Despite Its Recent Share Price Spike, Gran Tierra Offers Considerable Upside

| About: Gran Tierra (GTE)
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It has been a tough year for small-cap oil explorers and producers, with the price of crude gyrating significantly on the back of concerns over the direction of demand for energy and ongoing conflict in the Middle-East. This has seen many investors become averse to taking the lunge into the small-cap E&P sector. But one small-cap E&P play stands out as being undervalued is Canadian domiciled Gran Tierra Energy (NYSEMKT:GTE). At this time, Gran Tierra, despite seeing its share-price spike by almost 25% for the year-to-date, is still offering potential upside of over 30% and is trading with some compelling valuation metrics. This will potential be realized for investors over the next year as a range of positive catalysts continue to see Gran Tierra's performance improve and drive its share price higher.

Investment case summary

I last reviewed Gran Tierra in January 2013 and concluded that the company was undervalued, offering investors upside potential of just under 30%. I have revised my position. This is because of recent news concerning Gran Tierra's ability to significantly lift production, combined with a significant spike in oil prices and actions taken by the company to unlock shareholder value.

After revaluing the company using a net-asset-valuation methodology in conjunction with a higher crude price along with its significantly increased production it is clear that Gran Tierra is undervalued. Even after the recent surge in its share price it is still trading with a relatively low enterprise-value to EBITDA of just over 3 and a price-to-operating cash flow of 4. Evidently, the market has yet to incorporate the full value of Gran Tierra's increased EBITDA and cash flow into its valuation.

Gran Tierra has been able to generate solid production growth while continuing to follow its impressive exploration and development program. This in conjunction with a range of other positive catalysts leaves it well positioned to unlock further shareholder value. These catalysts include growing production resulting from less production disruptions, the recent spike in the price of crude and positive developments from its exploration program.

Company profile and background

Gran Tierra is the third largest operator in Colombia by proved and probable reserves as well as daily production behind state controlled Ecopetrol (NYSE:EC) and Pacific Rubiales (PEGFF.PK). The majority of Gran Tierra's production assets are located in Colombia representing the company's core operations. It also has production assets in Argentina and exploration assets in Peru and Brazil, the details of which are set out in the chart below.

Source: Gran Tierra Investor Presentation September 2013.

Gran Tierra's core production assets are its operations located in the southern Colombian department of Putumayo, along with a growing position in the northern central Llanos basin. Its exploration and production assets total 12.3 million gross acres across the four countries where it operates.

For the relatively short amount of time that it has existed, Gran Tierra has built considerable proved and probable reserves, with 41MMBOE of proved reserves (1P) and 56 MMBOE of proved and probable reserves (2P). This has seen it overtake Petrominerales (OTCPK:PMGLF) to become the third largest operator by 2P reserves in Colombia after Ecopetrol and Pacific Rubiales as the chart below illustrates.

Source data: All companies listed FY Financial Filings and Reserves Report 2012 and 2013.

Gran Tierra also has an impressive history being able to continuously grow its proved and probable reserves as illustrated by the chart below.

Source data: Gran Tierra Reserves Reports 2008 to 2013.

Since 2008, Gran Tierra's proved and probable reserves have grown considerably to now be 56 MMBOE, while its proven reserves have grown to 41 MMBOE over that period. This gives Gran Tierra a compound annual growth rate (OTCPK:CAGR) of just over 8% over that period for its 2P reserves, while for the same period, proved reserves have a CAGR of just over 11%.

In 2012 alone, Gran Tierra reported that its proven reserves had increased by 21% YoY, with a phenomenal production replacement rate of 205%. Essentially highlighting that Gran Tierra's proved and probable reserves are growing at a faster rate than production is able to deplete them.

An important aspect of Gran Tierra's 1P reserves is that 95% of these reserves are composed of light and medium oil, which receives a far higher benchmark price than heavy oil, bitumen or synthetic oil

All of which indicates, that Gran Tierra has had considerable success in building its reserves to sustainable and profitable levels. While historical performance is no guarantee of future performance, it certainly indicates that Gran Tierra is well positioned to continue growing its reserves at this rate. Despite this strong growth in Gran Tierra's reserves, it does appear to be somewhat expensive in comparison to its peers. As illustrated by the chart below, Gran Tierra is trading with an enterprise-value of 41 times its 1P reserves and 30 times its 2P reserves.

Source data: Gran Tierra, Pacific Rubiales, Petrominerales, Canacol and Whitecap Financial Filings 2Q13, Yahoo Finance and Fidelity.

