You might remember the old tale of plucky shale drillers leading the US toward energy independence and full employment with their ingeniously designed, enormously lucrative wells. It was a bestseller, until the reality of plunging oil prices intruded recently.

Now the popular story has greedy oilmen once again driving their industry over the cliff with heavy spending of borrowed money, ensuring a commodity glut that has investors ruing the day they heard about horizontal drilling and hydraulic fracturing.

Every day I see smart finance pros spread such gloom as small-cap shale stocks get drilled again and again. Some claim the industry is headed for multiple bankruptcies. Energy bonds are sporting significant discounts.

Let’s get away from the seesaw of emotion and speculation into the realm of facts and figures. Specifically, let’s look at the recent accounting by Aggressive Portfolio pick Emerald Oil (NYSE: EOX) to see if it’s really flirting with Chapter 11.

Emerald has lost 63% of its value since the end of August, and now has a market capitalization of $220 million. How does this compare with the value of its assets?

Emerald, a pure-play Bakken operator, is sitting on 13.2 million barrels of proved crude reserves. Proved reserves, under the Securities and Exchange Commission’s definition, are those that can be “estimated with reasonable certainty, from the analysis of geologic and engineering data, to be recoverable from well established or known reservoirs with the existing equipment and under the existing operating conditions.” If we were just to multiply Emerald’s trove of these by the current crude price of $81 a barrel, we’d get to $1.07 billion.


Source: Emerald Oil

Of course, things are rarely so simple. Of Emerald’s 13.2 million in proved reserves as of the end of 2013, nearly 5.8 million are in locations not yet drilled, and while they’re expected to be drilled, having the necessary finance to make it possible and the necessary oil price to make it worthwhile is not a certainty. So we’re left with 7.463 million of proved developed reserves — that is, those accessible by the wells already drilled (though in some cases not yet producing.)

Also, extracting crude from wells already drilled costs money, so the value of Emerald’s proved developed reserves  must be adjusted for those costs. In the second quarter of this year, for every barrel of oil the company produced it spent $11.45 on production expenses, $9.99 on taxes, $13.66 in general and administrative expenses and an additional $8.77 on non-cash stock compensation.

While that last bit is non-cash, since it dilutes shareholder interest in proved reserves let’s count it too. And while the G&A and non-cash compensation costs per barrel are declining rapidly as Emerald ramps up its output, let’s assume for the purposes of this exercise that these unit costs are static.

So that’s $43.87 in cash (and non-cash compensation) costs per barrel to be subtracted from the current crude price, along with the current discount for Bakken crude relative to the WTI benchmark. $81 – $43.87 – $5.40 = $31.73. Multiplying that margin estimate by the 7.463 million of Emerald’s proved developed reserves yields $236.8 million (before discounting for net present value.)  

Of course, it’s possible that Emerald is overestimating its reserves, or that even lower future crude prices would proportionally reduce the asset value.

On the other hand, it’s also possible — even likely — that in addition to the value of proved reserves beneath one of Emerald’s 77 productive or in-process wells (as of June 30), the oil beneath its 854 potential well locations spread across a net of 121,000 acres in the Williston Basin might also have some value. Multiplying all of Emerald’s 13.228 million proved crude reserves by the same (and likely artificially low) $31.73 margin gets us to $419.7 million (before applying a discount rate.)

This doesn’t include the company’s modest proved natural gas reserves or the likely big increase to reserves by the end of the year given its accelerated drilling program. Emerald plans to have drilled 25.5 net wells this year, and its proved reserves nearly tripled in 2013. In any case, it’s clear that the present value of the company’s proved reserves exceeds its current market value by a comfortable margin.

There’s also the matter of potential reserves, which given the estimated number of ultimate drilling locations must be vastly greater than the current proved amount. As of late September, Emerald was valued at 37% of the average valuation of its peers on a per-acre basis, adjusted for current production, according to a recent company presentation. The discount must be even wider now.  

But to get reserves out of the ground Emerald would have to survive long enough regardless of the oil price. Can it do so? Let’s look at the balance sheet and recent cash flows to get a better sense of the company’s resilience.

As of June 30, Emerald had $140 million in cash, but that was recently down to $56 million following the latest acreage acquisition. The company also had $200 million available on its untapped senior secured credit facility. That’s sufficient liquidity to finance its current three-rig drilling program deep into next year, though before the current slump Emerald had hoped to tap capital markets again early next year. The company has a $250 million drilling budget for the current year.

On the liabilities side of the ledger, the lone item of long-term significance is the $172.5 million in convertible bonds issued in March, which at this point looks like free money. That’s because the conversion price, at $8.78 per share, is by now in the realm of science fiction. And the interest rate is a nifty 2% annually, versus preferred and junk bond rates closer to 9% for many other oil companies of this size. The notes mature on April 1, 2019. They’ve recently been heavily discounted to an effective yield of 11% in the market, but the original buyers’ loss has clearly been a gain for Emerald.

This is money that’s largely been spent on this year’s drilling program, and cash, the credit facility and operating cash flow can likely sustain the same drilling pace throughout 2015.

In the second quarter of 2014 Emerald reported an adjusted EBITDA (earnings before interest,  depreciation and amortization) of $17.4 million. Subtracting the $1.1 million in interest costs, $3 million in stock-based compensation and $1.5 million in capitalized compensation expenses left it with 11.7 million in quarterly cash flow from operations, as adjusted for all cash and non-cash personnel costs.

That was based on a production rate of 3,781 barrels of oil equivalent per day (boepd). Emerald expects to exit the year with a production rate of 4,900 boepd. If it were simply to maintain that rate throughout 2015, keep unit costs flat and sell its crude at $81 minus the recent $5.40 Bakken discount, that would add up to 2015 cash flow of $56.6 million, and that’s treating stock-based compensation as a cash outlay.

Source: Emerald Oil

In fact, Emerald can likely do better than that if only because it has already hedged at least 1,242 boepd of its 2015 output at $96.24 a barrel. For 2014, 3,810 boepd was hedged at $96.70 per barrel as of mid-August.

Of course, the company is also highly likely to increase its output next year, as should become clear when it provides a 2015 forecast on Nov. 4, the morning after reporting its third-quarter earnings. Increased production is likely to drive a decline in unit costs, magnifying the increase in the cash flow.

So what we have here is a company currently paying a 2% annual interest rate on debt that’s not due for another 4.5 years, valuable reserves and acreage and the financial flexibility to continue profitably exploiting these, priced well below the fair market value of these assets. What we don’t have here is a bankruptcy candidate.

In the unlikely even of crude slumping to $60 per barrel, Emerald could hunker down and milk its current wells. And if crude merely stays where it currently trades the depressed share price has the potential to double. Buy EOX below $4.50.