Evolution Petroleum: Transition From Secondary Recovery Continues (NYSE:EPM)

bashta/iStock via Getty ImagesEvolution Petroleum (NYSE:EPM) had the Delhi asset for a long time as its either main or only producing asset. Relatively high-cost secondary recovery was therefore the business of the company since its startup. But recently the company has been venturing into both the conventional and unconventional business through the purchase of small interests. This marks a transition into a riskier but lower cost business. If the transition is successful, this could be a very different company in a few years from the secondary recovery business that market in the early years of the company. In line with the transition, the company has reported long-term debt of roughly $40 million from the latest purchase. Any debt can be dangerous for high-cost secondary recovery company because the higher costs limit or even eliminate cash flow during cyclical downturns. However, there may be enough conventional and unconventional business to allow that debt balance. Most likely, management will continue to pay down debt as fast as possible to limit the risk that debt poses. Still, this latest purchase was by far the largest. Investors need to watch this investment a little more closely at the current time until that debt balance declines significantly from current levels. Recent Purchase Management recently purchased an interest in some acreage in the Anadarko part of Oklahoma. This purchase marks the biggest jump away from the secondary recovery that was the basis of the company business for years. Management still does not operate any properties. Therefore, general and administrative costs remain low. Generally, these interests have low purchase prices due to a lack of liquidity. Therefore, higher operating costs are at least somewhat offset by lower location costs. Evolution Petroleum Oklahoma Purchase That Closed February 2024 (Evolution Petroleum Corporate Presentation March 2024)This purchase closed in the third quarter as guided by management originally. The average working interest is in the low single digits. Therefore, no one well is going to “make or break” the company. In fact, in the latest quarterly report management reports a bunch of wells in progress that together represent something like 0.2% of 1 well. For diversification purposes, that is excellent. This also means that no one well will strain the capital budget. Conventional Opportunity The wells likely to have the most impact are the wells where the company is a 50% partner. Evolution Petroleum Partnership With PEDEVCO Summary (Evolution Petroleum Corporate Presentation March 2024)This is a conventional opportunity that uses modern completion techniques and horizontal drilling. Therefore, the decline rate here is likely to be lower than was the case with the unconventional business. This partnership is likely to get off to a slow start due to a lack of initial cash flow. But this has the potential to materially grow the company once the program is well underway with established cash flow. Evolution Petroleum Well Profitability Summary In Partnership With PEDEVCO (Evolution Petroleum Corporate Presentation March 2024)These wells are smaller than the typical Permian well and so run a little cheaper. The payback period is excellent, even though this business likely does not attract the very large competitors that operate throughout the Permian. This is that rare opportunity where a small company has a low cost (and high rate of return) yet will not have to worry about large competitors taking away future business. It may lower the corporate average cost of Evolution Petroleum in the future. Natural Gas This company has a pure natural gas play through an interest in the Barnett shale in Texas. Evolution Petroleum Barnett Shale Interest Summary (Evolution Petroleum Corporate Presentation March 2024)Currently, overall production in North America appears to be declining in the dry gas producing areas like this one. Therefore, between the addition of exporting capacity over the next two years, and the declining production, natural gas prices should recover. The hot spell at the beginning of summer could accelerate the process if it continues. This is normally seen as a high-cost basin. So, more drilling of new wells is highly unlikely. But management paid for existing production and reserves. Therefore, the company likely has a very different overall cost than the companies that developed the field. This field is located close enough to a lot of developing export ability. This property could therefore lead the way to any commodity price increases in the near future. Evolution Petroleum Natural Gas Exposure To West Coast Pricing (Evolution Petroleum Corporate Presentation March 2024)The company also has an interest in a natural gas field that has considerable exposure to the strong West Coast markets. This production obtains a considerable premium to the going natural gas price in Texas (and adjoining areas). Secondary Recovery The interests in secondary recovery largely provide the cash flow for the ventures into the projects shown before. Many of these projects have low decline rates and the production will last a very long time. But for these projects’ growth is often somewhat limited. That has led the company to redirect cash flow into some of the projects shown above. As this process proceeds, the dependency upon some of these secondary recovery projects will decrease. As a result, the growth history should become much smoother. The company may also become more profitable at various commodity price levels, as the first projects shown often have lower operating costs than is the case with secondary recovery. Summary Evolution Petroleum has become more diversified so that any one project does not make or break the company. This will likely lead to steadier production growth in the future. The elevated debt levels from the latest purchase do pose some risk for a company with significant higher cost secondary recovery production. However, management will attempt to reduce that risk by paying down debt as fast as possible. Natural gas pricing could help this campaign considerably, as natural gas production is declining while the summer cooling season is the beneficiary of a very hot start. The strong buy remains in place. But the presence of debt elevates the risk of this investment until that debt comes down to a much lower level (and preferably gets paid off). This is a normally very conservative management that has long maintained a debt free balance sheet and large cash balance. Yet, management has levered the company just in time for an expected recovery of natural gas prices. That is yet another vote by an insider about the future of natural gas prices. Risks Repaying the long-term debt requires some cooperation with long-term commodity prices. There is no assurance that those prices will cooperate for the company to meet its goals. Management can hedge the production for some repayment help to lower this risk. Any upstream company is very dependent upon the exposure to the volatility and limited future visibility of commodity prices. Any sustained and severe downturn could materially change the company outlook in the future. This company relies upon operators for all of its investments. Should any operator prove to be incompetent or less than efficient, it could impair the partnership’s ability to make money for the company and support both debt repayments and dividends. So far, management’s evaluation of the operators appears to be very good. The loss of key personnel is particularly damaging to a company with few employees in the first place. So far, that has not been the case here.

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