Guest contributor Michael Corcoran is here this week with an analysis of some of Canada's leading mid-size energy companies and the opportunities they offer to patient investors. Michael is a Chartered Financial Analyst with seventeen years of experience in the financial industry, both in Canada and the U.S. He is now an independent consultant who researches and markets investment ideas. He is based in New York City. Here is his report.
Michael Corcoran writes:
The oil world is a tumultuous place these days. After years of strong pricing and attractive returns, we have seen a return to the volatility that seems to be oil's natural state of being. But times of unrest breed opportunity, so let's take a look at five of Canada's most prominent midsize exploration and production (E&P) companies and see if there might be some values to be had - and if there are some to avoid.
As you read this, remember that the risks involved with all E&Ps are consistent: they are vulnerable to declines in oil prices as well the possibility that their drilling programs are unsuccessful. Oil prices are likely to tread water around current levels for the next couple of years so none of these stocks should be purchased with the expectation of rapid gains. They are for patient investors who want some exposure to oil and natural gas and are willing to wait for a recovery in oil prices, while in most cases collecting dividends in the process. All target prices are looking out 18 months.
Three to buy
Vermillion Energy Inc.
Type: Common stock
Symbol: VET
Exchange: TSX, NYSE
Current price: C$44.70, US$33.96
Target price: C$60
Dividend: $2.58
Yield: 5.8%
Risk rating: Aggressive
Website: www.vermillionenergy.com
Background: Vermillion Energy, like all the others reviewed here, is an E&P company based in Calgary. It has over 60% weighting to oil and exposure to Brent-linked pricing. In 2014, it produced 49,573 barrels of oil equivalent per day (boe/d). VET has internationally diversified assets with properties in Canada, France, Australia, Germany, and the Netherlands. The company is an efficient operator and has strong growth prospects in the medium-to-long-term.
Recent developments: The company delivered good first-quarter results (second-quarter numbers are due Aug. 10). Cash flow of $1.08 per share was above street estimates of $0.93 but included a one-time gain from a cost recovery. Excluding the gain, cash flow was just below street estimates.
Production was 50,386 boe/d, while unit operating costs of $10.56 per barrel were 22% lower than last year, an excellent result. The company reaffirmed its 2015 production guidance of 55,000-57,000 boe/d and capital expenditure (capex) of $415 million. For 2015, the company has targeted $50-$60 million reductions in capex and operating costs.
The key event investors are waiting for is the start-up of the Corrib natural gas field. VET has an 18% working interest in the field, which is located offshore of Ireland and production is set for start-up in the second half of 2015. It is expected to contribute over $40 million to pre-tax cash flow ($0.30 per share) in 2015 and over $130 million ($1.20 per share) in 2016. Cash flow in 2015 and 2016 is expected to be approximately $520 million and $640 million, respectively, so Corrib will account for approximately 8% and 20% of cash flows this year and next.
Corrib will realize premium European natural gas prices while incurring low operating costs of about $1.40/mcf and zero taxes and royalties for the foreseeable future. Longer-term, Corrib will provide ongoing sustainable cash flow to help pay down debt and fund capex in other countries, as well potentially increase the dividend.
VET's balance sheet is in good shape. It has a $2 billion credit facility with $820 million in available borrowing capacity. It has increased the credit facility twice this year for a total increase of $500 million. This indicates that the company expects to make some acquisitions in the near future, likely internationally.
Conclusion: VET is a well-managed company with great growth prospects. Start-up of the Corrib gas field is imminent and will immediately contribute to profits and the current stock price offers an attractive entry point for the patient investor.
Action now: Buy. VET is a current IWB recommendation by Gordon Pape.
Tourmaline Oil Corp.
Type: Common stock
Symbols: TOU, TRMLF
Exchange: TSX, Pink Sheets
Current price: C$31.32, US$23.60
Target price: C$50
Dividend: None
Risk rating: Aggressive
Website: www.tourmalineoil.com
Background: Tourmaline's assets are 85% weighted to natural gas. In 2014, it produced 113,000 boe/d. It has 1.2 million acres of land, mainly in the Deep Basin and Peace River High regions with an inventory of more than 7,000 wells.
The key thing to know about TOU is that it has a large asset base of 2,300 net undeveloped sections of land, which is much higher than most of its peers. This means it has lots of room to grow production in the Lower Montney, Inga, and Deep Basin Montney areas. All of these positions are material in size, with good economics and have lots of activity by both the company and others in the industry. These assets alone are worth approximately $930 million or $4.25 per share. None of this is reflected in the share price as it is a more speculative valuation.
The company has detailed 234 locations to be developed that could produce an additional 25,000 boe/d. These properties could have a potential value of up to $2.4 billion or $11 per share.
