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Birchcliff Energy (BIREF) is a mid-sized Canadian natural gas producer with a simple formula for production and profit growth.

Overview

The company expects to exit 2014 with production of 37,500 to 39,500 boe/d, 24.6% higher than the current rate, which is estimated by the company at 30,500 (83% natural gas and 17% oil and NGL's). Net of a recent land acquisition, 2014 exit production is forecast to be up 20% over 2013.

The stock dropped off dramatically during early 2012 as natural gas prices slumped and an unsolicited bid for the company failed to reflect sufficient value so the deal fell apart. But the stock has just made an important move above its recent trading range. My one year target for the stock is $10.80 CAD per share, or 27% higher than the current $8.50 price. This is based on my estimate of $250 million gross cash flow in 2015 and $197.5 million cash flow net of financing and SG&A costs, or $1.35 per undiluted share (8 times).

I suspect NYMEX natural gas prices will be higher, not lower, by 2015, due to the number of industrial plants using gas as a feedstock that are planned for the USGC. A permitted LNG export facility would add to demand. Since there are no pipeline constraints impeding natural gas sales from Alberta to the core Chicago natural gas hub, I expect benchmark AECO prices to also go higher, aided by a weaker CAD.

Spot AECO natural gas closed at $4.27/mcf up 18 cents, with the twelve month strip increasing 10 cents to $4.12. My Birchcliff forecast does not depend on higher natural gas prices, but relies on an easily visible runway for production growth of processed gas the company has demonstrated since its inception in 2004.

Operations

Birchcliff has interests in twelve natural gas processing plants concentrated in the Pouce Coup area of Alberta, northwest of Grande Prairie near the British Columbia border. Four of the plants are wholly owned, and five are operated, but the one most important to the company's growth is the Pouce Coup South Gas Plant.

Phase I of the PCS plant was licensed to produce 30 mmcf of gas per day and commenced operation in March 2010. The plant began operating Phase III licensed to process 150 mmcfd in October 2012. This plant, which desulfurizes raw gas with an amine process and then dries it, had operating costs of only 35 cents/mcfe. As the plant is expanded, operating costs continue to decline due to efficiencies. At the same time, Birchcliff receives a premium price for its natural gas due to its heat content and value of recovered condensates. This premium averaged over 50 cents per mmcf in 2012. The company estimates it obtained a netback of $2.79 or 78% on revenues of $3.57/mcfe for gas processed at the PCS plant in Q3. The PCS plant processed 87 mmcfd gas in Q3 or 68% of corporate production. Phase IV will increase processing capacity to 180 mmcfd, and is estimated to cost only $10 million, with start-up in the fall of 2014. The company plans to drill and produce enough raw gas to fill the PCS plant and high netback PCS gas sales will double by 2015.

On January 15, the company released increased production growth guidance, plus an acquisition consolidating their working interest in gas producing lands proximal to the PCS plant. Estimated average production was 30,500 boe per day (83% natural gas and 17% oil and NGL'S) for the first two weeks of January 2014.

Birchcliff feeds PCS and its other plants by acquiring 100% interests in prospective land in the prodigious Montney/Doig natural gas play. The horizontal multi-stage fracking wells are drilled to 4000-5000 metres and as far as one mile and a half outwards. The wells have initial production of 2,000 to 8,000 mcfd and cost circa $5 million. The company had accumulated up to 2,106 net future drilling locations as of September 30. The company drills from four well pods to increase efficiency. The company is switching from four well per section spacing to eight per section per stratographic region to increase the number of drilling locations. The company has drilled 18 wells year to date in the Montney/Doig geological zone with 100% success rate.

Birchcliff's 2014 exit production guidance has increased to between 37,500 and 39,500 boe per day, up from between 36,000 and 38,000 boe per day, aided by the 1,600 boed acquisition noted in the press release. In addition to the core Montney/Doig gas play, Birchcliff has a proximal and second core resource to the north of Pouce Coup, the Worsely Light Oil resource, which exploits the Charlie Lake structure using waterflood secondary exploitation techniques, and produces approximately 4,000 boed of light sweet oil. The company drilled nine wells at Worsley YTD Q3 with another 3 expected in Q4.

