Penn West Petroleum Ltd. Is up Nearly 200% This Month. Don’t Trust the Rally?

The latest asset sale may not be enough to save Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) from bankruptcy.

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Teetering on the edge of bankruptcy just one month ago, shares of Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) have skyrocketed nearly 200% in October. Saddled with an inordinate amount of debt, renewed investor optimism mainly deals with the company’s resurgence towards solvency.

Since last quarter Penn West has reduced its debt by approximately $400 million to $1.8 billion. On the year, it has eliminated $810 million of debt, vastly exceeding its initial target of $650 million. While this should buy more time until commodity prices improve, some worry that the company risks gutting itself of future growth.

Is the recent rally a sign of fundamental strength? Or will investors be left with a mere shell of the former assets?

Asset sales actually look beneficial

When a company needs to focus on staying afloat rather than earning long-term profits, decision making changes dramatically. Rather than pour money into the highest-return projects, management is often forced to sell off its best assets, as these fetch the highest price on the market. Unfortunately, these sales often occur at fire-sale prices given that firms typically face liquidity struggles during industry downturns.

For Penn West, it seems as if the rough waters have been navigated fairly well.

Last quarter, Penn West had total debts of $2.2 billion, coming down to just $1.8 billion from roughly $400 million in asset sales this quarter. Over the last 27 months, the company has made over $1.9 billion in asset transactions. Incredibly, most have been non-core assets, meaning that Penn West’s most promising projects remain intact.

The sale of non-core assets can actually be beneficial for a company. Typically, core assets have the lowest costs and highest long-term returns. Non-core assets are often accumulated during industry upturns, when operators are flush with cash and willing to invest in lower-return projects. By focusing on primarily non-core sales, Penn West may actually be repositioning itself as a better business, all while dramatically reducing debt.

But can Penn West avoid selling its most prized asset?

Even after massive debt-reduction measures, there is no getting past Penn West’s remaining $1.8 billion in debt. This equates to a staggering six times cash flow. For a company worth only $610 million, this story could still end in tragedy.

One analyst at Dundee Capital Markets Inc. believes a major sale of a core asset is inevitable: “Frankly, I think they have to sell one of their jewels if they want to survive, the jewel being the Viking, most likely.” The Viking project is an oil well in Saskatchewan that produces light crude.

As with most core assets, the Viking project generates high returns and is worth an estimated $800 million. If Penn West is forced to sell some of its prized assets, which is probable, the resulting company wouldn’t look like the current operation. It would likely have a low-return profile, limited margins, and less growth prospects.

Today’s company is not the future

It is likely that at the end of the day Penn West will need a transformational asset sale to service its mounting debt. That means that whatever company investors are buying today, tomorrow’s structure will most likely be very different. Until that happens, its massive debt will continue to be a major headwind.

Unless you’re comfortable at guessing what the future of the company will look like and what assets it will be able to keep, it’s best to stay on the sidelines.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Ryan Vanzo has no position in any stocks mentioned.

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