Recent developments: At the end of June, TOU announced the acquisition of Mappan Energy for $94 million. It acquired 5,500 boe/d (mostly gas) and 260 net sections of land in the Deep Basin and Foothills. The price was $17,000 per boe/d, which compares favorably to a 12-month average value of $41,300 boe/d as well as TOU's own valuation of $61,200 boe/d. This was a very good acquisition.
TOU's current production is 154,000 boe/d but this is expected to increase to 200,000 boe/d by the end of 2015. These production estimates could very well be conservative, as they do not incorporate recent acquisition activity and planned drilling in the second half of the year. In addition, the company has 22,000 boe/d currently shut-in or waiting for access to facilities.
Tourmaline recently increased its primary credit facilities by $200 million to $1.8 billion. It also has a $50 million operating line and $250 million term facility for a $2.1 billion total current credit capacity. By the end of 2015, the company should be just over 60% drawn on that credit facility. We can expect to see it make some acquisitions going forward with the available credit.
TOU also recently did a bought deal financing that raised $168 million. The money was used to pay down debt to improve the debt ratios in the short term. The cash will be borrowed again in second half of 2015 for capex and working capital.
Conclusion: TOU has an experienced management team who own 20% of the company. It is one of best operators in the industry and has excellent growth prospects. It has very strong production growth at a reasonable cost and maintains a strong balance sheet. For an investor looking for exposure to natural gas, TOU is a good option.
Action now: Buy.
Whitecap Resources Inc.
Type: Common stock
Symbol: WCP, SPGYF
Exchange: TSX, Grey Market
Current price: C$11.59, US$8.86
Target price: C$16
Dividend: $0.75
Yield: 6.5%
Risk rating: Aggressive
Website: www.wcap.ca
Background: Whitecap's assets are over 70% oil-weighted. It produced nearly 33,000 boe/d in 2014. The company is focused on Pembina Cardium in Alberta and the Viking play in southeastern Saskatchewan. WCP has a solid track record of growing reserves and has good well economics and low leverage relative to peers.
The company has reasonable leverage with over $400 million of a $1.2 billion credit line expected to be undrawn at the end of 2015 so we can anticipate some acquisitions in the future. The stock trades at a discount to the dividend-paying peer group.
WCP is among the most efficient operators out there. The three-year weighted average cost to drill a well is $26,500 boe/d compared to the group average of $39,000. For 2014, the cost dropped further to $24,600 and it is expected to fall to $21,000 boe/d in 2015.
WCP expects to produce 39,700 boe/d in 2015. The company lowered its capex by $10 million to $235 million but it plans on drilling 86 additional wells. Note that production guidance for the year is likely to be conservative - for example, guidance doesn't include acquisitions. The company acquired a Viking light oil producer in the second quarter for $588 million with 5,100 boe/d (97% oil).
Recent developments: WCP delivered second-quarter funds from operations of $0.50 per share. Cash costs were down 20% from the previous year, including a 15% decline in operating costs to $9.67 boe. Production of 41,521 boe/d was up 36% from last year, mainly due to acquisitions. Operating netbacks in the first half were down 15% from last year due to lower pricing.
Dividend: The stock pays a monthly dividend of $0.0625 per share ($0.75 per year). This appears to be sustainable - the payout ratio for the first half was 87%, based on funds from operations. The company does not have a dividend reinvestment plan (DRIP) in place, which differs from the majority of dividend-paying E&Ps.
Conclusion: WCP is a conservatively managed company that is an outstanding operator. It has excellent financial and operational prospects, offering moderate, low-risk growth (5%-7% per share production growth).
For patient investors, it offers moderate, low-risk growth and a sustainable dividend with a very attractive yield and it should be able manage through this period of lower oil prices.
Action now: Buy.
One to monitor
Crescent Point Energy
Type: Common stock
Symbols: CPG
Exchange: TSX, NYSE
Current price: C$18.14, US$13.82
Dividend: $2.76
Yield: 15.2%
Risk rating: Aggressive
Website: www.crescentpointenergy.com
Background: Approximately 90% of CPG's production base is crude oil and liquids. In 2014, the company produced nearly 141,000 boe/d. The core area of operations is in southeastern Saskatchewan, where it is the dominant operator.
CPG has demonstrated its ability to identify early stage plays and capitalize on them by securing land and making acquisitions. The company's assets in the Bakken are an example of this. The Bakken is still in the early stages of development and will continue to evolve in the coming years.
Recent developments: On June 30, CPG's acquisition of Legacy Oil & Gas closed. The deal added 22,000 boe/d of production, 15,000 of which is in the core operating area in Saskatchewan. This was a sensible acquisition as it increased the company's position in its core area as well as increasing its exposure to the emerging unconventional Midale play, all while being accretive to cash flow.
Acquisitions of oil companies are often compared by the price per barrel paid. CPG paid approximately $76,000 per boe/d, which is 25% lower than comparable historical transactions in the area and compares to CPG's own valuation of $114,000 per boe/d. This tells us two things: CPG is a smart acquirer and that take-over valuations have fallen in response to lower oil prices. Both bode well for CPG going forward.
