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Does the Reward Outweigh the Risk for Penn West Petroleum Ltd.?

I thought Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) would be bankrupt by now. The price of oil has suffered tremendously the past few months and based on the financials of this little company, I couldn’t help but think Penn West would be the first of the small oil companies to go belly up.

Yet the company is still chugging along. Penn West reminds me of the book my mom used to read to me: The Little Engine That Could.

But just because the company has avoided bankruptcy—for now—doesn’t mean that it can’t still fail. That being said, the potential rewards might just outweigh the downside of the company. Here are a few reasons why.

1. Asset sales

One of the problems that former management made was that they bought assets that weren’t really necessary for the success of the company. On top of that, they borrowed a ton of money to make these ill-advised acquisitions.

Fortunately, new management is making moves to get rid of these assets and pay down the large amounts of debt that it has. Last week it was reported that Penn West had sold a significant amount of land to Freehold Royalties Ltd. for $321 million. This was a premium to what investors had anticipated it would go for.

If the company is able to continue selling these sorts of assets, it’ll be able to get its debt under control, which will put it in a better situation.

2. Oil prices

Oil is not back, but it is slowly coming back. And while I am still nervous about oil because of the sanctions being potentially lifted from Iran, the demand far surpasses supply right now. And if that demand continues, the price of oil will return.

If that happens, Penn West is going to rise. It’s so depressed right now simply because oil prices are. If oil jumps into the $70s or $80s, Penn West is going to be in a much better position.

The primary risk here is that oil prices don’t return to the $70s or $80s. If that doesn’t happen and the price stays where it is for a year or two, Penn West could really be in for some painful times.

3. It’s an acquisition target

There are no rumours to support this statement, but that doesn’t mean it can’t happen. For large companies, low oil prices don’t hurt as much, especially if they have a lot of money in the bank. For small companies like Penn West, low oil prices are detrimental. I’ve been predicting for some time that a lot of the small companies could get bought out or merge to form larger, more efficient operations.

Penn West is arguably one of the best acquisition targets right now. If we were to look at the hard numbers and book value of the company, Penn West should be trading at around $10 a share. Yet the stock is only trading at $3. Let’s assume a large oil company wanted to buy out Penn West. How much would it have to offer?

Even if the company were being very generous and offered to pay a 100% premium, that would still only be $6 a share, which is $4 less than its value. That’s more than a 100% discount.

But even if the company doesn’t get acquired and just starts to grow from here, I do think that the rewards far outweigh the risks. Oil prices should return to normal levels and Penn West should follow that return in price.

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Fool contributor Jacob Donnelly has no position in any stocks mentioned.

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