SSN transformed!

This is a really long research post and I've used a spreadsheet and fundamental principles from other O&G investments to provide some specific insight into what will be a SSN company transforming acquisition should MOB agree to provide funding. Snapshots of the spreadsheet at the end of this post. I'll also create another thread where I contrast SSN and LNR side by side.

Capital access is (IMO) being restricted to the best projects, as measured by marginal economics of the project. So those companies with multiple projects (e.g. OAS) have to high grade their projects to allocate capital to their highest return projects. This is not how it has worked in the past and the ZIRP of the US Fed and easy access to cheap capital allowed capital to be deployed to marginal projects by any company with access to a drill rig.

Investing is different now. In other words, don't measure who is growing production and reserves most rapidly. Measure who is growing equity return most rapidly for every given dollar of capital invested or for every given BOE of new fully funded reserves. Unless the company owns low cost/highly productive acreage then large land capture efforts and a large drilling inventory offer false comfort for shareholders (wish I had a dollar for every presentation that stressed number of drilling locations).

The stock market (equity capital) tends to look at all BOEs, cash flow or production in the same way i.e. no real quality adjustment to focus on marginal economics per BOE of production and free cash flows and the return on invested capital. I think we are seeing a basic change in philosophy with focus on 1P proved producing reserves (PDP and maybe also PDNP) instead of 2P F&D costs because only the 1P PDP is fully funded in the context of equity. This should be readily apparent as the capital to develop the 2P Reserves cannot actually be funded with the current share count or balance sheet.

I've made this mistake too many times – being seduced by companies that market their current “cheap value” premise by highlighting their 2P NAV, noting that they are cheap because their stock trades at a deep discount to reported 2P NAV. Instead, compare that same stock price to their PDP NAV (the NAV they can actually fund) and it may highlight how expensive the stock really is.

I haven't done this for SSN per se, but the theory implies the fully funded reserves per share (i.e. 1P PDP) has on average been dropping (generally due to new shares being issued) at the same time as debt per BOE of fully funded reserves has been growing. (Rob79 care to double check me on that??) I think in a prior post we showed how BOE production was growing per share (which just highlights watching the wrong number). The analysis I've done actually tries to keep production steady.

But E&P is capital intensive business because it is fighting a depletion curve. The question becomes how much capital is needed to “stand still” on a fully funded basis (i.e. 1P PDP). Any generated cash flow that is in excess of this “stand still capital” becomes free cash flow. Now it gets really tough because the depletion curve is a production measurement and so the immediate thought is to not shrink must mean to keep production relatively static. Probably nothing wrong with that thought, but possibly more important is to not shrink the PDP Reserves. In other words how much capital needs to be invested to keep 1P PDP Reserves static (so a 100% RRR at a minimum but preferably a 150%-200% target)

Simple example. If SSN was producing 1,000 BOEPD and the average F&D was say $20/BOE (not so easy to figure out and usually done on a rolling 3yr basis) then the amount of “stand still capital” to invest would be 1,000x365x20 = $7.3M. This is simply replacing the 1P reserves produced.

Clearly there are other ways of replacing reserves … such as by acquisition as is being proposed by SSN, and this acquisition fundamentally changes their F&D costs (I've noted this before) for the better.

It gets more interesting as in all likelihood the Reserves replacing the Reserves produced will have different economics assuming it is more profitable (a higher operating netback) then over time this “stand still capital” will produce higher free cash flow as the “older” lower margin product is replaced by the “newer” higher margin product. The analysis shows that.

This is also what (IMO) is behind what TB is trying to accomplish with this acquisition. If anyone is still reading the post, this is what I think could potentially generate 10x on the current share price (I know for many that wont get you back to even … sorry). That 10x return is based on the laid out Capex PLAN with the ESTIMATED capital efficiency (or intensity) values (I'll explain more on that later). You can see this coverage number in the model and it is increasing over time (a good thing as the higher the better) IF the premise of the initial capital efficiency is correct.

This doesn't mean forget about full cycle costs for F&D which should still be the prime consideration as it includes all the capital costs. However, I am going to concentrate on the half cycle costs which is analogous to just the drilling and completion costs (D&C) for the capital efficiency rate simply because the future capital that SSN will be spending is in the OAS acquisition acreage for D&C of wells.


