Thursday, December 17, 2015

Taught a Lesson by Gear Energy

I know the commodity space is run by guys who care little for shareholder value. I guess holding down a job in a boom/bust industry is tough, so managers do what they need to do by smoothing it out at the expense of the shareholder. And yet, I still got taken.

Even at the current level of oil prices, Gear Energy (GXE) generates a good amount of cash flow from operations, with minimal capex requirements, such that it traded at a mid-single digit EV/FCF. They lose money on an income basis, but all of those investments were already made; adding back depreciation to earnings results in decent cash flow.

Moreover, management talked a good game about how it was able to maintain production at the current level of capex, and repaying debt with its cash flow. This is exactly the kind of situation I love: a down and out industry, a low multiple, and sustainable cash flow being applied to lower the multiple even more. I was ready to ride this company into better times, even if they were years away.

But management apparently doesn't want to shrink the business. The company decided to spend most of its operating cash flow in order to increase production 6%. Despite oil prices falling through the floor, they decided to embark on an expansion program! Who expands when they are losing money?! Also, who expands when the price of the stuff they are selling is falling through the floor? If everyone behaved like this, oil prices wouldn't be cyclical, they'd be zero. "Oil prices are falling you say? Let's double-down on production!!"

Well, good luck expanding though, right? Because who is going to finance this expansion? The bank wants to reduce its exposure, so it wants the company to keep paying down the loan, which is fine by me! Well, management decided to issue shares, diluting current shareholders, in a private placement at a discount to the market price! Of course, they could have offered rights to current shareholders to raise the equity, but decided to issue the shares to a single party instead, with management tagging along as well.

Needless to say, with these actions the share price took a ginormous tumble. I feel shame. I know this industry behaves like this, and I still fell for it. I'm a big believer in the adage that a fool never learns from his mistakes, an average person learns from his mistakes, and a wise man learns from the mistakes of others. I can do no better than average now in this situation. Now I have to improve my process such that I don't end up as a fool.

Does anyone who saw this coming know what I could have done better? I have some ideas but they are not foolproof, which is probably the minimum of what I require.


Jordan said...

I'd usually expect Don Gray (who helped build Peyto) to practice good capital allocation. Peyto has always spent tons of capex during downturns as costs are much lower (the monthly letters here are really helpful). I agree that a rights offering would have been preferable, but I think the borrowing base change just put the company between a rock and a hard place. No position here, but I imagine if the company can just survive for a couple of years it'll be worth multiples on the other side.

Anonymous said...

What was management incentivized to do?

Packer16 said...

The reason for the offering was not to increase production but to pay down the line of credit ($20 million of the $25 million offering was to pay down the debt to $60 million - the redetermined borrowing base from $80 million on Sept 30). Due to the timing of the cash requirement (a matter of weeks), a rights offering was not done. The combined package is very favorable with the debt portion yielding 6% with no conversion if shareholders vote that way and only 20% dilution. Based upon the filings it looks like Burgundy was the firm providing most of this financing. Other O&G mezz financing has double digit interest payments and dilution. If oil prices stay low it would not surprise me if the capital budget is reduced much like it was through out 2015. Management and Don Gray participated in the offering and subsequent open market purchases. You can buy the shares today for less than the offering price. Don Gray has been selling Peyto and buying Gear. I also think if you look at price decline of Gear it is not different that many other Canadian Junior O&G firms. Management played the best they could with the hand they were dealt. If the lesson is to not play in the upstream O & G game that is understandable but the players you chose are pretty good players and in Q4 2015 they were dealt a poor hand.

Saj Karsan said...

Hi Packer,

I disagree that the dilution and the capex are totally unrelated. If capex needs were kept to maintenance levels only, I'd argue that a second lender would have been willing to pay down the LOC. Higher rates aren't really a big deal in such a case, as OCF would have had this extra loan paid down relatively quickly. That's how I see it anyway, so that's why for me the offering *is* to increase production.

Anonymous said...

You should read up more on Peyto and Gear.

Peyto has a record of waiting for more opportune times to do big amounts of capex (both drilling as well as land acquisitions), sometimes funded by doing equity raises. The service costs are a lot lower in periods of crisis, and thus achieve a higher return.
This I believe has happened with Gear.

I have been looking at this company as well and I'm still on the fence (mostly related to debt and the current low oil/no cashflow from operations situation).

Gear is not as immensely profitable as Peyto was/is, but the well they talk about in their September monthly letter appears to be on it's way to achieve that kind of profitability.

Peyto too was a story of gradual improvement, and I think the same is true for Gear, although I think they started Peyto with more experience in the natural gas area.

That aside, I believe the way they are going with Gear is the best way.
Those heavy oil reservoirs don't need fracking, and thus save on drilling costs, while also experience lower decline curves. The downside is that they are more expensive to operate, but I guess they are doing the best they can to navigate that challenge as efficiently as possible.