As you know, I bought MEG Energy last week. Now let me explain my point of view. This analysis will take a look at the cost profile of each company, their debt and maturities schedule and finally the NPV of the oil and gas reserves of both company.
First and foremost, while MEG produces bitumen only, more than 65% of Encana’s production is still natural gas. This in itself is a very good plus for investing in MEG: if I am to invest in one of these risky stocks, I prefer to be exposed to oil versus natural gas.
Let’s take a look at the operating cost profiles of both companies by excluding G&A and financing costs at first. MEG financial reports are in Canadian dollars: a USD/CAD ratio of 1.30 was used in this blog post to simplify the conversion process.
Let’s compare MEG’s bitumen production to Encana’s mix of natural gas and liquids.
MEG Energy & Encana - Operating Costs ($/bbl)
|MEG Energy (C$/bbl)||MEG Energy||Encana|
As we can see:
- MEG’s production is less valuable as we can see from the lower realized price.
- MEG’s transportation costs are significantly lower.
- MEG’s operating costs are over 60% higher.
However, we can see that the two netbacks are almost the same, while being a little lower for MEG. The netback from Encana is being dragged down by the very low price of natural gas. Of course, Encana’s liquid production has a better operating profile not because of lower operating costs but because of a better realized price:
- Operating costs are less than $8 per barrel. Interestingly MEG’s operating costs are lower: this is a consequence of a lower loonie value versus the USD and very low natural gas price, which is keeping MEG’s energy costs down. Most of Encana’s liquid production is concentrated in Texas and does not have the currency advantage.
- Netback is still more than $25 per barrel because of the higher realized sale price of light oil which compares favorably to MEG’s bitumen.
Encana’s liquid production has a very interesting cost profile in this environment. However, Encana will remain a natural gas producer in the medium-term, even though it shifts its focus to liquids as we saw in the 2016 guidance. Therefore, the netback advantage of Encana over MEG should be limited in the medium-term or until the oil recovers.
There is another dilemma: the more the price of natural gas falls, the more it will hurt Encana and help MEG. Indeed, the company burns natural gas to generate steam and extract the bitumen. These energy costs are substantial in the SAGD business.
This brings us to a tie: both netbacks are comparable as long as natural gas price stays low. This is one of the reasons why I currently prefer to buy an energy E&P entirely focused on oil production.
After looking at the operating costs, let’s take a look at the long-term debt both MEG and Encana carry, their annual financing costs and their debt maturities. As you know, both MEG and Encana are one of the most leveraged energy E&P companies listed on the TSX and as such, both carry a mountain of debt. However, we will see that while MEG carries lower debt, the burden on its smaller production is much bigger.
MEG Energy & Encana - Long-Term Debt And Interests ($M)
Let’s take a look at the corporate cost profile of each company using the estimated annual interests and G&A costs of Q4 2015.
MEG Energy & Encana - Corporate Costs ($/bbl)
|Total corporate costs||10.08||4.07|
Adding the operating costs and the corporate costs we know that MEG will be cash flow negative as long as the tough environment seen in Q4 endures or even worsen just like what we saw in early-2016. We can see this in the cash flow statement of the company: it had negative operating cash flow in Q4 if we exclude the change in working capital.
On the other hand, Encana still has a very slim cash margin in Q4 which translated into $450M of operating cash flow because of its higher production volume. The energy market was pretty tough: WTI oil price averaged $45 per barrel and Henry Hub natural gas price averaged $2.12 per MMBTU. Of course Q1 will be even more devastating to both companies as oil and natural gas prices are much lower.
The overall operating cash flow picture is to the advantage of Encana. The company will be able to generate positive cash flow even in a low price environment notably because of lower financing costs per barrel. Plus the company has a substantial hedging program in place in 2016.
Let’s take a look at the maturities of the debt of MEG first.
Source: Corporate Presentation
Then let’s take a look at the debt profile of Encana.
Source: Corporate Presentation
As we can see, Encana will have its first debt repayment a year before MEG’s in 2020. However MEG’s first repayment is substantial: the first two payments of Encana combined are less than MEG’s first payment of $1.2B in 2020. However I don’t see a clear advantage here. The fact is that both companies have a very good debt maturity schedule.
Lastly, let’s take a look at the after-tax NPV of each company’s oil and gas reserves, discounted at 10%. The 2P reserves are truly the backbone of an energy E&P.
MEG Energy & Encana - Oil & Gas Reserves
|Natural gas (Bcf)||0||7,034|
MEG Energy & Encana - After-Tax NPV Discounted At 10% ($M)
|MEG Energy (C$M)||MEG Energy||Encana|
Note that while Encana’s natural gas reserve is impressive, it’s worth only $3B.
The value of the company’s oil and gas reserves need to be way higher than the liabilities of the company. Clearly here the advantage goes to MEG in my opinion: the margin of safety is more appealing. The value of the bitumen reserves is truly impressive: 2 billion barrels is a lot of oil.
Let’s take a look at the margin of safety of MEG:
- Oil and gas reserves: C$15,789M
- Total liabilities: C$5,722M
- Total value: C$10,067M
The margin of safety left is well over today’s market cap of C$1.2B, which is exactly what we should be looking for.
On the other hand, the margin of safety is very weak when we look at Encana:
- Oil and gas reserves: $9,382M
- Total liabilities: $9,477M
Simply put, there is no value left. Of course one could point that the value of Encana’s NPV is tied to its staggering natural gas reserve, which is worth only a tiny $3B. The NPV of its natural gas reserve will increase substantially once natural gas recovers.
There you have it. Finally, let’s recap the main points here:
- Production tied to the oil price: big win for MEG.
- Operating costs: tied.
- Corporate costs: Encana wins.
- Funds flow from operations: Encana wins.
- Debt maturity schedule: tied.
- Oil and gas reserves: MEG wins.
- Margin of safety: big win for MEG.
As you can see, there was two major points that made me buy MEG instead of Encana. First, it’s an oil producer. I don’t want to be exposed to both natural gas and oil markets while investing in such a risky business. I believe that the future of oil for the short and medium-term is looking better.
Second, the oil and gas reserves of the company is very appealing. The NPV provides a good margin of safety compared to the total liabilities of the company. I think that we can’t deny that MEG could be a good takeover candidate for a bigger player looking to bank over 2 billion barrels of oil.
Therefore MEG is the best stock money can buy, that is if you are looking for a TSX-listed leveraged energy E&P company.
Disclosure: I am long MEG.