If You Give A Driller A Dollar…

I don’t mean to offend any Texans in the room, but if you ever met anybody from Texas, those guys know how to gamble, and if you let them stick a hole in the ground with your money, they’re going to do it.

Stanley Druckenmiller, January 18, 2015

Special thanks to Greenlight Capital for this presentation.

The mother-fracker can drill holes.

PXD StockCharts.com August 7

Source: StockCharts.com

And the father-fracker can drill holes.

EOG StockCharts.com August 7

Source: StockCharts.com

Is the shale bubble about to burst?

Why Did I Choose MEG Energy Over Encana

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.

Let me remind you that this is a series of blog post to find the best leveraged energy E&P stock listed on the TSX. You can read the other parts here: Part 1, Part 2 and Part 3.

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 EnergyEncana
Realized price23.1717.8219.44
Royalties0.250.190.82
Transportation costs5.864.517.58
Net sales17.0613.1211.04
Operating costs9.247.114.36
Netbacks7.826.026.68

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)

 MEG EnergyEncana
Long-term debt3,7995,350
Interests5.8%6.2%
Estimated interests220337

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)

 MEG EnergyEncana
G&A costs2.531.35
Interests7.552.72
Total corporate costs10.084.07

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.

MEG Energy Debt Maturity Schedule March 9

Source: Corporate Presentation

Then let’s take a look at the debt profile of Encana.

Encana Debt Maturity Schedule March 9

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

 MEG EnergyEncana
Liquids (MMbbls)2,246792
Natural gas (Bcf)07,034

MEG Energy & Encana - After-Tax NPV Discounted At 10% ($M)

 MEG Energy (C$M)MEG EnergyEncana
After-tax NPV15,78912,1459,382

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.

Choosing The Best Leveraged Energy E&P From The TSX: Part 2

There are seven stocks on my list as of now that can still make it to the number one spot. Let’s reduce the number of stocks on that list using simple investment rules before doing any digging. These rules are described in my financial commandments. You should read them if you haven’t already.

These rules will help us concentrate on our top stocks and avoid any waste of time.

How did we get here? Check out Part 1. Let’s take a look at our seven candidates so far:

Leveraged Energy E&P - TSX Screening - Concentrated North American Oil Producers

Company #TSX Tickers
1ECA
2MEG
3ERF
4PWT
5BNE
6BTE
7PGF

There are five additional companies that we can already remove from our list. Let’s see which company and why.

  • PennWest Petroleum: operating costs are sky-high.
  • Baytex Energy, Bonterra Energy, Enerplus and Pengrowth Energy: monthly dividends and DRIP schemes aren’t trustworthy.

Why dig in these companies if there is something as simple as that keeping us from investing in them?

We can also trace a parallel between paying monthly dividends and mediocre stock performance if we look at Baytex, Bonterra, Enerplus and Pengrowth. The monthly dividends drains a lot of cash from the company. When oil and natural gas crash, the company is left with little cash to survive the downturn. Although high monthly dividends could work if oil and natural gas price stay high forever, we know that this isn’t the case.

This takes us to our two finalists:

Leveraged Energy E&P - TSX Screening - Concentrated North American Oil Producers - Final

Company #TSX TickersCompany Name
1ECAEncana
2MEGMEG Energy

We can now analyze in detail both Encana and MEG Energy and choose the best of the best by analyzing each company’s debt and cash level, debt maturities and cash flow from operations. Stay tuned on Seeking Alpha for the final article of this series.

Encana’s Q4 2015 Earnings Highlights

Encana had a great run today, jumping more than 20% on its Q4 2015 earnings release on heavy volume.

ECA StockCharts.com February 24

Source: StockCharts.com

There a few takeaways from this earnings release:

  • The credit facility is available until 2020 and is pretty much rock-solid because of a very generous covenant. There is still $3.9B available as of year end 2015. Management is still not sure on buying debt in the open market using the credit facility but investors are told that the option is on the table.
  • The production of dry natural gas will fall hard this year according to the guidance, taking much of the expected production cut.
  • The 2016 capital expenditures seems to equal more or less the projected cash flow under low energy price.
  • There is no intention so far to continue asset sales in 2016.

As per their updated 2016 guidance, production will fall by as much as 15% to 340 Mboepd from an average 2015 production of 405 Mboepd. This figure includes 20 Mboepd of production from the previously announced sale of the DJ Basin assets, which is expected to close at mid-year. Ignoring the DJ Basin assets gives us an average 2016 production of 330 Mboepd, which is significantly lower than in 2015.

However, natural gas liquids and oil production will average 130 Mbblpd at most in 2016, while liquids production averaged 133 Mbblpd in 2015. Therefore the majority of the fall in production will be attributable to natural gas. It’s great news in my opinion: the netback is of course higher and it confirms the focus of management in its four core areas.

It seems the company is trying to tie its 2016 capital expenditures program to its cash flow according to the guidance provided by the company, which was visualized in my article. Capital expenditures of $1B reflects the lower price environment and is a major reduction from the previous guidance given in late-2015.

I don’t see any reason to buy the stock right now, unless there is a fundamental change in the oil market. As you know Encana is one of the finalist in my selection of the best leveraged energy E&P listed on the TSX. I will pull the trigger only after completing my analysis. Stay tuned!

Choosing The Best Leveraged Energy E&P From The TSX: Part 1

The basis of this investment is that the recovery of oil will happen sooner than later. I believe it is safe to say that the oil market will be balanced sometimes in 2017. Therefore, it could be interesting to find a leveraged energy E&P company that will still survive the current downturn and offer high upside once the recovery begins.

For the sake of stock picking, we have to find the one very best stock in the energy E&P sector. This is a gigantic task: this is one of the reason why I’ll separate the work in multiple parts. Let’s start with the initial screening of the TSX using these criteria:

  • Energy E&P sector.
  • Total Debt/Total Equity over 50%.
  • Market capitalization of over C$500M.

Let’s take a look at the tickers this search gave me. The tickers are sorted by current market cap.

Leveraged Energy E&P - TSX Screening - All Results

Company #TSX Tickers
1CNQ
2PEY
3VII
4VET
5ECA
6OER
7MEG
8ERF
9BIR
10PWT
11BNE
12BTE
13PGF
14POU

Because betting on the recovery of oil using a leveraged company is a very risky business in itself, I want to concentrate the risk on the pricing of oil, and minimize any other potential risks such as geopolitical or legal for example. Therefore let’s remove all companies with operations outside of North America. It is also interesting to have companies with concentrated assets in one area.

Leveraged Energy E&P - TSX Screening - Concentrated North American Producers

Company #TSX Tickers
1PEY
2VII
3ECA
4MEG
5ERF
6BIR
7PWT
8BNE
9BTE
10PGF
11POU

Let’s find the oil producers next. The production of selected companies should be at least 33% oil in their respective Q3 2015 MD&A. Therefore, a company with high liquids production but no oil production such as Seven Generation Energy was excluded from this list.

We now have the final selection of our leveraged oil producers operating in North America.

Leveraged Energy E&P - TSX Screening - Concentrated North American Oil Producers

Company #TSX Tickers
1ECA
2MEG
3ERF
4PWT
5BNE
6BTE
7PGF

The next step is to analyze each company’s debt and cash level, debt maturities and cash flow from operations. This will lead us to Part 2.