May 11, 2015 - 11:12am EST by
2015 2016
Price: 6.97 EPS 0 0
Shares Out. (in M): 89 P/E 0 0
Market Cap (in $M): 620 P/FCF 0 0
Net Debt (in $M): 173 EBIT 0 0
TEV ($): 793 TEV/EBIT 0 0

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  • Energy
  • Western Canada
  • Oil and Gas
  • E&P


Dee Three Exploration (Ticker DTX on the TSX) is a mid-sized oil and gas E&P headquartered in Alberta with two large, light oil-weighted assets in Alberta’s West Canada Sedimentary Basin (WCSB).  The company has announced plans to split itself via tax-free rollover into two companies, one tied to the growth-oriented unconventional resource play in the Belly River and the other to the conventional, low growth, low decline, free-cash-flow generating oil pool in the Alberta Bakken.   I believe that the upshot of the separation should be a higher market value for the parts than is currently ascribed to the whole.  From conversations with Canadian resource focused investors and analysts (the company remains largely unknown in the U.S.) I believe that the market disagrees and has created an undervaluation which is primarily a function of concerns about the loss of trading liquidity from the split and investor weariness from dealing with the CEO Martin Cheyne, who has somewhat of an abrasive personality.

If the shareholder vote on May 14th is successful, DeeThree will split shortly thereafter into a GrowthCo (Boulder Energy Ltd) and a DivCo (Granite Oil Corp).  One DTX share will equate to half a Boulder share and a third of a Granite share.  More details are in presentations for each new company posted to the DTX website on April 15th.

Boulder will house the Belly River Play, which was a gas focused reservoir exploited through vertical wellbores.  After acquiring the asset in late 2010, DTX was the first to apply horizontal drilling and fracturing technology to the field, which has been highly successful  at delineating hundreds of locations (with an average working interest  of 95%) for this a multi-zone oil weighted  play.   Since the initial success, well costs have come down every year, well productivity has increased every year and overall Belly River production has increased every year despite the natural well declines (approximately 40% in the first year).  At WTI-$60 per barrel, assuming a $7 oil price differential, the netback from this field is $40 per barrel, and the time to reach payback of well drilling/fracking/completion costs is 2.6 years.  The estimated IRR of 29% is higher than most if not all Canadian oil-prone resource basins at this oil price.  At an oil price of $70, the payback is under 2 years and the IRR is in the mid 40s.  This is based upon an experience set of over 60 wells so these type curves and economics are pretty robust relative to some of the earlier stage unconventional plays in the WCSB.  DTX’s land position of over 98,000 net acres equates to over 400 locations, which is sufficient to fuel high ROI production and cash flow growth for well over 10 years.

The budget for next year is to drill 23 Belly River wells at an average cost of $4.5 million per well.  At $60 WTI, this would generate an estimated cash flow of $98 million.  Using a peer group of Canadian intermediate, growth oriented producers like Tamarack Valley, RMP Energy, Raging River and Spartan, the median multiple of 2016 cash flow is 5.7x, which equates to Boulder equity value of $560million, or $6.30 per, DTX share.  I am calling this equity value instead of enterprise value as this cash flow figure, as in the convention in the E&P industry, is after interest expense.  At this valuation, the multiple of estimated 2016 average daily production of 9,400 boe is $59,600, which is towards the low end of the multiples for the peer group despite what should be a better than peer field-level ROI.  Note that the net debt at Boulder of $128 million is a reasonable 1.3x estimated 2016 cash flow at WTI-$60.

Granite will house the lower growth, recovery driven Alberta Bakken play and is set up to pay out its free cash flows as dividends.   This is a large, 100% owned 350,000 acre asset is highly concentrated and now includes key storage and transportation infrastructure.  As with the Belly River, DTX was early and pioneering in the development of the play, which allowed it to accumulate the attractive and non-replicable lands/infrastructure position.  This is a large, conventional oil pool with a Sproule estimated 222 million barrels of oil-in-place, less than 5% of which has been recovered so far.   There are upwards of 170 identified drilling locations which each well likely to continue the recent trend of lower costs and higher production efficiency, albeit with some variations around the declines and recovery per well.  This is not a sexy asset but it is highly cash generative and conducive to a yield-co vehicle.  The company has set the initial dividend at a modest $0.03 per share per month and estimates that it can support this distribution, corporate costs including servicing the initial Granite net debt of $45 million and its CAPEX plans at an oil price of at least $50.  This excludes hedges, which the company currently maintains on over half of its production for the second half of 2015, with more hedges to be layered on for 2016 production.

The estimated average daily production from the AB Bakken next year is 4,500 boe.  At a WTI of $60, this yields cash flow after debt service of $48 million.  This cash flow would be apportioned $32 million to CAPEX, $11 million for the dividend and $5 million free cash flow (likely debt pay down).  With the same 10 new wells drilled the following year but at $70 WTI, the cash flow is $72 million.  The key risk, other than sub $60 oil of course, is that the decline rate comes in higher than the 22% being modelled.  Choosing a peer group for Granite is a little more difficult given that there are fewer yield -oriented Canadian E&Ps  but looking at Cardinal Energy and TORC, their multiple of 2016 debt-adjusted cash flow is 7.9x. They are much larger and have a longer track record than Granite so I am using 7.0x, which results in an equity value of $336 million, or $3.77 per DTX share. 


So combining Boulder and Granite gets you $10 per share versus a current DTX price of $8.  I consider this 25% upside to be attractive given that they are based on $60 oil whereas the futures strip is in the mid-high $60s.  At $70 WTI and the same multiples on 2017 estimated cash flow, the combined equity value is $1,280 million or $14.4 per share  (80% upside).  DTX has a healthy balance sheet, as will both spun off entities so there is less downside than with some of the stretched Canadian peers.  Additionally,  I like the fact that the largest shareholder is GMT Capital,  a multi-billion dollar long/short  hedge fund  based  in Atlanta with an outstanding long-term track record and lots of experience with  smaller Canadian oil and  gas companies.  Kevin Andrus from GMT sits on the board.  

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Shareholder vote likely approving the tax free split-off of Boulder and Granite on May 14th.

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