On July 2, CPG announced a deal to buy privately-held Coral Hill which has 3,200 boe/d capacity for $258 million or $81,000 per boe/d. CPG and Coral Hill are partners and the property they own together has potential for greater production capacity under CPG's operation.
The acquisition increases CPG's 2015 production guidance by 1,000 boe/d to 163,500 but the dividend and the capex budget are unchanged.
CPG has issued a great deal of stock over the past few years to help fund its acquisitions. The market may be getting a little weary of these repeated issues but the key thing to remember is that if the acquisition makes sense, then the equity issuances probably do too. The current weakness in the oil price is an ideal time to make acquisitions and CPG has proven to be a smart acquirer so it is in an ideal position to grow its business at a reasonable cost.
Dividend: CPG's dividend yield is currently 15.2%. This is very high and implies the market is expecting it to be cut and/or that the company's prospects are in doubt. CPG is a very well run company with solid prospects so it appears the high yield is indicative of an expected dividend cut.
CPG appears to be readily able to fund the dividend for the balance of 2015 but the company has also said that it will not risk its balance sheet to maintain the dividend if oil prices fall in the future and they were unable to meet their hedging or cost saving targets. The 2016 hedging program is not as extensive as 2015 so we may see greater pressure for a dividend cut as we get closer to 2016, especially if oil prices weaken further.
In a worst case scenario, where the company cut its dividend, some believe that this could actually be a positive as it would allow investors to focus on CPG's attractive investment merits rather than on the sustainability of its dividend.
Conclusion: CPG is targeting 20%-30% in cost savings this year. It has a healthy balance sheet and has never cut its dividend. The company also has a strong hedge book with an estimated nearly 60% of its 2015 production hedged at approximately US$87.50 per barrel and over 30% of 2016 production hedged at approximately US$83.
Action now: Wait and see. CPG is a very well managed company that has great growth prospects. However, the extremely high dividend yield indicates that investors think a dividend cut is imminent. Until the issue of the dividend is resolved, it is best to sit on the sidelines on this one.
One to avoid
Enerplus Corporation
Type: Common stock
Symbol: ERF
Exchange: TSX, NYSE
Current price: C$8.01, US$6.10
Dividend: $0.60
Yield:7.5%
Risk rating: Aggressive
Website: www.enerplus.com
Background: The company's assets are nearly 60% weighted to natural gas with production of 103,129 boe/d in 2014. It has assets across Western Canada, North Dakota, and Pennsylvania. The largely conventional asset base in Canada has declining production, which is offset by growth opportunities in the Bakken and Marcellus regions.
ERF has strong operational performance supported by a disciplined investment approach. It has high quality growth opportunities but the business is challenged at current oil pricing. It has a solid financial position with a $1 billion credit facility that was only 4% drawn as at the end of May.
ERF's Marcellus natural gas assets are not very attractive currently as Marcellus gas receives a much lower price than NYMEX gas prices. And production growth from the oil assets in the Bakken/Three Forks area will be constrained due to tighter spending. Thus the company has good operational results but production per share is expected to decline by nearly 10% this year. Other issues are that SG&A (selling, general and administrative) costs rose significantly last quarter and the company reduced the monthly dividend to $0.05 per share from $0.09 with the April 2015 payment.
Recent developments: The company updated guidance in early June increasing production guidance to a range of 97,000-103,000 boe/d from 93,000-100,000 boe/d. It also announced that it would complete eight of the 19 drilled-but-uncompleted wells at a cost of $60 million. This increased the capex budget to $540 million from $480 million for the year.
Management highlighted the well economics, saying they estimate a 60% IRR (internal rate of return) at US$60 per barrel WTI on the completions. This is great but excludes the cost of drilling (which is significant) and thus overstates the true return on the full cost of the well. Treat this as a little sleight-of-hand by management!
ERF also added to its hedge positions. Fourth-quarter 2015 production is currently 44% hedged at a floor price of US$80 while 2016 oil production is 31% hedged at a floor of US$64.48. Second half 2015 natural gas production is 49% hedged at a floor price of US$3.82/mcf. The hedging program is expected to generate gains of nearly $300 million in 2015, or over 50% of cash flow. That's a positive number but not a sustainable one.
The question to ask here is whether the increase in capex is a strategic move, an attempt to position the company for higher oil prices? Or is it simply an effort to maintain revenues and cash flows? If oil prices rise in the near future, this could be seen as a very well timed move. However, if oil prices tread water or decline, it will look like an ill-advised attempt to boost revenues and cash flows in the short term at the expense of earning a stronger return on investment if the company had waited.
Conclusion: ERF trades at a discount to its peers and is in good financial condition with low leverage. However, its decision to increase capex in order to complete wells and increase production strikes me as premature and smells of an attempt at dressing up revenue and cash flow numbers rather than a well-considered attempt to earn strong returns on the investment.
Action now: Avoid.
