A little while back, there was some question as to why Granite Oil (OTCQX:GXOCF) management would want to sell stock now. The company sold about 2.3 million shares of common stock and received roughly C$16.5 million in gross proceeds. Then after the sale, the company management immediately deposited the proceeds into the bank which reduced the long term debt to about C$24 million from roughly C$41 million at quarter end. The numbers don't quite add due to some additional small flow through share sales. Management is projecting to end the year with about C$24.9 million in debt. So shareholders are wondering exactly how this maneuver will offset the dilution that they just experienced.
"Granite took advantage of competitive equipment and service pricing during the first quarter of 2016 to successfully complete several major facility projects, which considerably advanced the Company's long-term development and expansion of the EOR scheme. In addition to completing a number of field optimization projects, the Company installed and commissioned approximately 2,000 horsepower of additional gas compression equipment, as well as a utility pipeline and related meter station which will provide Granite with secure access to a long-term, reliable gas supply for use under the EOR scheme. With these facility expansions, the Company has built-in capacity for the further expansion of its EOR scheme and the future development of its Alberta Bakken oil pool with reduced capital commitments necessary for future growth. As well, during the re-pressurization phase, the Company is permitted to inject gas at rates greater than 100% VRR to return the oil pool to original pressure conditions. Accordingly, the Company is positioned to take advantage of current gas prices and its expanded facilities to optimize injection rates during this re-pressurization phase."
This announcement was made a few months back in April. With poor market prices, the company put its efforts into expanding the infrastructure while prices were favorable and probably successfully added some needed support capacity for the gas injection (and probably some related things) at a very desirable price (especially when compared to a couple of years ago). This is part of a counter cyclical expansion strategy that often adds significantly to company profitability. Infrastructure is usually expensive and capital intensive up front for any company. The last thing any company in a cyclical industry wants to do is spend money at the top of an industry cycle when costs are sky high because then the company is stuck with those high costs during the next industry downturn.
"With low commodity prices through the first half of 2016, Granite's primary focus was to create long-term value with the expansion of its Gas Injection - Enhanced Oil Recovery ('EOR') scheme in its 100%-owned Alberta Bakken oil pool. Throughout the first and second quarter, the Company implemented a major EOR expansion and optimization project. In the first quarter the Company reached a major milestone in its development by achieving a Voidage Replacement Ratio ("VRR") of over 100% in the core of the oil pool, covering 23 sections and containing an internally estimated original oil in place of approximately 200 million barrels. Since ramping up voidage replacement, the Company is seeing a material improvement on the rate of production decline on a pool-wide basis from both historical wells drilled before 2015 and from its EOR-optimized wells drilled in 2015."
"Granite has recently ramped up its production with increased 2016 drilling and continues to maintain a VRR of over 100%. Going forward, Granite will utilize built-in spare capacity from its recent facility expansion to match production growth with gas injection and maintain a minimum VRR of 100%."
That makes these two announcements a very big deal. The company now has the capacity to increase resource recovery for potentially 200 million barrels of oil in the ground. The increased recovery could easily add 12,000,000 barrels of oil recovered from this field. For a company with a market cap of $167 million at the close of the market on June 16, 2016, this is a very large significant deal. This announcement means that for at least a few years, all the company has to do to increase production is drill and hook-up wells because the low cost infrastructure is there. That foresight reduces all kinds of potential complications and expenses.
The company is exposed to the risk of carbon dioxide pricing because it purchases a fair amount of carbon dioxide for its program. But right now and for the foreseeable future, carbon dioxide pricing is low and usually linked to the price of oil.
Second, the company did not drill any new wells and because it instead concentrated on the infrastructure, production declined as the reservoir pressure dropped. As pressure builds up, some of that production decline will be recovered in future quarters.
Source: Granite Oil June, 2016, Company Presentation
The company has been experimenting with this model for some years and is now going to ramp up the model field wide, so there are definite risks of the model not working "in real life" as well as the smaller experiment. However, the preliminary projected results are shown above. The original recovery before experimenting was around 6% and now the company is looking at recovery at least three times that amount. Based on the targeted 200 million barrels, this injection project is expected to recover more than an additional 12 million barrels of oil. You can practically name your oil price and the revised C$5 million capital budget for facilities and infrastructure is a no-brainer. The company is closing in on 9% now which is already a significant advancement.
This idea of replacing the gas into the gas cap to maintain reservoir pressure is related to water flooding except that the company is using gas. The idea has been around for awhile, so that while there will certainly be engineering challenges with this reservoir in making it work, it's not a completely new speculative idea in uncharted waters.
But the improvements don't end with the infrastructure and gas injection.
"Granite continues to make material gains in reducing its capital costs, with the cost of its two most recent wells, drilled late in the quarter in the core Bakken oil pool, averaging C$1.2 million, including drilling, completion and tie-in costs. As a Company first, Granite drilled these wells back to back on the same pad realizing significant drilling and completion efficiencies and cost reductions. These costs represent a 30% reduction in all-in well costs from the C$1.7 million at the start of the year."
