Athabasca Oil: Best Way To Play The Oil Sands Recovery

Summary

• Athabasca has one of the highest torques to higher oil prices and Western Canadian Select ("WCS") discount improvement.
• Upcoming catalysts include normalization of WCS differential and potential monetization transaction of thermal oil infrastructure assets.
• Now is the ideal time to accumulate shares as we believe Q2 earnings release could be the inflection point that results in sentiment change.

(All values are expressed in Canadian Dollars unless otherwise stated)

We believe Athabasca Oil (OTC:ATHOF) (TSX:ATH) is the best way to benefit from the upcoming recovery in the Canadian oil sands industry, driven by a return to normalized levels for Western Canadian Select ("WCS") differential and supportive global oil prices. Athabasca has removed most of its leverage concerns through a transaction with Murphy Oil (MUR) in 2016 and its cash flows possess one of the highest torque to oil prices and WCS differential among the peers.

We see an upside of 42% in Athabasca share price under our base case which assumes US$68 WTI and US$20 WCS discount. We also see an upside of 74% in Athabasca shares should an asset sale of its thermal oil assets materializes in the near term. Additionally, Athabasca will also benefit from a potential improvement in sentiment for the Canadian oil sands stocks given now that Enbridge (ENB) Line 3 has been approved and the Canadian Government is backing the Trans Mountain expansion project.

Athabasca is one of the few remaining independent oil sand producers that combines a solid balance sheet with massive torque in cash flows to oil prices. In the near term, we believe Athabasca is poised to benefit from two upcoming catalysts: the improvement in WCS discount and the monetization of thermal oil infrastructure assets. Additionally, if oil prices rise above US$70 we see at least 68% upside in Athabasca due to its immense cash flow leverage.

Situation Overview

Athabasca completed its IPO on the TSX in 2010 and made a big splash in the energy market by almost doubling its offering due to strong interest from Asian buyers including PetroChina, a backer for the company. The IPO was priced at $18.00 per share and shares have since struggled ever since due to underperformance at its original oil sand asset. The share price lost more of its value during the oil downturn in 2014 and has traded around $1.00-$2.00 for the last three years. We believe the shares will be boosted by several tailwinds in the near term and see shares trading significantly higher as a result.

(Source: Bloomberg)

Oil prices have also been trading higher for the last year, rising more than 30% to settle around US$68 recently. While oil prices are still in backwardation as futures for December 2019 is trading at US$64.19, we are bullish on the mid to long-term outlook for crude as global demand has been growing impressively and geopolitical risks remain a potential catalyst for higher prices.

Trump's tweets on oil prices are politically motivated and we believe OPEC and Russia have every incentive to keep oil prices closer to US$70, and they will certainly do whatever they can to avoid another crash in the oil market. While it is impossible to predict oil prices in the future, we believe our base case of US$68.00 is conservative and supported by fundamentals in the market.

(WTI price chart, Source: Bloomberg)

Catalyst #1: Narrowing WCS Discount

Why investing in oil sands now? We believe oil sands companies have suffered from a double whammy of lower oil prices and widened Western Canadian Select differential ("WCS"). (For details on what is WCS and the impact on Canadian producers click here.) Now that oil prices are significantly higher as WTI is trading at levels not seen since the crash in 2014, there is another upcoming tailwind that makes now the ideal entry point for oil sands.

The WCS discount has been significantly reduced since the beginning of 2018. The discount blew up to US$30 at the end of 2017 due to a spill at TransCanada's (TRP) Keystone pipeline that caused a shutdown of one of the most important transportation lines for Canadian heavy oil. Since the spill in November 2017, the pipeline has been restored to full capacity. Railway companies had also been slow to respond to higher demand for shipping crude but are finally making progress in expanding supply.

Another major positive development for WCS is the recent approval of Enbridge (ENB) Line 3 Replacement project. Minnesota officials became the last U.S. state to approve the project on June 28, a major victory for the Canadian pipeline company and energy sector in general. We have written extensively on the benefits and importance of Line 3 for Canadian producers because the expanded capacity will make sure that WCS discount does not get blown out as it did in late 2017. Before the spill, WCS was trading at only US$10 below WTI and we expect the differential to return to historical levels of US$10-US$15 soon.

(Source: Bloomberg)

WCS discount currently trades around US$17.25 but we have assumed US$20.00 in our base case analysis to be on the conservative side. Any further narrowing of the discount would result in incremental benefits for Athabasca, as we will demonstrate later. We think the market has been hesitant to price in an improved outlook for WCS due to the recent memory of pipeline constraints and the inability for rail companies to respond fast enough.

However, with Line 3 approved and its construction set to begin soon, we think the market will realize that WCS discount will be reduced to historical levels as Line 3 will increase its capacity by 370k bbls/d to 760k bbls. It takes even longer for the improved fundamentals to be reflected in oil stocks as the Canadian energy stocks have been abandoned by many institutional investors over the past few years, in favor of U.S. shale producers.

