Introduction
There is one E&P company that has surprised me a lot during the last months. Sincerely speaking, I have not met another E&P company in the markets that I follow (U.S., Canadian, Australian, British), that combines a small enterprise value with a consistent production growth y-o-y and a meaty dividend. In the paragraphs below, I'll analyze Arsenal Energy (OTC:OTCQX:AEYIF).
Actually, Arsenal has been on my buying radar for two years now because some of its core properties in Canada are very close to the areas where Surge Energy (OTC:OTCPK:ZPTAF) and Rock Energy (OTC:OTCPK:RENFF) also operate. Those folks who have been following me since early 2013, know that I recommended both Rock and Surge during the first half of 2013, when they were at $1 and ~$3.4 respectively. Since then, Rock and Surge have risen 200% and 100% respectively. The former stands at $3.02 and the latter is at $6.73 as of today. My articles are here, here and here.
Is it likely for Arsenal to offer a return similar to Surge Energy and Rock Energy? The answer is yes. A triple-digit return is likely just because there are fundamentals to support this rise, and I'll elaborate on this in the next paragraphs.
The Assets
Arsenal's activities are focused in the US in the Williston Basin of North Dakota and in Canada (Alberta and British Columbia), as shown below:
Arsenal operates in North Dakota in three areas (Stanley, Lindahl, and Rennie Lake), targeting the Bakken and Three Forks formations, as shown below:
In Alberta, Arsenal's crude production is focused on establishing and maintaining a low decline base of production by identifying properties that are candidates for enhanced recovery through water flood. Properties in Provost and Princess in South East Alberta are ideal for developing and exploiting this type of production base producing both natural gas and crude oil. Wells in these areas have been predominately drilled vertically into pools that are declining and that require little capital to water flood to reestablish and maintain pressure, as witnessed by Arsenal's neighbors.
The Production And The Reserves
Arsenal holds 9.7 MMboe of proved reserves, and 14.9 MMboe of proven and probable reserves. The production is 4,200 boepd (~76% oil and liquids) currently with an exit rate for 2013 at 4,400 boepd. Arsenal's year/year base production decline rate is 26%, which is obviously low.
For instance, wells drilled before 2012 in the top U.S. shale gas areas indicate an average field decline of 37% a year. That includes 47% in the Haynesville Shale in Louisiana and 29% in the Marcellus Shale.
The company plans to grow further its oil production during the next couple of years, by focusing on its oil-weighted properties as illustrated below:
Rennie Lake is not a producing property currently. So this Bakken/Three Forks property will be one of the drivers for the company's production growth in 2014, because Rennie Lake is highly de-risked. As illustrated below, this property is surrounded by producing wells:
Thanks to the oil-weighted production mix, the company had a high operating netback of $36.08/boe in Q2 2013. The high netbacks are also due to higher realized unit prices and slightly lower operating costs.
The US production, which generates approximately 56% of corporate funds from operations, is 94% crude oil and NGLs. The Canadian production which generates approximately 44% of corporate funds from operations is 61% crude oil and NGLs and 39% natural gas. So the company's production is heavily oil and liquids weighted at both sides of the border between US and Canada.
Arsenal increased recently cash flow guidance for 2013 to $44 million. Arsenal anticipates that cash flow will show additional substantial growth in Q3 and Q4 2013 due to production increases from recently drilled Bakken wells in North Dakota and higher current realized prices.
To protect its cash flow for 2014, the company has already hedged 1,500 bbl/d (55% of its total oil/liquids production) at $93.52/bbl.
The Debt And The Dividend
As of September 2013, Arsenal's net debt is $65 million out of a credit facility of $90 million. I expect this credit facility to rise approximately $5 million this November 2013 during the company's next review date, as a result of the increased production compared to the first half of 2013.
Thanks to the fact that Arsenal is also producing cash flow in excess of the capital required to fund the company's growth strategy, the company announced a ten to one common share consolidation and declared its initial quarterly dividend of $0.06 per post consolidated common share in August 2013. This means $0.24/share annually, which translates into a 5% annual yield. Is there another E&P company in the US or Canadian or British or Australian market with an enterprise value of $145 million that pays 5% dividend? None.
Based on the latest increased guidance about Arsenal's cash flow ($44 million), the payout is lower than 10% when the group average is 41%. The dividend requires only $3.84 million annually out of the company's annual cash flow for 2013. So the dividend of $0.24/share is quite safe currently and has the margin to grow during the next quarters, even if the production does not rise at all, assuming we will not experience any sustained drop of the oil prices.
