Ring Energy Stock: It’s Debt (NYSE: REI)
(Note: This article originally appeared in the August 5, 2022 newsletter and has been updated as needed.)
Energy Ring (NYSE: REI) like so many others in the industry had a successful conference call and earnings quarter. Like so many others in industry, these results have been largely ignored. This left the stock at a favorable price level.
The reason for this lackluster share price action is the level of debt. The market is extremely impatient with the pace of debt repayments, regardless of how profitable the company is in the current environment. The focus is on profitability at dramatically lower prices that aren’t likely to “go away” anytime soon.
Acquisition of fortress
In order to get back to big operations and growth without all those misplaced worries about debt levels, management made an accretive acquisition that reduces debt and also puts two Putnam representatives on the board.
Debt levels could approach $500 million (but probably won’t). But it’s easy to see that the originally projected debt ratio of 1.5 after the acquisition will likely occur before another oil price crash. Even then, the management is busy covering with decent hedges “just in case”.
This acquisition is accompanied by a brand new bank loan that is much more comfortable and allows the payment of dividends. Meanwhile, the sale of some non-core leases is now much less important as the debt ratio will be lower. Given Mr. Stock Market’s and Mr. Debt Market’s current debt fix, this is a very reasonable way forward, despite the fact that drilled wells are profitable enough to allow the company to get out of debt.
The reasons for this market (and debt) concern would be the years 2008, 2015 and 2020. This is simply too much economic “disaster” (in the eyes of the debt market as well as the stock market) to leave the time to dig debt holes by drilling profitable wells. Obviously, the solution had to be “yesterday” and not a moment later.
So now “yesterday” has come. Despite more shares issued, this is considered accretive and the combined company is expected to do better than the parties. More importantly, Putnam should be able to add value in a number of ways now that it is represented on the board. Ranger Oil (ROCC) used a similar strategy which brought experience to the board and is now doing much better than before the deal.
Second quarter results
Now, after all that, the market can finally turn its attention to what should have mattered in the first place.
If Fiscal 2020 hadn’t happened, then Ring Energy would be drilling wells until production reached an amount that would allow positive cash flow to comfortably pay down debt. This was a “tried and tested” strategy used by many low-leverage and non-leveraged companies to convert to operations during the initial lease acquisition or start-up phase.
Fiscal 2020 changed all that to focus on operational results, whatever the situation, combined with the ability of those operations to service debt. This has put a lot of pressure on companies like this.
The fact that EBITDA doubled in the current quarter prompted a collective yawn in the market, as well as another fact that these wells are breaking even at an oil price received in the $20 zone. Wells like this pay off very quickly in today’s environment, so two or even three can be drilled with the same money in one fiscal year. If the loan market had allowed the company to return to its initial strategy, things would have been “corrected” in no time. This is a conventional enterprise with long-lived wells. It is therefore an exceptionally profitable opportunity with or without acquisition.
But as the saying goes, “here we go again” with the hope that there will be no more years like some in the past. Management has one platform in operation and may not need another until the acquisition is fully reviewed post-closing. Any acquisition tends to come with deferred maintenance that needs to be addressed before any discussion of drilling new wells (and increasing production).
Debt repayments accelerated to $10 million per month in the current fiscal year. In the past, that would have been more than enough. The acquisition is expected to deliver at least $20 million per quarter (for debt payments) as long as the current robust pricing environment holds. There is also a process for selling some non-essential acreage which would speed up debt repayment. In the current environment, this process should succeed this time.
There is a deferred payment that I include for conservative purposes under long-term debt in this discussion.
There is a risk for common stockholders that at some point Putnam will “want out.” If that happens, then there are a lot of stocks that will hit the market. But usually, a situation like this with two board members is a long-term affair. But this cannot be guaranteed.
Finally, the current war in Ukraine creates an unpredictable future. It always looks like demand will outstrip supply for some time. But politics can change things overnight in this very low profile industry.
This company has a good, if not somewhat speculative, future compared to many others in the industry. Wells are exceptionally profitable, even compared to the best offshore projects (which usually have a low break-even point to justify the huge up-front costs).
Despite all the new shares issued to overcome the challenges of recent years, the recovery potential of REI stock remains excellent. What has changed is the “strategy to get there”. The fact that these acquisitions are still ongoing means that many professionals still believe the industry as a whole remains undervalued. These professionals are using considerably lower prices over the long term than is currently the case (although assumptions vary).
As long as professionals are buying, it’s probably reasonably safe for investors to continue considering investments in the industry. The thing to watch is when people who have started and built successful businesses start selling the business they are currently running. Obviously, this is not the case now.
While traders may want a price target, long-term investors are much better served by waiting for insiders to sell their businesses in large numbers and examining the value achieved at that time. Having a price target to sell when insiders are buying, as is the case now, is a great way to miss out on big long-term gains. This is especially true for cyclical companies (even volatile ones like this).