Surge Energy Is Back On Track

| About: Surge Energy, (ZPTAF)

Summary

Drilling costs at Shaunavon are nearly cut in half over the last year.

The new bank line is C$250 million and is about half used. The company does not maintain a cash balance which will distort some ratios.

Valhalla leases have returns of more than 100% for each well drilled and more drilling locations have been identified.

Total cash costs averaged C$24.01 BOE and are dropping rapidly this year.

The stock price is trading for about half of the current reserves value as shown on the last slide.

The company was looking at a fair amount of debt as prices were collapsing and a dividend that was good for a wide range of commodity prices. Except very few ever saw where the price of oil would settle, and fewer still saw that it would stay there, probably for a very long time. Michael Filloon's latest article states that he thinks the price of oil will stay in the forties through the third quarter and then end the year above $60 per barrel. My concern is that the supply side of oil has surprised many experts for about two years now. With CEO's of several companies still not seeing the end of operational improvements in sight, then as we get closer to the end of 2016, I suspect that the price rise in oil may not materialize. In fact if operational improvements persist enough in unconventional oil, those improvements may push the long term price of oil lower still unless the demand side provides some balance.

In any case Surge Energy, Inc. (OTCPK:ZPTAF), company management all of a sudden was looking at an completely unexpected industry situation. So the company management sold more than C$500 million in assets and used the proceeds to pay down debt. Then management cut the dividend to the point where the dividend was sustainable in the new market conditions. Now management figures its time to concentrate on what is left and hit the growth trail hard again.

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Surge Energy Inc., June, 2016, Corporate Presentation.

"May 2, 2016 strip price forecast (2016 WTI: US$47.02/bbl; Henry Hub: US$2.46/mmbtu); a 1.5% per year inflation rate was applied from end of strip forecast (2024) to 2064. An inflating CAD/USD exchange rate of $0.80 (to max of $0.89 by 2064) was assumed."

The footnotes to the slide give very reasonable assumptions. So it is clear from the slide above that the first two locations have very considerable leeway for lower commodity pricing. The last location in South-East Alberta, would be the first project to become non-commercial if commodity prices dropped and stayed low. However, its clear that under most of the possible commodity pricing scenarios, this company has the locations to keep itself busy for some time. These locations are clearly low cost and profitable under some very adverse conditions.

The bank credit line was affirmed at C$250 million, and preliminarily, the bank debt amount is less than C$135 million as of June, 2016. For a company that had a goal of production of 13,000 BOED, that amount of bank debt is very comfortable. The company does have decommissioning obligations that are roughly equal to the bank debt. It is rare for an oil and gas company to have such high decommissioning obligations, nonetheless, those liabilities will not be paid for a long time from the current time.

So, with the flexibility given by the bank line, and the asset sales coming to a close, management began to work on operations. First, management announced that it had already met and exceeded the exit rate of 13,000 BOED and had only completed the first step of the drilling budget. The asset sales had caused production to fall. Now production is going to stabilize and begin to grow. Some highlights include:

Shaunavon (all figures in Canadian $ unless otherwise stated)

"At Shaunavon, Surge drilled eight consecutive wells driving the cost of drilling, completing, and tying-in a well down to an average of less than $1.25 million - which is down 43 percent from the cost of $2.2 million per well 20 months ago. The final two wells of the program were successfully drilled utilizing a monobore configuration, realizing a further capital reduction of approximately $100,000 per well.

Sustainable primary production added from this eight well program is more than 1,200 bopd (IP/180 day). Operating costs at Shaunavon are now below $7.75 per barrel, and this high quality, operated, sandstone reservoir has netbacks2 of over $30 per barrel at July strip crude oil pricing. Primary recovery from this drilling program is estimated to be 1.2 million barrels of oil3, providing an "all-in" finding cost4 of $8.33 per barrel."

With operating costs at C$7.75 BOPD and finding costs of C$8.33 BO , this company is looking at total breakeven costs in the Canadian twenty dollar range at most. Very few companies in the industry can make a claim like this. As shown above, the costs are dropping quite rapidly. This makes the first slide obsolete and the break-even a moving target in a very favorably way.

Sparky: Eyehill

"At Surge's Sparky core area, the Company is presently drilling five consecutive wells at Eyehill to add more than 500 boepd of risked production (IP/180 day), at an "all-in" on-stream cost of less than $5.8 million (i.e. $1.15 million per well). Surge anticipates recovering 140,000 boe10 for each Eyehill development well. Eyehill netbacks are over $23 per boe utilizing July strip pricing. These wells are being drilled as monobores, which will result in further operational improvements and capital reductions. Internally generated Eyehill type curve wells generate a risked rate of return of 43 percent at strip crude oil pricing11 (for primary production)."

"This high quality, operated reservoir has over 90 million barrels of OOIP net to Surge. Cumulative recovery factors to date at Eyehill are less than one percent, and Surge has currently booked less than four percent of the Sparky OOIP in the Company's year-end 2015 external engineering report. Surge expects to ultimately realize a recovery factor of over 20 percent at Eyehill based on risked development drilling and waterflood activities."

