One Lump or Two?

Monday, 25th November 2013 15:10 - by Moosh

What about AIM, the Alternative Investment Market?

With my desire for ‘jam today’, should I only be looking at FTSE listed companies or are there hidden fruits creating jam on the AIM? ¹ AIM is traditionally considered as a high risk market, with a general lack of liquidity, especially with many companies turning a loss, but what about profit makers? Does being listed on the AIM make the share price of a profitable company behave any differently to one listed on the FTSE, or does it all just come down to the core fundamentals of the company? I am going to assume that the market itself is irrelevant to proceedings, at which point, some readers may wince and consider me quite the fool, but let’s go with it for now, fool and all.

Now to introduce the AIM-listed company from the oil and gas sector which has deserved my time and attention this session – Empyrean Energy (TIDM: EME), of which I am happily a long term investor (since November 2008) and up to date with its fundamental and technical aspects. So where do we start with EME? I suppose the first question to ask is...do they make ‘jam’ today? Yes they do – even with a small % interest (up to 3%) in the Sugarloaf Block B project operated by Marathon Oil, which provides access to the prolific proven play of the Eagle Ford Shale (EFS), the latest full financial year (FY13) produced earnings per share (eps) of 0.93p, to give a PE ratio of ~7.8 (at mid-price close of 7.25p on 22/11/13), which may suggest that the current share price is undervaluing the company on earnings alone.²

But that’s old news though – how are things shaping up for this year and is it possible for the current financial year to at least match or better those earnings since I would expect investors to be buying and holding an investment if the potential for increased earnings is a real prospect. So how am I going to work this out? To begin with, I believe it would be worth looking at history to see if the revenue generated in FY13 could have been roughly (and quickly!) calculated using information that’s available to everyone. EME has been particularly thorough since April 2012 in terms of providing investors with production information in a monthly format and set it out simply so that current and potential investors alike can quickly view the data rather than having to sift through announcements looking for snippets of details here and there. That suggests to me that the chief executive officer (CEO) has a good idea in terms of what investors are looking for when choosing an investment and is happy to provide it in an orderly fashion. You may argue that it is their job after all, but you’d be surprised how many CEOs seem to just dish out puzzling news announcements that can leave investors with more questions than answers. It is also a positive sign with EME that operational updates have reduced to a quarterly frequency, in line with the other partners in the project since it vastly reduces the opportunities for short term traders to ‘sell on news’ since the news items are now expected to be few and far between, which is good for attracting long term investors who prefer price stability which may then give a chance for true company value to be seen in price appreciation, especially if the fundamentals of EME are firming up for the better.^{2, 3}

So back to FY13 production figures, from April 2012 to March 2013, EME had a net production of 136,386 barrels of oil equivalent (BOE); let’s assume the price of a BOE over that time averaged $41, then it suggests a total revenue from gas and oil of £3.634m, assuming a dollar to pound conversion rate of 0.65.^3-5 How does this rough calculation compare to the real figures? The FY13 total revenue was £5.893m, which was ~62% more than the estimate based on production alone using many assumptions, and includes the revenue from natural gas liquids (NGLs) which aren’t included in the monthly production data.² We are awaiting the current year interim results from EME, but an estimated revenue from production data (99149 BOE from April 2013 to September 2013) using a price of $41 per BOE (which is conservative in light of the rise in price of Western Texas Intermediate crude oil (WTI) for much of this year), suggests a starting point of £2.9m revenue for the first half of FY14 – this would be a 78% increase in revenue compared to £1.622m from H1/13, without including any contribution from NGLs or other projects.^{3, 6}

How is this stacking up when it comes to being a contender for ‘jam today’? I may be biased, but compared to when I first invested in EME back in 2008, the company does seem to have turned itself around into a bit of a beauty since becoming profitable from being a loss-making beast. However, just because a company starts making a profit doesn’t automatically mean that the price reacts immediately – of course it won’t. EME has been in particularly bearish territory since it fell from the highs of 100p+ from even before I became an investor in EME, but I’ll be honest, I don’t really care about the history here – my investment journey with EME began in November 2008 and I have never been more comfortable being a shareholder than I am today, and that is actually down to the management plugging away at firming up the fundamentals of the company, and on paper, that is exactly what they have been doing. Had I not already been invested here, then this is exactly the type of investment scenario I will be looking out for in the future when I’m searching for ‘jam today’ companies.

