Accrete is a gas-weighted junior energy E&P in Alberta, Canada. I believe management is preparing to sell all or part of the company, and start again.  Originally Accrete was spun off as a high growth junior E&P to grow for 3 years or to 3000 barrels of production per day, then sell out to a trust.  Their plan was interupted by the 2006 royalty trust tax law change but it is still their intention to sell to a trust, and while the market for their assets has slowed, it has not stopped.   Recent royalty rate changes will make some of their properties more attractive to royalty trusts effectively giving back some of the taxes (in the form of royalties) that the government took away in 2006.

 

Signal #1, Corporate buybacks.  Accrete originally caught my attention because the company actually bought shares back shares on the open market during the 2^nd quarter using debt.  Management has stated that they will only raise equity on favorable terms.  Buying back shares when the stock is trading at a discount to nav is reflective of that.  On the other hand, if they intend to be an ongoing company it doesn’t make sense to use funds for buybacks with current commodity prices and their high debt levels, as they’re going to be in a predicament when it comes time to fund their 2008 budget.  

 

Signal #2, Accrete did an equity financing at the end of last year at $8.40 share.  At the time, they were being touted in the media by energy guru, Joseph Schacter.  They raised $10.4 million.  They could have raised more but I believe they wanted a minimum amount of “new partners” at this stage in their life. 

 

Signal #3, Insider/Management options.  Time is ticking on nearly 1.5 million options that all expire around the same time in mid-2009 (this amounts to 8% of fully diluted shares).  Management & insiders own 28% of the company on a fully diluted basis and have been buying in the recent past at higher prices.  They were buying the month of October at higher prices.

 

Signal #4, Some unsubstantiated gossipy stuff:  Last week I jokingly asked the cfo if they were selling out because their website hasn’t been updated in 6 months.  He admitted they were “a company in transition” but left it at that.  (A day later they updated their website.)  Over the summer I talked to him about their hedges.  He said they would lock in new ones when the summer ones expired on 10/31, yet as of last week when I talked to him the company had no new hedges in place, nor are there any mentioned in the 3q report.  

 

My conjecture:

 

Accrete is run by an “organic” growth oriented management team.  To fund a growth oriented capex budget for 2008 they would need to spend as much, if not more, than their 2007 budget of $41M.   It will be easy to expand capex to $50M if they reach their production guidance and if commodity prices remain stable or improve.  In this scenario, their share price will at the minimum recover to $5.  However, if either they don’t make their guidance or if commodity prices soften, they would be forced to reel-in capex for 2008 as they are already on the high-end of their feasible debt load.  They won’t have the cashflow to support more debt.  There is the possibility that they would just wait-it-out, but I would argue that it is not their style to nurse mature assets.  They have delivered a 1200% per share increase in production since mid 2004 and are capable of moving into new areas and building production from the ground up.  If they can’t fund a larger capex budget for next year, they will sell out completey or sell assets so they can get maximum production growth from their capex in their undeveloped areas.  If they sell assets, they could sell them at market prices which are 50% higher than their current share price values them.

 

About Accrete:

 

Accrete’s Production Profile:

 

This is a unique production profile for an E&P in Alberta because it is abnormally high in natural gas liquids (34% of 2^nd Q revenue).  They talk down their natural gas liquids because they receive a low price for them (relative to oil) and they include a higher content of ethane but the neat thing about this product is that it trades at a suprisingly low (.30-.40) correlation to oil and dry natural gas.  Over the summer, the operating profit (on an energy equivalent basis) for these liquids was higher than for natural gas.  The natural gas liquids are not exported to the U.S. and tend to be used in chemical manufacturing. 

 

Liquidity & Debt.  The industry standard way of gauging debtload is to look at the ratio of debt to cashflow.  A low or moderately leveraged growth E&P would be around 1 to 1.5 (debt to cashflow).  Accrete is at 2.6x.  However, a more relevant metric is looking at debt relative to assets, specifically proven producing reserves.  Accrete is only slightly above average.  Proven producing reserves are arguably the hardest asset a company like this can own other than cash.  These are the existing wells, tied-in, and verified by a 3^rd party engineering firm.  As a final part of this “economic” view of debt, consider their ability to service debt via their below average operating costs.  Operating costs for Accrete are under $1.06/mcf vs. a peer average of  $1.77/mcf.  This, and their high natural gas liquid production mix, gives Accrete a competitive advantage.

 

Core property:   Most of their production comes from an area called Harmattan where the operating costs are industry leading, only $.83/mcf, despite the massive run up in service costs into 2006.  This is their most mature area and is their cashcow.  They have drilled ¾ of their targets here, only development targets remain.  Harmattan planning began while they were Olympia Energy and the area was spun off into Accrete when they sold Olympia to a royalty trust.  The area had zero production at that time in 2004.  Now, it is producing over 6000 mcf of natural gas and over 1000 barrels of oil & natural gas liquids (combined) per day.  Management said in their most recent quarterly report that this property continues to outperform the expectations of third party engineering evaluation firms, which implies the reserves will get an upward revision this year.  Harmattan is also the source of their high volume of natural gas liquids.  Harmattan makes up a large % of their value and would be a nice asset for a trust.  Management calls this property in the “fill and drill” stage of development.  The new royalty scheme set to go into effect in 2009 will increase the value of the reserves here with some minor reconfiguration of productive zones.

