Lundin Petroleum AB (OTCPK: LUPEY, OTCPK: LNDNY, OTCPK: LNDNF), the Swedish upstream company that I brought to the attention of my dear readers in late 2018, has recently published a few releases including the CEO’s letter to shareholders and amendment to the proposed 2019 dividend which shed light on how the company has been preparing to address the abrupt plunge in crude oil prices.
2020 had been a long-awaited inflection point when the company’s growth story was due to materialize. The start-up and ramp-up of the Johan Sverdrup oilfield offshore Norway was about to transform the company and catapult its free cash flow (to around $1 billion on average in 2019-2026 in a $65 Brent scenario), also bolstering the dividend. Given the price return in the second half of the 2010s, the market had high hopes for it. Unfortunately, given a shocking situation in the global oil market partly because of the catastrophic destruction of demand for crude and partly because of the adverse moves of the former OPEC+ allies, Lundin’s 2020 growth will not be as impressive as the investor community previously anticipated.
The accelerated ramp-up of the first phase of the Johan Sverdrup announced recently will do little to offset the downward plunge of the North Sea oil benchmark price. As of March 30, analysts are predicting the 2020 revenue and other income to increase by a meager 0.6% and reach $2.97 billion. An essential remark worth making here is that the 2019 total revenue was bolstered by a $756.7 million accounting gain on the sale of a 2.6% stake in the Johan Sverdrup to Equinor ASA (EQNR). Adjusted for this one-off item, 2020 revenue growth will be around 36% (assuming production will be between 145 kboepd–165 kboepd). As a quick reminder, as I mentioned in the article “Lundin Petroleum: Dry Silfari Well, Doubled Revenue By 2021,” in December 2018, analysts anticipated the 2020 top line to increase 1.7x in comparison to 2019 and surpass $4 billion.
Photo from Johan Sverdrup on 09 October 2018. Source: Equinor
Extremely low FCF break-even did not save the dividend from reduction
Phenomenally low FCF neutrality break-even makes Lundin Petroleum one of the most efficient oil companies in the world. One of the reasons is startlingly low operating expenses: the company expects them to remain in the $3.2-$4.2 per boe range in the long term. Thanks to the portfolio structure and strict cost management, the company can generate free cash flow (before debt repayment and dividend) even if oil price tumbles close to $17/barrel. If it settles at $17/barrel, net cash flow from operations will be equal to cash used in investing activities. This means if Brent is trading below $20 per barrel, Lundin is still excessively covering additions to oil & gas properties and other investing activities. Of course, if the benchmark slips to single digits (the possibility of this is increasing as tank storage capacity is approaching limits), there will be no FCF-positive companies in the world, including Lundin Petroleum.
Still, given the oil market turmoil, the Board decided to amend the proposed DPS from $1.8 to $1 in order to buttress liquidity during these uncertain times. To rewind, in the Capital Markets Day presentation, Lundin Petroleum promised to distribute $511 million in dividends in 2020. So, the reduction in DPS will save it approximately $226.8 million. For a broader context, its closest NCS-focused peer Aker BP (OTCPK:DETNF) has no intention to revise the DPS down (at least for now), but it trimmed capital investments (mainly related to the non-sanctioned Hod redevelopment project) and exploration spending. This can take a toll on the long-term production growth prospects, and I hope the firm had carefully pondered all the pros and cons. It also made emergency adjustments to production expenses.
There is no doubt the sharp reduction in shareholder rewards is disenchanting news for investors; however, I acknowledge this step was reasonable, as conservative balance sheet management must remain a top priority even for ultra-low-cost producers like Lundin Petroleum.
In the past, the cyclopean debt was not worthy of concern
But in this dynamic environment, everything is changing rapidly. For a heavily-indebted company, the unprecedented oil demand contraction raises one essential question: how it is going to pay interest and repay the debt if any maturities are due in the short term.
As of December 31, Lundin’s total financial liabilities stood at $3.95 billion. This is a terrifying amount considering total assets on the balance sheet were not sufficient enough to fully cover them. As 2019 EBITDAX added up to $1.9 billion, its Total debt/EBITDAX multiple was just slightly above 2x, an adequate and safe level for a company involved in a capital-intensive business. But when the denominator of the formula creeps lower dragged by ultra-low commodity prices, the multiple is edging to the territory that is far less safe. However, in the case of Lundin, 2020 EBITDAX is not about to plummet, as higher oil volumes produced can offset the debilitating effect of lower prices. This means leverage will likely remain the same or change only marginally.
Now, let’s briefly touch upon the debt structure. Lundin Petroleum’s debt is comprised of bank loans (reserves-based lending facility). The bulk of the $5 billion RBL has been already drawn, but the firm still has more than $1 billion in available liquidity that it can use if necessary. An essential remark is that in July 2020, the size of the committed facility will go down to $4.75 billion. In January 2021, it will be reduced to $4 billion (see page 84 of the 2019 annual report). However, the recently proposed dividend reduction implies it is unlikely the firm will need to boost the debt. On a negative side, Lundin’s cash pile on the balance sheet is not sizeable enough to adequately cover the borrowings; as of December 31, its cash & cash equivalents amounted to only $85.3 million.
The 2019 interest paid was $177.4 million; considering an around 36% 2020 revenue growth, I have no reason to question the 2020 interest will be more than sufficiently covered by operating cash flow. There are no sizeable maturities in 2020, except for repayment of $92 million in bank loans this year (see page 85 of the 2019 annual report). However, $1.5 billion in bank loans must be repaid within 1-2 years. Also, on page 84, it is said that there are material covenants like the net debt to EBITDA and the EBITDA to financial charges that can trigger an “event of default.” As I said above, I think 2020 production growth will buttress EBITDA and help to keep these ratios on required levels.
To sum up, though debt looks burdensome, I am fairly certain the insolvency risk is minimal.
The history of the Johan Sverdrup oilfield, the key value driver of the company, is a path from one oil crisis to another. In the mid-2010s, the previous crude price fall resulted in capex savings. But the current crisis jeopardizes the growth prospects of the first phase of this prominent project. However, while a 67% increase in 2020 revenue is no longer a realistic scenario, I hope the oil market will recuperate in 2021. At some point in the future, it will inevitably heal inflicted wounds, as V-shape recovery always follows the gloomy days of the recession. This means the second phase of the field, which is due to come on stream in the fourth quarter of 2022, will likely enjoy more favorable realized oil prices.
Lundin Petroleum has been trading at highly-inflated multiples as the market priced in its spectacular growth prospects cemented by the output surge in the early 2020s. As the short-term growth prospects have been trimmed, the rich valuation evaporated; the Enterprise Value/2P reserves multiple is now standing at ~12.6x compared to ~21.2x in September 2018 (see my first article on its closest peer Aker BP). Previously the market darling, the stock was severely battered. Though in late March the share price has partly recovered, the 90-day price return on Nasdaq Nordic is still negative 46%. If the oil price continues to slide, it will certainly suffer from more losses.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.