Heavy oil producers, especially oil sands projects, are greatly affected by WCS pricing because their oil productions are priced in WCS, instead of WTI. We will demonstrate in our analysis below that Athabasca is highly sensitive to WCS and that means its cash flow has been negatively affected by the higher WCS discount in the past few quarters.

Q1 results did not reflect the current state of the oil market (when WCS discount dipped below US$30) and we think investors should position themselves ahead of Q2, which is expected to be much stronger as both WTI and WCS improved. Athabasca will become one of the biggest beneficiaries among oil stocks from improved WCS pricing due to its heavy oil exposure from oil sands.

Catalyst #2: Thermal Oil Infrastructure Monetization

The second catalyst (first being the narrowing WCS discount and upcoming Q2 results) that we believe will result in positive share price reaction is the monetization of certain thermal oil infrastructure assets announced during Q4 2017 earnings release. The assets being marketed for sale includes a 300,000 barrels tank farm and pipelines between Leismer (one of its two oil sand projects) and Cheecham, Alberta where Enbridge's terminal is located.

Similar Monetization At Meg

For a nearly perfect example of such monetization, one only needs to look at Meg (OTCPK:MEGEF)'s sale of its thermal oil infrastructure assets. MEG announced the sale of a 50% interest in its access pipeline and 100% interest in its Stonefell terminal to an entity controlled by Canada Pension Plan for $1.6 billion representing an impressive 13.4x 2018 annualized EBITDA. The Stonefell terminal has a 900k barrel tank and is sold for $210 million whereas the access pipeline is sold for $1.4 billion.

In reality, Meg is incurring higher operating costs going forward in exchange for upfront cash payments that used to reduce its leverage. The agreement entered between Meg and the buyer will determine the EBITDA to be generated from these assets, which equals the additional costs that Meg will incur going forward.

Athabasca Follows Suit

After seeing the strong transaction economics achieved by Meg, we believe Athabasca is likely to see receive strong interests in its pipeline and storage tank assets given the similarity between these assets. Several research analysts have estimated potential proceeds from $200 to $300 million, which implies EBITDA impact of $19 million taking the mid-point of $250 million. Ultimately, both Meg and Athabasca are giving up EBITDA and cash flow for upfront cash and we think trading $19 million of EBITDA for potentially $250 million in proceeds is an accretive transaction because:

• Athabasca trades at 6.1x annualized DACF of $211 million, so selling at more than 13.0x is a good deal.
• Athabasca is paying 9.875% on its debt and it would be a good use of proceeds to retire expensive debt; interest savings of $24 million more than offset $19 million EBITDA hit.

We would expect proceeds from the monetization transaction to be used for debt repayment and expanding capital programs. While Athabasca does not need to repay all its debt for optimal capital structure, it will be able to easily reduce its leverage to below 1.0x DACF with the expected proceeds. Any remaining proceeds can be used to expand its drilling programs in its light oil division or to accelerate its expansion at thermal oil assets.

Similar to MEG, Athabasca could retain a partial interest in the access pipeline given the importance to its thermal operations while monetizing the assets taking advantage of favorable market conditions. We believe the market is not currently pricing in any upside from the potential monetization. Later in this article, we will illustrate the potential upside from an asset sale.

Athabasca Is Best-Positioned

Athabasca is the best oil producer in our coverage universe that combines a solid balance sheet with the highest torque to higher oil prices and improved WCS discount. Here is a list of the Canadian oil sands producers and you will see that Athabasca and Meg are the only two independent publicly-traded oil sand producers. We believe Athabasca is better-positioned than Meg and other producers to benefit from the anticipated improvement in WCS differential and higher oil prices due to two reasons.

#1 Highest Torque In Cash Flow

We believe Athabasca has the best cash flow torque among its peers due to the nature of oil sand projects. You need to understand that oil sand revenue is unique and different from other oil producers:

• Oil sand producer sells their oil at WCS pricing, however, they also need to purchase diluent (often natural gas condensate) in order to mix with their heavy thermal oil production for pipeline transportation. Crude extracted from oil sand is too heavy and dense and must be mixed with the diluent which represents a cost for Athabasca
• The break-even costs for oil sand projects differ but they are generally higher than light oil productions. Athabasca has the highest cash flow torque compared to other producers due to its 90% liquids weighting, fixed operating cost structure, low decline rate (10%), minimal capital expenditure required to maintain production.