Whereas Canadian peers, Pacific Rubiales, Canacol (CAAEF.PK) and Whitecap (OTCPK:SPGYF) are trading with an enterprise-value as a multiple of 1P and 2P reserves that is far lower.

Financial performance remains strong

Over the last year, Gran Tierra has delivered a substantial improvement in its financial performance. As the chart below illustrates, for the second quarter 2013, revenue declined by 18% QoQ, but rose 46% YoY, while net income fell by 17% QoQ but grew by over 200% YoY.

Source data: Gran Tierra 2Q12 to 2Q13 Financial Filings.

This strong growth in financial performance YoY can be primarily attributed to Gran Tierra being able to significantly increase production, which has grown by 1% QoQ and 57% YoY.

With more than 80% of Gran Tierra's revenue generated in Colombia, the QoQ decline can be primarily attributed to the weakening of the Colombian peso against the U.S. dollar. Already over the last year, the Colombian peso has fallen by 6% in value against the U.S. dollar. The key driver of the weakening of the Colombian peso against the U.S. dollar is the Colombian government's monetary policy aimed at devaluing the peso to make exports more attractive and the U.S. dollar rebounding as the U.S. economy has continued to improve.

This underscores that currency risk is one of the key risks for investors when investing in an oil explorer and producer that operates in an emerging market. This is particularly the case, because those currencies tend to be more volatile than those of developed markets.

However, despite the QoQ decline in financial performance, Gran Tierra has been able to maintain some solid margins particularly in comparison to its peers. For the second quarter 2013, Gran Tierra had an EBITDA margin of 72%, which with the exception of Whitecap is superior to its peers operating in Colombia as the chart below illustrates.

Source data: Gran Tierra, Pacific Rubiales, Petrominerales, Canacol and Whitecap Financial Filings 2Q12 to 2Q13.

This is a particularly solid EBITDA margin and indicates that despite the softening in the price of crude and the decline in the value of the Colombian peso Pacific Rubiales' operational profitability remains strong.

Gran Tierra's debt free status leaves it with a solid low risk balance sheet

A particularly appealing aspect of Gran Tierra is that the company has no long-term debt, leaving it with a remarkably solid balance sheet for an oil E&P junior. Yet despite not having any debt, the company has a significant amount of cash on hand which totaled almost $282 million at the end of the second quarter 2013. This leaves it well positioned to continue funding its exploration and development operations, while significantly reducing the risk associated with movements in the price of crude and disruptions to its production.

It has also left it with some very appealing risk metrics particularly in comparison to its peers as the chart below illustrates.

The most appealing of these is Gran Tierra's solid current ratio of almost 2.2, which indicates that it is well positioned to meet its current liabilities, as well as take on debt as and when required.

Production continues to grow because of reduced oil pipeline outline

The key factor that has driven Gran Tierra's better-than-expected financial performance has been the company's ability to significantly lift its oil production. As the chart below illustrates, second quarter 2013 production has grown by 1% QoQ and 57% YoY.

Source data: Gran Tierra 2Q12 to 2Q13 Financial Filings.

This growth in production output was also achieved despite 70 days of oil delivery restrictions in Colombia primarily caused by outages of the Trans-Andean pipeline. This pipeline is the primary means of transporting Gran Tierra's oil production from the Putumayo basin in southern Colombia to ports for export. The key driver of this increased production was a reduction in pipeline disruptions over the first half of 2013. This can be attributed to the peace talks between the Colombian government and the largest Colombian insurgent group the FARC.

The company was able to mitigate these disruptions by identifying and utilizing other transportation means including road transport. This along with the completion of new wells bodes well for it to be able to continue increasing production for the remainder of 2013. Already the company has revised its production guidance upwards increasing it by between 5% to 10% to 21,000 BOEPD to 22,000 BOEPD net of royalties for 2013. This will obviously boost Gran Tierra's bottom-line particularly when the recent spike in crude prices to over $100 per barrel is taken into account.

Maintains a high average realized price per barrel of oil

Despite the majority of Gran Tierra's production being higher price light and medium oil, the average price per barrel of oil that it received still fell during the second quarter 2013. This is because of lower oil prices for both West Texas Intermediate (WTI) and Brent during the period.

As a result, Gran Tierra saw its average realized price per barrel of oil fall by 14% QoQ and almost 8% YoY as the chart below illustrates.

Source data: Gran Tierra 2Q12 to 2Q13 Financial Filings.

However, with oil prices now spiking to over $100 per barrel, Gran Tierra's average realized price per barrel will increase and this in conjunction with the company's ability to increase production at this time certainly bodes well for its bottom-line.

