Management Robert S. Herlin, Chairman Randall D. Keys, CEO and President David Joe, Sr. VP / CFO Rod Schultz, Principal Accounting Officer and Director of SEC Reporting & Taxation Karon Mueller, Controller www.evolutionpetroleum.com Commentary by Dan Steffens Evolution Petroleum (EPM) is a small-cap E&P that got a significant step-up in production when their core asset reached Payout on November 1, 2014. EPM has a 7.4% ORRI in the Denbury Resources (DNR) operated Delhi EOR Project (a CO2 flood) that bears no capital costs or operating expenses for the life of the project. In addition to the ORRI, EPM has a reversionary working interest that at Payout increased their Net Revenue Interest ( NRI ) to 26.44% in this long-lived oil field. EPM is debt free and able to fund all anticipated capital expenditure through 2017 with cash flow from operations and working capital on hand today. Production at Delhi is expected to ramp up gradually through 2020. During the quarter that ended June 30, 2016, Evolution settled litigation with Denbury Resources (DNR). Evolution received $28.1 million in cash and other consideration. With this lawsuit behind them and some operational issues resolved by Denbury, I feel a lot more confident in my forecast model for EPM. I raised my valuation by $1.50/share since the last profile.
EPM is a one asset company and it is heavily weighted to oil. All of their production is unhedged as of September 30, 2016. This is a good thing if you believe oil prices are going higher. The big news for fiscal year 6/30/2017 is that an NGL recovery plant at the Delhi Field should be in service by December 2016. This plant is expected to significantly increase liquids recovery. My current Fair Value estimate for EPM is $7.75/share. Compare to First Call s Target Price of $7.25/share Disclosure: I do not have a position in EPM and I do not intend on buying or selling in the next 72 hours. I wrote this profile myself, and it expresses my own opinions. I am not receiving compensation for it from the company. I have no business relationship with any company whose stock is mentioned in this article. For those of you seeking high yield: EPM has a publicly traded perpetual non-convertible 8.5% Series A Cumulative Preferred Stock (EPM.PA) that pays monthly dividends. Since the company is debt-free, the dividends on the preferred stock are secure.
Company Overview Evolution Petroleum Corporation (AMEX: EPM), based in Houston, TX engages in the acquisition, exploitation, and development of properties for the production of crude oil and natural gas in the United States. EPM acquires properties with known, underdeveloped oil and natural gas resources and exploits them through the application of conventional and specialized technology to increase production, ultimate recoveries, or both. EPM develops, acquires and implements oil & gas development projects by applying its expertise and modern engineering technology to known petroleum resources, onshore in the U.S. As of June 30, 2016, its assets include 10.8 MMBOE of proved reserves. The proved reserves are 79.3% crude oil. EPM also has an additional 4.5 MMBOE of probable reserves (79.2% crude oil). EPM has a strong balance sheet with working capital of $28.6 million as of December 31, 2016 and no long-term debt (other than deferred income taxes).
Business Strategy EPM is focused on increasing underlying asset values on a per share basis. In doing so, they depend on a conservative capital structure, allowing them to maintain control of their assets for the benefit of their shareholders, including approximately 21% beneficially owned by all of their directors, officers and employees. EPM s strategy is intended to generate scalable, low unit cost, development and re-development opportunities that minimize or eliminate exploration risks. These opportunities involve the application of modern technology, their own proprietary technology and their specific expertise in overlooked areas of the United States. The assets EPM exploits currently fit into three types of strategies: Enhanced Oil Recovery Bypassed Primary Resource Unconventional Development especially utilizing staff expertise in horizontal drilling Fiscal Year ending June 30: 4 th Quarter & Year End Highlights EPM funded all operations, including $21.1 million of capital spending, from internal resources and remained debt free. EPM returned $6.6 million to common shareholders in the form of cash dividends during fiscal 2016. EPM remains committed to their dividend policy and rewarding long-term shareholders. EPM invested $1.2 million in the stock buyback program during fiscal 2016. They have up to $3.4 million remaining under this program. EPM increased working capital to $28.6 million at June 30, 2016 compared to $14.3 million at the prior year end. At June 30, 2016, working capital included $34.1 million of cash on hand. EPM entered into a new senior secured bank credit facility. The maximum borrowing base is $50.0 million; however, the initial borrowing base was set at $10.0 million. There are no outstanding borrowings.