The company has saved 30% since the start of the year in well costs, but that is not nearly the whole story. In the last article that was written, the well cost was down to C$1.5 million and was 47% below the cost a year earlier. Now the company has made additional very large and significant cost savings in addition to that 47%.
The company had been experimenting with longer laterals and more stages as well as the frac job (and other well designs). Evidently these savings were more significant but with the rest of the industry showing cost savings in this area as well, expect management at some point to turn its attention back to these topics for further cost savings.
Source: Granite Oil June, 2016, Company Presentation
The second slide shows how conservative (and out of date) the first slide is now. The company originally budgeted C$6 BOE (for fiscal year 2016) for operating costs and is already significantly below that forecasted amount. Using average pricing for operating costs, the current average operating cost is about 70% of the cost from the first quarter last year. The latest cost appears to be about 65% of the last year first quarter average. With the new gas injection scheme and increased flow rates, plus decreased well costs and improved well designs, this can be expected to significantly drop in the future. With the latest well cost of C$1.2 million, well costs are now approaching 25% of what they were in fiscal year 2014. That should tell any observer that depreciation is not going to relate to future costs (and returns) at all. In fact, for a while, depreciation will be just plain ridiculous when compared with the actual costs, payback, and projected profitability of new wells. Cost ceiling impairment charges and increases in well production cannot fix old costs that different from new costs although they can mitigate the problem somewhat. All those old wells with their capitalized costs will still be there, but they are history (sunk costs) and not representative at all of future costs, so depreciation (and the income statement) will take a few years to reflect these new costs once they have stabilized (and that may be awhile for stable costs). The cash flow statement will also be a mixture of old and new wells, but the increased cash flow of the new wells will have more of an impact on the cash flow statement (because new wells produce more in the early production stages).
The company had originally budgeted four wells for nearly $7 million. Now it is very close to drilling six wells for just a little bit more money if costs don't drop any further. By the end of year, that new number will probably be obsolete. The capital budget for well drilling and completion was increased to $10 million. By the end of the year, that could be enough money for as many as 10 wells as the cost cutting continues. The company has decreased well cost C$300,000 each quarter, leading an observer to wonder how much more costs can be saved, especially at that pace.
Some of the companies in the area, such as Birchcliff Energy (OTCPK:BIREF) and Peyto Exploration and Development Corp. (OTCPK:PEYUF) are drilling gas wells that are cheaper, so maybe it's still possible to save significantly more money drilling these oil wells. There are many variables that increase or decrease the well cost, so there are definitely no guarantees on future costs. All of the operators are experimenting successfully with ways to increase well production and reserve recovery that may lead to eventual higher well costs but lower BOE costs.
So the company definitely has growth plans for this year now that commodity prices have improved. But the "elephant in the room" is that with the lower cost structure promised by the new wells, the company can expand at much lower commodity prices than was possible just a year ago. All the company needs is enough new wells at the new lower costs to provide sufficient cash flow during lower commodity pricing in the future. When combined with the company's hedging program, the time needed may not be that long for a company of this size.
The first slide shows an all in well cost of $1.8 million and a rate of return of 28%. But with the new well costs of $1.2 million, and the projected lower decline rate as well as other improvements, that ROR has probably at least doubled in the worst case scenario. That would be an incredible greater than 50% return when oil prices in the United States are $32.50 and the costs are still dropping!
So management sold stock rather than borrowed money for a couple of reasons. First, the latest redetermination had reduced the credit line. For the company to have borrowed more money would have risked a liquidity crisis should the next redetermination decrease the credit line even more. The company instead reduced the debt outstanding immediately and will borrow at a time when the security offered to the bank is more valuable than when the debt was outstanding before the offering. Plus the company saved some interest charges in the meantime. In the current industry environment banks are far more comfortable with this method of expansion.
Second the company has an enticing operating model with the gas injection that it has tried out successfully on a small scale and will implement on a large scale. Whenever there is a ramp-up like this, there are always little (hopefully not large) hiccups that are better handled (because it's less risky) with new equity than with debt. If the project is successful, the increase in profitability should far outweigh the additional dilution of the stock offering. The company has done everything it can to minimize the risks involved in the ramp-up and management can be expected to continue that strategy. But there are always unforeseen risks that can occur, so this is a good conservative path to take for a small company.
The company intends to match its cash flow to expenditures and drill 3 new wells within the next quarter. Once the company is satisfied with results and the profitability of the wells it has the credit to expand at a far faster rate. In the original slide, the company showed the payback of the wells at 3.4 years. But costs are down so much and production is increasing so significantly that the payback on the new wells is probably below 2 years in a worst case scenario of $32.50 price of oil listed on the slide. At current pricing, the payback could be approaching eighteen months or even a year. Undoubtedly management will provide new guidelines when it is comfortable forecasting the new rapidly changing costs.
Last oil prices need to cooperate a little. This company has some of the lowest costs in the industry. But sustained plunging commodity prices could put a lot of this on hold until industry conditions improve. This is another reason for using equity rather than debt. With all the industry bankruptcies, it would appear that a sustained decline in oil prices is not likely, but not many forecasted this decline (both the amount of decline and the amount of time) either. All in costs could easily be C$15 per barrel of oil or lower by year end.
