additional drilling programs, workovers, or equipment upgrades to increase or maintain productivity.
The company is uniquely attractive for several reasons. It typically operates with no debt, with a capital light structure, and invests in overlooked Oil & Gas assets that are typically both of a smaller size and closer to the end of their lifespan. The company also typically does not hedge its production, something enabled by its lack of operational debt.
The Numbers on Evolution Petroleum
Currently priced at $7.16 per share, with a market capitalization of $231 million, Evolution Petroleum is a small company with eight employees. With a forward P/E ratio of approximately 6, and a dividend yield of approximately 6.7% ($0.48 annually) at current market prices, the company provides shareholders an attractive yield at a relatively low valuation. Due to the company’s capital light structure, it is also very profitable – with a net profit margin of 29%. The company has a total of 33.13 million shares outstanding, with significant insider ownership. The founder and current chairman of the board, Robert Herlin, owns slightly over 5% and total insider ownership amounts to approximately 9% of outstanding shares.
Though the company typically operates with zero debt, the company takes on debt to conduct acquisitions in addition to cash reserves on its balance sheet, and currently has a small amount of acquisition debt remaining, an amount that management has stated will be likely extinguished by the end of calendar year 2022, leaving the company debt free in 2023 in addition to a cash balance of approximately $10.7 million as of the most recent quarter.
Per the most recent investor presentation, the company currently produces approximately 7,500 BOE per day across a total of five properties, with combined proved reserves of 36 MBOE. The current commodity mix of the reserves is approximately 32% oil, 49% natural gas, and the remaining 19% NGL’s.
Unconventionally Attractive Assets and Disciplined Acquisitions
I believe that a major competitive advantage for Evolution Petroleum is the nature of the assets in which it invests. In contrast to capital intensive companies operating in the sector which typically seek to identify and develop new petroleum resources, Evolution Petroleum invests in established assets with a low decline rate.
Conceptually, I believe that an analogous type of business practice is found in the insurance industry, where specialized companies purchase “run off” lines from larger insurance companies. This practice occurs when the principal insurance company has decided to no longer underwrite a line of insurance and instead lets the policies expire, or “run off,” while the acquiring company pays a fixed price in cash and collects the premiums that are received for the duration of the remainder of the insurance line while assuming the risk.
For those who have not encountered this term, the “Decline Rate” is the natural rate at which production declines until the resources of an asset are fully depleted. Wells drilled with fracking typically experience the majority of their production in the first few years of life, after which production declines significantly at a high rate of decline.
In contrast, Evolution Petroleum focuses on established assets that have been producing for a long time (in the case of one of their Wyoming assets, over 100 years), with very low decline rates, and replenishing their reserves through acquisitions made at attractive prices. Due to the company’s small size, Evolution Petroleum is able to purchase assets that would not “move the needle” for larger companies, allowing it to take advantage of opportunities that may be economically very attractive but would be ignored by larger operators. After purchasing these assets, Evolution Petroleum also retains optionality, and can deploy capital to improve their productivity if the economics make sense.
I believe that in the current environment, it is somewhat unlikely that Evolution Petroleum will engage in further large acquisitions, particularly given the fact that the company has grown its production almost fivefold in the past four years.
An Underappreciated Latent Catalyst: A Denbury Acquisition
The Delhi Field, Evolution Petroleum’s first (and for much of the company’s life, only) asset, per page 8 of the company’s most recent investor presentation, accounts for approximately 15% of Evolution’s total BOEPD production. The Delhi Field is located in Louisiana and enjoys a premium valuation for its oil, which is priced off of Louisiana Light Sweet Crude, and is operated by Denbury (DEN), an EOR company that recently emerged from bankruptcy. Shares of Denbury have done extremely well since its reorganization, and the company now boasts a conservative balance sheet. Denbury specializes in C02 injection, which produces oil at both a low cost and with a low carbon footprint; two desirable attributes.
To make things more interesting, Exxon Mobil (XOM) was rumored to be in talks to acquire Denbury Resources earlier this year. Though I do not believe that an acquisition will necessarily transpire, it does raise important questions about the effects of a potential acquisition of Denbury for Evolution Petroleum.
