Buying the wrong company.
We would put the four words above in 100 size fonts if we could. The recent turmoil we saw in energy stocks is tough to handle. S&P 500 energy sector (NYSEARCA:XLE) is the worst performing sector in the S&P 500 (NYSEARCA:SPY), but none of this should come as any surprise for the long-term investor. Energy was the best performing sector last year, and the bottom we saw in oil prices in February last year was just the start of the bull trend.
Oil prices since the start of the year have fallen over 10% and is currently below $50, however, we view the recent sell-off as an opportune time to add to stable and profitable producers that can withstand the "lower for longer" scenario foretold by the consensus.
What Kind of Producers Should Energy Investors Buy?
The beauty of investing is that one can handicap the odds in their favor. Warren Buffett, the legendary value investor, has always said that investing is a "no-strike" game where one can wait for the perfect investment, rather than hit at every pitch.
We believe in the realm of energy investing, investors can handicap the odds by insuring that the valuation is at a discount to peers, and that the producer can grow production even in the case of "lower for longer" oil prices.
We believe the second point of buying E&P companies that can grow even in the face of lower for longer oil prices is extremely important, because it makes higher oil prices a " free optionality."
Similar to the " Say yes to more" commercial from Time Warner Cable, most investors would gladly receive "free optionality" for higher oil prices, while paying below average peer valuation for an E&P company. Who wouldn't want that?
The tough part about all this is that the stock market is much more efficient than in the days of when Buffett first started his partnership. We wish we could buy energy companies below liquidation value, but that's not the case anymore.
Instead, we grade E&P companies on five metrics that we think will benefit for all the readers.
Risk Weighted Capital Intensity
The first metric is the most important metric of them all. The risk weighted capital intensity ratio spells out exactly how much a producer needs to spend in order to grow production by an equal amount. If an acquisition was done to increase overall production, it is taken into account in this ratio.
Formula (capital intensity ratio):
(Capex + acquisition - asset sale) / (Average production in 2017 - average production in 2016)
This easy to use formula gives you an idea of what the producer's capital intensity is. The lower the capital intensity, the better the ratio. Producers that sport the lowest capital intensity ratio amongst its peer group will grow much faster relative to peers if "commodity prices stay lower for longer."
The second portion of this formula is calculating the overspend ratio. This is how much a producer will overspend relative to its capex budget to meet its desired production growth.
Formula (overspend ratio):
(Capex budget + acquisition - asset sale) / EBTDA*
* Notice it's EBTDA and not EBITDA. We subtract financing cost from this.
Overspend ratio gives us an idea of how much the producer is overspending or underspending relative to its capex budget.
Combining the capital intensity ratio and the overspend ratio, we arrive at the risk weighted capital intensity ratio.
Formula (risk weighted capital intensity ratio):
Capital intensity ratio X overspend ratio
The risk weighted capital intensity ratio would punish producers that are spending more than its cash flow, and reward producers that are underspending.
By comparing the risk weighted capital intensity ratio amongst a group of E&P companies, we can figure out who will likely continue to grow even if commodity prices remain lower for longer, and who will continue to struggle. This has allowed us to rank the E&P companies.
Strength of this method - The risk weighted capital intensity ratio allows us to get a quick overview of what companies have the lowest capital intensity ratio amongst its peer group. More often than not, this ratio does a good job telling us the overall growth profile of the company.
Weakness of this method - The weakness to this method is when the situation of the producer's growth plan is much more complex than a simple year-over-year average. In the case where a producer's capex plan is back half weighted, the overall average production could be depressed resulting in artificially high capital intensity. Using a two-year risk weighted capital intensity ratio solves this issue, however, most producers only give 1-year capex budget forecasts.
Valuation is self-explanatory. The cheaper the energy company trades for, the more appealing it is for the investor.
EV/EBITDA, EV/DACF, EV/PDP, EV/EBTDA, per flowing boe/d, and more.
An investor can use all sorts of valuation metrics, but we think a more appropriate metric is EV/EBTDA as it takes out interest burden.
