Given the large current Canadian heavy oil differentials we believe Baytex Energy presents a favourable risk/reward opportunity on the long side.
The state of the low Canadian oil prices has to do with limited egress from the Western Canadian Sedimentary Basin (WCSB). Keystone XL and the Trans Mountain pipeline were the ways by which the growth in heavy oil production would leave Canada. These pipelines faced well documented regulatory headwinds and will not be in place for at least a few years at the earliest (2022-2023). Enbridge has certain efforts to increase egress by late 2019/2020 from its Line 3 expansion and ‘other’ prospects which should all together add up to approximately 700kb/d of capacity (for size reference TMX would have been 590kb/d). Because of production growth this year from a few projects coming online there is not enough capacity to move oil out of the basin, on top of this refinery maintenance season is upon us and has reduced demand by approximately 980kb/d. Six Midwest refineries account for this and most of the maintenance started in September and should be completed from mid-October to mid-November. Today heavy Canadian crude sells for around $26 or a discount from WTI of approximately $44. Typically, this spread ranges from $10-30; in 2012 and 2013 when egress for heavy oil was last an issue the average spread was $23 but did spike during to the mid $30’s and low $40’s. For reference the cost of moving the crude to market via pipeline can range from $5-15/bbl and rail would be in the range of $15+. Until the aforementioned Enbridge capacity comes online there will be a need to move approximately 300kb/d via rail to bridge the gap; for reference the gap in 2012-2013 was slightly less. Additionally, we hear that some large producers will likely cut back oil directed capex in Q4 of this year which should help the supply side.
In early 2014 Baytex acquired Aurora Oil and Gas for about $2.6bn and gained its Eagle Ford production. Prior to this Baytex was primarily a heavy oil producer in Canada. In mid-2015 with the debt that it took on from the Aurora acquisition, Baytex discontinued its dividend. This summer to help delever from the Aurora acquisition debt, Baytex merged with Raging River (RRX) – although Baytex is the surviving entity, RRX shareholders ended up with 57% of the share count. By acquiring RRX, Baytex also diversified further from being exposed to heavy oil prices and acquired Viking production which is light oil which also trades at a discount to WTI albeit a much smaller one. Production in 2019 is forecast to come in at somewhere between 100,000-105,000boe/d with 85% of that oil and NGL’s. About one third of production is from the Eagle Ford which gets LLS pricing which is close to Brent prices. Viking accounts for about a quarter of production and heavy oil makes up just more than a quarter. The remainder is natural gas/NGL production. It must be noted that the Eagle Ford production is non-operated with Marathon as the operator. From our understanding Marathon is currently deploying capital at a slower pace than BTE would like.
In the RRX transaction RRX management who are debt averse joined the Baytex team. The founder and CEO of RRX is now Executive Chairman of Baytex, the President of RRX is now EVP and it’s a RRX VP would will now be in charge of Duvernay and Eagle Ford shale. Since RRX is arguably the more skilled operator we like that one of their senior execs will be focused on the shale assets. Current net debt to 2019 cash flow comes in at about 2.0x and is to be reduced to about 1.5x by early 2022. Baytex bonds all trade at approximately par, the next maturity is not until 2021, and we don’t believe with management’s actions to clean up the balance sheet and new management’s inclination to have low leverage that debt is an issue. If one has a slightly more bullish outlook on WTI prices, with WTI at $75, net debt to cash flow would come in at 1.3x in 2019.
Assuming a WTI price of $65 and WCS differentials of $25 (see sensitivity below for further stressing this number), the company should make operating cash flow of about $1bn. Sustaining capex to keep production flat comes in at about $575mm and real capex next year should come in at between $750-$850mm to generate growth per share of approximately 12%. Real FCF ($800mm capex) would then come in at $200mm or about $0.36/share (555mm shares outstanding) which on the share current price of $2.94 is a 12.3% FCF yield. If they spend the lower end of the capex range the FCF yield would be 15.3% ($0.45/share). Below you will find a sensitively table for their 2019 cash flow estimate. If one applies a more reasonable FCF yield to those numbers, say 8.5%, then the share price would be 40-80% higher. Although this does seem extreme please note that BTE was up 63% in May 2018 as WCS prices spiked due to an unexpected production outage. What one can see from playing around with the sensitivities is that the company definitely has torque to the oil price and to heavy oil differentials. Below you can see that even though the Eagle Ford generates the best returns at low oil prices, at higher oil prices the heavy oil wells really kick in which explains the torque. I will note that the company had shut in heavy oil production in the past and could do so again if differentials remain extreme.
Eagle Ford Monetization
In the midst of the energy crisis the company had undertaken to sell some of or its entire Eagle Ford asset. Clearly none of the offers were attractive. From early 2016 to now one can look at transactions in the Eagle Ford and see that EV/boe/d metrics have increased from about $50,000/boe to about $65,000boe/d. Given BTE’s 36,000 boe/d of production and assuming a discount for the non-operatorship let’s say they can monetize 100% of the production at $50,000 EV/boe/d – this would equate to about USD$1.8bn or CAD$2.3bn. Currently, BTE’s net debt is CAD$1.75bn and therefore could be paid off in its entirety and leave a few hundred million of cash to potentially return to shareholders or deploy organically say in the East Duvernay or through acquisition where Canadian oil and gas assets remain cheap. Alternatively, management outlines that using their sustaining capex ($575mm) to keep production flat, FCF of the Eagle Ford is about 50% of total or about $212mm – if they were to sell this at a 10% FCF yield proceeds, would be about CAD$2.1bn. Again leaving ample cash for ‘something else’ after reducing debt to 0.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.