Based on a go forward cash flow forecast of $31.50/boe, Arsenal anticipates that after capital to replace declines and after the dividend, it will have excess cash which can be used for growth and/or debt reduction.
From a debt perspective, the company doesn't also have any debt issues as the net debt to cash flow ratio is 1.47x, when the group average is 2.5x, as illustrated below:
Grossly Undervalued Per NAV
1) As mentioned above, Arsenal has 14.9 MMboe of 2P reserves (81% oil and liquids). According to the company's reserves report, Arsenal's 2P Present Value Before Tax discounted at an annual rate of 10% (PV10) is $245.9 million.
I will also assume that the company's undeveloped acreage (no reserves assigned into it) has absolutely zero value currently. This is quite theoretical of course, because the company's acreage (developed and undeveloped) is surrounded by producing properties that belong either to Arsenal or other companies. However, I make this assumption intentionally to prove Arsenal's gross undervaluation at the worst scenario.
As of September 2013, Arsenal has a working deficit of $7 million and $67 million long-term debt. I capture all this data into the table below:
2P Reserves (MMboe) |
14.9 |
|
2P Reserves Discounted At 10% ($ million) (Pre-Tax) |
245.9 |
|
Undeveloped Land ($ million) (Lowest Estimate) |
- |
Working Capital ($ million) |
(7) |
Long-Term Debt ($ million) |
(67) |
Shares Outstanding |
16,069,586 |
|
Net Asset Value Per Share (Lowest Estimate) |
$10.7 |
At the time of writing, Arsenal trades at $4.95, and this Net Asset Value per share represents an upside of ~110% for the potential investors. I point out here that this NAV was calculated assuming that the company's undeveloped acreage has zero value which is an unrealistic scenario of course.
2) Now I'll calculate Arsenal's PV-10 (per-tax) with a different way. I'll use the PV-10 (pre-tax) of its neighbors, Kodiak Oil (NYSE:KOG) and Northern Oil and Gas (NYSEMKT:NOG).
Arsenal has proved reserves of 9.7 MMboe (81% oil and liquids) and 5.2 MMboe (81% oil and liquids) of probable reserves. However, not all the probable reserves transition to the proven reserves category. Given the average industry estimate that 50% of the probable reserves become proven reserves, Arsenal's probable reserves that will most likely become proven reserves are approximately 2.6 MMboe (5.2 X 50%).
A) Based on Kodiak's Reserves: Kodiak Oil has 144 MMboe (86% oil) of proved reserves with NPV-10 (pre-tax) at $3.2 billion.
Based on this, Arsenal's NPV-10 (pre-tax) is:
$3.2 billion X 9.7 MMboe / 144 MMboe = $216 million.
$3.2 billion X 2.6 MMboe / 144 MMboe = $58 million.
This gives a total of: $216 million + $58 million = $274 million.
Adjustment for the oil/liquids portion: $274 million X 81 / 86 = $258 million.
All Kodiak's reserves are located in North Dakota as shown below:
B) Based on Northern's Reserves: Northern Oil and Gas has 67.6 MMboe (90% oil) of proved reserves with NPV-10 (pre-tax) at 1.287 billion.
Based on this, Arsenal's NPV-10 (pre-tax) is:
$1.287 billion X 9.7 MMboe / 67.6 MMboe = $185 million.
$1.287 billion X 2.6 MMboe / 67.6 MMboe = $50 million.
This gives a total of: $185 million + $50 million = $235 million.
Adjustment for the oil/liquids portion: $235 million X 81 / 90 = $212 million.
All Northern's reserves are in North Dakota and Montana as shown below:
C) So the average NPV-10 for Arsenal's reserves is: $258 million + $212 million = 470 / 2 = $235 million.
I will also assume that Arsenal's undeveloped acreage (no reserves assigned into it) has absolutely zero value currently. I sum up all this data at the table below:
Proved Reserves (MMboe) |
9.7 |
Probable Reserves (MMboe)* |
2.6 |
|
2P Reserves Discounted At 10% ($ million) (Pre-Tax) |
235 |
|
Undeveloped Land ($ million) (Lowest Estimate) |
- |
Working Capital ($ million) |
(7) |
Long-Term Debt ($ million) |
(67) |
Shares Outstanding |
16,069,586 |
|
Net Asset Value Per Share (Lowest Estimate) |
$10.02 |
* The probable reserves that will most likely become proven reserves.
At the time of writing, Arsenal trades at $4.95, and this Net Asset Value per share represents an upside of 100% for the potential investors. I have to point out here that this NAV was calculated assuming that the company's undeveloped acreage has zero value which is an unrealistic scenario of course.