Gran Tierra is also receiving a relatively higher price per barrel of oil in comparison to a number of its peers as the chart below illustrates.

Source data: Gran Tierra, Pacific Rubiales, Petrominerales, Gran Tierra and Whitecap Financial Filings 2Q12 to 2Q13.

Gran Tierra receives a higher average realized price per barrel than its Canadian domiciled and Colombian based peer Canacol. This is because approximately 10% of Canacol's oil production in Colombia and Ecuador is lower value tariff production. Gran Tierra's average realized price per barrel is also higher than Canadian peer Whitecap, which has a portion of its production made up of lower value Canadian heavy crude and bitumen.

But Pacific Rubiales and Petrominerales are realizing a higher average price per barrel than Gran Tierra, because a greater portion of their production is higher value light crude. But Gran Tierra's solid average realized price per barrel, along with further cost cutting initiatives is allowing the company be able to generate a solid netback per barrel.

Netback remains impressive despite recent declines

Despite declining for the last three consecutive quarters, Gran Tierra was still able to deliver a solid netback per barrel of $51.58 for the second quarter 2013. This as the chart below illustrates is a 9% fall QoQ but a significant increase of 28% YoY.

Source data: Gran Tierra 2Q12 to 2Q13 Financial Filings.

The QoQ decline in the company's netback can be attributed to increased transportation costs caused by outages in the Ecopetrol operated Trans-Andean pipeline during the quarter. During the second quarter 2013, 51% of Gran Tierra's oil and gas volumes sold were delivered to the point of departure by truck. This saw transportation costs per BOE increase to $11.30, when compared to delivering all of its Colombian production through the Trans-Andean pipeline.

But it is expected that Gran Tierra's netback will improve through the remainder of 2013 with a rebound in the price of crude combined with the company's cost initiatives gaining further traction. This reduction in costs will be primarily driven by fewer expected outages on the Trans-Andean pipeline because of fewer attacks on the pipeline by insurgent groups operating in Colombia and improved security and maintenance.

The current second quarter 2013 netback also is well above the average for small-cap oil producers and as the chart below illustrates, compares favorably to many of its peers.

Source data: Gran Tierra, Pacific Rubiales, Petrominerales, Canacol and Whitecap Financial Filings 2Q12 to 2Q13.

This high netback and its continued growth, bodes well for Gran Tierra to increase margins and profitability thus unlocking increased value for investors. It also indicates that it is a superior investment in comparison to many of its peers, particularly those operating in North America like Whitecap, which typically generate a netback of around $45 per barrel.

A diversified exploration and development program creates considerable potential

An appealing aspect of Gran Tierra, which further contributes to the sustainability of its production, is the company's strong exploration and development program. The company's development program is focused on its operations in Colombia as well as further developing its oil reserves in Argentina and Peru. The company's exploration program is focused on building its reserves in Colombia and Argentina, along with continuing its 'Elephant Hunt' in Peru and building exploration momentum in Brazil.

In 2013 alone, the company has budgeted and commenced drilling 10 development and delineation wells. The majority of these are located in Colombia, which accounts for five and the remainder are in Peru, Brazil and Argentina as the chart below illustrates.

Source: Gran Tierra Investor Presentation September 2013.

These development and delineation wells will allow Gran Tierra to further build its reserves, boost production and maintain its solid reserve replacement rate of over 200%. This will further boost the sustainability of Gran Tierra's production while increasing its net-asset-value and further unlocking value for investors.

For 2013, Gran Tierra's exploration program is focused on drilling six exploration wells across Colombia, Peru and Brazil, with the majority in Brazil as the chart below illustrates.

Source: Gran Tierra Investor Presentation September 2013.

This diverse exploration plan allows Gran Tierra to diversify its risks and rewards while building on its existing success in Colombia by expanding its core operations in Colombia's Putumayo basin.

Exploration and development in Colombia continues to create potential

Like Pacific Rubiales, Gran Tierra's onshore exploration assets in Colombia and Peru hold considerable promise, because they are located across the Sub-Andean Basins, which is one of the richest hydrocarbon trends in the world, as the chart below illustrates:

Source: Pacific Rubiales Investor Handout July 2013.

In the Colombian part of the trend alone, it is estimated that there are between 30 to 70 billion barrels of heavy oil. With Gran Tierra holding 22 blocks in the Llanos basin and being the largest landholder in the Putumayo basin, it is likely that it is only a matter of time before it makes additional commercially viable discoveries.