OK – still with me??

Here is the first part of the spreadsheet – the Base Assumptions. This is simply putting in place annual averages for the commodity price (e.g. WTI $38/Bbl for 2016), the Bakken differential and the production mix % to come up with an estimate (before hedging) BOE selling price. Hedges are then layered in as noted in most recent 10Q. Base Opex costs are layered in (again from most recent 10Q and then an uplift guesstimate to LOE, G&A to address the acquired acreage).

NOW THE IMPORTANT PART – the CAPEX PLAN and the PRODUCTION PLAN. I believe that SSN is working hard on this part to convince MOB that it is in their best interests to fund this acquisition.

In the Capex Plan the row titled “Prod. Capital Efficiency” is the most important concept to understand and how it relates to production itself. The basis of my production plan estimate is that SSN exits 2015 at approx 1,500 boepd (780 boped organic production and 720 boepd of acquired). In 2016 that 1,500 boepd of production has some decline associated with it I've got a corporate annual production decline estimate built in – whether that is low or high is anyone's guess (but if someone here wants to ask SSN mgmt they would have that estimate). They might also give out estimated production efficiency for the different projects.





So the 1,500 boepd declines by estimated 375 boepd. That needs to be replaced. IN ADDITION, SSN has told us it is going to aggressively go after the PDNP wells. I'm suggesting (no basis to support it) a target might be approx 2,025 boepd for 2016 and that this is the level at which to maintain production.

The question becomes how much capital is need to provide the 900 boepd (375 to replace the decline and 525 for new recompletions). This is really tricky. I'm giving SSN the benefit of the doubt here in putting in an extraordinarily efficient $5,000 boepd in 2016 (on the basis that they only need to recomplete and not drill). This accounts for the $4.5M is capital (5,000 x 900). Over time this (unfortunately) has to rise as the low hanging fruit has been plucked and more normalized D&C costs apply.

You can follow the future years across with the decline and “stand still capital”.

Please note that SSN has not provided any such details. It would be up to investors to ask for guidance (they certainly have indicative numbers, projections and proformas). I'm sure SSN will provide some kind of investor update when the acquisition has been completed. However, the equity investor needs to have some idea of a plan … and this is what I would be (am) looking at to see if SSN warrants buying.

With that set of base assumptions the next obvious thing to do is estimate some kind of Income Statement from the pricing/production/costs. From this we derive the estimates for EBITDA and for Free Cash Flow. Very important is the EBITDA Margin.



Most important to me is what happens in 2016/17. The commodity price is quite destructive at the low end (didn't bother with WTI $35 or less for $2016) and the EBITDA ratio is a problem thru 2017 but it turns in 2018 as both commodity price and layering in higher netback production from replacement production kicks in. This is also evident in the familiar $ per flowing boe per day valuation.

Taking the model to its logical conclusion what has occurred?

Well the assumption is MOB funds the acquisition and debt increases to $39M.
SSN then starts 2016 with ~$4M of cash.
Over the course of 2016-2021 SSN invests $31.75M of CapEx from cash generated by operations
SSN finished 2021 with debt of $0, Cash of $3.86M and 1,583 boepd of production in 2022.





That is an infinitely stronger company than where SSN stands today. I'm not here to pump SSN and I don't have a position or in fact a sentiment - but watching closely.. The real test is whether MOB believes and whether SSN mgmt can show a plan that instils into MOB the confidence that this planned acquisition is in both their interests. Otherwise I don't see a future (as in how does SSN repay MOB Jan 2017).

Assuming MOB comes on board, I would be looking for SSN to put out some form of proforma that provides some of the details I am guessing at here. I may initiate a (long) position if I get the sort of confirming information out of SSN proforma I'm looking for.

Buc, you said it earlier with there is lots of money to be made and my response was you have to pick the right stocks. IF what I laid out is in fact reasonable and supportive of what SSN can in fact deliver then yes there is money to be made – big money. A lot more upside than downside exists. (I mean only 0.003 – 0.004 per share left to lose).

GFTA (Good Fortune To All)