Antares: a star in the north

The share price of Antares Energy implies doom. Having reached highs of 60 cents in October, it now languishes at 38 cents, down 21% since recommending the stock in Antares Energy: Shale we dance? (Speculative Buy – $0.48)

The dwindling share price doesn’t marry with the operational performance of the business. Proven and probable reserves have risen from 26m barrels of oil equivalent (mmboe) to over 53mmboe; gas prices have doubled and production is up to about 2,000 boe per day (boepd). Don’t you just love these acronyms?

Best of all, drilling results have increased the upside at the developing Northern Star asset. The business is, in short, performing splendidly and our investment thesis is right on track. So why is the share price being punished?

In a word, debt. Shale production is capital intensive. Antares enjoys plenty of advantages over its peers in this regard (see Friday Fishing: Antares Energy and in the above linked article) but vast amounts of cash are still needed to develop assets.

Antares has a US$200m debt facility to do just that, but it’s due to be repaid or refinanced by the end of next year. As the repayment date nears, market anxiety is increasing.

Repayment risk

Non-repayment is a risk but a hardly a new or unforeseen one. In fact, management has tweaked its strategy to maximise the odds of the repayment going smoothly. Instead of drilling two wells a month to increase production at its Southern Star asset, it’s drilling the minimum required to achieve ‘held by production’ status. This is an important milestone.

Typically, when a driller acquires a lease, they must drill a minimum number of wells to retain it, regardless of whether it makes financial sense to do so. To do otherwise is to risk losing the asset. This explains why many shale gas producers have recently bled cash, and why gas prices fell so low.

It’s an ugly choice: drill uneconomic wells or lose the business altogether. This is no longer a choice Antares has to make at Southern Star.

The company can now drill at its discretion, which is why it has dramatically reduced drilling activity. Rather than drilling 36 wells a year at a cost of US$70m to increase output to 5,000 boepd, the company can maintain production at 2,000 boepd by spending just US$6m-US$12m.

That would turn last year’s negative cashflow of US$37m into free cashflow of about US$20m, enough to fund development work and make significant debt repayments. The change is already paying off with free cash flow last quarter funding a US$3.8m debt repayment. Debt now stands at US$59m.

Possible asset sales

For a company with a market capitalisation of just $100m, a debt of US$59m sounds like a significant burden. Yet the assets of the business are potentially worth a lot more and their sale could reduce debt quickly.

Antares has already announced the sale of a small holding at Hawkville in the Eagle Ford Shale, where BHP Billiton is drilling, for US$10m. The big prize, however, would be the sale of Southern Star. With over 4,400 acres producing at about 2,000 boepd, proceeds from a sale could exceed the current market capitalisation of the business.

Breitburn, a nearby driller, recently sold 4,600 acres producing 2,100 boepd for US$220m. This is within eyeshot of Antares’ leases. Other neighbouring transactions suggest Southern Star could attract prices between US$150m-US$200m.

In terms of cashflow and reserves, that valuation range appears fair. Southern Star comprises 13mmboe of proven reserves. We estimate it will generate about US$15m-US$20m a year in free cashflow. A sale at US$200m would value the cash flow on a multiple of between 10 and 13, which is fair considering there are 200 further drilling locations to be tapped. Proven reserves would be valued at $13 a barrel, again fair considering the high probability of reserves growth.

A sale would leave plenty of cash to develop Northern Star which could potentially be worth far more than its southern namesake. Here, substantial upside exists.

Northern exposure

Northern Star is about three times as large as Southern Star, comprising 12,400 acres. Drilling has just commenced with spectacular early results. The Cozart-19 well has been exceptional, producing at a peak of over 270 boepd, about four times the expected rate. Over 80% of production has been oil and rates of decline have been slow. The payback period could be half that of wells at Southern Star.

Of course, the success at Cozart-19 may not be replicated. Antares will drill multiple wells over the next few months to test production rates elsewhere along Southern Star but, with shales being continuous formations, it’s a bet with decent odds. If production rates can be repeated, Northern Star could be worth about US$40,000 an acre, or about $1.90 a share.

Today, Antares is a long way from that kind of payoff. It must still navigate a debt repayment and attempt a sale at Southern Star. That asset alone could be worth more than the market is currently valuing the entire business. If Northern Star reaches its potential, Antares could be worth multiples of the current price.

The presence of debt means Antares could go to zero in the worst case but, with Southern Star underpinning the current share price, that is unlikely. With significant upside, Antares is an intelligent speculation for no more than 2% of your portfolio. SPECULATIVE BUY.