3) To confirm once again that Arsenal's NPV-10 (pre-tax) is $235 million (minimum), I'll check out Triangle Petroleum's (NYSEMKT:TPLM) reserves which are a bit less than Arsenal's reserves.
Excluding Triangle's recent acquisition whose reserves have not been calculated officially yet, Triangle owns 14.6 MMboe of 2P reserves (86% oil) while Arsenal owns 14.9 MMboe of 2P reserves (81% oil and liquids). Furthermore, Triangle's 2P reserves in the Williston Basin are close to Arsenal's 2P reserves. As shown at the previous link, Triangle's NPV-10 (pre-tax) is $225 million.
Grossly Undervalued Compared To Its Peers And Neighbors
In this paragraph, I'll compare Arsenal to its peers: Northern Oil and Gas , Kodiak Oil , Lightstream Resources (OTC:OTC:LSTMF) and Whitecap Resources (OTC:OTCPK:SPGYF).
I would pick Triangle Petroleum if Triangle did not own an oilfield service firm and a midstream subsidiary. I picked the peers based on the following criteria:
1) They need to be growing junior or intermediate producers without any international operations.
2) They need to be 100% energy producers without any midstream or oilfield service subsidiaries.
3) They need to be heavily light oil/liquids weighted (production and reserves).
4) They need to have all or a significant part of their producing properties close to Arsenal's core areas in North Dakota and Canada. It will also be perfect if a company has producing properties at both sides of the border between Canada and USA.
All the peers above cover these criteria and they are intermediate producers. Actually, this is inevitable because it is impossible to find a junior E&P company with all the parameters above that also operates at both sides of the border between Canada and USA. Those folks who are concerned with this, they can discount the final result of this paragraph by 20%-30% in order to adjust it for the "junior" factor. However, I challenge them to discount it by 50%. The final result cannot still hide Arsenal's gross undervaluation at the current levels.
To give you now a better understanding about the location of Northern's and Kodiak's acreage, their core areas are shown in the previous paragraph. Lightstream's and Whitecap's core areas are shown below:
and here:
Furthermore, Lightstream Resources and Whitecap Resources are paying a good dividend of 14.7% and 5.2% respectively. Northern Oil and Kodiak Oil do not pay a dividend as of today.
So let's evaluate them by using the following key metrics:
1) Per EV/Production: Let's check out the table below:
Company |
EV ($ million) |
Production (boepd) |
EV/Production ($/boepd) |
Kodiak Oil |
5,600 |
35,400 (90% oil) |
158,192 |
Northern Oil & Gas |
1,500 |
13,000 (91% oil/liquids) |
115,385 |
Whitecap Resources |
2,360 |
21,650 (70% oil/liquids)* |
109,007 |
Lightstream Resources |
3,500 |
45,100 (78% oil/liquids) |
77,605 |
Arsenal Energy |
145 |
4,200 (76% oil/liquids) |
34,524 |
* includes the latest acquisition
Based on the data above, I get:
|
Average (Kodiak, Northern, Whitecap, Lightstream) |
Arsenal |
|
$/boepd |
115,047 |
34,524 |
Based on the average metric above, Arsenal's enterprise value would be: 4,200 boepd X 115,047 = ~$483 million.
2) Per EV/Proved Reserves:
Company |
EV ($ million) |
Proved Reserves (MMboe) |
EV/1P ($/boe) |
Kodiak Oil |
5,600 |
144 |
38.89 |
Northern Oil & Gas |
1,500 |
67.6 |
22.19 |
Whitecap Resources |
2,360 |
82.8* |
28.5 |
Lightstream Resources |
3,500 |
131.4 |
26.64 |
Arsenal Energy |
145 |
9.7 |
14.95 |
* includes the latest acquisition
Based on the data above, I get:
|
Average (Kodiak, Northern, Whitecap, Lightstream) |
Arsenal |
|
$/boe |
29.06 |
14.95 |
Based on the average metric above, Arsenal's enterprise value would be: 9.7 MMboe X 29.06 = ~$282 million.
3) Per EV/EBITDA: Let's check out the table below:
Company |
EV ($ million) |
EBITDA for 2013 |
EV/EBITDA |
Kodiak Oil |
5,600 |
700 |
8 |
Northern Oil & Gas |
1,500 |
260 |
5.77 |
Whitecap Resources |
2,360 |
240* |
9.83 |
Lightstream Resources |
3,500 |
520 |
6.73 |
Arsenal Energy |
145 |
45 |
3.22 |
* includes the latest acquisition
Based on the data above, I get:
|
Average (Kodiak, Northern, Whitecap, Lightstream) |
Arsenal |
|
EV/EBITDA |
7.58 |
3.22 |
Based on the average metric above, Arsenal's enterprise value would be: $45 million X 7.58 = ~$341 million.
