Monday, November 16, 2009

Callon Petroleum (CPE) Senior Notes

Callon Petroleum (CPE) is a small independent oil and gas company that engages in acquisition, exploration, development, and production in the onshore and offshore Gulf Coast region.

The market cap is only $35 million, with an enterprise value (adjusted) of $234 million. Practically all of their debt consists of one issue of 9.75% Senior Notes due December 2010 which are currently the subject of an exchange offer. The notes, totalling $196 million, have been trading in the 60-70 range to yield around 50% to maturity.

Third quarter 2009 earnings before interest, taxes, depreciation, depletion, and amortization (“EBITDDA”) were $12.66mm versus $25.15mm the previous year, caused by a $4mm drop in oil revenues and an $8mm drop in natural gas revenues. (Natural gas was under $4 this quarter versus about $9 last year.) Year to date EBITDDA has been $44.7mm versus $100.5mm the previous year.

Extrapolating their income is complicated by the fact that they hedge their production. The oil hedge - which was at $110 this year - expires in December. So we can probably expect their realized oil price to fall 30% next year. However, revenue should fall less because of the new onshore properties they acquired last month. The natural gas floor will actually step up in 2010 to $5 from $4.5 - about 11% increase.

I will do much more on hedges and cash flow in a subsequent post, but for now, I say ballpark of $50mm annualized EBITDDA for a debt/EBITDDA ratio of under 4x. According to the Q3 2009 conference call, they do expect to hedge 50% of their 2010 production by the end of 2009. Locking in today's futures prices would probably be a prudent move.

Exchange Offer
The company has offered to exchange each $1,000 principal amount of outstanding 9.75% Senior Notes due 2010 for $750 principal amount of new 13% Senior Secured Notes due 2016, plus 20.625 shares of common stock and 1.6875 shares of Convertible Preferred Stock (CPS). Each share of CPS would be automatically convertible by the company into 10 shares of common stock following shareholder approval. That is pretty much a formality, so it would be 37.5 new shares per bond.

The exchange offer is conditioned upon 80% of the notes tendering. Right out of the gate with the public announcement of the exchange offer, the company already had 73.5% of notes tendered. The deadline for the exchange offer is November 18, 2009 (this Wednesday), unless extended or terminated. If 80% tender it means that 5.7 million new shares will be issued. There are 22 million currently outstanding.

The trade that I am interested in is: buying the notes, holding out from the exchange offer, and hopefully receiving full payment in December 2010. If you assume that only the minimum 80% of holders tender, the remaining 20% of notes will amount to $39mm in principal. That should be less than 1x EBITDDA. Also there are two contingent gains of that size that I will discuss below.

One downside about this offer, from a holdout perspective, is that the company won't have any cash interest savings – 9.75% of $1000 is the same as 13% of $750. However, as holdouts, our likelihood of getting principal paid in December 2010 is vastly improved.

What's surprising to me is that people tendered for such a small share of the equity, and without (publicly) putting up a fight. It's possible that the largest noteholders were given confidential information that is bullish. Possibilities include settlement of the contingent gains that I will describe below.

One downside to being a holdout is that those who tender their notes are consenting to amendments to the note indenture, which will eliminate substantially all of the indenture’s restrictive covenants. However, the new notes will apparently have second lien until fewer than 10mm of the old notes are outstanding.

Another interesting thing the tendering noteholders are agreeing to is that, for a period of six months from the date of issuance of Common Shares pursuant to the Exchange Offer, they will not “directly or indirectly, offer for sale, sell, pledge, or otherwise dispose of [...] Common Shares in an amount that is more than 25,000 Common Shares per week.”

There are two complicated situations that affect CPE and which require careful review.

Minerals Management Service
First is the possibility that CPE may recover a substantial sum from the Minerals Management Service, the federal agency that collects offshore drilling royalties, for amounts that the company overpaid. The Company's explanation from the latest 10-Q is that they overpaid federal royalties on two leases,

Mississippi Canyon Blocks 538 and 582 (Medusa Field), when the prices exceeded the benchmark levels. A preliminary estimate for this recovery of a contingent gain indicates that the Company has overpaid royalties of approximately $40 million. The exact amount is subject to final determination including possible interest. However whether or not the Company will be able to recover all or part of these overpaid royalties is unclear at this time. Therefore the Company does not intend to recognize any benefit to income until it finalizes and files its claim to the MMS and determines that the MMS intends to refund the overpaid royalties.”
This alone would be enough to redeem the holdout Senior Notes in December 2010. The Company could also tender for them at a slight discount as soon as they receive a refund.

