Imagine the following scenario. I’m holding the ace of spades and the ace of hearts. For $20, I offer you a deal. If, after I randomize the cards, you can pick the ace of spades, I’ll give you $60. If you pick the ace of hearts, I get to keep your $20. You only get one shot at it. What would you do? If you had an unlimited amount of opportunities, the smart move would be to play this game all day long. But it’s entirely different if you’re only given one chance, since we know odds generally even up over…
To keep reading, enter your email address or login below.
Imagine the following scenario.
I’m holding the ace of spades and the ace of hearts. For $20, I offer you a deal. If, after I randomize the cards, you can pick the ace of spades, I’ll give you $60. If you pick the ace of hearts, I get to keep your $20. You only get one shot at it.
What would you do?
If you had an unlimited amount of opportunities, the smart move would be to play this game all day long. But it’s entirely different if you’re only given one chance, since we know odds generally even up over time. I say most people would still take a chance on the wager, because $20 isn’t a whole lot of money.
But what if I upped the stakes? What if I increased the bet to $1,000? Or $10,000? Would people still take me up on my offer if the risk was much higher?
I suspect I’d still get some takers, but most people wouldn’t do it. Even if the odds were in their favor, people aren’t going to wager that much money on the equivalent of a coin-flip.
How Penn West is similar
My hypothetical game is exactly the kind of situation that I see unfolding for shareholders in Penn West Petroleum Ltd. (TSX: PWT)(NYSE: PWE), a Calgary-based beleaguered energy producer. The company’s shares have dropped by more than 35% in 2014 alone, and that’s after years of underperformance compared to its peers. Shares currently trade below $6.
To top it all off, the company recently reported that it had mishandled its accounting for years. Essentially, it recorded operating costs as capital costs, which allowed it to record a larger cash flow than it was actually earning. To management’s credit, they immediately launched an internal investigation looking into the matter.
In September, management released good news. All the auditors found wrong was the initial confusion between different types of costs. The balance sheet stayed the same, and most importantly, the company reiterated its expectations for the rest of the year and maintained its $0.14 per share quarterly dividend.
And then, the price of oil starting sliding. For Penn West, the timing couldn’t have been worse.
The company is still struggling from acquiring natural gas assets during better times, which left it with a significant amount of debt on the balance sheet. One of the new management team’s goals is to pay down this debt by selling assets, which it has already started. Total debt has decreased by more than $1 billion over the last four quarters, with about $1.9 billion still owed.
Now that oil prices have declined, the market is skeptical that Penn West can continue its asset sales. You generally don’t get a good price for these types of assets during soft markets.
It’s not all bad
Investors are focusing on the negatives, but Penn West has some good assets.
The company is one of the largest players in some of Western Canada’s largest oil fields — Cardium, Viking, and Slave Point. Additionally, thanks to all the asset sales, the company’s production has become considerably more oil heavy over the last couple years.
Yes, Penn West has one of the highest break-even points in the sector, mostly because of its mix of poorly performing assets. But as it sells these off, the remaining wells should push up the company’s profitability. Additionally, almost all of the company’s capital expenditures are being spent on the the core areas listed. Focusing on the best areas is a smart move.
Essentially, everything comes down to this. If Penn West can sell assets, pay down debt, and become more profitable, there is a ton of potential upside. After all, it has a book value of nearly three times the current share price. But if it can’t and oil remains weak for a few years, it’ll be tough. Investors who look at the name now are essentially flipping a coin. Heads you win big, tails you lose.
Penn West is risky. Check out these 3 stocks instead!
Want nice upside potential without taking huge risks? Looking to expand your portfolio’s horizons? The Motley Fool has put together a special FREE report featuring “3 U.S. Stocks Every Canadian Should Own.” To get the names and ticker symbols of these three stocks, just click here to access your free copy!
Fool contributor Nelson Smith has no position in any stocks mentioned.