2019 Q1 Commentary
By Jason Lesh, Managing Principal
We have written extensively about risk, volatility, and valuations over the last several years. From our perspective, it’s important to continually talk about the fundamental values that drive our decision making.
Along those lines, we wanted to share a bit more about the process of evaluating a company and the decision to invest. This quarter, our portfolio manager Nick Fisher walks through his in-depth analysis of Peyto Exploration and Development and why he recently decided to add it to portfolios. Meanwhile, Alex Bridgeman, our newest employee, highlights why a modest allocation to a company like Peyto is a good idea that not every investor is able to make.
As you may be aware, the first half of 2019 has been good for your investments. With that said, volatility is returning and we will be addressing this in an upcoming note. And as always, please don’t hesitate to contact any of us if we may be of assistance. We would love to hear about any changes or just catch up as your schedule allows.
Warmest regards,
Peyto Exploration and Development (PEYUF) - Price: $3.22 USD (as of 6/5/19)
By Nick Fisher, Portfolio Manager
Peyto Exploration and Development is a 20-year-old natural gas producer located in Alberta Canada. They are the self-proclaimed 5th largest gas producer in Canada producing enough natural gas to heat all the households in Alberta and Saskatchewan. Their asset base is uniquely concentrated in the Alberta Deep Basin west of the province capital, Edmonton. The geographic concentration of their assets and increasing vertical integration has become a key component of their strategy resulting in a low-cost producer advantage. Despite the volatile nature of gas prices, Peyto has achieved 19 straight years of profitability.
Management of Peyto has done a wonderful job of educating its shareholder base on the intricacies of the business, clearly communicating and disclosing important information pertinent to the future of Peyto. A commodities business, however, is still at the mercy of commodity prices and gas prices in Canada have not been particularly strong!
The stock has been beaten up, having fallen 90%. In the meantime, profits have fallen ~50% per share.
At the heart of the issue is a glut of natural gas in Canada with limited egress compared to other parts of the world. The result is gas prices in Alberta (AECO) that are the lowest in the world. Currently gas prices at Henry Hub distribution point in Louisiana are nearly double that of AECO.
One catalyst for higher gas prices over the next year is the storage trend that currently exists. The chart below shows the lowest storage trend since 2014. In that year prices spiked as participants realized a need to replenish those stores by the time the winter heating season was underway. Obviously, weather plays a big part in this equation.
Over the long-term, Canada has plans to expand the egress of gas out of Canada by 32%. In 2024, plans currently call for expanded pipelines and export options (LNG) which will allow pricing to dramatically improve. The good news is that current futures pricing is showing improvement over time and is trending higher.
In the meantime, Peyto is planning their cost structure around AECO prices of $1.50 to maintain profitability in a worst-case short-term scenario of persistent low prices. This industry low cost structure combined with an increased focus on liquids production (which commands much better pricing) will lead to continued profitability and maintaining the 19-year streak of profitability.
On the balance sheet side of things, debt levels are on the upper end of management’s forecast, although still reasonable at ~2.2xEBITDA. In 2018 management shifted to a more conservative capital allocation position, cutting the dividend, and decreasing capital expenditures in favor of debt pay down with ~$100M paid down in 2018.
Valuation
The company has targeted production of 100,000 boe (barrels of oil equivalent) per day by 2022 and with a return to a more historically sustainable AECO gas price coupled with a) diversification of its revenue stream with liquids, b) increased storage to smooth out volatile AECO pricing, and C) additional North American market access; it doesn’t seem unrealistic to achieve a historically significant operating margin of $1.50 per mcfe (thousand cubic feet equivalent).
Worst Case Base Case Best Case
Margin per mcfe: $1.00 $1.50 $2.00
Production Target boe/d: 85,000 90,000 100,000
Est. Operating Income (CN): $186M $295M $438M
Multiple x6 x8 x10
Valuation (CN): 1.16B 2.36B 4.38B
Total Return: 55% 327% 608%
(based on current $720M CN Valuation)
Base Case 3-5 Yr. Annualized Return: 26.8%
The best-case opportunity revolves around whether Peyto can gain access to global markets. Demand for natural gas from India and China is expected to double over the next 5 years as they transition from coal to natural gas. If the liquefied natural gas (LNG) projects that are currently proposed and/or under development in western Canada open up Asian LNG pricing it would be a game changer and allow for significant pricing advantage for Canadian producers.
Risks
The most significant risks to our assumptions are around supply and demand of Canadian gas. If global demand falls significantly and/or if other Canadian gas producers continue to produce gas when pricing makes it unprofitable, gas pricing will remain challenged. While Peyto’s lower cost structure gives it staying power, it could still impact short-term profitability.
The political climate has been interesting to note as well. While the government in Canada has been taking a hard-line approach on greenhouse gas emissions, many of the Canadian Oil Producers have become much more efficient (in many cases cutting emissions in half). With this approach, the government has balked at assisting the industry in debottlenecking gas to market. This is partly the reason for lower prices and consequently the government royalties/taxes paid have decreased, incenting the provincial government to assist the industry. And the provincial government has more incentive than just the tax revenue because Canadian natural gas is some of the cleanest in the world and it makes most environmental sense to use local sources rather than importing.
Conclusion
With a long history of managing through wide ranging price environments, Peyto has been adept at maintaining profitability when other players in the industry struggle. Their balance sheet makeup, coupled with their conservative growth plans suggest the company has staying power in this environment. Current economics have proven challenging in the industry and investor sentiment has reached peak pessimism. Spectators and investors are expecting AECO pricing to remain low into perpetuity, which seems extreme and unlikely. Peyto has a strong foundation and focused strategy to emerge from this industry malaise. This is just the type of setup that we like. Heads we win big or tails we don’t lose much.