Callon Entrada
Second is a dispute the company is having over a joint venture with a company called CIECO. The adjustment to enterprise value that I made in the introduction was to exclude the “Callon Entrada non-recourse credit facility”, which is listed on the balance sheet as a liability of $84.45 million. Callon Entrada is a wholly owned subsidiary of the company which “entered into a non-recourse credit agreement with CIECO Energy (Entrada) LLC.” The purpose of this loan was to finance the development of the Entrada project, which was subsequently abandoned in November 2008.

Because it is a wholly owned subsidiary, the company is required to continue to consolidate the financial statements and results of operations of Callon Entrada, which means that Callon Entrada’s non-recourse liability is reflected in a separate line item in Callon’s consolidated financial statements.

The company says that, “based on the advice of counsel, [they believe] that Callon and its subsidiaries (other than Callon Entrada) did not guarantee and are not otherwise obligated to repay the principal, accrued interest or any other amount which may become due under the Callon Entrada credit facility.” Further, “The lenders under our senior secured credit facility have amended the Second Amended and Restated Credit Agreement dated September 25, 2008 to state that a default under the Callon Entrada non-recourse credit facility is not a default under their facility." I don't think the lenders would have done that unless it was totally clear that the debt was non-recourse.

Actually, CIECO might have more to worry about, litigation wise, than Callon. "Prior to abandonment of the project, CIECO Entrada failed to fund two loan requests totaling $40 million under the Callon Entrada non-recourse credit agreement with CIECO Entrada. CIECO Entrada also failed to fund its working interest share of a settlement payment in the amount of $7.3 million to terminate a drilling contract for the Entrada project." This is another possible bullish, upside surprise, though much more tenuous than the potential MMS refund. A settlement whereby CIECO pays CPE for its JV obligations could itself give sufficient cash to redeem the holdout 2010 notes.

Note that Callon Entrada has zero operating revenues and $5.4 million in interest expense. Also negative working capital. These should be backed out of the consolidated balance sheet.

Recent Acquisition
Another interesting prospect: around the time they annouced the exchange offer, they also spent $16.25 million acquiring oil and gas properties in west Texas from a subsidiary of ExL Petroleum, LP. The company estimates the total proved reserves being acquired to be approximately 1.5 million barrels of oil equivalent, with 23 producing wells that have a current production rate of 475 barrels of oil equivalent per day.

Despite the fact that the company is doing a distressed debt exchange, they are pursuing these acquisitions. Their plan is to use cash flow from their key offshore wells – Medusa and Habanero – to fund onshore properties in the Permian basin region. For example, they plan to drill 11 onshore wells in 2010. It would be nice if more of CPE's revenues were from onshore properties – that would reduce the hurricane risk.

Senior Secured Credit Facility
They have a credit facility which has no borrowings outstanding and $30.3 million currently available for future borrowings, and which matures on September 25, 2012. (That is, unless the 2010 Senior Notes have not been extended or refinanced to a maturity date occurring after September 25, 2012 in which case the credit facility will mature on June 15, 2010.) Borrowings under the credit agreement are secured by mortgages covering the Company’s major fields excluding the Entrada field.

The Company's lenders waived its noncompliance with two financial covenants. If the Company is not in compliance with these covenants at December 31, 2009, the Company will require similar waivers at that time.

One interesting thing to check out – and I need to look at the credit agreement – is whether the current note exchange will be considered an extension or refinancing of the Senior Notes. If so, and if the company would be allowed to use the facility to redeem the Senior Notes that remain, that would be extremely bullish for us holdouts.

Disclosure: I own CPE senior notes and I am short CPE equity.

1 comment:

Geoffrey Rocca said...

I ran across your post after I wrote my own piece analyzing the Callon Petroleum bonds and tender offer. I agree entirely with your view that rejecting the tender offer is likely to be safer and more lucrative than accepting it, because the firm's future really is in a tenuous situation and, as you state, the tender offer does nothing in terms of reducing their debt maintenance costs.