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Canadian Energy: The Ultimate Contrarian Bet

Canadian energy represents the ultimate contrarian bet. This is because oversupply, bloated takeaway capacity and irresponsible federal policies have sunk prices to fresh 25-years lows, while staggering losses erased dozens of billions of shareholder value.

Investors deserted en masse and dumped their stakes in oil and gas producers with little regard for the underlying fundamentals or the nature of the industry, which is to ease cyclical bumps. As a result, on the basis of normal earning power and asset factors, the stocks of many well-run businesses appear undervalued.

A word of caution before getting to the crux of the matter: the author has studied or performed vast quantities of financial models to value upstream operators by using traditional financial yardsticks; experience, however, has repeatedly demonstrated that such models were flawed and inaccurate, if not outright fantasies.

In effect, volatile commodity prices entail uncertain returns on capital expenditures, thereby inflating or deflating valuations to extreme degrees. Addicted to permanent funding to acquire land, drill and expand operations — or, in the worst case, to maintain unsustainable dividends — and thus highly dependent upon the kindness of strangers, producers are left praying for these expenditures to prove economic; if not, for their public relations efforts to succeed in sedating investors’ impatience.

Yet a few rare birds deserve special attention when threading through this minefield. One would be Pine Cliff Energy, a $75 million natural gas producer rightly dubbed the “garbage man of its industry”, listed in Toronto and 14%-owned by its directors.

Pine Cliff is chaired by George Fink, the oil patch veteran of Bonterra Energy fame, and seeks to replicate the latter’s highly successful, private-equity like playbook in natural gas. To that end, it acquires small, mature and developed producing fields from distressed operators at bargain valuations.

Because these properties have extinguished their growth potential and mostly consist of dry gas — which, unlike wet was, isn’t enriched by compounds like ethane and butane that can be separated and sold on their own to alleviate the pain of depressed gas prices — they stand as prime targets for fire sales when their owners face urgent liquidity issues.

Positioned on the other side of the trade, Pine Cliff steers clear of risky development expenditures, and instead focuses on buying on the cheap before maximizing recoveries from established properties — a practice proverbially known as “milking the cow”.

This led the company to deliver robust pre-acquisitions free cash-flow of $75 million between 2011 — when the current strategy was set in motion — and the first nine months of 2018 despite the troubled backdrop against which it operated.

Since acquisitions, capital expenditures and additions to working assets amounted to roughly $400 million over the period, levered returns on deployed capital flirts with 20% — an uncommon feat among its money-losing peers.

From 2015 to the third quarter of 2018, Canadian natural gas traded between $1 and $3 per thousand cubic feet (mcf) — with brief but unnerving phases below $1 per mcf — at the absolute bottom of its long-term trading range, yet Pine Cliff still managed to deliver $40 million in cumulated free cash-flow.

We know the company sits on 50 million barrels of oil equivalents (boe) in proven reserves, or 300 million cubic feet of natural gas. Since we’re at it, let us count for zero the 27 million boe in probable reserves, the working capital, the small stake in Bonterra Energy, the undeveloped acreage and the various infrastructure assets — which include four gas plants and five pipelines connected to Saskatchewan and Montana — deemed highly strategic by management. Better safe than sorry after all!

That leaves us with 300 million cubic feet of natural gas as the sole asset held by the company, against — per latest annual report — $250 million in long-term liabilities, of which $188 million are decommissioning provisions.

Let’s dig in. The company produced 7.8 million barrels of oil equivalents in 2017, or 46.8 million cubic feet. Operating expenses — excluding non-cash items such as depletion, but including share-based payments and finance charges — amounted to $95.2 million, or $2 per mcf.

Once added capital expenditures of $13.5 million, or $0.3 per mcf, breakeven stood at $2.3 in 2017, which we’ll round up to $2.5 per mcf.

In 2016, the company produced 8.2 million barrels of oil equivalents, or 49.2 million cubic feet. Operating expenses — again excluding non-cash expenses, except share-based payments — amounted to $100.5 million, or $2 per mcf. Once added capital expenditures of $9.2 million, or $0.2 per mcf, breakeven stood at $2.2.

