Why Stone Energy Will Struggle to Grow

Stone Energy's (NYSE: SGY  ) management announced during the past few days that the company has divested some non-core Gulf of Mexico properties to Talos Energy Offshore LLC for $200 million in cash. Stone also assumed future undiscounted abandonment liabilities estimated at approximately $117 million. In total these assets produced 77 million net cubic feet per day of natural gas during the first quarter, the reserves amounted to 9% of Stone's year end 2013 estimated proved reserves.

These latest disposals take Stone's total non-core Gulf of Mexico divestments over the past year to around $300 million, with $140 million in future undiscounted abandonment liabilities. The company's two remaining assets within the region are currently producing approximately 6,000 boe/d, of which 86% is oil.

Realignment
These latest disposals are part of Stone's long-term plan to refocus operations, selling off non-core low-margin assets in favor of more attractive opportunities.

However, unlike the majority of Stone's domestic peers, the company is not selling these assets to fund an aggressive onshore shale drilling program, searching for higher-margin liquids over gas. No, over the next few years, while Stone is aiming to increase production, the company is aiming to maintain its production profile.

Specifically, the company's current liquids/gas mix is around 40% liquids and 60% gas. Management is targeting a doubling of output by 2018. Presently the company is producing around 50,000 boe/d, this is set to hit 100,000 boe/d by 2018.

Surge of deals
There has recently been a surge of deals within the Marcellus region, which could be of benefit to Stone. Indeed, last week it was reported that just under $700 million worth of deals were done within the region during one day. One of these deals was Warren Resources'  (NASDAQ: WRES  )  $352.5 million deal to acquire all of the Marcellus assets of Citrus Energy Corp. and two working interest owners.

This deal gives Warren a new platform in the Marcellus region, adding to the company's existing California oil and Wyoming natural gas assets. That said, at present the assets are only producing 82 million net cubic feet per day of natural gas, although estimated net proved reserves total about 208.3 billion cubic feet.

Still, Warren is confident that the deal is a good one. The company believes that its engineers can identify additional resource within the region, potentially unlocking further value.

Stone's attack plan
Stone's strategy for growth has three main prongs of attack. Firstly the company, like many of its peers is looking to ramp up shale oil output. Stone has 90,000 acres in the Appalachia Marcellus formation. Here the company is looking to drill 30 wells annually -- in comparison to some of its peers, this drilling program is relatively small.

Stone's second prong of attack to drive growth is the development of several conventional shelf and deep gas assets on the Gulf Coast. The third prong is the development and exploration of 122 deepwater leases within the Gulf of Mexico. Here the company has real potential with a drilling schedule running until the end of 2017 where Stone has an interest in drilling 17 wells.

The deepwater prospects are where most of Stone's capital spending is heading over the next few months. The company has earmarked $825 million to spend on development during 2014, 58% of which is going toward deepwater prospects.

However, here's the problem. To meet current development targets, Stone is planning to spend a minimum of $900 million per annum on capital projects through 2017. The company has factored in an additional $200 million oversupply per annum, so capital spending could hit $1.2 billion per year. The thing is, Stone cannot afford this spending.

Weak balance sheet
Stone has an especially weak balance sheet. Looking at Stone's reported figures for the first quarter of this year, the company reported a total debt pile of $1.03 billion, retirement obligations of $416 million, and a cash balance of $203 million. Net debt to equity was just under 100%.

What's more, during the quarter the company only generated $115 million in cash from operations; free cash flow was negative $173 million after including $289 million in capital spending. Further, Stone has not been free cash flow positive since 2010, every year since the company's capital spending has exceeded operating cash flow by more than 10%. As a result, from year end 2010, to the first quarter of this year, Stone's debt has risen around 80%.

Based on figures supplied over the past four years, Stone's annual operating cash flow has not exceeded $600 million, only around two thirds of the amount the company plans to spend on capital projects over the next year.

And it gets worse, as Stone recently tapped the market for cash, issuing 5 million shares, or 10% of its current free float to raise money for its development program. This may not be the last time Stone has to ask shareholders for additional cash.

The bottom line
So overall, while Stone has some impressive plans for growth, the company is running out of cash. Due to its heavy dependence on natural gas, Stone's earnings have fallen over the past few years and cash flow has been squeezed. As a result, the company is struggling to generate free cash flow. It looks as if the company is going to be heavily reliant on secondary issues or additional borrowing going forward as it progresses with growth plans.

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