Peyto Has The Potential To Be An Energy Success Story (OTCMKTS:PEYUF)
For a country often depicted by its overtly apologetic nature; political debates often show a far more standoffish tone from Canadians. In the current economic crisis, many have criticized the government for its plans of an oil and gas stimulus package. Claiming many producers in the industry were already on their last leg due to the low commodity prices and thus need not be saved. While these claims hold many truths, they fail to understand the economic fundamentals that drive the Canadian economy.
From oil and gas to lumber, maple syrup, fisheries, and agriculture; the economic history of Canada is in large part history of natural resource extraction. These industries have and continue to play a vital role in shaping the Canadian economy and Canadian culture. The efficient and sustainable development of resources drives environmental policy. Economic development and environmental sustainability are more positively correlated then many realize. The poorest nations often have the worst environmental policies; climate change is of no concern to those who go hungry.
Despite modest push back it seems every more likely the federal government will provide this stimulus. While this will likely prove beneficial to support businesses in the short run; long term success will need to come from increased cost management and flexible capital. The current political tension between OPEC members and its former allies could very well be the beginning of prolonged volatility in energy commodities, and only those businesses that can adjust operations to manage these prices swings will prove successful.
Peyto’s (OTCPK:PEYUF) disciplined investment strategy has positioned it as one of the industry’s lowest-cost producers. Its ability to adjust capital expenditures allows Peyto to potentially remain cash flow positive through difficult price environments. A healthy balance sheet, low cost of capital and ample credit; Peyto should prove a successful long term investment despite the current crisis. The investment, however, comes with a high degree of risk and uncertainty, and should only be made with funds one is willing to forfeit.
A Strong Financial Position to Weather Weak Commodity Prices
The recent operating environment has led to a widespread deterioration in financial health. Lower commodity prices have left producers strapped for cash and the inability to raise capital has led many to sell assets, increase indebtedness and employ greater leverage.
Through these years, Peyto’s disciplined investment strategy has allowed the company to grow operations while keeping its financial position in good standing.
With a debt to total capital ratio of approximately 40%, Peyto has shown an outstanding ability to fund the majority of its expenditures with internally generated cash flow.
(Source: Authors own Calculations)
Managements disciplined approach has placed Peyto as one of the industry’s lowest-cost producers and gives the company a unique ability to handle the current economic downturn. A low sustaining CAPEX requirement gives the business greater flexibility to reduce the expenditures and produce positive free cash flow even with depressed commodity prices. Allowing management to make modest improvements to its net debt position, during a time when many in the industry are seeing their balance sheets deteriorate.
(Source: Peyto 2019 Q4 MD&A)
Significantly reduced market valuations leave the prospect of equity issuance as a last dying effort of any firm within the industry. While Peyto had often issued equity in the past to fund approximately 50% of any expenditures not covered by cash flow; its inability to do this moving forward will require diligent management of cash flow to ensure it can maintain its capital structure and avoid becoming over-leveraged.
(Source: Peyto 2019 Q4 Financial Statements)
With maturity dates staggered and nothing due within the near term, Peyto’s cash flow should prove sufficient to maintain all contractual obligations. However, the low commodity price environment will still require diligent management to ensure funds are available to retire notes when they are due, or earlier if it proves beneficial.
The current sentiment towards the industry would likely create difficulty issuing notes, however, Peyto’s smaller size and respectable track record would likely allow it to raise funds where needed. With interest rates at significantly lower levels, it is difficult to assume the premium necessary to compensate for the negative sentiment would prove to be material in impacting Peyto’s cash flow.
The business also has a $1.3 billion credit facility, with $595 million in available capital. Given the rate on the revolving line is variable; it would likely save Peyto on interest to retire some of its notes with funds taken from this facility. The action would have no impact on its balance sheet or any of the company’s financial covenants.
