Obsidian Energy: A Risky Investment With Uncertain Oil Prices (NYSE:OBE)

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Investment Thesis

Despite the efforts to improve its financial health, Obsidian Energy (NYSE:OBE) is not an attractive investment and we assign it a Sell rating. The company’s cost and expansion plan are attractive on elevated energy prices, which are not guaranteed given oil oversupply concerns. A detailed analysis follows in the sections below.

Overview

Obsidian Energy is a Canadian company that explores, develops, and produces petroleum resources. Oil production represents 87% of the operations, and gas amounts to 13%.

With a daily production of 32,937 barrels of equivalent, the company operates in four places in Alberta, Canada. Cardium accounts for 71% of the operations, Peace River 21%, Viking 7%, and Legacy 1%.

Obsidian Energy has achieved the highest EBITDA margin at 110.80% and a five-year return of 91.95% among its peers. However, a closer examination reveals an alternative viewpoint. Valuation metrics unveil a less favorable market perception because the company performs poorly in two out of six valuation metrics compared to its peers, having the lowest P/E and Price to Book.

The first reading shows a contradiction: Obsidian Energy has good returns and EBITDA margins, but, at the same time, it has a pessimistic market valuation. Analyzing the oil market and digging into the financial statements are necessary to find an answer.

Macroeconomics

Since 2017, the oil market has suffered a significant scenario, the Coronavirus outbreak in 2020, with the lockdown starting in most of the country in the first quarter of 2020. This situation caused a massive decline in the world supply and consumption. At the bottom, in the second quarter of 2020, world consumption dropped 14.2% in six months. The world’s oil supply and consumption must wait until 2023 to recover the pre-pandemic levels.

From 2021 to 2023, the world supply has stayed over the world’s consumption, indicating an excess supply for almost two years; during this period, the oil price declined.

In the previous image, the forward curve shows future market expectations about oil prices. The curve is in backwardation, which indicates that as time passes, the market expects lower prices, for a producer is more convenient to sell today than store for future sales. This situation leads oil companies to reduce their inventories, adding more supply to the market. For example, suppose a company agrees to sell oil in January 2024. In that case, the settling price will be US$68.61 per barrel, but if the agreement is for June 2026, the settling price will be US$65.32, a lower selling price. Based on the forward curve, market participants expect a decline in oil prices.

Oil Production

The following chart shows the Obsidian Energy production and WTI price per barrel, where the barrel of oil equivalent (BOE) is the amount of energy contained in a barrel of crude oil. According to Obsidian Energy’s quarterly and annual reports, from 2017 to 2021, oil production decreased from 31,723 to 24,605 BOE per day; this production decline is due to lower oil prices, which forced the company to reduce their gas and heavy oil activities in Peace River, Alberta Viking, and Legacy areas. However, in the same period, Obsidian Energy prioritized increasing the oil production in Cardium, an area with light oil and lower production costs. From 2021 to September 2023, the BOE per day increased to 32,376. This increase was due to higher oil prices, allowing the company to reactivate its operations in Cardium, Peace River, and Viking areas.

Since 2017, the strategy to mitigate low oil prices has been closing the gas and heavy oil operations when they have become economically unviable to extract. Conversely, when oil prices increase, the company has reactivated those wells.

Financial Analysis

Before analyzing the financial information, it is important to know the effect of oil prices on a company’s oil reserves. When prices increase, some reserves become economically and technically feasible to extract. The opposite effect occurs when oil prices decline. A company needs to adjust these reserves because they are part of property, plant, and equipment PP&E; the procedure to reflect that change is through impairment. For example, suppose the oil price increases from US$50 to US$80 per barrel; the reserves, which at US$60 were economically unviable to extract, now hold economic value. In that case, an impairment (reversal) must reflect the new reserve values.

In this section, we will use Obsidian Energy’s annual and quarterly reports and WTI historical price data to construct charts and analyze trends.

In 2019 and 2020, Obsidian Energy registered impairments for C$657.7 million and C$766.2 million, respectively. The total revenues in 2019 and 2020 were C$382 million and C$309.7 million, respectively. Therefore, the impairment costs were around twice the revenues in both years. In 2021 and 2022, Obsidian Energy made a new impairment (reversal) adjustment to reflect the recent increase in oil prices, adding an inflow of C$319 million and C$286 million, respectively.