In addition, the Putumayo basin, which has only been of real interest to oil explorers and producers over the last ten years, is the northern extension of Ecuador's Oriente basin. This basin is estimated to hold around 850 million of proven BOE, and has seen considerable oil production activity, with a number of oil explorers and producers operating there since the early 1960s. The scope of the Putumayo-Oriente Basin and its location as part of the Sub-Andean Basins is shown in the chart below.

Source: USGS, The Putumayo - Oriente - Maranon Province of Colombia, Ecuador and Peru - Mesozoic - Cenozoci and Paleozoic Petroleum Systems.

The geological structure of the Putumayo - Maranon basin is also favorably disposed towards the presence of hydrocarbons as the chart below from my earlier article on Gran Tierra illustrates.

Source: Colombia Sedimentary Basins: Nomenclature, Boundaries and Petroleum Geology, a New Proposal, ANH Colombia.

As a result, Gran Tierra has concentrated a considerable part of its exploration and development program on the Putumayo basin as shown by the chart below.

Source: Gran Tierra Investor Presentation September 2013.

It has also expanded its exploration efforts into the Sinu-San Jacinto basin and the Cauca basin, which also sit in the Sub-Andean Basins, which bodes well for further oil discoveries.

The 'Elephant Hunt' in Peru Continues

Gran Tierra has also embarked on an ambitious exploration program in Peru, where it holds 6.4 million gross acres and is continuing its 'Elephant Hunt' by seeking an oil discovery of 1 billion BOE or more. It is doing this by focusing on the Marañon basin and the Iquitos Arch as illustrated by the chart below.

Source: Gran Tierra Investor Presentation September 2013.

Both are southern extensions of the Oriente basin in Ecuador and form part of the Sub-Andean hydrocarbon trend. Already this exploration program is yielding results with Gran Tierra making a discovery in its block 95 in the Marañon basin, which is estimated to hold proven contingent reserves of 11.5 MMBOE.

The company's exploration efforts in the Iquitos Arch in the Ucuyali basin in Peru are also showing promise with proven prolific hydrocarbon accumulations identified. These are estimated to be in the range of 500 to 800 MMBOE of non-gas liquids, boding well for the success of Gran Tierra's Elephant Hunt.

Exploration in Brazil is gaining momentum

Gran Tierra has also established a solid exploration footprint in Brazil with the company now having seven onshore and one offshore blocks, of which 3 were awarded as part of its 2013 bid as the chart below illustrates.

Source: Gran Tierra Investor Presentation September 2013.

All of these blocks hold considerable promise and have served to diversify Gran Tierra's exploration program away from Colombia. It also gives it potential access to what have been claimed to be among the largest oil reserves in the world, which further bodes well for Gran Tierra's ability to build its reserves.

Argentine despite heightened political risk remains promising

Gran Tierra also continues to see success in Argentina, a country much maligned by investors particularly since the expropriation of YPF (NYSE:YPF) from its Spanish owner Repsol (OTCQX:REPYY). Its principal assets are located in the Neuquen and Noroeste basins as the chart below illustrates.

Source: Gran Tierra Investor Presentation September 2013.

For the third quarter of 2013, Gran Tierra has plans underway to drill a second horizontal multi-stage fracture stimulated well in the Loma Monosa formation in the Neuquen basin. This bodes well for increased production and with Gran Tierra focused on re-establishing production in Argentina, it will help to mitigate the risks of the majority of the company's production being located in Colombia.

Overall, Gran Tierra has some particularly impressive exploration assets and a success rate that is the envy of many other oil and gas exploration and production companies. The large majority of these exploration and development assets are located in the Sub-Andean Basins across Colombia, Ecuador and Peru, which is thought to be one of the richest hydrocarbon trends in the world, all of which bodes well for Gran Tierra to continue growing its proved and probable reserves.

The outlook for crude remains uncertain

The outlook for crude continues to remain mixed and while it has fallen by 6% from its August 2013 high, it continues to be at over $100 per barrel for both WTI and Brent. At the time of writing, WTI futures contracts due in November are trading at just over $100 while Brent contracts are at almost $108.

Furthermore, it is forecast that the average price per barrel for WTI in 2013 will be $97 and in 2014 it will be $93, while for Brent it is $106 for 2013 and $100 in 2014. This represents an almost 16% increase over the price for crude used in my January review of Gran Tierra and accordingly I have factored this into the valuation model used in this review. Demand along with crude prices is also expected to grow over the long-term with ongoing tensions in the Middle East and supply outages in the region.

What is Gran Tierra's indicative fair value?