Returning to EME and taking a look at its production in the latest operational update – the last 6 months (to September 2013) sees the production from Sugarloaf Block B plateau to an average of ~16,500 BOE per month net to EME.³ The relevance of this is fairly obvious – if production is flattening and not increasing then where’s the investment case to support a growing production profile so why am I even bothering to consider EME as a long term investment?

- At the end of September 2013, EME had an interest in 101 producing wells in the Sugarloaf Block B project in Texas, and the project as a whole is initially estimating ~250 wells to be drilled, so there is indeed plenty more to come from Block B and the drilling plan for next year has yet to be released.³

- There have been recent test wells into the Austin Chalk (AC) which overlies the EFS, and initial flow rates from these AC wells have been similar to the flow rate from a well targeting the EFS, so the results are looking promising for now.³

- A further recent (positive!) twist to events has exposed EME to an interest in the EFS structure of Sugarloaf Block A, for which flow rates have yet to be announced. EME is no stranger to Block A hydrocarbons since it still has a 7.5% interest in historical wells operated by Texas Crude Energy International from 2007-2008.^{2, 3}

- For much of this year, the Sugarloaf Block B project has had a ‘downspacing’ initiative being trialled, to see whether reducing the spacing between wells can increase hydrocarbon recovery to ultimately create value for us shareholders, and the results of these are hopefully going to be out by the end of 2013.³

So I ask again, is there a case for long term investment despite a production plateau from Sugarloaf Block B? After being invested this long, I have no reason to sell up in bulk right now given the many developments still to genuinely come over the next year.

Back to square one then – where’s the jam? As I said earlier, the latest PE ratio of 7.8 is based on old results, but assuming a fair value price range exists between a PE ratio of 10-20, then it indicates (for eps ~0.93p) a broad range of 9.3p to 18.6p to use as a guide. We already have a clue that H1/14 interim results should yield greater revenues than H1/13, though I’m not brave enough to calculate an estimated eps so I will wait for the interim results to see how things stand and to figure out if using production data from operational updates can be used reliably as a guide to aid investment decisions.

With respect to financing, EME has access to a loan facility of up to $50m with Macquarie Bank and the company has had no problem in making the quarterly repayments either, so I am satisfied that management is in complete control over costs.^{2, 7, 8} I also mentioned earlier that this year has seen an appreciation in the WTI price and EME responded favourably to potential future fluctuations in WTI price by sorting out a hedging deal with Macquarie for a portion of their future production, and with the WTI price having recently dropped below the fixed price of $95.90 per barrel of oil of the commodity swap transaction, that decision looks like a sensible move since it provides some form of stability to revenue generation over the 12 month period over which the transaction is in place.⁹ While it may seem like an obvious thing to do, it’s the first time I’ve come across an AIM oil/gas company which has done this and that decision suggests to me that the EME management are flexible enough to react to whatever factors could play havoc with the fundamentals of their company, and that they also appear to have a good working relationship with Macquarie Bank.

All this being said, don’t forget that EME have up to a 3% interest in the majority of their Sugarloaf Block B wells, but despite that, the earnings generated still appears to undervalue the company, and doesn’t take into account any future potential arising from current tests and trials from Block A EFS wells, Block B AC and EFS wells, and the downspacing pilots. The world of EME though doesn’t entirely revolve around Sugarloaf. While there is also current production from the Riverbend project (10% interest), there is also some major developments yet to come from their Eagle Pool project in California, which has been on hold for a few years but has proved reserves in place, and interestingly here, EME has over a 50% interest in the play but there’s no point speculating about its potential on earnings and the like until the project reawakens from dormancy and we have proper facts in place.^{10, 11}

To conclude, if the core fundamentals are the driving force to price movement, especially if guided by earnings, then the market type itself should have no influence on this whatsoever so there would be no need to consider the AIM and FTSE as two different entities. One further observation which does seem to go over the heads of many investors is the rate at which price moves for loss-makers and profitable companies. The price of a loss-making company can move up really quickly according to sentiment, and once this happens, most investors assume that this is how it will always be. Unfortunately (from experience!), this isn’t the case. Once a company becomes profitable with growth, then price is more likely to move according to fundamentals, over a much longer period of time – and this is where many investors get disappointed too soon. In the case of EME, there currently seems to be a transition in shareholders where stale long term investors who held on tightly through the loss-making days have got bored and need to be replaced by future investors who have been waiting for the company to strength the foundations of their fundamentals before settling in with a holding. Now is the time for potential long term investors to decide whether or not Empyrean Energy is worth their time, attention, and capital.

References

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.

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