Battalion: Even with risks, new joint venture comes at a higher price (NYSE: BATL)

ADragan

Oil Corporation Battalion (NYSE: BATL) will likely benefit from the recent increase in the price of oil and gas. However, the recently signed joint venture could also improve productivity and efficiency, and boost free cash flow. In my opinion, most investors are not taking into account the recent increase in reserves and the joint venture to assess the valuation of Battalion Oil. Even taking into account the dramatic consequences of the company’s geographic concentration risk, inflation and supply chain issues, I think the current stock price is too low.

Battalion Oil: New joint venture could improve future production

Incorporated in Delaware, Battalion Oil Corporation develops oil and gas assets in the United States. Already selling and producing oil and gas, the company reports nearly 96,000 million barrels of oil equivalent and recently signed new agreements, which could improve future oil and gas production.

10-k

10-k

The most interesting thing about Battalion Oil seems to be the recent joint venture signed to build an acid gas processing facility. I believe that most financial advisors only assessed the valuation of future oil and gas production and forgot to check the joint venture.

In May 2022, we entered into a joint venture agreement with Caracara Services, LLC to develop a strategic acid gas treatment and carbon sequestration facility in Winkler County, Texas. The joint venture, trading as Brazos Amine Treater, LLC, has also entered into a gas processing agreement with us for the production of gas from our Monument Draw area. In exchange for contributing to the joint venture a wellbore with an approved license for sour gas injection and surface lands, we retained a 5% interest in BAT, an unconsolidated subsidiary. Source: 10-Q

With the new facility, the company expects to reduce opex and possibly unlock new reserves. Management provided further information in a recent investor presentation.

Presentation

Presentation

Battalion Oil Corporation is doing a really good job drilling and developing new reserves. Since 2019, the number of proven reserves has increased by more than 11%. In addition, proved undeveloped reserves increased from 24.1 million boe in 2019 to 53 million boe in 2021. A further increase in the amount of reserves through a new joint venture will likely improve future free cash flow.

10-k

10-k

Balance sheet

As of June 30, 2022, Battalion Oil Corporation reported $43 million in cash, net oil and gas properties worth $334 million, and total assets of $449 million. With a significant number of proven reserves and already producing oil and gas, Battalion Oil also has a healthy balance sheet.

10-Q

10-Q

The company declares a certain debt. However, in my opinion, the future production of the company seems predictable enough to have the current amount of debt. The long-term debt amounts to nearly $189 million and the net debt would be $177 million.

10-Q

10-Q

Presentation

Presentation

The base case would include productivity improvements, new business combinations, stable commodity prices, and drilling and fracking efficiencies

In this scenario, I would first expect more joint venture agreements with other operators and perhaps new M&A deals. In my view, as net leverage decreases and free cash flow increases, financial institutions might be willing to hear Battalion Oil’s M&A proposals. Inorganic growth will most likely increase the company’s valuation.

Presentation

Presentation

In my base case scenario, I have assumed improvements in drilling and fracturing efficiency, beneficial market hedges and substantial production growth from 2022. In addition, I have also assumed that d Any increases in EBIT would likely reduce net debt. As a result, the Company’s interest expense will likely decrease, which will improve future free cash flow and may lower the Company’s cost of equity.

I used the most recent figures provided by Battalion Oil Corporation to assess the valuation of the company’s oil and gas production. I used a price close to $73.99 per boe or barrel of oil equivalent, which was reported in the last quarterly release.

Presentation

Presentation

Furthermore, I have assumed a constant production close to 5.92 million barrels of oil equivalent per year, which is close to the figure published for the year ended December 31, 2021.

10-k

10-k

Putting it all together, with a drop in price per Boe and total reserves of around 95.8k million Boe, I got a revenue stream of around $400-420 million. Also assuming a decline in EBIT margin from 40% in 2023 to -20% in 2034-2035, the 2023 NOPAT would be $131.1 million. I tried to be as conservative as possible by using an effective tax of 22% for the NOPAT calculation.

My DCF model

My DCF model

With working capital changes close to $2 million and D&A close to $151 million, I had free cash flow of about $137 million in 2023 and -$8 million in 20235 I think my numbers are pretty conservative.

Assuming an 8% discount, the net present value of future free cash flow would be $460.7 million. Subtracting the net debt and dividing by the total amount of shares outstanding, the fair price would be $17 per share.

My DCF model

My DCF model

My bearish case scenario would involve $10 per share

Battalion Oil Corporation primarily produces oil and gas in the Delaware Basin in West Texas, representing significant geographic concentration risk. Higher wages, supply chain issues and new government regulations could squeeze the company’s free cash flow margins. As a result, I think the fair valuation of the company would decrease. The stock price could fall:

We are a single-basin pure-play operator in the Delaware Basin of West Texas. Due to this geographic concentration, we may be more exposed to the impact of regional supply and demand factors, production delays or interruptions due to government regulations, processing or transportation capacity constraints, market limitations, water shortages or other conditions that adversely impact our ability to produce or market our output. Such events could have a material adverse effect on our business, financial condition, results of operations and cash flows. Source: 10-k

Geologists may not predict future reserves or find what they expected. As a result, management would report lower production and free cash flow. Once journalists take notice, I think further reports could drive down the company’s valuation. The company disclosed these risks in its investor materials:

Exploration, development, drilling and production activities are subject to numerous risks, including the risk that commercially productive reservoirs will not be discovered. We invest in properties, including undeveloped leasehold space, that we believe will result in projects that will add value over time. Source: 10-k

Finally, Battalion Oil could experience increases in the cost of electricity and materials, which could also affect production and possibly revenue growth. In the worst case, the future production of the company may not become profitable and the management may decide to stop its operations.

Cost increases may also result from various factors beyond our control, such as increases in the cost of electricity, steel and other materials that we and our suppliers rely on and increases in the cost of services to process, process and transport our production. Any increase or expansion in rates could result in increased costs and affect a wider range of materials we rely on in our business. Source: 10-k

Under very dramatic conditions, I assumed that future production would be below expectations. I got a total production of 81 million boe. With a drop in price per boe from $71 to $37, revenues would fall from $420 million in 2023 to approximately $250 million in 2035. Additionally, with a declining EBIT margin of between 30% and -25% , the 2025 NOPAT would be nearly $105 million. .

My DCF model

My DCF model

Now, with a 9.5% discount, the net present value of future free cash flow would be nearly $335 million. If we also subtract net debt of $177 million and divide by approximately 16.3 million shares, the implied stock price would be $10 per share.

My DCF model

My DCF model

My takeaways

Given the current price of oil and gas and conservative future projections, Battalion Oil Corporation could be worth well over $17 a share. The fact that management recently signed a new joint venture, which could improve future production, has not been sufficiently assessed. I also think that new joint ventures and acquisitions could take place once the net debt decreases, as promised by the management. Even considering a bearish scenario with inflation, supply chain risks and faulty geological models, in my view the upside potential seems greater than the downside risk. I certainly find more catalysts to justify going long on the stock.

Eleanor C. William