Energy Prospectus

First let me explain something to those of you that don't have a Masters in Accounting: There are two accounting methods ("Full Cost" and "Successful Efforts") that are approved by the SEC for upstream oil & gas companies. Both methods are covered by Generally Accepted Accounting Principles or "GAAP" rules. Combined with the GAAP rules for accounting for derivatives (hedges) both methods are extremely misleading to investors.

This is why Wall Street came up with "Adjusted Earnings". They are still not perfect, but a heck of a lot better than GAAP or "Reported Earnings".

Now to PDCE: Here is what they had in their Q2 Results Press Release. My comments are in blue.

Net loss for the second quarter of 2018 was $160.3 million, or $2.43 per diluted share, compared to net income of $41.3 million, or $0.62 per diluted share, for the comparable period of 2017. The year-over-year difference was primarily attributable to a $112.3 million increase in crude oil, natural gas and NGLs sales being offset by $174.1 million difference in commodity price risk management between periods. Additionally, as a result of widening gas differentials, increased well costs and the timing of lease expirations, the Company recorded an impairment charge of $159.5 million (a non-cash expense) to select higher-GOR, non-focus area acreage. This impairment is not expected to impact the Company’s estimated focus area drilling inventory of approximately 450 mid-reach lateral equivalent locations.

Adjusted net loss, a non-GAAP measure defined below, was $84.5 million, or $1.28 per diluted share in the second quarter of 2018 compared to adjusted net income of $12.5 million, or $0.19 per diluted share for the comparable period of 2017. Excluding the aforementioned impairment expense and related tax impacts would have led to an adjusted net income of $36.8 million, or $0.56 per diluted share in the second quarter of 2018. < This what should be compared to First Call's EPS estimate and my forecast of net income of $29.7 million or $0.45 EPS.

Net cash from operating activities was $175.7 million in the second quarter of 2018, compared to $132.9 million in the comparable 2017 period. Adjusted cash flows from operations, a non-GAAP financial measure defined below, were $199.3 million in the second quarter of 2018, compared to $142.9 million in the comparable 2017 period. < This is what should be compared to my cash flow from operations forecast of $187.1 million or $2.84/share.

So.....
1. PDC had a solid quarter, beating my forecast.
2. PDC raised their production guidance, with a much higher exit rate (~135,000 Boepd) which causes me to raise my 2019 production forecast.
3. PDC is going to ramp up production sharply into year-end, thanks to increased gas processing facilities being added in the DJ Basin and outstanding well results in the Delaware Basin.

Since PDCE released Q2 results, four analysts have submitted updated forecasts/valuations to Reuters/First Call. Their valuations range from $65 to $86 per share.

I have updated my forecast/valuation model for PDCE. My valuation stays at $90/share, but I think it has a lot more upside for us because they should exit 2018 on a roll. They are now funding all of their D&C expenditures with cash flow from operations. An upstream company growing production YOY by 25% to 30% and generating FREE CASH FLOW FROM OPERATION should be trading for a lot higher multiple than what I am using to value it. PDCE and SRCI are dealing with the "Colorado Issue" of environmentalists groups that are constantly trying to shutdown drilling in the state. As I posted yesterday, they have little chance of succeeding because this industry is extremely important to the state and most of the politicians and citizens know it.

This is the last of the Sweet 16 companies that I needed to update. A few common issues I see.
1. Natural gas prices in the Permian Basin are terrible and will remain well below Henry Hub through mid-2019 because the pipeline takeaway issue is worse for gas.
2. Offsetting lower gas prices are better NGL prices and the fact that all of the our pure plays on the Permian Basin are heavily weighted to liquids.
3. Most of our Permian Basin companies have a good handle on the marketing of their liquids.
4. The Eagle Ford and other areas that can get their oil to the Gulf Coast are getting a premium to WTI less the transportation costs.

In all of my forecast/valuation models I am assuming WTI at $65/bbl for all future periods adjusted for regional differentials and hedges. I've also put a sizeable "cushion" in my forecasts for all of the Permian companies to account for the big differentials to WTI.

Just keep in mind that the takeaway capacity issues in the Permian are being resolved by the midstream companies and should be solved by this time next year.

Re PDCE, why are you the only one who seems to understand this? It is hard to imagine that the stock got hit because uninformed retail investors such as I represented more shares for sale than others were willing to buy. If supposedly informed institutions (hedge funds, mutual funds, etc) understand what you understand, then the share price should have held up, if not gone up. It leaves me scratching my head.

I am not the only one who understands this, as you can see from the high valuations given to PDCE by the four analysts that quickly sent updated reports to Reuters. BTW of the four analysts that updated their reports, the one I have the most respect for (who is quite conservative) rates it a BUY with an $82 price target. His report is dated August 9, 2018.

There are a lot of money managers, handling $Billion of other people's money, who do not understand the complex accounting rules for this industry.
In a former life, I was a consultant for a small hedge fund. I made a few trips to New York to meet with some Wall Street money managers. I will never forget a meeting we had with a group that had over $3 Billion under management. The fund managers were "children" that looked like "deer caught in the headlights" when we discussed upstream oil and gas companies. I'm sure that they all had MBAs from fine schools, but they had no real world experience.

Fund mangers are just people and a lot of them let computers do their trading. Just like with oil futures, one fund hitting the "sell button" because they didn't like something in a quarterly report can causes lots of "stop loss trades" initiated by computers.

The point of all this is that investors in this sector (or any other sector) must have a basic understanding of the GAAP accounting rules for the sector. I urge EPG members to focus on cash flow from operations and production growth. At any point in time, an upstream company is worth the NPV of future cash flow from operations and that comes from production.

Your "homework" is to sit down with one of my forecast/valuation spreadsheet that you download to Excel. Look carefully at how I calculate Cash Flow From Operations. Since the Excel spreadsheets are "macro driven" you just need to put your curser on the cell to see the formula. BTW the Statement of Cash Flow is one of the three primary financial statements that must appear in every public companies 10Q. IMO it is the most important.

Here is why PDC Energy is in the Sweet 16:
Year / Production per day / Cash Flow From Operations / CFPS

2016A / 60,552 Boepd / $466.8 million / $9.52 CFPS
2017A / 87,138 Boepd / $582.1 million / $8.81 CFPS
2018E / 113,000 Boepd / $857.1 million / $12.96 CFPS < Compares to First Call's CFPS estimate of $12.71
2019E / 140,000 Boepd / $1.111.1 million / $16.80 CFPS < Compares to First Call's CFPS estimate of $17.96

FYI I worked for Hess Corp. (NYSE: HES) for over 18 years (1983 to 2002). They used the "Successful Efforts" method of accounting. I was the U.S. E&P Division Controller (officially an Assistant Controller for the parent company) from 1994 to 2000. My last two years at Hess, I lead a Business Development Team with seven MBAs working for me and we tracked over 50 small-caps looking for takeover targets. During those two year, Hess made $3.2 Billion in acquisitions.

As the Head Bookkeeper for the USE&P Division, I learned a lot about GAAP Accounting Rules. It was the Enron crash that caused lots of really stupid and IMO misleading accounting rules for upstream companies.