Obsidian Energy’s return on equity has been erratic in recent years. From 2017 to 2020, the company consistently obtained negative returns, culminating in 2020 and 2021 with massive declines of 72.1% and 238.8%, respectively. These results are due to lower oil prices that forced the company to reduce its operations and implement impairments. However, since 2021, Obsidian Energy has managed to obtain positive ROEs. This turnaround is due to several factors, including higher commodity prices and impairment (reversals).

Given the distortion caused by the impairment, the previous chart shows the total expenses per BOE (without including impairments) and sales per BOE. The chart is in U.S. dollars, and the conversion rate is the yearly average exchange rate between Canadian and American dollars based on daily data. From 2017 to 2020, the average total expenses per BOE exceeded the average sales price. From 2021 to September 2023, the average sales price exceeded the total expenses. A comparison between the first three years and the last three years shows a lower cost to produce a BOE in the latter three years due to the strategic decision to produce more oil in Cardium, the area with light oil. The impairment average value per BOE between 2017 and 2022 was US$11.77.

From January to September 2023, the production cost without impairment was US$35.14 per BOE, and the average sale price was US$46.17 per BOE, resulting in a margin of $11.05. In that year, the average WTI price was US$77.27 per barrel. The WTI price and possible impairments must be considered to determine Obsidian Energy’s break-even point.

In 2022, Obsidian Energy made an impairment (reversal) of US$25.5 per BOE due to higher prices in the energetic market. The increase in the average WTI price between 2021 and 2022 was US$26.76 per barrel, similar to the impairment change. The decline in the average WTI price between 2022 and the first nine months of 2023 was US$17.65 per barrel. Therefore, the company will generate losses if Obsidian Energy implements an impairment of US$16 per BOE in 2023 proportionally to the WTI price decline.

Another aspect to consider is Obsidian Energy’s debt situation because fluctuations in oil prices can cause solvency problems. The following two ratios to analyze are the Current Ratio and the debt-to-equity ratio.

The Current Ratio, an indicator for evaluating the ability to meet short-term obligations, has shown steady improvement from a precarious 0.1 in 2020 to 0.45 in September 2023. This upward trend suggests that Obsidian Energy has improved short-term commitment payments. However, values under one indicate that the company is still struggling to pay its short-term obligations.

Turning to the debt-to-equity ratio, Obsidian Energy has maintained low levels of long-term debts, with a notable exception in 2021. It reflects a cautious orientation to financing its operations and maintains low long-term obligations.

Risk

Oil and gas prices are Obsidian Energy’s main risk because sales depend upon those prices. The company intends to increase daily oil production from 6,810 to 24,000 BOE in the Peace River area in three years. However, according to the company, the WTI has to be higher than US$70 to expand its operations by self-funding. If this plan succeeds, the total production will increase to 50,000 BOE daily, representing a 56.3% growth.

Peace River is the area in which Obsidian Energy had extracted almost exclusively heavy oil. In 2022, the company had 15.5 million barrels of heavy oil and bitumen as part of its total proved plus probable reserves and the average heavy oil price per barrel manifested by the company was US$ 64.42; therefore, the market value of those reserves without any discount will be US$ 998.58 million. Extracting 24000 BOE daily, the heavy oil and bitumen reserve life is 1.71 years. It remains to wait until the company reveals how many unrisked inventory reserves are economically viable to extract.

The second scenario is how likely the WTI oil price is under US$70 because, under that price, the company cannot self-fund its investment. Using daily data, the average WTI price from January 2016 to September 2023 was US$61.45 per barrel. During this period, the number of days with prices equal to or higher than US$70 per barrel was 31.28%. This calculus suggests that Obsidian Energy will need prices over the historical levels to increase its operations.

Conclusion

The first factor to consider is the company’s internal situation. Since 2021, Obsidian Energy has improved its financial position with positive results and better debt indicators. This positive figure is because it has placed more emphasis on light oil production. However, its expansion plan to produce extra heavy oil requires higher prices. In the event of low oil prices, the company has to reduce its production to mitigate losses or curve its expansion plan.

The second factor to consider is the macroeconomic outlook on energy. In the last two years, there has been an excess of global oil supply, pushing prices down. The expectation for the future is that prices will continue to fall, as the forward curve shows. For oil companies, selling oil now is more profitable than storing it for later sale.

We recommend selling because it does not guarantee a return on investment. Even before the coronavirus, the company was losing money. The company had positive results in recent years due to higher oil prices. We do not want a company in my portfolio that may have a negative return on equity of 30%. This scenario is a possibility for Obsidian Energy. Although the company has improved, there is still room for more improvement.