EPM s hedging program resulted in $3.4 million in net gains during fiscal 2016. In fiscal 2016, EPM management used derivative instruments to reduce exposure to oil price volatility in order to support the capital expenditures for the Delhi NGL plant and to protect the dividend policy. They have no hedges in place beyond September 30, 2016. Operations Highlights Fiscal 2016 net income to common shareholders was $24.0 million, a substantial increase from fiscal 2015 net income of $4.3 million. During fiscal 2016, litigation settlement proceeds, insurance proceeds and realized hedging gains contributed to significantly higher net income, offset in part by increased DD&A expenses, litigation expenses and higher income tax expense. This is the fifth consecutive year of reporting net income to common shareholders. EPM settled the litigation with the operator of Delhi field. In the settlement, EPM received $27.5 million in cash and a working interest in the Mengel Sand, a separate interval within the Delhi field that is not currently producing. EPM also reached agreement on the ownership of the CO2 recycle facility and on the long-term costs of purchased CO2. Installation and construction of the NGL recovery plant at Delhi is approximately 90% complete. Technical completion and start-up of the plant is scheduled to begin in November 2016. EPM s net share of capital expenditures for this project is $24.6 million, and has been funded through cash flow from operations and working capital. Approximately $3.1 million remains to be spent as of fiscal year-end 2016. Net oil production volumes at Delhi increased by over 46% year-over-year. Monthly production has been steadily increasing over the past year as a result of a conformance program and greater efficiency with the flood. The majority of the increase in net production stems from the reversion of the 23.9% working interest and associated 19.0% revenue interest in the Delhi field which became effective on November 1, 2014. EPM had only eight months of working interest volumes in the prior fiscal year. EPM transferred their oilfield technology operations to a new entity and expects annual cost reductions of approximately $1.0 million. EPM retained a minority equity interest in the new Company and will receive a 5% royalty on all future gross revenues from the technology. In addition, they have an option to increase their equity ownership and can use the technology in any of their operated wells. Oil & Gas Reserves Highlight (based on SEC oil price of $40.91 per barrel in effect as at June 30, 2016) Delhi proved oil equivalent reserves at June 30, 2016 were 10.8 MMBOE, a 13% decline from the previous year. The Standardized Measure for proved reserves declined 51% to $78 million as a result of a 44% drop in the oil price from $72.55 to $40.91 per barrel. Proved reserves are 79% oil and 21% natural gas liquids, and 66% of these reserves are developed and producing. Delhi probable reserves at June 30, 2016 were 4.5 MMBOE, a 52% decrease over the previous year Delhi possible reserves at June 30, 2016 were 2.7 MMBOE, a 10% decrease over the previous year Note that proved, probable and possible reserves will increase if oil prices increase through extension of the properties economic life. Dan Steffens
"The settlement of our Delhi field lawsuit removes the uncertainty and significant legal expense of continuing litigation, while adding $27.5 million in cash and other significant value to the Company. This clears the slate for a more productive relationship with the operator and the opportunity for other meaningful growth opportunities. We had a very productive year, with the Delhi field outperforming our production expectations and generating very strong cash operating margins in this challenging price environment. We are nearing completion of the NGL plant in the Delhi field, a $25 million capital project net to Evolution, and are looking forward to a substantial increase in liquids production as a result by the end of this calendar year. With the majority of this capital spending behind us, the near-term financial outlook is very positive. We have an exceptionally strong balance sheet, consisting of $28.6 million in working capital and the additional resources of an undrawn reserve-based credit line. Our current cash flow from the Delhi field prior to the contributions from the NGL plant is significantly above our current dividend requirements, which further increases our financial capabilities. We ended the current fiscal year in our best position since this industry downturn began two years ago." Randy Keys, President and CEO
Financial Results In the quarter that ended June 30, 2016, EPM reported operating revenues of $7.2 million, based on an average realized oil price of $42.95 per barrel, and generated $1.0 million in income from operations. In the prior quarter, EPM reported a $0.7 million loss from operations on revenues of $5.1 million, which was based on decade-low oil prices of $30.00 per barrel. Production volumes increased slightly to 1,856 barrels of oil equivalent per day from 1,835 BOEPD in the prior quarter and were 10% above the year-ago quarter rate of 1,683 BOEPD. Quarterly net income to common shareholders was $20.7 million, or $0.63 per diluted share, which includes the after-tax effect of the $27.5 million cash litigation settlement in the quarter. Production costs in the Delhi field declined 7% from $2.2 million in the prior quarter to $2.0 million in the current quarter as lower volumes of purchased