|Shares Out. (in M):||165||P/E||0||0|
|Market Cap (in $M):||3,450||P/FCF||0||0|
|Net Debt (in $M):||1,135||EBIT||0||0|
|Borrow Cost:||General Collateral|
Note: CAD $20.91 is stock price as of August 4th 2017 when memo was written; price as of August 15th 2017 close is CAD $20.07.
Over-valued vs. NAV
Unsustainable dividend funded by equity issuance
PEY Business Description:
Peyto (“PEY”) is a Canadian exploration and production company focused on producing natural gas from Alberta’s deep basin in the Western Canadian sedimentary basin. PEY’s current production is 92% natural gas and 8% NGLs, and future production will maintain this ratio. PEY has 450k net acres, with economic drilling activity in the current commodity price environment concentrated in what is known as the Spirit River formation. The Spirit River is a collection of stacked tight sands that are typically organized in channels a mile wide or so at their widest. Generally the Notikewin, Falher, and Wilrich are the producing reservoirs that are considered to make up the Spirit River formation. A given Spirit River well will only perforate one of these reservoir sands. The Spirit River sands were deposited in a barrier island environment on an ancient coast line, as a result, the relevant strata/reservoir is less continuous than, for example, a shale play would be. For any given surface area foot print, only one of the three sands may exist, or none at all. As a result, well locations must be identified by 3D seismic and or well logs to avoid the risk of dry holes. The sands that make up the Spirit River cannot be assumed to produce across a large surface area foot print, and therefore a statistical approach to modeling future wells cannot be assumed. Peyto considers the Bluesky reservoir to be similar in quality to the Spirit River, and has included it in their description of the Spirit River play. PEY maintains a high working interest across its acreage. On PEY producing acreage its working interest is ~99%. PEY also owns a 98% interest across 9 processing facilities which have capacity to process more than 100% of PEY’s existing production. However, given the location of PEY’s processing plants vs. its producing acreage, PEY does use some third party processing assets.
Over-valued vs. NAV:
PEY is valued aggressively relative to its NAV at the current commodity forward curve. In our analysis, we give credit for all the locations identified by Peyto management in the economic formations (the Spirit River plus the Blue Sky). We apply type curve estimates across the total location count that are superior to management’s assumptions (fourth table). Reserves are generally classified as proved, probable or possible. Proved reserves are expected to be equaled or exceeded with 90% probability (P90). Proved reserves are subject to stringent rules regarding offset production data, well logs, cores, and 3D seismic, which must be present in order to support a proved drilling location. Probable reserves are expected to be equaled or exceeded with 50% probability (P50). PEY provides a 2P estimate of well locations which is slightly more than half the locations we are using here (724 2P locations vs. 1,302 total locations). Possible reserves are expected to be equaled or exceeded with only 10% probability and are generally considered to be an optimistic economic forecast of total achievable production from a given resource. In the U.S., companies do not provide 3P or even 2P reserves estimates. In the U.S., companies also use the last 12 month average spot prices to forecast production value and economically viable reserves / and locations. In Canada, it is standard to present Probable or 2P reserves. In addition, economic viability is determined with respect to an independent reserve engineer’s in house / proprietary forward estimate for commodity prices. In the case of PEY, viable probable reserves were determined using Insights proprietary price deck as of the year end 2016 which is reproduced below from the form NI 51-101.
As you can see the price deck assumed for well location viability is much more aggressive than the current forward curve – achieving USD $85/bbl oil WTI price by 2025 and USD $4.83/MMBtu Henry Hub price assuming the 1.18 CAD/USD listed exchange rate and a USD $1.00 AECO vs. Henry Hub differential (which is lower than the current AECO differential of $1.25).
It is important to point out that the 1,302 total location count that we use in the economically viable region to value PEY is beyond 3P. This represents the total location count estimated by PEY management across their acreage. Based on our conversations with management, we understand the unbooked location count to be the maximum possible, and therefore, more aggressive than the 3P location count.
Very little may be known about a reservoir, particularly in the case of a resource which is non-continuous like the Spirit River formation, some distance from existing well bores (as opposed to the Marcellus for example – where further extrapolations could be supported by the depositional environment). Generally, the 2P estimate or P50 case for total hydrocarbon recovery based on available information might be used in an acquisition process or valuing a company in the private markets. Were we to use the 2P location count in the Spirit River of 724 locations, we would obtain valuations that were substantially lower as seen in the second table below.