- Long-term debt plus bank overdraft and letters of credit not to exceed 3.5 times trailing twelve-month net income before non-cash items, interest and income taxes (this covenant is scheduled to reverse to 3.25 times for the fiscal quarter ending December 31, 2021); as at Dec 31, 2019- 2.99:1
- Long-term debt and subordinated debt plus bank overdraft and letters of credit not to exceed 4.0 times trailing twelve-month net income before non-cash items, interest and income taxes; as at Dec 31, 2019- 2.99:1
- Trailing twelve months net income before non-cash items, interest and income taxes to exceed 3.0 times trailing twelve months interest expense; as at Dec 31, 2019- 7.0 times
- Long-term debt and subordinated debt plus bank overdraft and letters of credit not to exceed 55% of shareholders’ equity and long-term debt and subordinated debt plus bank overdraft and letters of credit; as at Dec 31, 2019- 40%
The $595 million available would allow Peyto to retire all of its senior notes and leave $180 million of capital to fund any shortfalls in cash flow. This puts Peyto in a firm position to handle the current downturn without the need to raise additional funds. The only issue would pertain to the credit facility’s maturity due Oct 2022.
It would seem likely that the issuing bank or syndicate of banks would roll over the facility as Peyto is in a strong financial position and easily covers any costs to borrow. However, the difficulties facing the industry leave no certainties when it comes to raising capital. Since issuing equity is off the table, the business will need to either roll over its credit or issue new notes. By any financial assessment, it seems likely that one of these options would prove successful and would still come in at a cost below Peyto’s historical cost of capital, 7-8%. The analyst should monitor this situation moving forward. Government stimulus could also come in the form of support for banks to continue supplying capital to the industry; only time will tell.
While Peyto currently finds itself in a comfortable financial position, its ability to remain there relies heavily on internally generated cash flow. In the past, the business has elected to fund cash flow shortfalls 50/50 between equity and debt, and since equity is out of the question, this will require continued reductions in expenditures or increased cash flow to make up for the lack of available market funds.
Reduced Hedges Leave Cash Flow Exposed
In the previous 8 quarters, Peyto’s defense expenditure program and its fairly significant dividend cuts assisted the company in posting positive free cash flow. For 2020 management had anticipated a return to “offense” through greater commodity price exposure to capture potentially rising prices and CAPEX increases of 25-40%.
(Source: Peyto March 2020 Presentation)
Thus far management has indicated they will continue with the previous guidance, pushing much of the expenditures to the second half of 2020 in hopes of stabilized prices. If prices remain suppressed for a prolonged period this guidance may need to be revisited, Peyto’s flexible cost structure should allow it to reduce expenditures on fairly short notice if necessary.
Using the high end of the CAPEX range we can figure that Peyto will need to generate about $395 million in funds from operations (CFO + Changes in Non-cash working capital + Provisions for performance-based compensation + performance-based compensation) for the year to remain cash flow positive and continue making improvements to the balance sheet, as would be desirable for shareholders given the capital scarcity in the region.
Management made further improvements to net debt a goal for 2020 and the previous CAPEX guidance had factored this in, but again with current hits to the energy industry whether this will be achievable at current prices is yet to be seen; Q1 results should provide clarity.
(Source: Authors own Calculations)
Production approximate levels to meet the necessary cash flow would be 90,000 boe/d. The decision to remove much of its hedge position has created greater price exposure and leaves Peyto vulnerable to negative cash flow even if it can maintain these production levels. Approximately 20% of natural gas sales will have a minimum price of $2/mfc, while close to 6% of crude oil production is hedged at $60 USD/ bbl. These positions will likely post a modest gain but given the small nominal value of the positions, it is unlikely to have a material impact on revenues. If 2019 is any indication, the positions could post a gain somewhere between $10-20 million.
The timing could not have been worse for Peyto to remove its historically successful hedging strategy, the decision will require greater capital efficiency; Peyto has proven this to be a strong point.