(Source: Company presentation)

#2 Light Oil Provides Growth

One of the differentiating factors for Athabasca compared to some other oil sands producer such as Pengrowth (OTCQX:PGHEF) is its light oil program. In January 2016, Athabasca formed a joint venture with Murphy Oil whereby it sold a 70% working interest in its Duvernay asset and 30% interest in its Montney asset. Duvernay represents one of the most promising light oil shale formations in Canada and several firms have been ramping up drilling and production in the area, including Raging River (OTC:RRENF).

The JV was formed in May 2016 and Athabasca was able to minimize its capital outlays by getting a $225 million capital carry in the Duvernay from Murphy over a period of five years. We think it was a great deal by Athabasca to monetize its light oil land base during a time when it does not have the capital to develop these assets on its own. The JV transaction included $250 million in cash proceeds and $225 million of carry and allowed Athabasca to participate in a highly attractive emerging light oil shale play in Canada.

Athabasca's light oil assets boast one of the highest netbacks due to the quality of its land positions. Per the press release, the JV is expected to invest over $1 billion over the five-year period in the Duvernay, including the carry commitments from Murphy.

(Source: Company presentation)

Torque To Oil Prices And WCS Differential

We have analyzed the cash flow sensitivities of Athabasca under various oil price scenarios. In the table below, we have assumed a conservative WCS differential of US$20 and illustrated the impact on debt-adjusted cash flow and cash flow after capex based on the latest capital budget. Our model uses Q1 for various cost inputs which are prudent and conservative in our view, as we expect subsequent quarters to show significant improvement.

For 2019 DACF (2018 affected by a slow Q1 due to abnormally wide WCS discount), we think Athabasca should be able to generate $211 million of cash flow under US$68 WTI (current WTI price) and US$20 WCS discount (US$17.25 currently), relatively conservative assumptions for both metrics. With $211 million of cash flow, Athabasca is trading at 6.1x EV / DACF which is below what we think would be a normalized multiple of 8.0x EV / DACF.

To illustrate its cash flow torque to oil prices, we found that for every US$5 improvement in WTI, Athabasca's cash flow improves by $70-80 million! If WTI averages US$75.00, Athabasca's cash flow would be $316 million, which would imply an EV / DACF multiple of only 3.9x. The immense leverage to higher oil price is laid bare in the chart below. Note that the downside for Athabasca is also substantial should oil prices stay below US$60 as its cash flow turns negative. If oil falls to US$55, cash flow could really become a problem but we would also expect management to reduce capital programs to conserve cash.

(ATH Cash Flow Sensitivity Analysis)

Besides WTI, Athabasca is also highly sensitive to WCS differential due to its thermal oil production. Our base case calls for US$20, a conservative number given historically the discount ranged between US$10 and US$15. If the discount narrows by US$5, we would see Athabasca's cash flow improve by ~$65 million, a significant improvement that will have a material positive impact on the operating performance and share price.

With $140 million in total capital expenditure, the company is comfortably funding all its capex with organic cash flow with residual cash available for debt repayment. Our commodity assumption calls for a very low risk of WTI falling back to below US$60 for an extended period due to the rebalanced global oil market, and we are forecasting an improvement of WCS to US$15 by the end of 2018, both of which would be hugely beneficial for Athabasca's cash flow.

WCS Discount	(US$10)	(US$15)	(US$20)	(US$25)
Operating Netback	$30	$25	$21	$16
DACF	$342	$276	$211	$145
Cash after capex	$202	$136	$71	$5
Cash after capex and dividends	$202	$136	$71	$5
Dividend Payout	0%	0%	0%	0%
All-In Payout	41%	51%	66%	97%

Click to enlarge

(Source: Author estimates)

We believe Athabasca shares have a fair value of C$2.56 per share based on US$68 WTI and US$20 WCS discount, which represents a 42% premium over its current share price. The torque to higher oil prices is immense and we see an upside of 68% should oil prices reach US$70. Absent higher oil prices, we still see the upside in Athabasca shares highly appealing, in addition to the upside from oil infrastructure asset sale that is not included here.

WTI	$68	$70	$75	$80	$85	$90
DACF	$211	$241	$316	$392	$468	$543
Target EV / DACF	8.0x	8.0x	8.0x	8.0x	8.0x	8.0x
Implied Enterprise Value	$1,685	$1,927	$2,532	$3,137	$3,742	$4,347
- Net Debt	($367)	($367)	($367)	($367)	($367)	($367)
Equity Value	$1,318	$1,560	$2,165	$2,770	$3,375	$3,980
Shares O/S	515.0	515.0	515.0	515.0	515.0	515.0
Implied Share Price	$2.56	$3.03	$4.20	$5.38	$6.55	$7.73
Current Share Price	$1.80	$1.80	$1.80	$1.80	$1.80	$1.80
Upside to Current Share Price	42%	68%	134%	199%	264%	329%

Click to enlarge

(Source: Author estimates)

Upside From Asset Monetization

Our analysis so far has not incorporated the impact from potential monetization of thermal oil infrastructure. To illustrate the impact of an asset sale in the near term, we will assess Athabasca's cash flow and valuation assuming a transaction completed at 13.4x EBITDA for total proceeds of $250 million. The corresponding EBITDA loss would be $19 million as discussed earlier in this article. We also assume that the entire proceeds will be used for debt reduction, which results in interest savings of $25 million (9.875% on $250 million).

