Patience with Penn West

Benj Gallander and Ben Stadelmann
Friday, Tuesday February 3, 2015

Welcome to the Twilight Zone of budgeting. If the numbers are not working, or if volatility is making it harder to formulate a financial plan, simply delay it, as the federal government has done with this year’s budget. Or even postpone it until the next year.

Now, we mere mortals or businesses do not have that luxury, but if you are the Canadian government, with a trillion-dollar-plus budget, why not?

Our thinking is that this approach is irresponsible; those in power counter that it will give them better information with which to prep the plan.

The thing about budgeting is that, no matter when the proposal is created, there are always assumptions that must be applied. Perhaps the minister of Finance should read Benj’s best-seller, The Canadian Small Business Survival Guide, now in its 12th printing, in which forecasting is presented front and centre. If the mechanics of projecting read like Chinese to those preparing the numbers, there is also a Chinese edition. Really.

If you want to see where it’s really difficult anticipating next year’s cash flow, cast a glance to the oil-and-gas patch. One of the companies that Benj purchased in November has delivered what has proved to be his quickest thrashing in well over a decade: Penn West Petroleum.

When the corporate budget was presented in November, management crowed about how more than $1 billion of asset sales had been made, important to this highly leveraged enterprise. Over the preceding 12 months, they noted how cash costs had dropped 23 percent and drilling and completion costs had dropped 30 percent. The quarterly dividend of 15 cents per share was deemed sustainable.

The assumptions outlined in a corporate press release were, “of $86.50 (Canadian) per barrel of Canadian light sweet, $3.69 (Canadian) [per thousand cubic feet AECO natural gas prices], and a Canadian to US dollar foreign exchange rate of $1.04.” That was then, this is now.

One month later, upon recognizing that the suppositions were faulty, the company chose not to avoid a troubling situation, but rather to face it dead on. Penn West changed its budget. The dividend was slashed to three cents a quarter, which will save the company about $160 million. The capital budget was cut from $840 million to $625 million.

Since then, the company has stated that it is in talks with bond holders to seek relief. It is difficult to prognosticate how these negotiations will play out, but the likelihood is that, at the end of the day, it will increase the company’s cost of capital while negatively impacting the bottom line.

Of course, the fastest relief for the company would be higher oil prices. Over the past decade, this commodity has spent about 60 percent of the time over $80 (US). Being guys who don’t polish their crystal ball in public, it seems reasonable to us that, over the next 12 months, oil will surpass $65 again. No certainty, though.

Penn West was purchased for $4.01 (Canadian). As of midday Tuesday, it was trading at $2.66, up 24 percent on the day. The initial sell target is $21.44. Given the current state of affairs at the company and the oil price, it could easily take a decade or more to retrace to the level where it was in 2011, if it manages to get there at all.

As an aside, given the pickle that many of our governments currently face, with deficits the norm, this seems like an opportune time to raise the gasoline tax. Perhaps an additional nickel or dime per litre. That would add to public coffers and, given the steep drop in prices at the pump, should not cause consumers much angst. Ideally, if the price of oil recovers, governments could then reduce their take.

Corporations regularly have to adapt to a changing business climate. Effectively, they have to evolve, and sometimes switch operations dramatically, or perish. Penn West is doing just that.