All in all, a conservative breakeven level can thus be assessed at about $2.5 per mcf, which compares favorably with an average price for Canadian natural gas of $4 per mcf over the past two decades.

If the classical financial theory holds true, an asset is worth the sum of cash profits it will put into its owner’s pocket — minus a discount rate for opportunity cost, but we’ll spare ourselves these elaborate considerations for now.

Running a graceless back-of-the-napkin valuation, and also keeping in mind that Pine Cliff holds $380 million of tax pools, we compute that:

1. If realized price climbs to $3 per mcf, the company would earn $0.5 per mcf, and its reserves would be worth $150 million; minus $250 million in liabilities, Pine Cliff would have a negative value of about $100 million.

2. If realized price climbs to $4 per mcf, the company would earn $1.5 per mcf, and its reserves would be worth $450 million; minus $250 million in liabilities, Pine Cliff would have a net value of about $200 million ($0.60 per share on a fully diluted basis), for a market capitalization of $75 million today ($0.25 per share).

3. If realized price climbs to $5 per mcf, the company would earn $2.5 per mcf, and its reserves would be worth $750 million; minus $250 million in liabilities, Pine Cliff would have a net value of about $500 million ($1.5 per share).

Naturally, the valuation hypotheses outlined above are grossly imperfect. Higher demand for gas field or transportation services could drive expenses up, and lower netbacks in return. Realized prices could also climb to much desirable levels — say, $4 or $5 per mcf — but only after several years of pain and losses, meaning asset value would turn out to be a blend of turds and raisins.

Hence the preliminary word of caution: financial models — even the basic one articulated above — rarely fail to disappoint; this is why we took the liberty to discount probable reserves, working capital, equity investments, undeveloped acreage and strategic infrastructure assets in our calculations, trading uncertainty for any kind of margin of safety we could get our hands on.

Pine Cliff just refinanced its bank debt — brought down to zero — with additional promissory notes, and now carries $60 million of the latter, of which $41 million mature in 2020, and $19 million in 2022. Sale of assets, joint-ventures, hybrid financing — such as notes associated with warrants — and rights issues all remain actionable options.

Noteholders should behave in a more accommodating fashion than typical lenders. Chairman Mr. Fink holds a fifth of the notes, and Alberta Investment Management Corporation — a crown corporation — the other four-fifths. Staying power is weak nonetheless. Leverage amounts to two years of funds flow, so a dilute equity issue cannot be ruled out.

What if natural gas prices keep lingering at their all-time lows, or sink beneath? Surely the outcome won’t be pretty, though Pine Cliff has done a fine job at bypassing the pipeline bottlenecks, as it now sells half of its production outside AECO, realizing higher prices.

Progress won’t happen overnight, but there are reasons to hope amidst the current climate of total abdication: multiple companies shut in production; provincial and federal governments finally got their act together, and undertook to protect their sovereign economic interests; new LNG projects should come online soon; midstream operators ramp up capacity; and of course, demand is still expected to rise over the next years as utilities give up on coal.

(No position.)

Another rare bird would be Peyto Exploration & Development, the fifth largest natural gas producer in Canada.

Run by Darren Gee, founded twenty years ago and still chaired by Don Gray — one of the shrewdest entrepreneurs in the oil patch — the company has long been a value investors’ darling for its extraordinary returns, low-cost operations, insiders’ shareholdings, no-nonsense communications and brutally rational approach to capital allocation.

By the numbers: over its two decades in business, Peyto invested $5.9bn — from $1.7bn raised in equity, $1.2bn issued in debt and $3bn self-funded from cash-flows — and generated profits of $2.5bn, distributed in full to shareholders.

In the process, the company built hydrocarbons reserves worth $6.5bn (net present value of proven plus probable reserves discounted at 5%) and a sizeable midstream infrastructure. Management claims that its track record of generating $0.40 of earnings for every dollar of capital invested ranks the highest among peers.

All these merits notwithstanding, Peyto isn’t immune from the prevalent distress afflicting the while upstream segment of the industry. Trouble is real — as discussed above — and generally depressed commodity prices across the North American continent leave little to rejoice about.

