Granite Oil Is Injecting Natural Gas To Increase Production And Lower Costs

| About: Granite Oil (GXOCF)

Summary

The long-term debt to cash flow ratio is 1.7:1, a very conservative ratio.

Cash costs of production are about 25% of revenue, an unusually low figure. So cash flow from operations runs about 75%.

The latest well cost was a little more than half the cost a year ago.

Management aims to triple its booked reserves, but could easily overshoot those goals with all the improvements so far and more in the future.

The dividend is secure and has an above average chance to grow from either improved industry conditions or operational cost decreases.

The management of Granite Oil (OTCQX:GXOCF) has long argued that there was about 479 million barrels of oil on the leases that the company is developing. Since there are roughly 31 million shares outstanding, then there is about 15 barrels of oil behind each $5.85 (based upon the closing price on May 12, 2016). That is one fantastic bargain if the company can actually produce those reserves profitably. Even if the company recovers 2 barrels of oil per share with a reasonable profitability, the shares would be a bargain. Management actually has a (very) long term plan to eventually produce about three barrels of oil (20% of reserves) in their sights (beginning with a plan to triple the booked reserves) and they are going for a lot more. Some companies in the industry claim a recovery rate that eventually amounts to 40% of reserves, so this company could have a very bright and profitable future IF such a high recovery figure becomes possible.

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Source: Granite Oil April, 2016 Presentation

The company has been experimenting for some time with gas injection to increase reservoir pressure. Basically this is a secondary recovery scheme that uses gas instead of water. The gas is reinjected back to the lease area to maintain the pressure that enables a higher production rate. Normally production rates decline as more oil is produced, but reinjecting the gas near the top of the reservoir is mitigating that decline.

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Source: Granite Oil April, 2016 Presentation

Management figures they can triple the reserves by adjusting the injection model as shown above. Currently the website shows net proved producing reserves of 4.111 million BOE. That is a very small fraction of the oil in place. Since management tends to convert old producing wells to injection wells, that will minimize capital expenditures and lower costs. The company already has a gas plant in place and much of the basic infrastructure to inject gas is already there. All that needs to happen is for the old wells to be converted and hooked up. Capital needs for this operation appear to be relatively low currently.

In the first quarter of this year, this model produced funds flow from operations of about C$6 million. Since revenue was C$8 million, the cash flow from operations was 75% of revenue. Even considering there is a hedging program in place for about half of the production, that cash flow margin is fantastically good (and improving) and validates management's opinion as to the profitability of this production even in a low price environment such as this. Even better, management is forecasting an increase in production to 3,000 BOED from the current 2,876 in the second quarter. Production will probably increase above that level as management wants to average 3,000 BOED for the year. So cash flow will probably increase because of a production increase as well as the recent commodity price rally.

Since the company has about C$40 million of debt, the long-term debt to cash flow ratio is about 1.7:1, an extremely conservative ratio. Management has an unused portion of the bank credit line of another $40 million, so operations can increase quickly if management chooses to ramp up the operations. Right now management has permission to operate its gas injection model on 23 out of about 80 sections that have been leased. As management obtains permission to expand its production model, more of those potential reserves will be booked. Plus more reserves will be booked as the new efficiencies demonstrate a profitable track record.

To beat some of the forecasts on the slide above, management has taken the opportunity of current low equipment pricing to expand the gas injection capability of the infrastructure with some one-time purchases. Plus, the company announced the drilling and completion of a new well at $1.5 million. This was a re-entry of a previously drilled well where the new completion dropped the cost 47% from the year before and 17% from the previous quarter. Since these leases have been producing for a very long time, there are plenty of re-entry well candidates available, and management believes that the cost of completely new wells will continue to drop, possibly to comparable levels.