 

The rest of their properties are in the early to mid development phase which would make them good picks to go with the spinoff (if they take that route).

 

Claresholm is their 2^nd biggest producing area and is growing fast.  They recently announced a discovery & plant expansion in late 2^nd quarter that would increase this area’s existing production of 3617mcf per day by 130%.  They had zero production here when they started in 2004.   It has similar low operating costs as Harmattan.

 

Pouce Coupe is their northernmost property.  It’s a small area that they began operating here in 2005.   It has some significant upside but is not a core property.

 

Edson is a deep, expensive resource play which means they can potentially unlock a repeatable play.  Wells costs 2.5-3 million.  This is also a non-core property.

 

Saxon is their largest growth area and they tout it as having similar economics as Harmattan.   They have little production from there now.  Little or no value from here is attributed in their NAV.  They have drilled one well based on 2d and are excited about a 3d seismic program set for December.  They have recently acquired $6 million worth of land here.

 

I’m posting junior energy companies operating in Alberta within similar production ranges because they share the same issues, i.e. balance between capex required to maintain declines, replace reserves and grow.  

 

 

 

 

Accrete is guiding for a significant increase in production by year end (3654 daily barrels equivalent year end exit target vs. 2700 average in the 2^nd quarter, and 3373 currently).  If they deliver on their guidance and gas prices remain stable then $5/share is doable, just maintaining their existing depressed cashflow multiple.

 

There have been 2 acquisitions of similar sized Canadian E&Ps during 2007.  Both of these E&Ps were showing production declines, unlike the 25+% growth in production ytd for Accrete.  The assets were of lower quality, as well, as shown by higher operating costs and higher depreciation:

 

Acquisition closed: August 21, 2007 for a combination of shares and cash.

 

 

 

 

In the most recent corporate presentation, the CEO cites some M&A data saying acquisitions have averaged $17 per barrel of oil equivalent putting Accrete’s value in the $8 range.

 

Why is the market giving us this opportunity to buy Accrete at this cheap price?

 

The market is looking at their relatively high debt load and ignoring the fact that they have higher quality assets and can handle more debt than a comparable junior.

 

Accrete is experiencing a “clientele effect.”  It grew production rapidly for the first 2 years, but lately it has slowed down.  For the company to buy back shares on the heals of several quarters of virtually flat production growth is like nails in the coffin from a growth investor’s perspective.  

 

The market hates Canada.  In the last couple of years the government has increased taxes on trusts and increased royalty rates on high-rate wells (the death knoll for my previous energy write-up, West Energy).  The strong Canadian dollar and escalating service costs have been another reason to stay out of Canada. 

 

Macro look at Natural Gas:

 

Excess North American natural gas storage is holding the price of natural gas down.  A “normal” winter will help reset the storage imbalance and at the very least making the price of gas less disconnected to the price of oil.  

 

Since January of 1999, on average the price of a barrel of oil has traded at 9x the price of an mcf of natural gas in Canada.  Right now, oil in Canada is trading at over 16x the price of an mcf of gas.  Only 1 month, July 2002, did the month average a bigger multiple.  If you would’ve bought natural gas that month you would’ve tripled your money over the following 6 months.

 

As of September, natural gas prices in N. America and Canada are the lowest in the developed LNG-importing world. http://www.ferc.gov/market-oversight/mkt-gas/overview/2007/ngas-ovr-wld-pr.pdf which is diverting further imports of LNG.  LNG imports that do make it will come at the direct expense of the higher cost Canadian producers.  Accrete’s costs are in the low range for Canada (and even the U.S.).  Accrete will benefit from lower service costs, less competition for rigs, and lower trucking costs (management says they’re already seeing this).

 

In the second quarter of 2007 Canadian producers drilled only 1,415 development wells (the lowest level since 1999) and only 321 exploratory holes (the fewest in 14 years). Excluding test wells, operators drilled 1,744 new wells for the period, a decrease of 41% over 2006.   Only 1,058 wells completions were reported for the month of June, the second month in a row with levels at the lowest since 1999.  For the first half of 2007, completions are down 11% from the first half of 2006 (completions are the last part of the process so you might expect this metric to lag). 

 

The EIA short-term energy outlook is predicting the average price of natural gas to be U.S. $8.03/mcf in 2008.  At that price, with just Accrete’s existing production, trading at Accretes existing cashflow multiple, would put the share price at $5.90.  It would increase the NPV of their reserves by a similar %. If Accrete can sustain their bullish production guidance throughout 2008 then we would see $6+.  In the near term, this is still a gamble on gas prices but Accrete is a low cost producer that will survive another warm winter if it must.

 

Accrete just gave a presentation at SEPAC that highlights more of their reserve valuation & reserve growth history than I touched on.  The CEO uses a lower discount rate making his NPV numbers higher:  http://www.newswire.ca/en/webcast/viewEvent.cgi?eventID=2077680