In a recent article I took a closer look at troubled oil producer Penn West Petroleum (TSX: PWT)(NYSE: PWE) to determine whether it is truly undervalued. A number of market pundits have called it a bargain buy due to its low price-to-book multiple and its improving fundamentals, including higher prices and narrowing price differentials for Canadian crude.
These claims mirror those being made about another troubled Canadian intermediate oil producer in the midst of its own strategic turnaround: Lightstream Resources (TSX: LTS). In my earlier article I concluded that Penn West was fast approaching fair value, with a number of factors weighing heavily on its profitability. So now let’s take a closer look at Lightstream and see whether it is undervalued.
A key driver of these claims is Lightstream’s low price-to-book multiple of 0.8, which indicates it is trading at a 20% discount to its net asset value. But this book value takes into account all of Lightstream’s assets, including those marginal assets earmarked for divestment.
Like Penn West, the aim of Lightstream’s restructure is to restore its balance sheet and conserve capital, with a key component being the divestment of producing and non-producing assets so that the proceeds can be used to pay down debt. This has seen Lightstream complete divestments totaling $335 million to date, with the proceeds of those divestments earmarked to reduce its massive pile of debt so that its net debt is reduced to 2.5 times its funds flow by the end of 2015.
What is Lightstream’s indicative value per share?
While it is easy to rely on a range of ratios to determine whether an oil company is undervalued, ranging from generic to industry-specific, the key determinant of an oil producer’s value is the value of its core assets, or oil reserves. This is different from an oil company’s book value, because it only takes into account the net present value, or NPV, of all future cash flows generated by those reserves, with a 10% discount rate applied to future values in order to give an NPV.
Plant, equipment, and other fixed assets, which are included in calculating book value, are typically deemed to have no value to an oil producer because they are solely the means of production.
Currently, Lightstream has discovered net oil reserves of 198 million barrels of crude after the most recent divestments are taken into account. These reserves, before income tax and with a 10% discount rate applied, have an NPV of $4 billion, which equates to $19 per share, or almost 2.5 times higher than its current share price.
After taking into account income tax, this value drops to $3.2 billion, or around $15 per share, which is an 85% premium over Lightstream’s current share price. After deducting Lightstream’s massive pile of net debt, totaling $1.7 billion, the company has an implied market cap of $1.5 billion, or around $7.40 per share.
This is almost 9% lower than its current share price, indicating just how much of a burden Lightstream’s monster debt load is for the company. It also indicates, after seeing its share price recover by a massive 37% for the year to date, that Lightstream is trading at or near to its indicative fair value per share.
However, Lightstream has some considerable advantages over Penn West, including a higher proportion of its production mix being made up of crude liquids. For the first quarter of 2014 they made up 80% of that production mix compared to 65%, leaving it better positioned to take advantage of higher crude prices.
Furthermore, Lightstream only produces light and medium crude, which trades at a significantly lower price differential to WTI than Canadian heavy crude, which for the same period made up 12% of Penn West’s production mix.
Lightstream is also generating higher margins for each barrel it produces than Penn West, making its oil and gas production more profitable than Penn West’s. For the first quarter of 2014, Lightstream reported an operating netback per barrel of $56.11, which is 53% higher than Penn West’s $36.67 for the same period.
The key drivers of this higher profitability are Lightstream’s lower operating costs and capital expenditures, required to sustain production because of higher asset quality and lower well decline rates.
This indicates that if — and I stress if — Lightstream is able to bring its debt problem under control, the company’s financial performance is set to rebound, and this would drive its share price significantly higher. But at this time it is still a gamble for investors as to whether Lightstream can successfully pull off its restructure.