Analyzing Penn West (PWT)

August 5th, 2014

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

If you read Canadian business news regularly, you probably know that Penn West is in the headlines for all the wrong reasons. Basically, Penn West announced that they found accounting irregularities, which are being investigated.

This is good news for me personally, because I've held put options on Penn West stock since early this year. I didn't suspect any accounting irregularities, though. I just thought that the stock was overvalued. The options expire on Aug 16, so

In this article, I will give a rough estimate of Penn West's value using the methodsI've discussed(part 1, part 2).


Penn West has 3 major areas (called 'plays') that they plan on drilling. They are: Cardium, Viking and Slave Point. Let's examine the well economics of each play.

According to Penn West's July presentation, each new Cardium well will potentially produce 160-210 thousand barrels equivalent (boe) over its lifetime. I say 'potentially', because as I've said, this is a statistical estimate produced by an "independent" reserves evaluator, paid for by Penn West. However, let's put that aside for now and assume they're telling the truth - let's assume that each well produces 180 thousand barrels equivalent.

Also, we should be aware of what 'equivalent' means. Cardium wells produce both oil and natural gas. Since each 6 thousand cubic feet (mcf) of gas has the same energy content as one barrel of oil, most companies use the unit 'boe' to mean either one barrel of oil or 6mcf of gas.

Unfortunately, I couldn't find information on Cardium's oil/nat gas mix from their presentation. 183 mboe (thousand boe) could mean 150 mbbl (thousand barrels) of oil and 180 mmcf (million cubic feet) of gas, or it could mean 120 mbbl and 360 mmcf of gas. Thankfully, we can take a cue from the reserves report. The report seems to suggest that each new well contributes 18 mcf of natural gas for every 21 barrels of oil. Assuming this ratio for Cardium wells, we can assume that each Cardium well yields around 160 mbbls, and 23mmcf of gas.

Generally, an oil well produces about a third of its production in the first year, another third in the next 4 years, and another third in all the years after. Currently, oil prices in the U.S. (where Penn West and other oil companies export to) are forecasted to be around $96 USD for the next year, $88 USD 3 years from now, and $87 in the long term.

However, these prices are U.S. market prices. Because of transportation costs, grade of oil, etc, Canadian companies usually receive a lot less than these amounts. Last year, oil price in the U.S. averaged $98 USD per barrel. However, Penn West received only $88 CAD per barrel last year. Let's be slightly generous and assume slightly lower discounts in the future and suggest $90 CAD per barrel next year, $82 CAD per barrel in years 2-5, and $81 CAD for the long term.

Now, let's talk about royalties. Right now, Alberta gives special royalty treatment for fracked wells of the type that Penn West is drilling. The royalty regime is about 5% for the first year, and then a variable rate up to 40% from year 2 onwards. Penn West paid about 17% or revenues as royalty last year, so let's assume that royalties roughly works as follows: 5% for first year, 30% in years 2 to 5, and 15% in years 5+.

This means that net of royalties, Penn West will receive $85.5/bbl the first year, $57.4/bbl in years 2-5, and $68.85/bbl in years 5+. Over the lifetime of each well, Penn West will receive $11.3 million, net of royalties from oil.

Each well also derives revenue from selling natural gas, but not as much. Last year, each mcf of gas fetched $3.31 gross, and $2.71 after royalties. Assuming a modest price increase to $3/mcf after royalties, natural gas will contribute just $415,000.

When you combine the revenues from both oil and gas drilling each Cardium wel is expected to generate $11.7 million in revenues.

Sounds like a lot of money, doesn't it? Doesn't it seems like Penn West should make a lot of money from this? Let's see.

As I've explained in my article on well economics, it costs money to extract each well. Last year, it cost Penn West $24 to extract and transport each barrel of oil, whereas it cost $2/mcf to extract each mcf of gas. If we assume that this cost stays constant throughout the lifetime of each well, this means it would cost Penn West some $4.1 million dollars to operate the wells.

Also, in 2013, the average Cardium well supposedly cost around $2.6 million to drill. I say "supposedly", because the Penn West is investigating whether that number is correct. Anyway, let's assume for now that future wells will cost $2.6 million.

Then, taken altogether, each Cardium well will generate $11.7 million, but will cost 4.1 + 2.7 = $6.8 million. Drilling each well will therefore net the company $4.9 million.

That's a good number, isn't it? The company can spend $2.6 milion and receive $4.9 million, even if it will take years to collect that amount.

Unfortunately, this is not the full story. We haven't yet factored in other expenses, and those are facilities and SG&A.

When you peer into the company's financial statments, you'll see that the company spent $543 million in drilling and completion last year, but also a whopping $332 million in facilities. The $2.6 million per well only accounts for the $455 million, but not the facilities. In the year prior in 2012, Penn West also spent $675 million on facilities vs. $1,148 million on drilling on completion.

Therefore, I think it's very reasonable to factor in about half of drilling and completion costs as facilities expense for each well. For Cardium wells then, that number would be $1.3 million for each well.

We would also need to factor SG&A into account. Last year, Penn West spent $4.5 for each boe produced by their wells. Assuming that amount for the lifetime of each well, we would need to expense another $0.8 million for each well.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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