Peyto’s formerly successful counter-cyclical blueprint is now at risk of failing to deliver, and may even turn against the company. Over the last decade, in effect, management ramped up capital investments as natural gas prices lingered under $3 per mcf; but in this context rewards may prove hard to reap, and value destruction substantial.

However, Peyto has built an enduring cost advantage by securing the best plays in the Alberta’s Deep Basin, where it extracts sweet gas from liquids-rich, low-permeability reservoirs that decline at a moderate rate. It also controls its own production and processing facilities, and benefits from low transportation costs due to the strategic location of its infrastructure.

Such competitive edge highlights management’s acumen — the former has to be built in the long run; it just can’t be bought over — and adequately positions the company to survive in a supply-driven market, before it can hopefully prosper in a demand-driven market.

Staying power is good. Peyto’s reputation is pristine and leverage looks tenable once compared against cash-flows and reserves. Remarkably, management hasn’t given up on their contrarian strategy, and keep acquiring land in the midst of an unprecedented turmoil for the industry.

The company sits on 2.7 trillion of cubic feet equivalents in proven reserves and breaks even at $2 per mcfe — thousands of cubic feet equivalent, cash and capital costs included — which again compares favorably with an average price of $4 per mcf of Canadian natural gas over the past two decades.

Running a similarly graceless back-of-the-napkin valuation in which we’ll count for zero probable reserves and processing facilities, we compute that:

1. At a depressed price of $3 per mcfe ($3.3 realized in 2018), the company would earn $1 per mcfe, and its reserves would be worth $2.7bn; minus $1.7bn in liabilities, Peyto’s net value would amount to $1bn, or $6 per share (vs. a price of $7 today).

2. At a realized price of $4 per mcfe, the company would earn $2 per mcfe, and its proven reserves would be worth $5.4bn; minus $1.7bn in liabilities, Peyto’s net value would amount to $3.7bn, or $22 per share.

3. At a realized price of $5 per mcfe, the company would earn $3 per mcfe, and its proven reserves would be worth $8.1bn; minus $1.7bn in liabilities, Peyto’s net value would amount to $6.4bn, or $39 per share.

Valuing an oil and gas producer — or any commodity producer for that matter — is often a challenge, so the safest way to proceed consists in blending different approaches before powdering results with a healthy dose of common sense, of course without forgetting to demand a large margin of safety.

As such, and in addition of the basic calculations above, at $7 per share Peyto trades at 6x its average annual dividend over the past decade. Whereas, on an enterprise value basis of $2.5bn, it trades at 5x its depressed operating cash-flow ($500mil in 2018), and 12x its conservatively assessed but equally depressed free cash-flow for 2019 ($200mil).

Finally, and albeit anecdotal, in 2015 and 2016 the company raised $344 million in new equity capital at an average valuation of $33 per share — five times higher than today. In response to recent price action, the board just renewed its authorization to purchase up to 12 million common shares, or approximately 10% of the public float.

Critics will point out several strategic misses and miscalculations, such as not diversifying soon enough from AECO prices, shunning liquids for too long, or continuing to pay a generous dividend when the voice of reason commanded to cut it and deleverage. Besides, as the company has now grown into a large producer, nimbleness and strict cost control may not warrant results as satisfactory as before.

Management has addressed these concerns with a new business plan that seeks to further integrate the value chain — that is, to further develop its mid and downstream capacities — but the market doesn’t buy it, and assumes that forever cheap natural gas plus debt equal to a bleak future.

Things could be framed differently: as the best-run, lowest-cost producer stuck in the midst of a (likely) temporary macro nightmare, Peyto stands out as one of the finest contrarian bets in equity markets today, as well as a perfect instance to illustrate the virtue of time arbitrage.

The proposition violates the canons of academic value investing — in which an operation must guarantee the safety of principal plus an adequate return — but it carries an exciting speculative feature and may well find its place within an adequately diversified portfolio of securities.

(Long PEY at CAD $4.5 per share and GXE at CAD $0.5 per share.)

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