The company was able to obtain about 9 more sections that the company will drill in 2017. That will be in addition to the 150 locations already available. But the key is that as of the date of the release

"July 4, 2016 strip price forecast (first year WTI: US$51.24/Bbl; Henry Hub: US$3.17/MMbtu; a 1.5 percent per year inflation rate was applied from end of strip forecast (2024) to 2064. An inflating CAD/USD exchange rate of $0.78 (to a max of $0.90 by 2055) was assumed."

Assumptions are important because oil and gas prices rose from the time of the slide shown above. So a fair chunk of the ROI improvement from the slide to the announcement was due to the increase in the commodity pricing forecast. The rest was due to cost decreases. But it is clear from the above quotes that management is nowhere near through with the operational improvements. When management states that about 4% of the reserves are booked and they have a goal of booking 20% of the reserves, there is only one way to get there, and that is from operational results.

The Valhalla properties have no new highlights except that the success to date will enable to the company to downsize spacing to drill more wells than previously anticipated. It is not surprise that with the rate of return on those properties the company is not finding many opportunities to expand its lease holdings.

Also notice that with the strip pricing increasing significantly from the first quarter, that surge is going to be reporting margins that are more than double the first quarter. The average selling price in the first quarter was $23.89 BOE. The realized price of oil was $29.28 BO in the first quarter. In the second quarter, the price of oil is averaging about C$15 per barrel higher (very roughly). Since gas prices have also rallied, the bottom line could easily be triple the barrel-of-oil-equivalent-amount in the first quarter.

Cash flow from operating activities in the first quarter was C$5 million taking into account an unfavorable C$1 million from the non-working capital accounts. There was also another C$1 million working capital adjustment later in the cash flow statement to account for management's statement of cash flow before adjustments of C$7 million in the first quarter. All of that cash flow came from a realized gain on commodity futures contracts of C$7.5 million. The company sold about C$44 million worth of properties, which enabled the company to pay down debt, pay the dividends, and meet the capital requirements.

Average costs were (all amounts in Canadian dollars):

Lease Operating Expenses $13.25 BOE Transporation Costs $ 2.33 BOE G & A $ 1.96 BOE Finance and Transaction $2.01 BOE Royalties $3.14 BOE Interest Expense $1.32 BOE

Total Cash Costs $24.01 BOE

These figures are slightly off from the reported figures for a couple of reasons. Lease operating expenses had a one time classification of expenses to transportation. Without those one time benefits, the lease operating expense is as shown above. Transporation expenses were higher than normal because management was trying to avoid a production shut-down. In doing so, some production needed to be trucked which raised the production expense. Management does expect the transportation system to return to normal and when it does, transportation expenses will decrease about C$.50 BOE or so from what is shown above. Similarly there were some transaction costs which may decrease as sold properties are disposed of, and no more sales are generated. That would chop another C$.10 or so off the finance and transaction.

At Valhalla, the company's most profitable lease by far, processing charges have dropped from C$1.25 MCF to C$.45 MCF. When combined with the comments about Shaunavon above, it is a very safe assumption that lease operating costs will be decreasing significantly in the second quarter, and probably the rest of the year. The market will need a few quarters of no repositioning to establish a historical basis for a better stock price. All the charges associated with repositioning a company confuse the market. So even though the company basically operated at break-even in the first quarter before the commodity gains, it is very clear that the company is going to be showing a very significant profit and cash flows in the second quarter. Plus if prices happen to retreat back to the first quarter levels, the company now has lower costs with plans to decrease costs further. So from here on in, the company can show a profit in the lower cost environment if that were to happen. On the other hand, should commodity prices rally significantly in the fourth quarter as some expect, this company could have giant margins.

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Surge Energy Inc., June, 2016, Corporate Presentation

The property disposals are coming to an end. Management has already exceeded its guidance of 13,000 BOE exit rate at year end for the focus areas. Due to the dry conditions up in Canada, the company has started the second part of the capital budget by drilling those wells a few weeks early. With the cost savings already achieved, management will have the choice of drilling more wells than budgeted, or just not spending the capital and save the money for later.

It will take the market time to realize that the company is no longer in a state of repositioning, but is now back on the growth path. Smart investors can get in now, when the company's price is half the value of the NAV listed above. First quarter break-even is unlikely to recur in the future unless commodity prices drop lower than they did in the first quarter. Cost cutting and operational improvements continue to lower the company's break-even further. So this already favorably placed company is getting into an even more profitable position.

With low cost wells, this company can increase activity and production significantly as soon as management believes such a change is indicated. None of its core areas have long lead times, or need a lot of capital to handle more activity. So the company is very flexible. Cash flow this year could easily top C$50 million and may go as high as C$70 million. Since management intends to grow production at least 10% a year, the company stock could easily double over five years. Plus the dividend stands a very good chance of being restored to its former levels over a longer period of time. Right now the dividend yields an attractive more than 3% of the current stock price. This would be a good stock to own as part of a basket of companies because diversification when investing in smaller companies usually decreases investment risk significantly.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

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.

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