CO 2 more than offset an increase in CO 2 costs, which are tied directly to realized oil prices in the field. If we experience increasing oil prices in the future, EPM may experience their CO 2 costs trend back up, but this should be more than offset by higher revenues and an expanding field margin. Depletion, depreciation and amortization expense decreased slightly to $1.2 million from $1.3 million in the prior quarter, as a small reduction in the DD&A rate per barrel exceeded the effects of slightly higher production. General and administrative expenses were $3.0 million for the quarter, which represents a substantial increase over the prior quarter and year-ago quarter. The majority of this increase resulted from higher litigation expenses and also higher non-cash stock-based compensation expense associated with the achievement of net income performance targets. Financial Results for the Year Ended June 30, 2016 For fiscal 2016, net income to common shareholders was $24.0 million, or $0.73 per share. Revenues for the year totaled $26.3 million, based on net production of 1,800 BOEPD and an average realized price of $39.68 per barrel. Revenues in the prior year were approximately 5% higher at $27.8 million, on a much higher average price of $61.37 per barrel. Net production was substantially lower in 2015 as EPM did not earn their reversionary working interest until November 2014 and only had eight months of working interest production, combined with lower gross field production. During the year, EPM initiated and executed an oil price risk management program that resulted in net gains of $3.4 million. These gains, which are reported as other income, had the effect of increasing their realized oil price by $5.22 per barrel, or 13% of actual realized oil price.
Reserves Update For the year ended June 30, 2016, proved reserves in the Delhi field totaled 10.8 MMBOE, a reduction of 1.6 MMBOE from the prior year. This net change in proved reserves is comprised of 0.7 MMBOE of production in the prior year and 0.9 MMBOE of revisions to part of the remaining eastern development area. The area Evolution management refers to as Test Site 6, which is the development area on the farthest eastern edge of the field, was deemed to be uneconomic using the low SEC price assumption for the remaining life of the field. The larger part of the eastern development area, which is referred to as Test Site 5, totals 1.4 MMBOE, and remains solidly economic even in this low price environment. Test Site 5 has industry-competitive future development costs of slightly over $8.00 per barrel. It is noteworthy that even in this very low price environment, EPM did not lose significant future production volumes or economic life from proved developed producing reserves at Delhi. The remaining economic life of the proved reserves in the field under these low price assumptions is still approximately 25 years. Under the probable reserve case, the field has a productive life in excess of 30 years.
Probable reserves, however, declined significantly as a result of lower price assumptions, dropping from 9.5 MMBOE in the prior year to 4.5 MMBOE. The majority of these revisions resulted from lower prices and their effect on the deemed economics of future development projects, while a lesser portion resulted from changes to the operator's long-term development plans for the field. Possible reserves of 2.7 MMBOE were affected to a much lesser degree than the probable reserves as the removal of certain proved and probable projects from the reserves report was substantially offset by positive revisions from improved field performance. With the significant revisions to probable reserves, current probable and possible reserves now reflect only the incremental recoveries associated with the existing proved reserves. These recoveries are based on a range of assumptions, from a conservative view of 13.8% recovery in the proved case, to 18.0% total recovery in the probable case, to a total recovery of 20.5% in the possible case. The discounted value of future net revenues from proved reserves is typically computed under two different methods. One measure, which conforms to GAAP, is the after-tax Standardized Measure of Discounted Future Net Cash Flows ("SMOG"), which is calculated as the present value of estimated future net revenues discounted at a 10% interest rate and reduced by estimated future income tax expenses associated with the properties, with such taxes discounted at 10% based on the expected date of future tax payments. The other method is PV-10. The discounted values under the two methods are located beneath the image below.
Standardized Measure of Proved Reserves (after-tax) $ 78.0 million Future Income Tax Expenses Discounted at 10% 22.9 million PV-10 Value of Proved Reserves $ 100.9 million Operational Results The Delhi field has performed well above production expectations from a year ago. In the reserves report as of June 30, 2015, reservoir engineers were projecting an average gross production rate for the 2016 fiscal year of slightly over 6,200 BOPD, whereas the actual rate was almost 6,800 BODP, an increase of almost 10%. The majority of this improved production is attributable to efforts to selectively improve the performance of the CO 2 flood through conformance efforts and other relatively low cost production enhancement projects. It did not result from new drilling or development to any significant degree. This bodes very well for the long term recovery outlook in the Delhi field.