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Source: Granite Oil April, 2016 Presentation

One of the nice things about the recent announcement with the new lower well cost is the slide above is already obsolete in a very positive way. Management has already knocked more than C$1 off the finding and development cost. The opportunistic equipment purchases will lower future production costs. The success of the gas injection has increased initial flow rates and lowered decline rates. So one wonders just how much better that 75% cash flow from operations margin can get.

Every company including this one lost reserves when the oil prices crashed. But in this case, those reserves may begin to come back as the already very low costs go still lower. If management can get the payback shown for the $32.50 barrel of oil below 2 years, then this company will probably begin to expand its operations whether oil prices sustain the latest rally above $40 or not. Usually, a payback within two years is an industry condition to begin expanding operations, by drilling more and increasing production. With well costs down almost half in a year, a lower declining production rate, and opportunistic purchases of equipment, management certainly appears well on its way to achieving that 2-year payback. This company has one of the most profitable futures in the industry at the current time.

There are some risks to this rosy future. First, oil and gas prices could unexpectedly decline further. While that seems to be a stretch even in the current environment, it is certainly possible. Second, the company purchases gas to supplement its production, usually carbon dioxide for injection. Should the price of gas unexpectedly escalate in the future, it could cause the costs of production to materially increase. Right now many kinds of gas are cheap and will continue to be cheap for the foreseeable future. Third, the company is an opportunistic purchaser of equipment and an opportunistic hedger. If and when there is an industry recovery, equipment prices will at least firm and could soar if industry activity levels return to previous highs. Management has in the past had an incredible record of hedging before the market turned. Right now the low level of hedging is probably a bullish sentiment by management about oil prices and management could be wrong (with some unfavorable profitability consequences). There are more risks listed in the company filings and interested investors are advised to read them.

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Source: Granite Oil April, 2016 Presentation

The company model, using some older costs than what were just announced at the end of the first quarter, appears to still work at some fairly low pricing. The good news is that with the lower well costs and all the other operational improvements made, this slide will probably get redone at still lower costs and provide the investor with quite a bit of cushion. The company may easily be able to afford another well above guidance as well costs continue to drop. The current dividend yield is more than 5% (using all United States Dollars). That very generous dividend appears secure under some fairly conservative scenarios. Plus the company is really not that leveraged so it could choose to borrow to pay the dividend in an extreme case. As operational improvements change the cost picture, the slides showing growth become viable at considerably lower pricing. This provides more growth opportunities for this stock than management has shown above. In short, the slides above are now very conservative. This company could be showing growth without much if any help from commodity pricing as long as the operations continue to improve. The chance of a price decline is dimming as operations show improved results.

Using all Canadian dollars, the market cap is roughly C$220 million and the debt is about another C$40 million. Given cash flow of about C$24 million (first-quarter annualized), the ratio of equity and long-term debt to cash flow is about 11:1. While that is normally a little expensive for an investment, this company will be making some money after the non-cash ceiling charges mitigate, and it has the ability as a small company to add to its production materially very quickly should industry conditions improve sufficiently. Already, the company has forecast a production increase for the second quarter and commodity prices rallied considerably. With the low costs shown above, this company will require a lower level of improvement than many of its competitors to expand. So this stock will probably be one of the first industry stocks to rally as conditions improve. There is the very good possibility that the stock will rally on very improved operations with no help from industry conditions. The cash flow could easily top C$30 million for the year just from the commodity price rally, the increasing production and the production improvements already made. That alone would drop the long-term debt and equity to cash flow ratio to less than 9:1, a very reasonable ratio. Relatively few stocks in the industry offer that possibility. So this stock has an above average chance to double in price as cash flow easily doubles over the next five years and increase its dividend. The stock is a bargain for reasons few in the industry can match.

Disclaimer: I am not a registered investment advisor and this article is not advice to buy or sell stock in any company. The investor needs to do his own independent investigation that includes reading the company governmental filings, and press releases, as well as anything else relevant to determining if this company fits the investor's risk profile.

Disclosure: I am/we are long GXOCF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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