Contributing editor Ryan Irvine joins us this week with a look at a new investment opportunity that is emerging right in his own back yard of British Columbia. Ryan is one of Canada's leading experts in quality small-cap stocks and the CEO of Keystone Financial (www.KeyStocks.com). Here is his report.
Ryan Irvine writes:
Quietly this past week, our Natural Resources Minister announced the approval of four long-term liquefied natural gas (LNG) export licenses. They were awarded to Pacific NorthWest LNG, Prince Rupert LNG, WCC LNG, and Woodfibre LNG. The four export licenses combined will allow for the export of up to 73.4 million tons of LNG per year.
Along with the announcement, Minister Greg Rickford stated that Canada is well positioned to help meet the growing market demands for liquefied natural gas. LNG from Canada's West Coast can get to Asian markets in less than two weeks compared with the month it takes a tanker to leave from export terminals in the Gulf of Mexico.
These are hardly revelations but support a theme we have been covering for the past 18 months. We have already benefitted from the anticipation of this coming boom in a number of the oil and gas service companies we have recommended. Having said this, the true benefits in terms of hard cash flow are likely more than a year in the future. But once they kick in, they may last for decades.
At this stage, we are likely only in the first inning and we would not be surprised to see some hiccups along the way. These could provide long-term opportunities for investment in solid companies. Right now, our bias is towards energy and infrastructure service stocks with existing strong businesses which are positioned to benefit from an LNG boom in British Columbia if and when it occurs but can stand on their own two feet without it. We already have half a dozen of these types of companies in active coverage that are positioned for potential explosive growth if the boom does in fact take place.
Quick LNG Related Stats
- Canada is the fifth-largest producer of natural gas in the world and has up to 37 trillion cubic metres of marketable natural gas resources, enough to meet our current production for over 250 years.
- The International Energy Agency's 2013 World Energy Outlook predicts world energy demand will increase by 33% by 2035. The rapidly rising economies of China, India, and the Middle East will drive growth, commanding more than 58% of the rise in global energy demand. India's energy needs alone will double over this period.
- The Conference Board of Canada estimates that potential growth in British Columbia's natural gas sector alone could attract $180 billion in new investment and create 54,000 jobs per year between 2012 and 2035.
- Each Canadian LNG facility will be subject to a thorough environmental assessment and regulatory review to ensure it can be developed safely.
Recently, a report authored by RBC Dominion Securities singled out Pacific NorthWest LNG (led by Malaysia's state-owned Petronas) as the B.C. project that has been taking large strides toward reaching the goal of supplying energy-thirsty customers in Asia.
"Pacific NorthWest LNG has established a high degree of momentum, with a final investment decision expected by the end of 2014," according to the global study by RBC's energy team headed by Greg Pardy and Kurt Hallead.
Pacific NorthWest LNG, one of 14 projects proposed for British Columbia's coast, has grabbed headlines of late as the Malaysian government adds new Asian partners for the joint venture.
The company estimates that almost $36 billion will need to be spent in order to make its export plan a reality in late 2018. The massive budget includes nearly $11 billion for the export plant to be built at Lelu Island, near Prince Rupert.
Having said this, a West Coast LNG boom is by no means a slam-dunk as global competition, environmental issues, funding, and the tax regime are amongst a number of issues still to play out.
Let's start with the B.C. government's document on its proposed new tax regime. To date, the information provided publicly consists of a short two-page backgrounder tabled just over a month ago along with the provincial budget. The document indicated a two-tier income tax on LNG production, with 1.5% to be charged on net proceeds up front and a second rate of "up to 7%" scheduled to kick in once the operator's capital investment has been covered.
Opponents include Jack Mintz, an economist at the School of Public Policy at the University of Calgary, who also happens to be a director of Imperial Oil (a company that has a stake in one of the proposals to develop B.C. LNG). He points out that B.C. already taxes natural gas by collecting royalties on the extraction of the resource at the wellhead. However, as Mintz notes, the proposed special tax would impose a rather atypical second levy on the processing of the resource in liquefied form.
"Applying a special tax on LNG is akin to applying special refining taxes in oil and gas and mining or manufacturing phases in forestry, which has not been pursued by other provinces," noted Mintz.