Despite Gran Tierra's share price spiking by almost 30% for the year-to-date, it still offers considerable upside for investors particularly with the recent surge in crude prices and other emerging catalysts that indicate it is under-valued. On a price-per-flowing-barrel basis, it does appear expensive - particularly in comparison to its peers - it is currently trading with an enterprise-value to EBITDA of only four times, as shown by the chart below.

In addition to which, its price-to-operating cash flow of only four times also indicates that is still trading at less than its fair-valuation, particularly when unlike its peers, it has no long-term debt and strong cash flows.

But despite these metrics providing a useful picture for investors as to whether Gran Tierra will continue to grow in value they do not provide a complete indication as to its indicative fair-value. In order to do this, I have determined Gran Tierra's indicative fair-value per share using a net-asset-valuation (NAV) methodology.

In order to do this, I have determined the present value of Gran Tierra's after-tax cash flows generated by its net proved and probable reserves. I have then divided this by the number of common shares outstanding and used the following assumptions:

  1. I have taken Gran Tierra's 2P reserves of 56.2 MMBOE and discounted the difference between its 1P reserves of 40.6 MMBOE by 50%, so as to represent the accepted likelihood of those probable reserves becoming proven reserves.
  2. I have discounted the future value of the company's cash-flows derived from those reserves by 10%, to determine their present value.
  3. I have assumed an average basket price per barrel of oil of $90, representing the outlook for oil.
  4. I have factored in a minimum royalty rate of 9% reflecting the standard minimum Colombian royalty rate of 8% (except for heavy oil) and the additional wildcat royalty applied to heavy oil, which has a royalty rate starting at 6%.
  5. I have conducted the valuation over a 10-year period.
  6. I have calculated the present value of debt and asset retirement obligations using a 3% growth rate (representing the long-term GDP growth rate) over the valuation period, factoring in the likelihood that these will continue to grow in value as the company expands.
  7. Despite the particularly positive exploration and development outlook, I have not factored in any increase in reserves from those operations or future discoveries, because of the uncertainty that surrounds oil exploration.

After applying these assumptions and factoring in each of the catalysts discussed, I have calculated an indicative fair value for Gran Tierra of $9.56 per share, as displayed in the chart below.

With Gran Tierra trading at around $7.30 at the time of writing this, indicative fair-value per share represents potential upside of 31% for investors, clearly making Gran Tierra a deep-value investment opportunity. This becomes even more compelling when the conservative valuation methodology and substantial margin of safety is considered.

Other risk factors

Investors should also be aware of the additional risks that they have to accept when investing in a company that operates in a foreign jurisdiction in what is classified as an emerging economy. Key among these risks are:

  1. Currency risk, particularly with the Colombian peso now having fallen by around 6% against the U.S. dollar for the year-to-date.
  2. There is increased political risk with the bureaucratic and legal system of emerging economies not being as transparent as those of developed economies along with higher degrees of patronage and corruption.
  3. There are ongoing risks associated with oil production, particular with bringing undeveloped reserves online. But with around 70% of Gran Tierra's proven reserves being developed, this risk is mitigated significantly.
  4. Gran Tierra's over-reliance on Colombian production to generate revenue has created a key dependency risk. This will have a significant impact on the company's future production and revenue if the civil conflict in Colombia escalates to its earlier levels.
  5. Gran Tierra is currently involved in a royalty dispute with the Colombian oil industry regulator the Agencia Nacional de Hidrocarburos (ANH). At this time, the estimated worst case financial impact is $24.8 million, although Gran Tierra has not provisioned for a loss because it is unclear as to how this will be resolved.
  6. Gran Tierra is also engaged in a separate dispute with the ANH over whether certain transportation and related costs are eligible to be deducted in the calculation of the additional royalty. At this time, the discussions are ongoing and the worst case financial impact is estimated to be $19.6 million.

But overall, many of these risks are mitigated by Gran Tierra's diversified exploration and development program along with its low leverage and lack of long-term debt. This makes it a particularly low risk investment in comparison to many of its peers like Petrominerales that have experienced liquidity and licensing issues.

Bottom line

Gran Tierra continues to represent solid value for investors particularly when its solid balance sheet, lack of long-term debt, growing production and strong exploration program are taken into account. Furthermore, despite seeing its share price spike on the back of its solid first quarter 2013 financial results, the market has yet to fully acknowledge Gran Tierra's true value. This leaves investors with the opportunity to take advantage of the 30% upside that is now present in a company that can be considered prudently managed and low risk in comparison to many of its peers.

Disclosure: I 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.