EPM has already seen a strong indication of this in their reserves report as the expected ultimate recovery of probable reserves has been increased from 17% to 18% and the timing of recovery has been significantly accelerated as well. The production rates for the proved developed producing reserves have also been accelerated. Evolution management believes the NGL plant, nearing completion, will be a near-term catalyst for significant production growth from the field. This project was authorized in February 2015 and has an expected technical completion date of November 1, 2016. After a short period of startup testing, EPM expects full production around the end of the calendar year. The NGL plant costs are projected to be close to the original budget of $25 million net to the Company and there are no indications of any significant cost overruns thus far.
Capital Expenses During fiscal 2016, the net share of capital expenditures was approximately $19.0 million, all which was incurred at Delhi and primarily for the NGL plant. There have been and will continue to be recurring maintenance capital expenditures required for a field of this size. These expenditures are generally for testing and strengthening of well bore integrity, including previously plugged wells, drilling and completion of monitoring wells and larger projects to recomplete or workover wells which may be capitalized instead of being charged to operating expenses. Known capital expenditures over the next fiscal year are expected to total approximately $3.1 million, net to the working interest, primarily for the remaining costs of the NGL plant. There will likely be additional maintenance capital expenditures, but the amount of these is not expected to be material to EMP s financial position and cannot be estimated accurately at this time.
After completion of the NGL plant, there are two remaining capital projects to exploit the eastern part of the Delhi field. The first phase of this project was underway in the fall of 2014, immediately after reversion of the working interest. However, based on the decline in oil prices, the operator significantly reduced its capital budget and suspended work on this phase. EPM believe the Phase V project, which has an estimated cost of $11.5 million net to working interest, has favorable economics, even in this lower price environment, and expect the expansion of the CO 2 flood to resume within the next two years. Phase VI has less favorable economics and will require a significant increase in oil prices or other improvements to the economics of the project before it is expected to move forward. The economics of both projects will be improved subsequent to the completion and startup of the NGL recovery plant in late calendar 2016.
Liquidity Update EPM has historically funded their operations through cash available from operations. The primary sources of cash in fiscal 2016 were from funds generated from the sale of oil and natural gas production and the litigation settlement. A portion of these cash flows were used to fund capital expenditures. While EPM will continue to develop properties near term, such development will be more limited while commodity prices remain low and unstable. The Company will manage any development activity in the context of its operating cash flow and existing working capital. Evolution s liquidity position is very strong, with $28.6 million of working capital, undrawn liquidity under their reserve-based credit facility and the expectation of significant free cash flow over the next fiscal year. This cash flow is dependent, of course, on the net prices received for production, net of any proceeds for price risk management activities. Based on a solid financial position, Evolution management expects to continue their common stock cash dividend program for the foreseeable future, and will evaluate the options of increasing common dividends, resuming the purchase of shares under their stock repurchase program and potentially redeeming preferred shares.
On April 11, 2016, the Company entered into a new credit agreement with MidFirst Bank. The Facility replaces the Company s previous unsecured credit facility which was set to expire on April 29, 2016 and was terminated in early April. The Facility provides a senior secured revolving credit facility with an initial borrowing base of $10.0 million and a maximum borrowing amount of $50.0 million. The Facility matures on April 11, 2019, and is secured by substantially all of the Company s assets.
Hedging Update The fair value derivative instruments where the Company is in a net asset position with its counterparty as of June 30, 2016 totaled $14,132 For the year ended June 30, 2016, the Company recorded in the consolidated statement of operations a gain on derivative instruments of $3,439,229 consisting of a realized gain of $3,315,123 on settled derivatives and an unrealized gain of $124,106 on unsettled derivatives. The following table from Evolutions financials sets forth a summary of the Company s crude oil derivative positions at average NYMEX WTI prices as of June 30, 2016. Volumes (in Bbls./day) Weighted Average Floor Price per Bbl. Weighted Average Ceiling Price per Bbl. Weighted Average Collar Spread per Bbl. Period Type of Contract Months of July 2016 through September 2016 Costless Collar 600 $45.00 $55.00 $10.00
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