While we believe the sitting B.C. government, which has made the development of LNG a priority, will eventually implement a competitive tax regime, the current uncertainty and/or lack of a competitive structure could help serve to derail some of the capital investment that will be necessary to develop a number of the large scale proposed projects. Corporate capital is mobile and will not wait in limbo forever as a country dithers over environmental work, special tax regimes, and the concerns of other special interest groups who want their pound of flesh. Eventually, the capital is employed elsewhere.
Additionally, Canada is trailing the United States in the North American LNG export race, RBC cautions. The United States has the advantage because major proposals south of the border are "Brownfield" projects that call for reconfiguring existing import facilities and converting them to process LNG exports. By contrast, Canada is relying on "Greenfield" projects that effectively mean starting from scratch.
RBC also noted that Australia is emerging as an LNG heavyweight, bolstered by seven export projects under construction.
"Australia is set to eclipse Qatar as the largest global supplier of LNG by 2018," the report said. Australian Greenfield LNG projects, however, have been stung by cost overruns.
Again, we believe it wise to have exposure to the potential LNG boom, but we stress that it must be done prudently with a bias is towards energy and infrastructure service stocks with existing strong businesses which are positioned to benefit from an LNG boom but can operate profitably if it is delayed or doesn't happen.
This provides an excellent segue to our first update, High Arctic Energy Inc.
High Arctic Energy Inc. (TSX: HWO)(HGHGF)
Originally recommended on Sept. 3/13 (#21332) at C$2.85, US$2.55. Closed Friday at C$4.42, US$3.90 (March 31).
High Arctic holds a solid energy services business in Western Canada, but remains a Buy due to the strong cash flow generated from its core business in Papua New Guinea (PNG). We introduced IWB readers to High Arctic in early September with the stock trading at C$2.85. Today, with the stock closing at C$4.42, we review the company's recently released 2013 annual results and its dividend increase.
HWO is an international oil and gas services company with operations in both Papua New Guinea and Western Canada. The company's substantial operation in PNG is comprised of contract drilling, specialized well completion services, and a rentals business, which includes rig matting, camps, and drilling support equipment. HWO's Canadian operation is focused on the provision of snubbing services and the supply of nitrogen to a large number of oil and natural gas exploration and production companies operating in Western Canada.
HWO posted a strong end to 2013 with fourth-quarter adjusted EBITDA increasing 25% to $12.5 million compared to the same quarter last year. A continuation of strong performance in the PNG operation offset lower activity in Western Canada. Revenue for the fourth quarter of 2013 was $38.7 million or roughly flat compared to the previous year. Full year revenue increased 4% in 2013 to $152.7 million. Full year adjusted EBITDA was $41.5 million, or 5% higher than in 2012.
Funds from operations for the year were $35.3 million ($0.72 per share) compared to $34.9 million ($0.71 per share) in 2012. For 2013, HWO generated free cash flow of $28.3 million ($0.57 per share) and declared dividends of $7.2 million ($0.145 per share) equating to a payout ratio of 25%. HWO continued to generate solid returns on capital employed with return on equity and return on invested capital of 25% and 31% respectively for 2013.
HWO's balance sheet continues to strengthen with a cash balance of $33.7 million and long-term debt of $6.8 million for net cash of $26.9 million. Net cash has nearly doubled over the past 12 months from $13.6 million as of the start of 2013.
On March 17, the company approved a 20% increase in the monthly dividend amount. The new monthly amount is $0.015 per share or $0.18 per annum. The new dividend rate equates to an annual dividend cost of $9 million, which is a conservative 25% of HWO's reported funds provided by operations in 2013 of $35.3 million. The current yield is around 4%.
Conclusion: HWO continues to generate a relatively consistent cash flow profile from its presence in PNG. The company operates right along the lines we look for, generating solid free cash flow which is used to reinvest in the business, pay dividends, reduce debt, and grow the cash balance. Our forecasts for 2014 are based on what we consider to be conservative assumptions and on a longer-term basis we think that HWO is well positioned to benefit from potential LNG development booms in both PNG and Western Canada.
Considering the valuation (approximately six times expected free cash flow), the balance sheet ($0.54 net cash per share), and the growth opportunities over the next one to three years, we continue to view HWO as an attractive opportunity in the international oil and gas services space. Despite the stock jumping 55% since our original recommendation, we maintain our Buy rating as the stock is just now starting to garner further interest on Bay Street.
Action now: Buy.