What is that competitive advantage? You must be the low cost operator. Being the low cost operator gives you a huge advantage over you competitors, not only in higher profit margins during the good times but more importantly it ensures profitability when prices fall. This article will investigate Peyto’s low cost advantage and how profits drive returns. Part two of this article will look specifically at Peyto to see if it is a bargain and compare it to PetroBakken.
Peyto Energy - A Unique Competitive Advantage?
Peyto Energy is a pure play natural gas company that operates in what is called the central deep basis of Alberta, Canada. Over the last twelve years the company has offered the highest total returns for any E&P on the TSX, at a little over 60% annually. While history never indicative of future performance, it definitely raises an eyebrow as to how they accomplished such returns.
What separates Peyto from other companies is their low cost advantage. As already mentioned this offers the best defense against falling commodity prices. This has particularly been true with Peyto’ continued profitability, and increased capital expenditures during the low point in the current commodity cycle. While it often doesn’t make sense for many company’s to expand when prices are low, it does in Peyto’s case since they not only have low operating costs, they also offer some of the lowest finding and development (F&D) costs in the industry.
Peyto Energy – Solid Management
Peyto has proven over the past decade that it definitely has some of the best management in the industry. Not only does management own a significant stake in the company but, much more importantly, the focus has consistently been on maximizing the return on every dollar invested. Peyto, unlike many of their peers, built their company through internally generated drilling opportunities and not through acquisitions. As we will see they can find natural gas much cheaper than it can be purchased for. Their biggest target is the liquids rich Cardium formation but they also target the Notikewin, and Wilrich.
Not be distracted by geological terminology, Peyto’s operating margin have averaged 70% and profit margins have averaged 45% over the last several years. These high margins are driven by their low operating costs of $2.28/boe ($0.38/mcf) in the last quarter (not a typo). Most competitors have operating cost in the range of $6-$10/boe range. Total cash cost, including operating, transportation, royalty, G&A and interest, total of 6.96/boe (1.16/mcf) net of royalties. Gas prices have to go much lower before they are below total cash costs.
For a comparison of total cash cost for many Canadian and US NG companies, see the November President’s newsletter Read Here. Many companies have total cash costs much higher than current NG prices.
So these low costs obviously allows Peyto to remain profitable long after other companies’ shut-in production when NG prices fall. What allows them to have these low operating costs? The answer is mainly in the wells they drill. The Cardium formation offers very long life, liquid rich, and low maintenance natural wells. The long life nature is also evident in their reserve life index of 29 years (2P). In fact, their proven (1P) reserve life index beats many companies proven + probable (2P) reserve life.
So how have they created this company with such long life, low cost wells? A clear focus on generating high full cycle returns on every dollar of capital invested. I believe this is best stated in their 2006 report and I quote,
Peyto has now achieved a milestone in its history. For the first time, we are operating solely on our internally generated capital, having delivered all of the unitholder’s equity back in distributions. Since Peyto’s inception, we have invested a total of $1.3 billion in capital, raised $404 million in unitholder’s equity, distributed $445 million in distributions, and built an asset that is worth $3.7 billion ($3.3 billion after adjusting for debt, P+P NPV5). Unfortunately, this does not mean that all unitholders have enjoyed their fair share of returns. At times our unit price has reflected our value, at other times it has not. What it does mean, however, is that our long life, low cost natural gas business has invested significantly less than the value we have created. We will continue to use our technical expertise and our ability to execute our ideas to create future wealth for our unitholders.
Funding Sources for Capital Since Inception (from 1998 to 2006)
|% of Total|
|Cash flow from projects found and developed by Peyto||$ 898,928||70%|
|Net Equity ( Equity issued of $403.5 million less Accumulated Distributions of $444.9 million)||$ (41,442)||-3%|
|Net Debt (year end 2006 excluding future performance based compensation)||$ 426,356|
|Total Capital Expenditures||$ 1,283,842||100%|
Now for those not familiar with the income trust structure in Canada, it allowed companies to distribute cash to their shareholders without paying corporate taxes. Instead the profits are taxed as ordinary income in the shareholders hand. It is similar to the MLP structure in the USA. The income trust structure is being phased out in Canada by the end of 2010. Peyto is converting back to a corporation at the end of the year.
It is truly amazing that in just eight years the company has become internally self-funding and has such a large asset that will generate cash for years to come.
Now, I received a comment from a fellow on my post on Petrobank that companies should trade at a premium to NAV because he likened it to book value. Read here. At times a premium to NAV is appropriate and at other times it is not, but that is beyond the scope of this article. With that said, a company will only trade at a premium to book value if the expected cashflow from the wells exceeds the cost which it most certainly does in Peyto’s case.
Using Peyto in 2006 as an example, it can be said the book value of all the wells the have drilled to date was $1.3 billion. This is what they paid for the assets. Now, the asset value was considerably more, as it was worth $4.2 billion (asset value (NAV5-2P ) + cashflow already extracted), or 3.2 times. This means that for every dollar Peyto invested in drilling wells they generated $3.20 dollars in cash, or they are recycling cash at 3.2 times. (Note: Peyto uses a 5% discount rate because that is their cost of capital, however, that may not be your cost of capital.)
The comment on fair share of investment returns in also quite interesting because this gets to the heart of value investing. Assets don’t always sell on the market for their true value. One must be careful what you pay for the assets.
It is also important to note that many investors in energy (and precious metals) think that they are great investors because they have done well with those investments over the past ten years. In essence, they have been fooled. This is because commodity prices have generally risen across the board. Any idiot can be a successful investor under such a tailwind. Will the next decade offer the same increases in prices? Now that is a good question, and one should be prepare (and invest) for lower prices.
Finally, returns on invested capital matter big time. In the next article I will look at Peyto’s asset value and compare it to PetroBakken. Any blind fool will be able to determine which company can allocate capital and which earns terrible returns on capital.
To Read Original Investment Idea – Peyto Energy (Part 2) Click Here.
Disclosure: Long PEY.un, I have been a happy shareholder for years.