Original Investment Idea – Peyto Energy
In order to make money in any commodity type business there is only one competitive advantage a company can have, and I believe Peyto (OTCPK:PEYUF) has got it by a mile.
What is that competitive advantage? You must be the low cost operator. Being the low cost operator gives you a huge advantage over you competitors, not only in higher profit margins during the good times but more importantly it ensures profitability when prices fall. This article will investigate Peyto’s low cost advantage and how returns drive profits. The second half of this article will look specifically at Peyto to see if it is a bargain and compare it to PetroBakken (PBKEF.PK).
Peyto Energy - A Unique Competitive Advantage?
Peyto Energy is a pure play natural gas company that operates in what is called the central deep basin of Alberta, Canada. Over the last twelve years the company has offered the highest total returns for any E&P on the TSX, at a little over 60% annually. While history is never indicative of future performance, it definitely raises an eyebrow as to how they accomplished such returns.
What separates Peyto from other companies is their low cost advantage. As already mentioned this offers the best defense against falling commodity prices. This has particularly been true with Peyto’s continued profitability, and increased capital expenditures during the low point in the current commodity cycle. While it often doesn’t make sense for many companies to expand when prices are low, it does in Peyto’s case since they not only have low operating costs, they also offer some of the lowest finding and development (F&D) costs in the industry.
Peyto Energy – Solid Management
Peyto has proven over the past decade that it definitely has some of the best management in the industry. Not only does management own a significant stake in the company but, much more importantly, the focus has consistently been on maximizing the return on every dollar invested. Peyto, unlike many of their peers, built their company through internally generated drilling opportunities and not through acquisitions. As we will see they can find natural gas much cheaper than it can be purchased for. Their biggest target is the liquids rich Cardium formation but they also target the Notikewin, and Wilrich.
Not be distracted by geological terminology, Peyto’s operating margin have averaged 70% and profit margins have averaged 45% over the last several years. These high margins are driven by their low operating costs of $2.28/boe ($0.38/mcf) in the last quarter (not a typo). Most competitors have operating cost in the range of $6-$10/boe range. Total cash cost, including operating, transportation, royalty, G&A and interest, total of 6.96/boe (1.16/mcf) net of royalties. Gas prices have to go much lower before they are below total cash costs.
For a comparison of total cash cost for many Canadian and US NG companies, see the November President’s newsletter (.pdf). Many companies have total cash costs much higher than current NG prices.
So these low costs obviously allow Peyto to remain profitable long after other companies’ shut-in production when NG prices fall. What allows them to have these low operating costs? The answer is mainly in the wells they drill. The Cardium formation offers very long life, liquid rich, and low maintenance natural wells. The long life nature is also evident in their reserve life index of 29 years (2P). In fact, their proven (1P) reserve life index beats many companies' proven + probable (2P) reserve life.
So how have they created this company with such long life, low cost wells? A clear focus on generating high full cycle returns on every dollar of capital invested. I believe this is best stated in their 2006 report and I quote:
Peyto has now achieved a milestone in its history. For the first time, we are operating solely on our internally generated capital, having delivered all of the unitholder’s equity back in distributions. Since Peyto’s inception, we have invested a total of $1.3 billion in capital, raised $404 million in unitholder’s equity, distributed $445 million in distributions, and built an asset that is worth $3.7 billion ($3.3 billion after adjusting for debt, P+P NPV5). Unfortunately, this does not mean that all unitholders have enjoyed their fair share of returns. At times our unit price has reflected our value, at other times it has not. What it does mean, however, is that our long life, low cost natural gas business has invested significantly less than the value we have created. We will continue to use our technical expertise and our ability to execute our ideas to create future wealth for our unitholders.
Funding Sources for Capital Since Inception (from 1998 to 2006)
% of Total
Cash flow from projects found and developed by Peyto
Net Equity ( Equity issued of $403.5 million less Accumulated Distributions of $444.9 million)
Net Debt (year end 2006 excluding future performance based compensation)
Total Capital Expenditures
Now for those not familiar with the income trust structure in Canada, it allowed companies to distribute cash to their shareholders without paying corporate taxes. Instead the profits are taxed as ordinary income in the shareholder's hand. It is similar to the MLP structure in the USA. The income trust structure is being phased out in Canada by the end of 2010. Peyto is converting back to a corporation at the end of the year.
It is truly amazing that in just eight years the company has become internally self-funding and has such a large asset that will generate cash for years to come.
Now, I received a comment from a fellow on my post on Petrobank (OTCPK:PBEGF) that companies should trade at a premium to NAV because he likened it to book value. At times a premium to NAV is appropriate and at other times it is not, but that is beyond the scope of this article. With that said, a company will only trade at a premium to book value if the expected cashflow from the wells exceeds the cost which it most certainly does in Peyto’s case.
Using Peyto in 2006 as an example, it can be said the book value of all the wells they have drilled to date was $1.3 billion. This is what they paid for the assets. Now, the asset value was considerably more, as it was worth $4.2 billion (asset value (NAV5-2P ) + cashflow already extracted), or 3.2 times. This means that for every dollar Peyto invested in drilling wells they generated $3.20 in cash, or they are recycling cash at 3.2 times. (Note: Peyto uses a 5% discount rate because that is their cost of capital, however, that may not be your cost of capital.)
The comment on fair share of investment returns is also quite interesting because this gets to the heart of value investing. Assets don’t always sell on the market for their true value. One must be careful what you pay for the assets.
