Surge Energy Earnings: Heavy Losses

|
About: Surge Energy Inc. (ZPTAF)
by: Hervé Blandin
Summary

Surge Energy released the Q4 results.

The company generated negative total netbacks because of the depressed WCS prices.

Yet, the market doesn't value the company at a discount compared with similar producers that generate higher netbacks.

The discount to my estimation of fair value is not important enough to justify buying shares.

Surge Energy (OTCPK:ZPTAF) released its Q4 results. The depressed Canadian oil prices, especially with the WCS prices, impacted the company. The total netbacks amounted to a negative C$17.04/boe after hedges.

Management communicated a reduced 2019 capital program to avoid increasing the net debt while targeting production of about 22,000 boe/d.

Despite these difficulties, the discount to similar producers that generate higher netbacks is not obvious. And the discount to my estimation of fair value is not important enough to justify buying shares.

Image: Surge Energy

Note: All the numbers in the article are in Canadian dollars unless otherwise noted.

A disastrous quarter

As a result of the Mount Bastion acquisition, the Q4 production grew by 34.3% year-over-year to reach 21,047 boe/d.

Surge Energy Q4 earnings: production

Source: Q4 2018 MD&A

The depressed Canadian oil prices during Q4 impacted the company. The realized price dropped to C$30.02/boe from C$54.89/boe during the previous quarter.

Surge Energy Q4 earnings: realized prices and benchmark prices

Source: Q4 2018 MD&A

The decrease is important as a part of the production depends on the WCS prices.

The company doesn't provide much information about its exposure to different hubs, though. But the 2018 Annual Information Form suggests heavy oil volume represents about 25% of the total production. Most likely, the company sells this heavy oil production at WCS prices.

Surge Energy production mix

Source: Annual information form 2018

Whitecap Resources (OTCPK:SPGYF) and Torc Oil & Gas (OTCPK:VREYF) operate a similar production mix.

Surge Energy Q4 earnings: production mix compared with Whitecap Resources and Torc Oil & Gas

Source: Author, based on company reports

But these two companies, with no exposition to the WCS prices, reported higher realized prices than Surge Energy during Q4.

The table below compares the realized prices and the per-unit costs of the three producers.

Surge Energy Q4 earnings: costs and netbacks

Source: Author, based on company reports

The total cash costs are similar. But the lower royalty costs offset the higher operating costs for Surge Energy.

Also, due to acquisitions and with the growth profile, assessing the replacement costs (DD&A) is challenging. The three-year average proved FD&A costs from the 2018 reserves report amount to C$17.77/boe.

Surge Energy FD&A costs

Source: Q4 2018 press release

But the proved FD&A costs in 2018 and the Q4 DD&A costs from the income statement amount to C$25.34/boe and C$20.29/boe. Besides, the company doesn't communicate the sustaining costs. Thus, I chose the DD&A costs from the income statement as an approximation of the replacement costs. These costs are in the middle of the range of the different FD&A costs listed in the reserves report.

As a result of depressed realized prices during Q4, the company generated a total negative netback of C$17.04/boe after hedges.

Adjusted funds flow dropped to C$6.2 million against C$40.6 million during the previous quarter. And with a capex at C$33.6 million and considering the C$299 million acquisition, the net debt increased to C$461.2 million. The net debt to TTM adjusted funds flow ratio reached a high level at 4.1. But this ratio is inflated as the Mount Bastion acquisition contributed only two months to the company's results.

Also, because of the Canadian oil prices, the company recorded an impairment of C$72.2 million in 2018 after another impairment of C$24.1 million in 2017.

Not a bargain

With this context, management reduced the 2019 capital program to C$135 million. The goal is to pay the dividend and support the capex within the cash flow while targeting a production volume of about 22,000 boe/d.

Considering the lower netbacks the company generates compared with Whitecap Resources and Torc Oil & Gas, the lower flowing barrel valuation is logical.

Surge Energy Q4 earnings: flowing barrel valuation compared with Whitecap Resources and Torc Oil & Gas

Source: Author, based on company reports

And, based on the reserves, the market doesn't value Surge Energy at a discount compared to the two other producers.

Source: Author, based on company reports

The market even considers Surge's resources are worth more than Whitecap Resources.

Due to the volatility of the netbacks, the calculation of the intrinsic value is tricky. The total negative netback of C$17.04/boe during Q4 contrast with the positive netback at C$8.64/boe during the previous quarter.

If I assume the company will generate a total netback of C$7/boe over the long term, my estimation of fair value amounts to C$2.18/share. This estimation corresponds to a 12x multiple of the profits from the total netback of C$7/boe while keeping the production flat.

Surge Energy Q4 earnings: Estimation of intrinsic value

Source: Author, based on company reports

With a stock price at C$2.18, the market currently offers a 36% discount to my estimation of fair value. But the volatility of the netback is important. The 36% discount to the estimation of fair value is not wide enough to represent a sufficient margin of safety.

Conclusion

The exposure to the WCS prices depressed the Q4 results. The company generated a negative total netback of C$17.04/boe after hedges.

With the uncertainties around the Canadian oil environment, the company reduced the capex. The goal is to pay the dividend and reach a production of 22,000 boe/d without extra debt.

Yet, taking into account the valuations of the reserves and considering the flowing barrel valuation, the discount to other producers generating higher netbacks is not obvious. Also, with the volatility of the results, the 36% discount to my estimation of fair value doesn't constitute a sufficient margin of safety.

Note: If you enjoyed this article and wish to receive updates on my latest research, click "Follow" next to my name at the top of this article.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.