A significant portion of the Delhi Oilfield has yet to be developed, and the acquisition of Denbury by a larger operator such as Exxon Mobil, another supermajor, or Occidental Petroleum (OXY) (an EOR specialist) would likely increase the amount of capital invested in the field as well as the rate of development, potentially significantly increasing its productivity which would then benefit Evolution Petroleum in turn. In addition, should a large company acquire Denbury, Evolution Petroleum will benefit from a (presumably) higher quality and more stable operating partner or perhaps receive a one-time cash payment and have its interest in the field acquired as part of the Denbury transaction.
Share Repurchases When External Acquisitions Don’t Make Sense
Prosperity is often dangerous in cyclical industries, as long periods of it can prompt management to increase operational risks only to be caught in a compromising position when the cycle inevitably turns or, to paraphrase Warren Buffett, risk being caught “swimming naked when the tide goes out.” One method of mitigating these risks is for companies to utilize low or no leverage, which allows them to reduce or totally avoid the risk of bankruptcy in the event of a sharp downturn. Acquisition discipline is another, as purchasing assets at high valuations during good periods can turn disastrous when conditions reverse.
In addition to practicing the first two methods, Evolution Petroleum has recently instituted a $25 million dollar share repurchase program, which I believe is extremely prudent when it comes to creating long term value and mitigating the risks of a downturn by opportunistically repurchasing shares at attractive prices.
In contrast to Royalty Trusts and Master Limited Partnerships, Evolution Petroleum is able to easily repurchase shares due to being organized as a C Corp, and now has the option of providing shareholders with increased exposure to the earnings power of its existing asset base, at potentially significantly attractive valuations, by means of repurchasing shares in the public market.
If fully exercised at current price levels over the course of a year, the company would be able to repurchase approximately 10% of its total outstanding shares, which could potentially translate to a 10% increase in earnings per share as well as a 10% dividend increase. The company can also theoretically pay a special dividend if it finds itself flush with cash with no acquisition on the horizon or reinvestment opportunities available in its current portfolio.
The presence of this program also helps reduce the temptation of participating in “empire building” behavior through a series of sub-par acquisitions that can ultimately erode shareholder value – the hazard of which is omnipresent in cyclical industries like Oil & Gas.
Risks
In spite of being insulated, Evolution Petroleum is not immune from risks which abound in the Oil & Gas sector due to its inherent cyclicality.
The first and foremost risk is that of valuation and earnings quality. Due to the fact that Evolution Petroleum typically does not hedge its commodity exposure, investors are vulnerable to a significant variance in earnings, and must be aware that the earnings power of the business is typically tied to the performance of the Oil and Natural Gas markets. Though hedging is occasionally employed in accord with the terms of the company’s credit facility through which acquisitions are funded, or in the case of extremely anomalous events such as the aftermath of the Covid-19 pandemic, investors must make peace with the fact that there will be significant earnings volatility – for better or for worse.
Another risk to be aware of is counterparty risk, as Evolution Petroleum does not operate any of its assets and instead depends on its operating partners. Any issues with its partners at the corporate or field level could potentially effect production, leading to a drop or cessation in asset productivity.
Acquisition risk is another thing to consider. Evolution Petroleum’s acquisition record has, thus far, been quite satisfactory – however it is important to be aware of the fact that a larger acquisition conducted later in the cycle could carry significantly more risks – particularly if debt is used. Share repurchases may also carry risk, if the company’s shares are acquired at prices that are too high relative to the intrinsic value of the company.
The company’s small size is another thing for investors to consider – as the departure or incapacitation of key personnel may reduce the operational capabilities of the company as well as the intellectual capital of the firm, which is necessary for making intelligent operational and acquisition decisions.
Conclusions
I believe that Evolution Petroleum is an attractive long term investment for investors seeking to obtain exposure to Oil & Gas while avoiding some of the pitfalls that plague the broader industry. As a result of its structure and shareholder orientation I believe that long term shareholders have much to look forward to including further acquisitions, increased productivity of existing assets, growing dividends, the presence of a latent positive catalyst combined with incremental value generated through share repurchases over the coming cycles.
Though current price levels are attractive, I would caution investors to gradually purchase shares – and add the company to their watch lists in the event of a sharp or prolonged downturn in commodity prices.
Additionally, I believe that because the company does not hedge its commodity exposure, that shares of Evolution Petroleum may function as an attractive speculative vehicle during periods of significant volatility in the Oil and Natural Gas markets. Should any events occur on the global stage that cause the price of oil or natural gas to increase for sustained periods, traders can likely expect that Evolution Petroleum will announce an earnings beat in the coming quarter.
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