Shares Of Advantage Oil & Gas Are A Bargain

| About: Advantage Oil (AAV)

Summary

Finding and development costs of C$.77 MCFE could drop another 50% within the next year. These costs were unthinkable as late as two years ago.

Cash production costs of C$.75 MCFE are a record low and are going to be significantly lower by next year.

Even though these costs are fantastic, Peyto Exploration and Development has lower costs. So Advantage can significantly lower its costs still.

The company expanded to 200 MMCFED this year and plans to expand to 350 MMCFED. This is a high tech growth rate seldom seen in the industry.

The total debt to trailing cash flow ratio was 1.2:1. Even with the drop in prices this year, the company had first quarter cash flow of more than C$30 million.

Every now and then an investor finds a company that ignores the carnage around them and keeps growing profitably. Advantage Oil & Gas (NYSE:AAV) is such a company. The company not only grows through the downturn, it grows very fast through the downturn. Management is still expanding production as if the industry downturn never happened.

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Source: Advantage Oil And Gas Ltd, June, 2016 Corporate Presentation For Investors

As shown in the upper left hand corner of the slide, this company has not missed a beat. In fact, in several cases it is significantly beating the budgeted performance. The company previously had a goal to expand production to 200 MMCFE/D. Now management is adding the infrastructure and plant capacity to go to 350 MMCFE/D. The company is expanding production by more than 20% a year currently. Company management sold about 13.4 million shares to help fund the expansion. However, the expansion of production is at a faster rate than the one time dilution from the stock sale. The industry in general is cutting back and a lot of companies have some measure of financial distress, but one would certainly not know that looking at this company.

"Advantage Oil & Gas Ltd. ("Advantage" or the "Corporation") is pleased to report strong cash flow of C$30.2 million or C$0.17/share for the first quarter of 2016 supported by a 25% increase in production to 167 mmcfe/d (27,854 boe/d) and an 11% reduction in its total cash cost to a corporate record and industry leading low cost of C$0.75/mcfe."

Part of the reason has to be that record low cash cost. Even for a gas company such as this one, that cash cost is extremely low and provides cash flow at price levels many competitors can only dream about. Plus the finding and development costs shown above are only C$.77 MCFE. Combined that is a total cost of C$ $1.52 MCFE. Given the recent weakness of the Canadian Dollar to the United States Dollar, that total cost is one very large competitive advantage.

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Source: Advantage Oil And Gas Ltd, June, 2016 Corporate Presentation For Investors

The company was planning to live within the amount of cash flow should the gas prices stay at C$1.40 MCF. Much of the industry does not have a cash flow to live within when the gas price is C$1.40 MCF. The company was already planning an expansion as part of the budget, but now it actually is running a budget surplus. The company can choose to hedge comprehensively and continue to expand like gang busters. Management has already noted they have the option to accelerate the construction of the plant and the infrastructure. The average investor can bet that those contractors will be glad for the work and not charge much if anything to accelerate the work. So this company has the choice of making money or making more money at current prices because it has the option to increase its drilling pace to match a faster infrastructure increase pace. Life can be really tough sometimes.

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Source: Advantage Oil And Gas Ltd, June, 2016 Corporate Presentation For Investors

The company management is not sitting still though. Even though those costs are among the lowest in the industry, the company is lowering costs further. Shown above is the increasing rates of production, both initially and throughout the life of the well. There is enough higher production in the new wells to favorably influence payback and prepare the company for an eventual appreciation of the Canadian Dollar to the United States Dollar. Now the company has flow rates that are twice as great as the flow rates just two years ago. So management only needs to drill one well (instead of two) for the same amount of gas. But management is now trying to double those rates one more time and appears to be about half way there with the latest best well.

"During the first quarter of 2016, Advantage continued to achieve outperformance in its Glacier well results. In particular, one of our Lower Montney wells which included a new cemented port completion design with 37 frac ports and 20 frac stages significantly exceeded Management expectations by demonstrating an on-production rate of 18.3 mmcf/d (3,050 boe/d) and proved up another extension area of high quality Lower Montney reservoir at Glacier. This Lower Montney well was drilled, completed and tied-in at a cost of $5 million (10% less than budgeted) and confirmed additional opportunities to improve capital efficiencies as a result of advancing our drilling and completion technologies. Five other Lower Montney wells with an average of 21 frac stages were production tested during the quarter and demonstrated an average per well rate of 12.3 mmcf/d, exceeding Management expectations by 30% (see additional information in the Operational Update section below). "

As shown in the slides above the quote, management will cut back production to enhance total recovery. But these latest flow rates put the company in a whole new era. The company will eventually experiment with higher cut-back flow rates and of course have faster payback times. All of this will favorably influence profitability. Interestingly, the company at this time is "only" up to 20 frac stages. There are competitors that have two to three times as many frac stages and more contact points, so there is room for improvement potentially on even these excellent flow rates. The company may still have the ability to lower costs quite a bit from the already low costs shown above. Peyto Exploration & Development Corporation (OTCPK:PEYUF) is a neighbor that has lower costs than this company at the current time. Shareholders will benefit as these two companies vie for the low cost leader title in this geographic location.