To sum it up, this is Arsenal's enterprise value based on the average metrics of the peers:
1) Per Production = $483 million.
2) Per Proved Reserves = $282 million.
3) Per EV/EBITDA= $341 million.
Based on these three figures, the average enterprise value for Arsenal should be:
483 + 282 + 341 = 1106 / 3 = $367 million.
Since Arsenal's net debt is ($65.3) million, the market cap should be ~$302 million. Dividing this market cap with the 16,069,586 outstanding basic shares, I get ~$18.79/share (basic).
Even if the most strict investor discounts this final result by 50%, he will get $9.4/share (basic). At the time of writing, Arsenal's price is $4.95/share. This is a valuation gap of approximately 90% from the current levels.
Grossly Undervalued From An Acquisition Perspective
In this paragraph, I'll evaluate Arsenal from a third perspective. Although Arsenal's buyout is a speculative scenario, the company could be acquired by another E&P player one day. The metrics of the deals that have taken place at Arsenal's core areas since 2012, are indicative of Arsenal's outrageously low valuation.
So firstly, let's check out the deals of Arsenal's peers, as mentioned above:
1) In June 2013, Kodiak Oil acquired Liberty Resources whose acreage (42,000 net acres) is located in the Williston Basin of North Dakota. Liberty was producing 5,700 boepd and owned 22.66 MMboe of proved reserves. The purchase price for Liberty was $660 million in cash.
2) Whitecap Resources has acquired four companies since early 2013. They are all located in Canada. Let's check out the details:
A) In March 2013, it acquired Invicta Energy (80% oil and liquids), paying $110,400/boepd of production and $21.13/boe of proved reserves.
B) In April 2013, it acquired oil weighted assets (95% oil and liquids), paying $122,000/boepd of production and $30.18/boe of proved reserves.
C) In June 2013, it acquired oil weighted assets (56% oil and liquids) in Valhalla and Garrington, paying $59,900/boepd of production and $15.69/boe of proved reserves.
D) It acquired oil weighted assets (73% oil and liquids), paying $88,200/boepd of production and $19.1/boe of proved reserves.
Now, let's check out some other deals that also took place around Arsenal's core areas:
1) In January 2013, Bonterra Energy (OTC:OTCPK:BNEFF) acquired Spartan Oil for $480 million. Spartan was producing 4,000 boepd (82% oil and liquids) and owned 19.18 MMboe of proved reserves.
2) Novus Energy (OTC:OTC:NOVUF) was acquired by Yanchang Petroleum for $320 million in September 2013. Novus produced 4,050 boepd (80% oil and liquids) and owned 14.85 MMboe of proved reserves.
Now let's visualize all these transaction metrics at the table below:
Deal |
Per Boepd of Production ($/boepd) |
Per Boe of Proved Reserves ($/boe) |
Kodiak Oil - Liberty |
115,789 |
29.13 |
Whitecap - A |
110,400 |
21.13 |
Whitecap - B |
122,000 |
30.18 |
Whitecap - C |
59,900 |
15.69 |
Whitecap - D |
88,200 |
19.1 |
Bonterra - Spartan |
120,000 |
25.03 |
Novus - Yanchang |
79,012 |
21.55 |
Average Transaction Metrics |
99,329 |
23.12 |
By applying the average metrics on Arsenal, I get:
- Per Production: 4,200 boepd X $99,329/boepd = $417 million.
- Per Proved Reserves: 9.7 MMboe X $23.12/boe = $225 million.
- Average EV: 417 + 225 = 642 / 2 = $321 million.
Since Arsenal's net debt is ($65.3) million, the market cap is ~$256 million. Dividing this market cap with the 16,069,586 outstanding basic shares, I get ~$15.93/share (basic). At the time of writing, Arsenal's price is $4.95/share. This is a valuation gap of approximately 220% from the current levels.
Furthermore, an investor must not discount the final result of this paragraph, because several of the acquired companies above have much lower production and reserves than Arsenal's.
You can find more information about several oil/liquids weighted deals of the Williston Basin in my article here. As shown in that article, the average transaction metrics for the oil/liquids weighted deals of the Williston Basin from late 2012 to early 2013 were $144,700/boepd of production and $25.45/boe of proved reserves.
Insiders' Purchases
Another good thing is that insiders' ownership is high. It stands at 14% currently, aligning the shareholders' with the insiders' interests. All the insiders have also been adding on their positions since early 2013, as shown here.