Valuations like per flowing boe/d do not take into account cash flow valuation, and we believe a simple per flowing boe/d metric is more often wrong than correct. We urge investors to stay away from using per flowing boe/d metric.
Example of per flowing boe/d metric:
Peer trades at $45,000 boe/d.
Then company X, currently trading at $22,000 boe/d, should also trade at $45,000 boe/d.
Per flowing boe/d = EV / company production
Another flaw in the valuation metric is PV-10, which is usually reported by the company at year-end's reserve report. This metric can be manipulated by changing assumptions in the commodity price deck, and investors should not use that as a gauge of value.
We use raw production growth to gauge how fast the producer is growing. This just gives us an idea of how each producer ranks with one another.
Average production in 2017 / average production in 2016
Strength of this method - This gives us a quick overview of how each producers compare on a total production growth basis.
Weakness of this method - It does not take into account share dilution into the calculation. A potential fix is by using cash flow per diluted share.
Cash Flow Margin
This is the "corporate netback" of a producer. The higher the cash flow margin, the lower the breakeven operating cost for the producer.
Revenue per boe - royalty cost - operating cost per boe - transportation cost per boe - G&A cost per boe - interest cost per boe - taxes = corporate netback
Strength of this method - Cash flow margin gives us a good overview of how the company's corporate netback looks like without taking into account maintenance and growth capex.
Weakness of this method - Cash flow margin is not free cash flow margin and does not spell out how profitable the company is AFTER capex (maintenance and growth). However, the other metrics in our formula takes capex into account.
Debt to EBITDA
The last metric we use is the debt to EBITDA ratio. The lower the ratio, the lower the indebtedness of the producer. This gives us a good sense of how distressed the producer is relative to its peer group.
Debt / EBITDA
Strength of this method - Debt/EBITDA gives us a quick look at the debt stress level of the company.
Weakness of this method - Debt/EBITDA does not tell us the interest burden which can be fixed using EBITDA/Interest Expenses. In the case of high commodity prices, Debt/EBITDA could be artificially low as the company's EBITDA is high resulting in a lower ratio. This can be fixed by using a stress test scenario.
What Results Did We Get?
Using the five-metric evaluation system, our analysis of 11 Canadian oil companies are listed below:
(We use higher oil prices in our assessment to include potential torque upside for levered producers)
We have already conducted a similar analysis with US natural gas producers, and look to incorporate the entire E&P universe as we utilize our evaluation system.
Using our data from the 11 Canadian oil companies above, Raging River stands out as currently the best priced oil producer out of the 11. This is followed by Gear Energy, which is ranked second amongst our 11 producers.
Looking across the five ranks, Raging River ranked 4th cheapest in valuation with an EV/DACF of 6.04x while Gear Energy was ranked as the cheapest producer with an EV/DACF of 3.66x.
Raging River came in at 3rd best in production growth with 27.37% year-over-year growth and Gear Energy came in 5th best with 23.08% year-over-year growth.
Raging River sported the lowest debt/EBITDA ratio clocking in 0.57x while Gear Energy sported the 3rd lowest debt/EBITDA ratio clocking in 0.78x debt/EBITDA.
Raging River scored the highest on cash flow margin with an estimated 71% margin, while Gear Energy scored 7th highest with 46%. (Be mindful, Raging River is predominantly light oil, while Gear is mostly heavy oil. Baytex, for comparison purposes is mostly heavy oil, has a cash flow margin of just 35%.)
Lastly, Raging River scored third best in risk weighted capital intensity of 20.69 with Gear Energy following closely at fourth best at 29.84. Peer average is 36.37 if we exclude Pengrowth and Baytex, which have the max capital intensity score (1,000).
We believe the biggest mistake energy investors can make today is by being impatient. Finding the right E&P company that's trading below peer average while growing faster than peers could offer downside protection in the case commodity prices stay lower for longer, but also receive free optionality in the case oil prices do rise.
Disclosure: I am/we are long GENGF, RRENF.
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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.