Athabasca Oil: The Need For Scale
Summary
- The per unit costs decreased during Q3 thanks to the growing production. And with higher oil prices, the funds flow increased QoQ and YoY.
- Management communicated a flexible capital program for 2019. But the decision to reduce the oil production in Alberta impact the strategy.
- The low flowing barrel valuation reflects the lack of scale to reduce the costs.
Athabasca Oil (OTC:ATHOF) Q3 results show the increase of the production lowered the per unit costs. Also, with high oil prices, the company generated positive total netbacks.
Management communicated the 2019 capital program would depend on the oil prices. But with Notley's decision to reduce the oil production in Alberta, the company will not have much flexibility.
In any case, the flowing barrel valuation is low. The market takes into account the lack of scale. The company needs to grow the production to lower the per unit costs and to enhance the free cash flow potential.
Image source: jplenio via Pixabay
Note: All the numbers in the article are in Canadian dollars unless otherwise noted.
Q3 earnings
Production grew by 12% YoY to reach 40,612 boe/d.
Source: Q3 2018 MD&A
As the production is growing, the per unit costs dropped compared to last quarter.
Source: Q3 2018 MD&A
We can see Athabasca realized lower netbacks compared to MEG Energy (OTCPK:MEGEF). The comparison is not perfect as the companies don't produce the same parts of heavy oil, light oil, and gas. But this table shows Athabasca needs higher oil prices than MEG Energy to operate at a profit.
The realized prices improved QoQ and YoY thanks to improved liquids prices during Q3.
Source: Q3 2018 MD&A
As a result of a higher production, improved prices, and lower per unit costs, adjusted funds flow reached a record C$62.2 million.
The net debt amounts to C$372 million. Considering the record quarter, the net debt to annualized adjusted funds flow ratio amounts to a reasonable 1.5. But if we consider TTM adjusted funds flow ratio, the ratio rises to 3.
Adapting to WCS prices
As bitumen represents 75% of the production, the company depends on the WCS prices. And considering the drop in WCS prices since the end of Q3, management announced slowing down the thermal oil production by 5,000 to 8,000 boe/d for the rest of the year. Despite this limitation, management maintained the FY 2018 guidance.
Source: Q3 2018 press release
The modest hedging position is favorable to the company but it covers less than 20% of the total production. And the company has no hedge after Q4.
Source: Q3 2018 MD&A
Management indicated the 2019 capital program would stay within cash flow. Even if the current depressed prices persist, the low 10% production decline will allow the company to maintain the production with a modest capital.
Management stated:
The Company’s priority is to maintain balance street strength by aligning 2019 activity levels to forecasted cash flow and is prepared to implement a minimal capital program until Canadian differentials improve. Growth projects beyond this level will be evaluated in the context of maintaining financial flexibility, corporate free cash flow and external market conditions. - Source: Q3 2018 MD&A
But since this communication, Rachel Notley imposed restrictions on oil production in Alberta during 2019 to compensate for the lack of oil transportation capacity. This decision will reduce the flexibility of the capital program.
Impact of the oil production cut in Alberta
As shown in the picture below, the whole production is located in Alberta. Thus, Athabasca is part of the Canadian producers that will have to reduce the production.
Image source: Presentation September 2018
The decision doesn't impact the first 10.000 boe/d, but it still impacts about 30,000 boe/d, or 75% of the production.
As shown in the graph below, management had communicated on a 10% production CAGR till 2020.
Image source: Presentation September 2018
We have seen above that the scale allowed the company to reduce the costs per unit. These lower costs and higher volume translate into higher free cash flow, as shown in the graph above.
Thus, the decision to cut the production will help the company in the short term as higher WCS prices will support higher cash flows. But the lower production volume will increase the costs per units. It will also delay the important free cash flow potential the company can realize with scale.
Valuation
The table below compares the flowing barrel valuations betweem Athabasca Oil and MEG Energy. 
Source: author
MEG Energy realizes higher netbacks than Athabasca. But Husky's offer is a factor in the much higher valuation of MEG Energy compared to Athabasca.
In any case, Athabasca's flowing barrel valuation is modest. But it takes into account the high oil prices and the scale the company needs to generate free cash flow.
Conclusion
During Q3, Athabasca lowered the costs per units thanks to the growing production volume. And with higher oil prices compared with last year, the company generated positive netbacks.
Management had communicated a plan to grow the production at a CAGR of about 10% till 2020. But the recent decision to reduce the oil production in Alberta impacts this goal.
The production decline in Alberta will support higher WCS prices. But a lower production will involve higher per unit costs. This decision also penalizes the free cash flow potential management planned to generate with a higher production volume.
The low flowing barrel valuation reflects the lack of scale and the need for high oil prices to generate an important free cash flow.
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