Peyto Exploration (TSX: PEY) $28.00 – A great company stuck in a cheap gas world…

DISCLOSURE: One of us owns this and one of us thinks it’s just too expensive.

Ebenezer William "Wild Bill" Peyto was quite the character. A veteran of both the Boer war and World War I, he was also one of the first park wardens of Banff National Park in Alberta with a lake named after him. A bit of fun reading can be found here -

Wild Bill also helped inspire the creation of Peyto Exploration & Development Corp., or at least the name. Peyto is arguably one of the best natural gas companies in Canada. The best in class, and its stock has dropped from a 52-week high of $39.41 to $28.00…

Oil has received the headlines; going from US$100+/bbl to below $30 and now stuck in the $50s. What’s received much less press is natural gas and the pain natural gas producers have been going through. We’ve included a chart below of Henry Hub, a common U.S. benchmark, but the pain has only been worse for our poor Canadian producers as they are at the end of the pipes (or the start, depending on your perspective). Some of the natural gas produced in Alberta and B.C. is used locally of course, but the rest is shipped mostly east and south. There is a lot of gas out there and being at the end of the pipe means our gas is last in line leading to bottlenecks and high transportation costs. AECO, the most commonly discussed Canadian benchmark, has improved from its lows but remains stuck around $2.50/mcf on the spot market. Producers can also hedge their production but the curve is as flat as a pancake being around $2.50 for the next five years.

So how is Peyto handling this underwhelming gas market and, more importantly, are they worth investing in? We must start by saying we don’t like energy companies. Or mining companies. Or really any sort of resource company. It’s terribly hard to get to the bottom of what their assets are worth or going to generate dollar-wise without access to the company’s in house books and plans. And even if you did have access you have to be confident that they’re not going to go out and complete a crazy merger (an unfortunate common occurrence) or some other change in strategy by buying assets in the latest hottest play. Peyto is different. The Company has an outstanding management team led by Darren Gee. Their presentations have heartwarming things like “our focus should be on maximizing the return on invested capital – your capital.”, but they mean it. We’ve had the opportunity to meet their management team a few times before over the years. They keep things simple, they’re focused, they hedge heavily, and they’re obsessed with lowering their costs. They have great assets with 99% of their production is processed in their own plants, creating industry leading all in total costs of <$0.75/mcfe.

No need for us to re-state the wheel – Check out their presentation and financials -

We care about cash flow, in the case of Peyto surplus cash flow over what’s required to maintain production. So we’ve done some math based on the following assumptions: 1) They will continue to successfully replace reserves as they have done, 2) They will continue to manage their costs, 3) We have calculated net cash flow assuming they stop growing and just maintain production (their actual plan is to grow). That said, if they’re investing profitably (and we assume they will continue to do this) growth is great.

The final result is net cash flow to shareholders after sustaining capex and the cash multiple based on current prices. The lower the better. Buying a growing great business for 10-12X cash flow is fantastic… Peyto can get there but not easily. The key issue is where are gas prices going to go? We have no idea, of course, but we’d bet a coffee that Peyto will survive regardless. We’re just less sure how profitable their survival will be. 

What about using this cash flow approach for other energy companies? We are still debating this amongst ourselves. The pro-Peyto owner believes that although this cash flow approach (or using it to create a net asset value) can be used to “value” an energy company, it is not appropriate in most cases. In fact, this is the only company he’s currently comfortable using it on. If a company is growing their play from scratch and want to grow production fast at any cost, is a frequent acquirer with a haphazard shotgun approach, or has a diverse and complicated asset base (e.g. different types of producing assets in multiple provinces)  this simply would not provide you with any value calculation you could depend on as you have no idea where the company will actually be in a few years. Investing in those kinds of companies will stay in the too hard pile for now. 

2018 Scenarios

2018 Scenarios

Company Cost Breakdown

Company Cost Breakdown