Description

Thesis:

Trilogy Energy has been thrown out with the bathwater as the recent decline in crude oil prices has resulted in bargains rarely seen before: we think this is one of the most exciting shale plays you've never heard of.  Yes, there is a giant shale opportunity in Alberta, Canada, called the Duvernay, with properties similar (but in many ways more profitable) to the Eagle Ford in Texas.  Trilogy, while at an early stage in the Duvernay, provides the most leverage to this play of any exploration and production (E&P) company in Canada.  And based on Chevron's very recent transaction right in Trilogy's backyard, one could easily argue that Trilogy's Duvernay land value alone is worth about 83% (C$2.2B / C$2.7B) of the company's enterprise value.  Stripping this out, giving no credit for the higher quality of Trilogy's acreage vis-a-vis Chevron's, nor accounting for the fact that net debt will decline in the second half of 2014 (latest available financials are 6/30/14, a seasonal peak for debt), we get a EV/debt adjusted cash flow (DACF) for 2015 of 1.4X vs a peer group range of 5.3X to 9.4X (the low end populated by lower quality, lower growth peers).  Getting back to the low end of this range, at 5.5X would get us to C$26 per share in value, for 67% upside.  Given the uncertainty around oil and natural gas prices, we think it's prudent to take a conservative approach, but the upside could be far greater as we start seeing more drill results from the Duvernay.

Background:

Trilogy Energy Corp. (TET CN) is a Canadian exploration and production company formed through a spinout of assets from Paramount Resources in April 2005. The new entity was comprised of assets in the Grande Prairie and Kaybob regions of Alberta. Originally an income trust, Trilogy back-filled production with acquisitions, acquiring Redsky Energy (2,300 boepd, 80% gas) and Blue Mountain Energy (2,100 boepd, 70% gas) in 2006 while making distributions under a high payout, low growth strategy. Then in February 2010, Trilogy converted to a corporate structure, and shifted to a high growth strategy. Management demonstrated acute responsiveness to changing commodity prices, shifting the production mix from 80% gas to 55% gas as gas prices declined. By shifting their focus and resources from the Presley Montney gas to the North Montney oil development, Trilogy has showed chameleon-like adaptiveness to a changing commodity price environment. All-in, Trilogy has grown its production from 20K boepd in 2009 to 36K boepd in 2014 (12% CAGR), while 2P reserves have grown from 72M boe in 2009 to 105M boe.at year-end 2013 (10% CAGR).  Note that the company is ultra conservative in how it books reserves, which skews the stats a bit but is comforting in that it dramatically lowers risk of an asset impairment. 

Trilogy retained a portion of Paramount Resources’ leadership, with CEO James Riddell (President and COO of Paramount), Chairman of the Board Clayton Riddell (CEO and Chairman of Paramount) and President and COO John Williams (formerly COO of Paramount). The Riddell family, through direct ownership and through Paramount Resources, owns about 52% of the company, so they have considerable skin in the game.

Value Drivers:

Trilogy has 3 primary assets: 1) Liquids-rich Montney gas at Presley, 2) Montney oil at North Kaybob, and 3) the Duvernay at both South and North Kaybob.

• Montney gas pool at Presley: This asset would arguably be the “crown jewel” of many other companies in its own right, with decades of low risk drilling locations, and a profit to investment ratio of over 100% at C$4-5/mcf AECO natural gas prices. At the current C$3/mcf the Presley wells still offer about C$4M in NPV on $C5M of invested capital. The issue is that these economics pale in comparison to Trilogy’s other two opportunity sets: Montney oil and the Duvernay. Management would surely devote more capital to Presley if the natural gas pricing environment improved dramatically. Trilogy still has over 175 undrilled and unbooked future locations at Presley, representing potential value of C$0.7B to C$1.0B.

• Montney oil pool at North Kaybob: The economics of this resource, which Trilogy began developing in late 2010, are mind-boggling. While the company initially struggled with production shortfalls (partly due to the trickier science of oil vs gas pools in this area), which led to quite a bit of downside volatility in the share price (even before the recent collapse which was arguably driven entirely by the falling price of crude), consider that within 4 years it will have built a 12K boepd pool from scratch, recovered 100% of its invested capital, and maintained another 300 future undrilled and unbooked drilling locations with NPVs of C$5-6M per well (assuming $90-100/bbl oil) vs capital costs of C$4M per well. Even at $80/bbl oil the profit to investment ratio is over 100%. If we get back to $100/bbl oil, the IRR is 280% with a 7 month payout. Depending on your assumptions, those 290 wells represent C$1.5-1.8B in future unbooked value. Below are some stats that help illustrate the economics of the pool, and the cash flow characteristics under a couple different pricing scenarios.

• Duvernay: While this is still early stage, the Duvernay is the real prize at Trilogy. As it is one of the few true shale plays in Canada (some call it the Eagle Ford of Canada), it gets special royalty treatment: a three year maximum royalty of 5% on all products with no production volume cap. While the unit economics aren’t quite as favorable as those of the Montney oil pool, the sheer size of the opportunity is awe-inspiring. Based on early production data the condensate rates range from about 90 bbl/mmcf to 400 bbl/mmcf resulting in IRRs at current gas and condensate prices of about 40% to well over 100%. Capital costs are currently C$12M per well with NPVs ranging from around C$10M to over C$40M. Quite a range, but the early results are very promising. Trilogy has identified up to 2,000 future undrilled locations, and with average NPVs of at least C$10M, we could be looking at C$20B in future unbooked value. 

Valuation:

Given the early stage in the development of the Duvernay, and the up-front capital that is being committed to it ahead of the production ramp up period, we think it makes sense to look at Trilogy a little differently from its dividend paying peer group. While we do think that as production results roll in, investors will be impressed with the sheer size and profitability of this elephant, at this point a land-based appraisal is easier to digest. Fortunately, we have a recent transaction right in the heart of the Kaybob Duvernay that is very relevant and comparable. On October 6, 2014, Chevron announced a JV with Kuwait Foreign Petroleum Exploration Company (KUFPEC) whereby it is selling a 30% interest in 330K gross acres of Kaybob Duvernay lands for $1.5B. This equates to $15,152/acre (C$17,218/acre at $0.88/C$ current exchange rate). Looking at type curves provided by Chevron and comparing them to Trilogy’s, it appears that Trilogy’s wells are showing significantly stronger results. In other words, the C$2.2B in implied value for Trilogy’s 128K net acres in the Duvernay is probably a pretty conservative figure. If we strip out that C$2.2B in value from the C$2.65B in enterprise value, and remove the estimated $100M in debt adjusted cash flow (DACF) tied to the Duvernay from consensus estimates for 2015, the EV/DACF drops from 7.0X to 1.4X. This compares to a peer group that averages 7.4X. Even if we take the low end of the peer group average, at say 5.5X (the going rate for low growth, resource poor dividend payers in Canada), the implied fair value for Trilogy would be roughly C$26 per share.

Risks:

• Further deterioration in commodity markets
• Unsatisfactory drill results from Duvernay - so far so good, but there's going to be a lot of variability in early results
• Further production issues at Montney oil pool - after 2 years of production misses, it seems management has finally gotten their arms around this, and now knows how to guide the Street, but there's a history here

Catalyst

• Drill results at Duvernay illustrating the economics
• Transactions involving Duvernay acreage (similar to the recent Chevron deal)
• Cold winter could tighten AECO nat gas market dramatically