Causes For The Mispricing
1) What keeps Arsenal at the current levels is the extremely low awareness. Arsenal is listed on the main Toronto board (TSX:AEI) which is not as popular as the US markets. Furthermore, you can try as hard as you want, but you cannot find an analysis about this growing E&P gem in any online financial publication.
2) The stock fell off in Jan/Feb 2013, because it followed all the other E&P Canadian firms with oil-weighted production that also corrected significantly during the same period as shown below. To prove this, this is the chart of Renegade Petroleum (OTC:OTC:RPTTF):
This is the chart of Pinecrest Energy (OTC:OTCPK:PNCGF):
This is the chart of Lightstream Resources:
This is the chart of Arcan Resources (OTC:OTCPK:ARNBF)
This is the chart of Novus Energy:
This is the chart of Trioil Resources (OTC:OTC:TRIAF)
This is the chart of Surge Energy:
So all these junior and intermediate oil-weighted producers from the Canadian energy patch corrected in Q1 2013 because of the significant oil price differentials during Q4 2012. The spread between WTI and Edmonton Par hit a peak during Q4 2012 due to infrastructure constraints and refineries shut down for maintenance, upgrades or expansion. The spread between WTI and WCS (Western Canadian Select) also hit a peak for the same reasons during the end of 2012.
Due to these differentials in Q4 2012, Arsenal realized oil prices that were 15-20% lower compared to 2011, as shown here. Nevertheless, Arsenal managed to offset this problem and its funds from operations rose in Q4 2012 versus Q4 2011, thanks to its increasing production versus 2011 that reached 3,934 boepd in December 2012.
It was also unknown back then, how long this spread would last. Would it last for 3 months or for one year? Fortunately, both problems were resolved in H1 2013. The refineries returned back on-line, and the North American energy infrastructure has been consistently improving since 2012, as shown in my articles here, here and here.
After all, the spread eliminated and some grossly undervalued oil-weighted Canadian players have risen since then, as shown above.
Please also check out the chart below:
and compare it to the chart below:
It is clear that the stock price hit $8 in 2012 when the production was 3,555 boepd. Since then, Arsenal's production and reserves have risen, and the company also initiated a meaty dividend a couple of months ago. In other words, Arsenal is fundamentally much better today than it was in 2012.
Meanwhile, we all know how many bullish views have been expressed on the Bakken/Three Forks formations of the Williston Basin over the past few quarters. We all know how much the highly publicized US-based Bakken/Three Forks players have risen during the last two years. However, Arsenal has not been credited for any of its Bakken/Three Forks success thus far.
Catalysts
1) Gross Undervaluation: Arsenal's current valuation is the definition of the gross undervaluation. The company tiptoes through North America's major shale plays, and this article will definitely increase Arsenal's current low awareness among the international investors. So Arsenal's light will not remain hidden under a bushel for long, and the fundamentals will prevail sooner or later.
2) Acquisition: Warren Buffett bought a stake into Suncor (NYSE:SU) and Carl Icahn initiated a position into Talisman (NYSE:TLM) lately. After the major deals of 2012 in the Canadian energy patch that were presented in my article here, the Canadian E&P sector is ripe for acquisitions once again.
Could Arsenal Energy be next? The thing is that Arsenal Energy operates among several intermediate and major producers both in the Williston Basin and in Canada. Its properties are close to properties that belong to EOG Resources (NYSE:EOG), Kodiak Oil, Northern Oil, Hunt Oil, Slawson Exploration, Murex Petroleum, Lightstream Resources etc. So all options are likely.
Risks
Arsenal carries the typical risks of any E&P company. It is a commodity-based company, so its top and bottom lines along with its dividend policy are dependent on the oil prices. Since the oil prices do not incur a sustained and substantial drop below $85/bbl, Arsenal will keep growing and reward handsomely the income seekers. The thing is that the marginal cost of production is most likely going to continue to creep higher as shown in the chart below, providing a significant cushion to the extent of any future oil price drop.
Additionally, the company's acreage both in the Williston Basin and in Canada is highly de-risked, because it borders producing properties owned by intermediate or major US-based or Canadian producers, as shown above.
My Takeaway
Thanks to SA, I have the chance to present lesser known value stocks and help them become greater known value stocks. As a result, if you are seeking income and want to combine it with value investing, you do not need to "kiss plenty of frogs to find the prince." The total package is before your eyes now. Arsenal Energy is currently in the bargain bin but is ready to roar, offering triple digit returns that range from 90% to 220%, as shown above. Until the stock roars, you can collect a 5% dividend annually. Can you afford to overlook it?
Disclosure: I am long OTCQX:AEYIF. 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.
