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Original Investment Idea – Peyto Energy (Part 1)

November 05, 2010 | About:
In order to make money in any commodity type business there is only one competitive advantage a company can have, and I believe Peyto (TSE – PEY.un) has got it by a mile.


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)


($000)
% 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

33%
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.

Best Regards,

Kevin Graham

canadianvalueinvesting.blogspot.com



Disclosure: Long PEY.un, I have been a happy shareholder for years.

About the author:

Kevin Graham
I am a Professional Engineer from Canada. I am over the top passionate about value investing and reading. If I could get paid to read annual reports for a living I would gladly switch careers. Feel free to contact me at Kevin4u2(AT)hotmail.com. My value ideas can be found on gurufocus and at my blog canadianvalueinvesting.blogspot.com

Visit Kevin Graham's Website


Rating: 3.2/5 (10 votes)

Comments

NFichter
NFichter - 3 years ago


Interesting (I have read part 2 also), but very suspicious of the use of 5% for cost of capital. That is a low number that will have the effect of making distant returns look a whole lot more valuable than if a more typical cost of capital, say 8 or 10% (or even higher) were used, and you specifically remark on the long life of this company's reserves so I think the possibly distorting impact of the 5% cost of capital may be quite relevant. Do you have any explanation for why they are using such a low cost of capital. I do not think I have seen such a low number before in any analysis.
Kevin Graham
Kevin Graham - 3 years ago
Hi NFichter,

Typically their borrowing costs have been quite low at less than 4%. If they can borrow at that cost they can compare their return on investment at that rate. Even if you use a 10% discount the value is still there, you just placing more enphasis on cashflows closer to today (part 2). Like I also said, your cost of capital might be higher.

Obviously they management feels that if you compare two companies with equal NPV discounted at 10%, the company with the longer reserve life is worth more. NPV 5%, or NPV 0% will make this very clear. The longer reserve life also means they are much less risky. I could go on.

ATPG's borrowing cost is 12.75%. Now I can personally borrow at much lower rates than that. That tell you a lot about what the bankers think about the risk of the company repaying.

Good Luck,

Kevin


LwC
LwC - 3 years ago
Thanks for the article.

I hope you don't mind if I quibble with one of your assumptions: you have estimated Peyto's operating cost as C$6.96/boe based on the industry standard of NG (SCF) being about one-sixth of oil on a BTU energy value equivalence. However, we all know that the relationship does not hold in the real world when considering the relationship as calculated on an actual price basis. Currently the price ratio is in the upper teens, or something like that.

Several months ago there was some discussion in a thread here on GuruFocus about this very issue. Documentation was provided (some by me) which showed that when considered on a price/BTU basis the longterm average is about 8-10:1, and that when the price relationship varied from that average, it was more often in the 11-12 range than in the 6-7 range. Since Peyto is considered by you to be a "pure play natural gas company", wouldn't it be more realistic to estimate the cost of production on actual average costs per unit of gas production adjusted for the price contribution of any liquids production, rather than rely on a convenient but IMO unrealistic assumption such as the 6:1 convention?

Kevin Graham
Kevin Graham - 3 years ago
Hi LwC,

Thanks for your comments.

You are absolutely correct that the 6:1 is only applicable on an energy equivalency basis (burner tip). Historically the ratio on price has been 8-10:1.

So to answer your questions Peyto's all in gas cost per unit is $1.16/mcf. I just multiplied by 6 and gave the per boe equivalent at 6:1 as that is common practice in the Canadian oil patch. This all in cost is much lower than current gas prices and the best in Canada. If you know if a company with lower cash costs in NG please let me know.

When I say Peyto is a pure play NG company you should note that their natural gas wells, particularly the cardium, are liquids rich. These liquids are condensates and they command a price equivalent to oil approximately $80/boe. Peyto strips the liquids and sells them separately from the gas.

Best Regards,

Kevin

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