Citadel Sees Potential in a Small-Cap Energy Name

 | Dec 24, 2012 | 10:40 AM EST
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Since the end of the third quarter, Ken Griffin's Citadel Investment Group has gone from owning about 40,000 shares of the oil and gas producer Penn Virginia (PVA), according to its most recent 13F filing, to 2.6 million shares, per a recent 13G filing. Penn Virginia is a $210 million market-cap company, but over the last three months, an average of 1.4 million shares have been traded daily, and the current market price is about $4.60. As a result, we believe there is plenty of dollar volume in the stock. Penn Virginia operates in the onshore U.S.

The company's natural-gas production was down 46% in the third quarter of 2012 from the same period in 2011, while production of liquids (oil and natural gas liquids) was up. As a result, the company managed to shift its product mix from being two-thirds natural gas in the third quarter of 2011 (going by MMcf as a share of MMcfe) to about half natural gas last quarter, with the rest of output being oil and natural-gas liquids. As a result, while production fell 24% in terms of MMcfe, revenue was down only 8% from a year earlier.

While this isn't positive, if we strip out the impact of a loss item, operating losses have declined slightly, despite lower revenue. Operating losses, even including that item, decreased 44% in the first nine months of 2012 compared with the same period in the previous year, despite a large drop in the prices of natural gas and natural-gas liquids (though higher oil prices have certainly helped the company).

This suggests that Penn Virginia has some upside if natural gas prices start to rise -- that market is more or less a race between very high supply and growing demand. Total U.S. net electricity generation decreased 1.3% in the first 10 months of 2012 compared with the same period in 2011, but generation from natural gas was up 25% as power producers have shifted somewhat from coal. In addition, there is increasing interest in exporting natural gas, a trend which would tend to lead domestic producers' realized prices higher.

Wall Street analysts don't expect that Penn Virginia will be profitable in 2013 either, and we'd say that even if there is a strong recovery in natural-gas prices, the business' performance wouldn't carry it into value territory there.

However, the company is a bit more interesting if we consider cash flow: Cash flow from operations was $190 million in the first nine months of 2012, and while the debt load is high, the enterprise-value-to-EBITDA multiple is only 4.4x. That actually compares favorably with two larger natural gas companies: Chesapeake Energy's (CHK) enterprise value is 7x trailing EBITDA, and SandRidge Energy's (SD) is even higher. However, the EBITDA multiple is competitive with energy producers such as Apache (APA) and Devon Energy (DVN), which are more oil-focused, and these companies are also much larger in terms of market cap. As we've seen, oil is currently responsible for a sizable share of Penn Virginia's production.

Chesapeake and SandRidge are also currently struggling with profitability, as the decline in natural gas prices has hit them hard. Chesapeake in particular had followed a strategy of production increases, and it has had to sell off some assets in order to meet its cash-flow requirements this year. Analyst consensus is for Chesapeake to at least prosper next year, with a forward P/E of 13.

We'd certainly be careful of any company that is currently unprofitable, but Penn Virginia might be an alternative to play an increase in natural gas prices if Chesapeake and SandRidge look too troubled. The stock would also likely have less of a downside, given its shift in production mix toward oil, if prices remain low.

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