Description

Summary

Junior Canadian E&P stocks are not normally mentioned in the same sentence as value but the recent drop in oil has created some event driven situations with limited downside.  We believe oil’s latest move has created an opportunity to acquire several top tier companies and their management teams at a significant discount.  One of our favourite ideas is Raging River Exploration Inc. (RRX CN) where management’s track record in their last two companies is very strong.  RRX could soon be sold and if not, management has a very attractive asset to create substantial longer term value. We believe at the current share price of $8.05, the stock has conservatively 50-60% upside.

Description & Economics

RRX is a ~$1.5bn market cap (~$1.6bn EV) E&P company operating in Canada. More specifically it operates in the southwest of Saskatchewan where it is primarily focused on the Dodsland area. RRX’s most recent guidance calls for average production of 10,500boe/d in 2014, with an exit rate of 12,500boe/d. Production is 95% light oil.  Cash flow from operations is forecast to come in at ~$220mm this year, with capex being $260mm, this would take its net debt at Q2 of $89mm to ~$135mm at year end.  At Q2 2014, RRX had drawn $43mm of its available $300mm credit facility leaving it sufficient room.  These assumptions use ~$99 WTI prices, with the caveat that the company has hedged 2,600bbls/d in Q3 and Q4 at $106 CAD.  Guidance was recently revised upwards as has been typical for this management team who seem to consistently under promise and over deliver. In its most recent presentation management addressed lower oil prices and outlined that production per share growth could be maintained at a rate of 20-25% per year with debt to cash flow remaining under 1.0x even at $75 WTI prices. Without increasing debt levels (only spending cash flow), the company’s sensitivity analysis shows that with $70 WTI prices it can still growth production per share at ~6%.

The company has proven to be a very low cost operator and management understands they are in a commodity business and thus being the low cost producer is typically the only ‘strategy’ available. Capital efficiencies (exploration and development) are approximately ~$38,000/boe/d, which is the cost per bbl/d that management is able to bring production on stream.  RRX currently trades at a multiple of production of ~$127,000/boe/d.  Cash operating costs run around $17/bbl which place RRX as one of the lowest cost producers in their area.  The break even oil price is somewhere around the low to mid-$50 range.  Management believes its corporate cash flow netback is around $58/bbl at around a CAD$100 oil price.  Since Q2 2012 to Q2 2014, production per million shares has steadily increased from 14bbl/d to 55bbl/d respectively.  In that same time period, cash flow from operations per share has increased from $0.24 to $1.25 on an annualized basis.  We believe these statistics to be very attractive as research has shown that, at least in the Canadian junior E&P space, a primary indicator of success of E&P companies is highly related to attractive production per share growth and low operating costs.

On average across all of its areas, RRX’s individual well economics are very attractive. The cost per well is approximately $900k, with a before tax NPV of $1.3mm, a payout of 10-12 months and IRR’s of in excess of 100%.  The most recent presentation states that at $79 WTI prices, the NPV’s go to $830k and IRR’s of 75%. The company has a risked drilling inventory of ~2,400 (3,700 unrisked) locations which they believe would allow them to drill for the next 8-10 years under their current development plan.  At a $55 oil price, RRX believes that it would have close to 1,000 economic drilling locations. The company has also started several water flood projects and all forecasts do not include the potential for increased well spacing which management believes could increase the risked inventory number by 25%.

Management & History

We believe the RRX team is one of the premier management teams operating in the Canadian E&P business. Their last two companies, Wild River (private) and Wild Stream (WSX), were both sold to Crescent Point Energy (CPG) and generated significant returns for original shareholders.

Wild River managed to generate a 36% IRR to original shareholders in the midst of the financial crisis (initial financing Feb 2007, sold in June 2009).

Wild Stream was a recap that took place in Oct 2009, and the original financing was completed at $4.50 per share.  In Jan 2012 Wild Stream was sold generating a 39% IRR to those who bought in the original financing.  RRX is the spinoff of certain Wild Stream assets. Although shareholders who participated in all financing rounds of Wild River made generous returns, the same is not true at Wild Stream. In April 2011, when Wild Stream’s share price touched highs close to $13/share, the company raised equity at $11.55 to purchase assets. Shortly after this, the operating performance stumbled and the share price subsequently declined to the high $8/share range. Management decided to cut loose and sell Wild Stream to Crescent Point at what was effectively an at market deal. As part of this transaction, management spun off the assets which have effectively become RRX. This was done to make it up to investors who had committed funds at the $11.55 financing round. If shareholders would have hung onto the RRX shares that they received they would have been very much in the money. However, management decided to take a large cut of the equity of RRX at inception to the annoyance of some shareholders who chose to dump RRX shares after the spinoff.  If an investor had purchased RRX shares on the initial day of trading the resultant IRR to date would have been in excess of 55%.

Management’s stake in RRX is currently 14% and 21% on a basic and fully diluted basis, respectively. The dilutive securities have a strike price of $4.22/share. Historically, management has sold their companies after approximately 2-3 years of proving their concept or typically at 7,000-10,000boe/d of production.  We believe management wants to sell the company but the valuation, up until recently, had curtailed buyer interest. Knowing the position they were in, management decided to come up with a development plan that demonstrates how they would develop the rest of the asset instead of selling it on to a larger entity.  We believe the development plan is a good one as far as the optimal way of exploiting the asset and generating shareholder value is concerned. However, we do believe management’s preference is for a sale of the company.

Valuation

Given current strip pricing of oil, we believe RRX is worth ~$14/share. The base NAV and land value we believe is around $6.50+ per share, net of debt. The additional upside in the Dodsland area is worth $8.00+ per share. We think that our valuation range is conservative, and note that on management’s estimates, although a bit stale dated with the recent drop in price of oil, the 2,400 locations (which may be increased), at an NPV of $1.3mm per location have a value of close to $16/share. This would allow a potential acquirer to pay substantially in excess of $14/share with lots of run room to develop the asset. On an EV to debt adjusted cash flow basis, RRX trades just shy of 7x, which is slightly cheap relative to peers who we believe don’t possess the track record of this management team.

Risks

The obvious risk here is the oil price received by RRX, the driving factors of this would be WTI prices and differentials on Canadian light oil.  Given that management has typically sold out when its prior companies have been smaller enterprises, if a buyer does not show up, the team will be forced to run a company that is larger than they are used to.

Catalyst