Those who believe in the presidential cycle may "know" that traditionally the economy and the stock market tend to be weak the first year or so of a new presidency. Using equity exposes the company to far less risk during a price decline from a soft economy. Economic downturns happen periodically without much warning, so this concern needed to be factored into the equity vs. debt decision. The operating costs are low enough to withstand most projected economic (and oil price) scenarios; the key is to not load so many financing costs and debt that a downturn would stress or sink the company. This company is very good at timing its hedging program and can also use that hedging program to decrease its risks.
|All Figures in Canadian Dollars/BOE||2018|
|First Quarter, 2016||Forecast|
|Total Operating Transportation And Royalties||$15.01||$13.54|
|G & A Expense||$2.88||$2.88|
|Total Overhead Expenses||$3.99||$3.99|
|Profit Before Acquisition and Development||$11.63||$22.47|
|Derivative Gains Realized||$11.14|
|Funds Flow Netback||$22.77||$22.47|
|Non-Cash Charges (Income)|
|Unrealized Losses On Derivatives||$10.17|
|Non-Cash Share Based Compensation||$4.23||$4.23|
|Depletion and Depreciation||$17.56||$10.00|
|Deferred Income Tax Expense||($1.50)||($1.50)|
|Total Non-Cash Charges||$31.39||$13.66|
|Net Profit (Loss) In C$ (000's)||($2,259.00)||$16,078.25|
Source: First Quarter, 2016 Report. Forecast - Author's Assumptions
This forecast using the first quarter numbers as a basis may prove to be very conservative. First, the operating expenses are already at C$5.00 BOE and could very well be 20% lower in two years. There are partial years in the near past where those expenses have dropped that much. At some point the rate of decrease in operating expenses will slow but right now it keeps dropping at an extremely high rate. Second, I am assuming some more borrowing, but a slight increase in selling prices above the assumption, or continued decreases in finding development and acquisition costs may negate the need for more borrowing. Finding and Development Costs have probably dropped from the $9.00 listed in the slide above to below $6.00 and may drop more as further improvements are achieved.
Lately, for example, management has not mentioned the increases in stages or improvements in well design probably due to the low drilling activity but costs have dropped a lot anyway. At some point well design, and stages will probably drop costs significantly again as they are dropping in much of the rest of the industry.
The company had C$19.00 of cash costs to produce the oil and gas sold. Add in another C$6.00 of finding and development costs and the company has an "all in" cash cost of about C$25 BOE. If the continuing cost decrease rate does not slow, future costs of C$20 BOE or less are within view which is amazing. Really any cost between the C$25 BOE and C$20 is fantastic in this industry.
Oil price revenue is projected at C$ 40 BOE. If the current exchange rate remains, then oil prices could drop considerably and this company would still show a significant profit improvement. If on the other hand the exchange rate changes towards 1:1, then profits still improve considerably from this latest quarter as long as the company increases its pace of drilling to increase production.
Originally the company figured it needed to drill about three wells to maintain production each year, but with the expected improved results, that could easily change. The company reported current production of 3,200 BOE and forecasts an exit rate of 3,500 BOE. That is more than 20% above the first quarter average production rate and probably conservative. But with the reduced loan balance from the stock offering as well as another C$3 million from a separate private placement, the company has the option of accelerating its activity and exiting at a higher rate of production. The cash flow from operations is projected to be more than C$24 million in the second half of the fiscal year. That amount is a sizeable jump from the C$6 million first quarter and is very comfortable for long term debt that is projected to be nearly the same amount.
Management just needs to be comfortable with the performance of the latest wells under the expanded gas injection scheme. Management may take the time to "tinker" with some details, but the infrastructure is clearly in place, so the next step is to drill the wells, keep the reservoir pressurized, and hook those new wells up (then collect lots of cash). Accelerating development and making that projection for 2017 look conservative would be very easy for a company of this size. The cost reduction progress is industry leading and breath taking. The total bank line is C$80 million and with the latest commodity price rally, infrastructure additions, and cost reductions, that credit line is very unlikely to be reduced at the next redetermination.
Well costs are very likely to be below $C 1 million by year-end. If the well costs do not decline, then management will probably have found some other equivalent or better value improvement from another source to decrease costs. In any event, if prices stabilize or increase slightly, the ability to drill 15 wells next year is very reasonable and will within the ability of the company. Very significant growth would be the result (probably more than 20% from this year).
The cash flow is slightly more than $C1 per share. A normal price ratio for a growing company of about 13 would imply a near doubling of the latest price (of C$7.36) to $C 13. Investors in the United States may do even better because the Canadian dollar has been unusually weak when compared to the United States currency as the Canadian dollar strengthens over time. Currently United States investors can purchase the stock in the five dollar range. The risk of the Canadian dollar becoming weaker seems low as the exchange rate is near a historical low. More likely, the exchange rate becomes closer to 1:1 and provides the United States investors with an additional return. The additional return from a fairly generous dividend of more than 5% adds to an already attractive return from expected production growth.
Disclaimer: I am not an investment advisor and this article is not an investment recommendation. Investors are urged to read all of the company's filings and press releases to determine for themselves if this company fits their investment 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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