Birchcliff had a third non-core resource area to the east of PCS (Progress Doe Creek), which the company sold subsequent to the Q3 for $59 million. The 4.5 million 2P reserves sold at $14/boe and the funds were re-deployed into the core Montney gas play.

As of Q3 2013, Birchcliff owned 536,771 net acres of land primarily in their core natural gas producing leaseholds. Recent land sales have been in the $600/acre area, meaning Birchcliff's undeveloped lands are worth alone over $300 million. Birchcliff has paid even more than that price to obtain 100% working interests near its PCS operational area, due to the value that gas has to the plant in returning high netback revenues.

Reserves and Recycle Ratio

Birchcliff reported proven and probable reserves of 286 million barrels of oil equivalent net of royalties in their year-end 2012 NI-51-101 activities statement. Birchcliff's 2P FD&A costs were only $5.89 per boe in 2012 (less than $1/mcf), excluding future development costs.

The 2P reserves recycle ratio was a highly attractive 3.3 times. The company expects material reserve and resource additions in all categories when it releases its statutory activities filing for 2013. I should note that the AECO natural gas strip has increased from about $3/mcf end of 2012 to $4/mcf at the end of 2013 so there will be technical reserve visions to the upside based on product pricing alone.

CAPEX and Balance Sheet

Birchcliff expects to spend $275 million in 2014. YTD in 2013, the company generated $118 million in cash flow and spent $197.4 million in CAPEX. The growth trajectory is aggressive but low risk and revolves around the core and proven richness of the Montney/Doig gas play.

Birchcliff has funded its growth over the past couple of years primarily with increases to its revolver and term debt capacity. The last equity significant common equity issue was 8.075 million shares at $7.65 CAD back in April 2012. The company simultaneously issued 5 million shares at $7.65 to a strategic shareholder Mr. Seymour Schulich. Gold mining billionaire Schulich owns 40 million shares or 28% of Birchcliff and his interest has been to support the company's capital needs during its growth trajectory, mitigating financial risk.

Birchcliff had $487 million in net debt as of September 30 with a $600 million maximum. The company said in its Q3 report that it expects to fund its 2014 capital program using internally generated funds and available credit facilities and expects its debt to funds ratio to decline by year end 2014. I wouldn't completely rule out an equity issue though, if the stock rallies enough. And I consider Birchcliff a likely takeover candidate for larger players adding to their operations in the Montney.

Birchcliff has also issued two preferred shares issues ($42.9 million "A" series at 8% and $50 million "C" series at 7%). Both issues are only redeemable by the holder after five years, with the earliest dates being September 2017 and June 2020 respectively. The company has the option of issuing common shares when they mature. Along with the "A" issue came 6 million listed warrants outstanding with an exercise price of $8.30 per share and an expiration date of August 8, 2014. Fully diluted including options and performance units, the outstanding shares would be 163.4 million. There was a small short position of 3.8 million as of January 15.

Conclusion

Birchcliff offers good exposure to higher natural gas prices, and an exciting formula for reliable growth to 2015. The company was unhedged on natural gas up until a recent move to lock in 30% of 2014 production at an attractive $4.20 price. The company is also unhedged on currency, and benefits from a declining Canadian dollar.

Birchcliff's five year plan calls for the company to be producing 61,500 boed by 2018, which is double current production. With this growth, and in spite of the financial leverage which I believe is mitigated by Schulich's interest, I believe the stock deserves a cash flow multiple of 8 times.

The Street recently upgraded the stock with the increased 2014 exit production announced on January 15. National Bank raised its target price for Birchcliff to $12, TD kept it at $8.50 and RBC raised from $9 to $9.50. CIBC raised Birchcliff to Sector Outperformer. Our target price for BIR is $10.80 based on our conservative 2015 CFPS estimate of $1.35, implying 27% capital appreciation potential with a one year time horizon.

Source: Birchcliff Energy: A Simple Growth Formula