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Source: Advantage Oil And Gas Ltd, June, 2016 Corporate Presentation For Investors

Company management projects that well costs are continuing to decline. However, that could change as some competitors find that a longer well with more stages and a lot more proppant (and other enhancements) are cost effective ways to increase production. Management is already beating its budget and there is a good chance that this slide is obsolete. The slide now represents a very worst case scenario because performance is already better. Well costs are nearly half what they were a few years back, so there is tremendous improvement on both the cost and production parts of the cost equation.

What should be clear from the slide above is that the wells are currently obscenely profitable when compared to many wells in the industry and management has made enough progress that should the gas prices decline significantly, new wells will continue to be very profitable at far lower numbers than before. It is possible that management could chop the finding and development costs in half to go below C$.40 MCF at the current rate of improvement. That is a possibility that was probably unthinkable as little as a year ago. But with flow raise rising very fast with each new well design, and costs of wells decreasing a the same time, finding and development costs will drop relatively quickly.

With wells that are at least 30% above management expectations of an increase in performance for the previous year, some very significant progress has been made to cutting the finding, development and acquisition costs by a very significant amount. There is still another half of the year to go. With one well already flowing initially at 18 MMCFED, management has every incentive to duplicate that result and investors will be cheering management on, as that initial rate is triple the initial rate of just a couple of years ago. It may take a few practices to get this result regularly, but even the failures are going to be improvements from last year. Plus management has indicated that they believe they can increase that rate more in the future.

These new wells will also lower the average "all in cash cost" significantly. So shareholders can look forward to continuously lower operating costs for some time even if the exchange rate between the United States dollar and the Canadian dollar returns to some more average rates.

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Source: Advantage Oil And Gas Ltd, June, 2016 Corporate Presentation For Investors

In addition to all the advantages listed above, the company has a hedging program that could be expanded if needed. The company tends to focus on low costs and vertical integration for competitive advantages instead. So far it has succeed admirably. The latest expansion plans more than cover the recent dilution from the equity offering and keep the balance sheet very strong. This management has a very conservative line of credit that could probably be easily renegotiated should the proper opportunity arise. In the meantime, expect management to continue to conservatively manage the balance sheet.

The latest gas price rallies have the stock priced at somewhere between eight and nine times projected cash flow. While that may be a reasonable average, the cash flow is rapidly growing with some very significant production increases. Plus this company has a fair amount of unused credit that could easily be used to drill another twenty to forty wells and expand production faster. This company has no real cost worries right now if the work is accelerated because much of the industry is in a recession and there is a fair amount of excess capacity in a lot of areas.

Many companies need time to transition to the new lower costs wells. The older wells will have production as long as they provide cash flow even if they are more expensive to produce. So the transition is the time it takes for the new lower costs to dominate. With a company such as this that is growing production rapidly, that transition time will be much shorter. Still depreciation and other costs can be expected to run higher than the cost of the new wells until enough older wells have been retired that they have a very minimal effect on the average reported cost. But each new well drilled at the lower cost (and better design) will have an outsized effect on cash flow.

For the current price, the investor receives some of the best assets in the industry with some of the lowest costs and definitely one of the far better than average managements. Plus the growth prospects of this company are far above the industry average. So the stock is really a bargain. The current and future cost reductions will protect the investor against a future exchange rate that is much less favorable, and will lower breakeven costs to previously unthinkable levels. This company will be making an adequate return at gas prices that bankrupt much of the rest of the industry. At current gas prices, this company practically has a license to print money. This is an opportunity that investors should be able to cash in on fairly quickly. This stock could at least double over the next year if gas prices maintain the latest rally. Should gas prices sink again, this company is in a far better position, both from balance sheet strength and low operating costs, to wait out a period of lower gas prices than many of its peers.

Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents, and press releases to see if the company fits their own investment qualifications.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.