The expectation to one again achieve profit margins above 20% could be somewhat optimistic. As can be seen, the price expectation to achieve the desired level of revenue currently sits above-market prices. While hedging will make up some of this gap, it is not likely to have any material significance. Where some relief on cost guidance may come from could be in other key areas.
Energy Crisis and Government Stimulus
Details surrounding the potential government stimulus have been scarce. Reports claim the support will total $15 billion, how this stimulus will be distributed is anyone’s guess at this point.
The Alberta government, already in a weakened fiscal position, does not have a great deal of capacity to support the industry, proposing aid to pay for decommissioning liabilities. Alberta Premier Jason Kenney has called on the federal government to support the industry in a similar manner freeing up room on balance sheets to ensure firms stay solvent.
Peyto, as discussed previously, has made very disciplined investment decisions and thus has done a respectable job keeping decommissioning liabilities low, as efficient investments in development projects ensure lest waste and thus less cost to reclaim the lands after their useful lives are realized. With only $165 million in decommissioning provisions outstanding, Peyto would certainly benefit from this type of stimulus, but not to the same extent as other firms.
In addition, it seems likely a reduction in royalties and taxes would be levied by both Provincial and Federal governments (royalties are only provincial). While royalty payments were not significant for Peyto in 2019, greater cost savings can only support the company in remaining cash flow positive. With the margin likely to be tight these small items could make the difference.
Conclusion and valuation
The numerous issues facing Canadian energy producers make any investment in the industry one with a great deal of risk. The reality remains that the industry will survive in some state as its contribution to the Canadian economy is too large to simply be wiped away. Despite the best efforts of many, renewable sources are not yet capable of replacing oil and gas in developed countries, let alone globally where underdeveloped areas, such as Asia, still use coal to a significant degree.
Natural gas could very well provide a more environmentally friendly alternative on a global stage, and Canada’s abundance of resources allows it to remain a significant player. While the industry will likely experience a significant reduction in size as high-cost producers are bought up or squeezed out of the market, those who can maintain flexible cost management will provide significant returns to investors in the long run. Finding these producers is an extremely difficult task and possesses a great number of unforeseen risks, as the industry is operating in unknown territory.
It should be reiterated here to ensure the point is abundantly clear. Any investment within the Canadian oil and gas industry should be made with funds one can afford to lose. These unprecedented times bring about potential pitfalls that even the most thorough analysis could fail to predict. While the government has indicated it will support the industry; its track record with oil and gas in recent years leaves many questions. Investors should approach investments in these producers with a great deal of caution.
Valuing companies in this environment is difficult given the high uncertainty surrounding the future of commodity prices. Peyto should be able to maintain sufficient cash flow to help it survive the crisis, but an intrinsic value is all but uncertain at this point; previous Net Present Value (NYSE:NPV) calculations can provide a benchmark value to work with.
(Source: Peyto 2019 Reserves Press Release)
Taking only the Proved Developed Producing assets, those currently generating cash, the NPV would approximate to roughly $11 per share. Removing the net debt position leaves a hypothetical intrinsic value slightly above $4 per share.
(Source: Peyto 2019 Reserves Press Release)
The prices used in the calculation could be overly optimistic given the current environment. By the same token, they could prove to be accurate if global energy markets stabilize. Predicting with accuracy the movement of commodities is highly uncertain and would not prove of significant benefit. If Peyto were to liquidate its assets and only receive 25% of its net value it would still pay out just over $1 per share. This provides a margin of safety for investors but the high uncertainty surrounding the industry calls these assessments into questions and leaves virtually no certainty in their accuracy.
Investors looking for deeply discounted securities may find a success story in Peyto. Its low-cost structure gives the business great flexibility that should allow it to survive through these unprecedented times. The level of risk surrounding not just Peyto but the entire industry is significant, and thus investors should seriously consider their personal liquidity needs and asset allocation before considering any investments.
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Disclosure: I am/we are long PEYUF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.