Below is our SOTP for Peyto where we drill out their entire inventory using management’s 1,302 location count. At August 4th closing stock price of $20.91, PEY is currently 56% over-valued at current strip pricing. When only including 724 2P locations (second table below), PEY is 66% over-valued at strip pricing as of August 4th close. Additionally, we also show PEY’s valuation at flat WTI oil / Henry Hub price decks where we apply a $1.00 flat AECO differential (the current differential is $1.25 and compresses to ~$0.80 over the next 5 years based on forward pricing).
Valuation using management 1,302 Spirit River location count
Valuation using 724 2P locations in the Spirit River
Economics table – Assumptions and output vs. PEY disclosure:
The internal rate of return of the wells in our analysis are also more attractive vs. what PEY has presented in management disclosures at the same price deck. This benefits Peyto and makes the short analysis more conservative.
PEY has maintained a dividend going back to 2003. Between 2011 and the current date, PEY has traded at a dividend yield of 3% - 6.5% (based on monthly dividend annualized and end of month stock price). As the dividend has grown, the stock price has grown. The stock currently trades at a dividend yield of 6.3%. Starting in November 2015 the dividend became a topic of discussion on PEY investor calls with investors concerned with PEY’s ability to fund the dividend. The CEO of PEY, Darren Gee, and the research firms we have spoken to, believe that holders of PEY shares are very focused on the dividend as an estimate of the company’s long-term earning potential. Looking at PEY stock price historically, large stock price declines preceded reductions in the dividend.
PEY describes a sustainable dividend as a dividend that can be funded with Net Income (“Earnings”). There are two issues with this approach.
Based on our analysis, dividends since 2006 have exceeded earnings, resulting in a continually increasing share count as the company has financed the dividend and its drilling activity with equity issuance.
D&A is not a good estimate of the sustainable capex required to maintain cash flow or the current level of hydrocarbon production. PEY provides estimates of the “Capital Efficiency Ratio” that most research analysts focus on when building their model. The capital efficiency ratio indicates that in 2015 and 2016 maintenance capex required to hold production constant was ~ 3x larger than the D&A that was expensed. There are many factors that result in depletion being a poor estimate of replacement cost, including:
Production beyond originally estimated reserves for older wells which results in production with no associated D&A expense,
Legacy well costs, particularly for companies like PEY that have been drilling wells since 1998 and where a decent portion of existing production is from vertical wells which have a lower total cost per unit of expected ultimate hydrocarbon recovered.
Using the organic decline rate and capital efficiency ratios provided by PEY management in investor materials, PEY has significant shortfalls annually in their ability to fund the dividend without equity issuance. The last table below presents the cash flow shortfall against the dividend that the company pays to shareholders.
In many ways, the business model for PEY is similar to the business model for the E&P MLPs that went bankrupt in 2016 in the U.S. - issue equity to pay for growth capex and the difference between D&A and true organic sustainable capex. The primary difference between PEY and the E&P MLPs, historically, is the amount of leverage that PEY uses. In addition, many of the E&P MLPs acquired somewhat worse assets from a break-even commodity price perspective during their growth period, and so they did not have meaningful opportunities to deploy new capital at attractive rates of return once commodity prices collapsed.
We believe that PEY takes an aggressive approach to representing their resource base vs. peers. PEY has 703 net sections of surface lands, or 450k net acres. However, PEY likes to multiply its surface area by the number of potentially producing zones that are present. Across Cardium, Dunvegan, Notikewin, Falher, Wilrich, Bluesky, and Cadomin zones, PEY believes they have 2,987 net sections of resource. This is a highly unusual way of presenting a resource base. Particularly, when in the case of PEY, they acknowledge publicly that many of the additional non Spirit River sections – eg. Cardium, Dunvegan, and Cadomin are not economic at this time. Nor have many of these zones been explored enough to have a strong sense of where they might be economic. In analyst lunches that we have attended regarding PEY there has been concern expressed by investors that the PEY land position is relatively limited, which could mean the remaining undrilled well locations are limited.
Risks to Short Thesis:
The primary risks to the PEY short is that management is very well liked by investors and most investors in Canada appear to own PEY without performing any valuation work. PEY is considered a “yield stock” by Canadian equity research and many investors. The company has cultivated a loyal investor group. PEY submits a monthly president’s letter to shareholders, and provides a monthly dividend. Most investors like PEY due to low leverage, consistent production growth, and a consistent dividend that has been growing since 2011 (after it had been cut by more than 50% prior to 2011).
PEY is unlikely to be acquired given that it is very expensive vs. its asset base. PEY is unlikely to acquire additional acreage based on comments made by management to this effect. Additionally, we believe that the IRR at the well level is likely higher than they could achieve in acquisitions, and they would likely dilute their very high working interest across their acreage, which is a point of differentiation for management and shareholders.
Bridge from Peyto presentation Spirit River locations to memo type curve locations
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