Athabasca does not currently face cash taxes, due to its operating losses so there is no impact from the tax shield. Most investors value upstream producers using debt-adjusted-cash-flow ("DACF"), not EBITDA. DACF is basically EBITDA subtract interest expenses, which means that Athabasca will actually increase its DACF metric by saving more interest than the loss of EBITDA, mainly due to expensive coupons on the existing debt and attractive multiple for its infrastructure assets.

Athabasca's net debt was $367 million as of 2018 Q1, representing only 1.7x net debt / 2019 DACF of $211 million. The proceeds from the monetization would reduce Athabasca's leverage from 1.7x DACF to 0.5x DACF, thus significantly strengthening its balance sheet and sets it apart from highly-levered peer such as Pengrowth.

Asset Sale Price	$250
EV/EBITDA Multiple	13.4x
EBITDA Loss	$19
Debt repayment	$250
Interest Savings (9.875%)	$24.69
Current Net Debt	$367
2019 DACF	$211
Current Leverage	1.7x
Pro Forma Net Debt	$117
Pro Forma 2019 DACF	$217
Pro Forma Leverage	0.5x

Click to enlarge

(Based on 2018 Q1 financials)

The potential impact on valuation is also significant should the asset sale go through. Using the $217 million of DACF derived above and apply our target multiple of 8.0x, we arrive at a target price of $3.14 per share, representing a 74% return over its share price of $1.80 per share.

Pro Forma 2019 DACF	$217
EV/DACF	8.0x
Enterprise Value	$1,733
Net Debt	($117)
Equity Value	$1,616
Shares Outstanding	515
Implied share price	$3.14

Click to enlarge

Q2 Could Be The Inflection Point

Q1 was a transitory quarter for Athabasca because the WCS differential reached over US$30 due to the spill and pipeline shutdown. However, the WCS differential has been significantly reduced and the continued normalization is expected due to new rail capacity and recent pipeline approvals. We expect Q2 to show a normalization in cash flow and investors would then get a sense of the earnings potential from Athabasca as Q2 represents a much more realistic run-rate for the company.

We expect production to remain heavily geared towards liquids and the light oil segment is expected to continue its aggressive growth agenda. Murphy's committed capital carry will provide an attractive way for Athabasca to retain upside while paying minimal funding. We look for continued growth in the light oil division and strong free cash flow as a result of minimal capital outlays.

Q2 will most likely prove to be a quarter that shows the true potential of Athabasca and we are expecting funds flow of $50 million which would imply 2018E funds flow of around $150 million. Note that our 2018 DACF estimate of $150 million is lower than our 2019 or run-rate estimate due to Q1 2018 results that were impacted by abnormally high WCS discount, which means that it has been reduced by the lost cash flow from Q1 this year.

Conclusion

We wanted to start by highlighting the biggest risk for Athabasca which is also a direct result of its strength, its immense torque to oil prices. Should WTI fall below US$60 for an extended period of time, we would expect cash flow to turn negative. However, we strongly believe that current oil prices are sustainable and see opportunities for further gains.

We won't belabor this article with our macro oil thesis but wanted to point out that ultimately, investors need to take a stance on where oil prices are going before investing in Athabasca. We see the company as one of the best opportunities given our bullish macro thesis calling for higher WTI in the near future.

Even if oil prices remain range-bound around US$68.00, we have highlighted that Athabasca is expected to benefit from two upcoming catalysts that we believe will yield a substantial upside for the stock price. The narrowing of WCS discount has already occurred during Q2 and we believe the upcoming earnings could drive this point home with investors. Regarding the announced process to monetize thermal oil infrastructure assets, we believe the market has not priced in potential proceeds and we see the potential for debt reduction and additional growth from higher capital programs.

Athabasca is the best way for investors to participate at the beginning of a trend that will see sentiment change for oil sands assets underpinned by the recent approval of Enbridge Line 3 and government backing for Trans Mountain Expansion. We think Athabasca shares have 42% upside based on current strip pricing and the upside increases to 68% should oil price stays at US$70. The outlook for WCS differential and Canadian heavy oil production remains positive and the sentiment could start turning as soon as Q2 as the differential has already narrowed substantially since Q1.

We also expect an update on the monetization process during the second half of 2018, which has an upside of 74% to the current share price. We believe now is the ideal time for investors to position themselves strategically in this oil sands stock.

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.

Analyst’s Disclosure: I am/we are long ATHOF. 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.