DISCLOSURE: Some of us own this.
Back in February of last year, we did a write up on Peyto Exploration, noted as having what we believe to be some of the best natural gas assets in Canada led by a very focused and diligent management team (see our write up).
Since we wrote Peyto has declined from $28.00/shre to ~$11.00, a tremendous drop that has happened along with most of the Canadian energy patch. A drop like that deserves a revisit.
So, what’s the problem? Canada is 1) at the start of the pipe for both natural gas and crude oil – where most of it gets shipped to the U.S. or back east and 2) Canada can’t seem to get any new pipelines built – either oil or natural gas. While U.S. WTI oil has had a nice run up and natural gas has held up (at approximately $3.00 / MMBTU per below), realized current and expected future prices of Canadian producers have not.
Canadian Natural Gas – What’s happening?
While there are issues with oil differentials, we want to focus on natural gas and the following chart says it all. Since this time last year the curve has shifted dramatically, with natural gas this summer floating around $1.00/mcf compared to ~$2.40 a year ago. To put this into perspective, Peyto’s best in class all in cash cost to get gas out of the ground (operating costs + transportation + G&A + interest) is approximately $0.70/mcf. And there are some assets in western Canada that are closer to $3.00 breakeven (never mind recovery of capital, or a return on investment..).
Peyto – A “Defensive Bias”
In response to this absolutely brutal pricing environment, Peyto has materially cut its capital program, cut its dividend almost in half to $0.06/share/month (from $0.11), announced a share buy back plan, and says they will shift capital to more liquids rich properties (which we also believe would have a higher ROI based on today’s prices). We agree with all of their decisions, though would strongly prefer for them to have eliminated the dividend completely and instead focus on debt repayment and share repurchases. You can’t always get everything you want though right?
Analysis – What do you get if you buy today?
When we’re looking at Peyto, we’re 1) very comfortable with the management team and the asset base and 2) don’t believe that $1.35 AECO gas prices are sustainable, but also don’t know when they will recover and what “recovery” would mean.
This leads to two questions: 1) Can Peyto survive and prolonged downturn and 2) At today’s stock price, what natural gas price do you need for a reasonable return?
Scenario 1 – Cheap gas through 2021
Under this scenario, we assume: 1) gas is $1.35 for the next three years and “recovers” to $2.50 in 2021, 2) the Company manages is debt profile to stay within covenants (3.00x max), 3) prudently eliminates its dividend in 2019, and 4) begins to increase capex again in 2021.
Long story short, Peyto survives (helped by their strong hedging program) and you end up buying an asset today at ~9.5x 2021 free cash flow.
Scenario 2 – A bit faster recovery, return the growth
Under this scenario, we assume gas (and capex) increases to $2.00 in 2019, and $2.50 in 2020, and have run both a $2.50 and $3.00 2021 scenario. Under this scenario you are getting the company for between 6-10x 2021 FCF.
Things we don’t consider
Our mindset is not “What will happen?”, but rather, “What is a reasonable conservative base case and would we be happy with this based on today’s share price?” We consider three years at $1.35 and an improvement to $2.50 a pretty conservative case (reasonable considering a US$3.00 MMBTU Henry Hub price), and under this you get a company for 10x FCF. We don’t consider things such as share buybacks, the impact of a shift in capital towards liquids rich wells, or improved capital efficiencies. These are basically free upside options and our analysis does not depend on them happening.
We’re not sure where commodity prices are going to go but this is potentially the best risk/return buying point in Peyto’s recent history. In the meantime, Peyto will keep on standing.