It is also important to note that many investors in energy (and precious metals) think that they are great investors because they have done well with those investments over the past ten years. In essence, they have been fooled. This is because commodity prices have generally risen across the board. Any idiot can be a successful investor under such a tailwind. Will the next decade offer the same increases in prices? Now that is a good question, and one should be prepared (and invest) for lower prices.
Peyto Energy – A Bargain?
Now, before we look at the numbers we must keep in mind that the single largest driver behind future return will be the gas prices. Have I said that before? Gas prices are at multi year lows and changes in the shale gas market may keep them low for a prolonged period. Investors must be aware of this risk. Anyone who makes an energy recommendation and doesn’t tell you this upfront, stop listening to anything else they say.
Now, just for the sake of comparison let’s look at Peyto compared to Petrobakken. All numbers are based on Year-end 2009 results (my previous post used the more recent Q2 numbers where PBN has less debt but a lot more shares outstanding). This is a straight up, apples to apples comparison at year-end 2009.
NAV10 - BT 2P
Stock Market Price
To be fair, NG prices have fallen relative to the prices used in the 2009 reserve report, and that should reflect on the lower market price for Peyto. Now for Petrobakken, they have an asset that is worth less than invested capital when future cashflows are discounted at 10%. This doesn’t mean they have generated a negative return on invested capital. Now I don’t know exactly what Petrobakken’s cost of capital is, but it better be below 8-9% or they are destroying capital. And likewise with Peyto, they have earned returns well in excess of 10%. As for Petrobakken going to $30 per share, Devin Shire (CanadianValue) better give us a better explanation of how he proposes they do it (Note: I am still waiting for that explanation). They will basically have to spend a lot of capital at low returns to get the asset value there, or pray for oil to go up.
If we look specifically at Peyto their ROE has averaged 41% and return on invested capital (ROIC) comes in an average of 21%, for the past 10 years. Obviously, any company that can earn 41% ROE over the long-term will perform well.
Now history is fine, but definitely not the whole story. Going forward it appears that Peyto’s returns will be quite strong based on their new horizontal drilling techniques. Returns on these wells appear to be quite strong in spite of the low gas prices. If and when gas prices do recover Peyto will no doubt benefit from that tailwind as well. From the end of 2009 to end of 2011, they are forecast to nearly double production with just under $600 million in capital expenditures. Now this will rival Peyto’s investment returns from their early days.
The success over the past twelve months is clear evidence that horizontal multi-stage fracturing technology has reduced Peyto’s cost to add new production by as much as 50% and enhanced the returns significantly. The current internal rate of return estimate for the 2010 capital program is 38% using first year gas and oil prices of C$3.87/GJ and C$80/bbl, respectively and the current future strip for subsequent years.
Now is Peyto a bargain, I guess that depends your outlook for NG prices. Each will have to make up their mind and vote with the own cash. Being able to earn 38% IRR on invested capital at $3.87/GJ prices is fantastic given that gas price is the lowest in years. What will happen when NG prices rebound?
Stock Options – Is The Hand in the Cookie Jar?
I personally believe how a company handles stock options/bonuses are very telling to whether they are shareholder friendly or not. Unlike my previous discussion PBG, which was definitely not shareholder friendly, Peyto only pays bonuses when management adds value. To do this Peyto pays both a reserves based bonus and a market based bonus.
The reserves bonus is a pool of 4% of the incremental increase in value, if any, adjusted to reflect changes in debt, equity, distributions, general and administrative costs and interest, of proved producing reserves calculated using a constant price at December 31 of the current year and a discount rate of 8%. In other words, they only pay a reserve bonus when management add value with all other variables held constant. A truly pay for performance agreement.
For the market based bonus, they offer share appreciation rights that vest over 3 years and are cancelled at the end of the three years and are paid out in cash. These rights are offered at the current market prices and will reward management for increasing the underlying price for the shares.
Now both of these are clearly aligned to shareholders and definitely get a passing grade.
Peyto proves to be an interesting case study as they are both the lowest cost producer of NG and also quite possibly the lowest cost finder and developer of NG in North America. The have done an excellent job historically with ROE and ROIC being 41% and 21% respectively over the past ten years. They have profitably generated very high returns on invested capital. Going forward, their recent advancements into horizontal drilling could possibly generate some of the best returns in their history, especially if NG prices rebound. Also, since converting to an income trust in 2003 Peyto has delivered $1.1 billion in cash to shareholders ($10.51/share). Now you can fake your accounting books but you can’t fake cash.
Finally, as for valuation, they trade at a discount to their 2009 YE NAV discounted at 10%. It should be noted that NG prices have fallen and may be a strong reason why they are trading below that price. However, being a value investor means being counter cyclical and NG is definitely at the low point in the commodity cycle. Now the price could stay low for an extended period of time, but likely doesn’t have much more room to go down.
Personally, I feel NG prices are below the marginal cost of production for mostly all companies. Recent announcements from Encana (NYSE:ECA) have confirmed this fact. Peyto has so far being counter cyclical and has increased its capex during this downturn to increase drilling. The cost of services (like drilling) are cheap right now and their low cost structure and focus on total returns allow them to profitably invest right now.
It definitely is ironic that Peyto just broke a new 52-week high and gas prices are near record lows. Remember, being the lowest cost producer in a commodity type business is the key.
I have been a happy shareholder for years. I refer you to Peyto’s corporate presentation on their website, where you will find a wealth of information. Their corporate presentation and appendix provide ample comparison to the competition. Their most recent monthly newsletter provides industry comparisons of total cash costs of many competitors.
Disclosure: Long PEY-UN.TO