Description

This is a follow-up to a 2018 report on the bonds and a 2016 report on the equity.

Thesis

Notwithstanding a significant run-up in its stock price, we believe Frontera Energy Corp’s Equity trades at a significant discount to its intrinsic value. There is the potential to earn 120% should the equity trade to fair value of US$25 / C$31 assuming a mid-cycle price of $60 Brent / $55 WTI. There is 220% upside to US$36 / C$45 if you use a mid-cycle price of $70 Brent. There is further upside from continued positive indications out of Guyana and a transaction with a supermajor or NOC.

Macroeconomic and Geopolitical Environment

The current macroeconomic environment for oil and gas is clearly strong with Brent at $108/barrel. However, this is usually a negative for oil and gas stocks as investors tend to value stocks as if the high prices will last forever. We believe this is not the case with Frontera.

The United States is the largest producer of oil and gas. Oil and gas companies in the U.S. face obstacles related to ESG and now populism (excess profit taxes). These obstacles raise the cost of capital for U.S. oil and gas companies and are positive for mid-cycle commodity prices. The second-largest producer of natural gas and third-largest producer of crude oil is Russia. Russian companies will face permanently higher costs of capital even if the war were to end tomorrow. We think an investor benefits from these trends by investing in a company like Frontera with operations in Colombia, Guyana, and Ecuador.

The political situation in South America is not without risk. Gustavo Petro, a far-left candidate, is leading in Colombian polls. He is hostile to the oil and gas industry, so it’s worth discussing the implications of him winning.

-          Colombia has checks and balances in its government that will prevent drastic changes if Petro wins

-          Restricting oil and gas development isn’t as popular as it was pre-Russian invasion

-          Powerful nations (i.e., the U.S.) have a vested interest in Colombian production being strong and a South American nation not being led by someone who might want closer ties to Russia

-          Oil represents 55% of total Colombian exports

-          Petro can stop bid rounds, but Frontera has plenty of existing licenses with exploration opportunities in Colombia as well as Guyana and Ecuador

-          Banning fracking is an easy headline win as fracking isn’t used in Colombia

As for Guyana, the country found the golden goose in offshore oil and gas. It is unlikely that politicians will want to stop it. Furthermore, Frontera’s partner in Guyana, CGX Energy (OYL CN), is viewed as the local oil and gas company, which is better than being viewed as an outsider in our belief.

Company Overview

Frontera Energy is a Canadian listed oil and gas company with a combination of E&P, infrastructure, and development assets in Colombia, Ecuador, and Guyana. Most of Frontera’s value comes from its E&P assets. In addition, Frontera owns infrastructure assets, namely a 21% stake in the ODL pipeline in Colombia and a 97% stake in the Puerto Bahia port in Cartagena. Frontera also has substantial NOLs.

Note: Frontera reports in USD.

Capital Structure

CGX Energy (OYL CN) and the Puerto Bahia port are consolidated in Frontera’s financial statements.

Valuation Analysis

We value Frontera using a sum of the parts analysis, stripping out CGX and Puerto Bahia.

(1)    E&P Value

We use a $60 Brent (~$55 WTI) price, which we believe is an appropriate mid-cycle price as below $55 WTI, U.S. onshore E&P companies struggle to earn acceptable full-cycle rates of return.

We estimate maintenance Capex at $175 mm, which would equate to a 12% EBITDA-Capex yield.

Other approaches to the E&P value include:

BTAX PV 10 Proved Developed Reserves: $1,009 million (~$70 Brent) and BTAX PV 10 Proved Reserves: $2,110 million (~$70 Brent).

A lot of investors use Proved Reserves value, which would add $11/share to our valuation (100% upside).

Finally, we don’t think it would be unreasonable to assume $70 Brent mid-cycle pricing (versus the $60 price we are using) as the forward curve reaches an asymptote at $75. Modifying this price assumption would also add $11/share to our valuation.

(2)    2022 Excess Free Cash Flow

We assume that Frontera earns the strip for just 2022 before prices go back down to mid-cycle levels. Frontera could easily hedge above $60 or $70 for multiple years, which we believe adds further potential upside.

(3)    Peru Inventory Value

Frontera had an E&P block in Peru where the license expired in early 2021, but from which Frontera has rights to 480,200 barrels left in the pipeline. We value this at $100/barrel.

(4)    ODL Value

Frontera owns 20.98% of the Oleoducto de los Llanos Orientales S.A. (“ODL”) pipeline. The accounting is a little confusing as Frontera reports the gross participation interest 35% and backs the delta out through NCI. The 35% interest produced $38mm of income (and $41.6mm of dividends). We think 8x Net Income for a South American pipeline is very reasonable versus corporate comps and precedent transactions.

(5)    Puerto Bahia Value

We value Puerto Bahia at its net PP&E less net debt. Its current earnings power doesn’t justify book value, however, there is line of sight to increased earnings should it be hooked up to the Reficar refinery. There is an MOU in place and Ecopetrol is expanding the Reficar refinery. However, it is highly unlikely that anything happens until the election is over.

(6)    Guyana Value

We value the 285mm shares Frontera owns in CGX Energy (OYL CN) at the current share price and the 1/3 direct interest in the block at 1/2 the EV of CGX Energy (1/3 direct interest = 1/2 * 2/3 that CGX owns).

Note: We believe Frontera would not be able to monetize its stake in CGX in an orderly fashion given the high % ownership.

When Apache announced a JV with Total in its adjacent Block 58 and that they are encouraged by the Maka Central-1 well’s preliminary information, Apache added ~$1.5bn of market capitalization.

The Exxon Liza development is slated to produce 120 mboe/d at a cost of $4.4 billion.

While these development blocks are different than the Frontera/CGX block, we believe that they illustrate what is driving excitement in this area of the world.

Guyana

Focusing on the value from Guyana through CGX Energy, Frontera owns a direct 1/3 interest in the Guyana offshore blocks and a 79% equity interest in CGX Energy, which owns the other 2/3 interest in the Guyana offshore blocks.

Catalyst

Additional data from the first Guyana well and further Guyana drilling successes

An outright sale or JV with a supermajor or NOC for the Guyana assets

Free cash flow generation and continued share buybacks

Split-up – E&P Company, Infrastructure Company, Guyana Company