Canacol Energy: Colombia's Largest And Cheapest Independent Natural Gas Producer

Summary

• Solid expansion plan: ~200mmcfpd by June 2019 and ~315mmcfpd by 2022 and replacing Chevron as the largest supplier of gas to the Caribbean coast.
• Fixed contracts should guarantee strong and predictable cash flow from operations: ~$160MM by the end of 2019, ~$200MM-2020 and ~$250MM- 2022 with ~50% CFO to revenue ratio.
• Capex ~$100MM-$120MM to maintain 200% replacement ratio goal with a 80% success rate.
• Comfortable bullet maturity in 2025, but interest expenses are burdensome and should be reduced.
• 2P Reserves at 559 BCF. Significant reserves could be added this year through Acordeon-1 exploration. Up to 100 Bcf of unrisked recoverable gas resources.

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Colombia’s Natural Gas Supply Deficit

According to Wood Mackenzie and UPME, the demand for natural gas is expected to grow 3% annually until 2025.

Canacol is replacing Chevron as the largest supplier of gas to the Caribbean coast as the 3 most important fields of gas in Colombia are located on the Caribbean coast: Chuchupa, Ballena and La Creciente (in the interior). These fields are depleting their production at a rate of 20% per year due to their natural maturation.

The Caribbean region consumes approximately 37% of the gas generated in the country. Canacol has a long term strategy to provide natural gas as its projects formed part of a wider plan to ensure Colombia's energy security amid rising demand from thermoelectric generators and industrial sector. Over the last 6 years, Canacol has become the only active explorer.

Solid Plan Expansion: Projects and Catalysts

Canacol has had a strong and consistent production and sales growth over the last years:

"Source: Company"

• Promigas: Jobo and Cartagena pipeline

The Promigas expansion between Jobo and Cartagena is on target to deliver an additional 80 MMscfpd of new transportation capacity in June 2019, which will raise gas sales to approximately 215 MMscfpd for the rest of 2019. This means an average production of ~170mmcfpd-180mmcfpd in 2019.

• Road to Medellín

Finally, progress is being made towards signing sales and shipping agreements for a new pipeline that will transport 100 MMscfpd of new gas sales from Jobo to Medellin in 2022.

Given the length of the path, which is approximately 300 kilometers, they are looking at the potential cost of a 20 inch pipeline with first stage compression in the range of $350 million of cost to build the project.

Whether that's with existing pipeline operators in Colombia or with a private consortium, their strategy is to participate as a working interest partner at 25% so that they can affect the timing of the project, specifically the delivery dates, given their expertise with respect to managing environmental processes and the community issues.

With respect to the rationale of choosing to expand to Medellin instead of Cartagena and Barranquilla, they see quite sufficient transportation capacity to Cartagena. They have chosen to expand their footprint to the interior.

For the next years, production and revenue outlook should be something like this:

"Source: Author based on Company data"

"Source: Author based on Company data"

Reserves and operations: A history of discovery and success

"Source: Company"

They have a success rate of exploration of 83% and a 2P reserves historical CAGR of 55%. Massive reserves, with massive potential up to 2.6TCF (prospects and leads included):

"Source: Company"

Reserves	Bcf	After tax NPV-10
1P	380	$784,700,000
2P	559	$1,082,000,000
3P	739	$1,324,500,000

Click to enlarge

"Source: Company"

Acordeon: A boost in reserves?

Looking forward to the remainder of 2019, they are about to spud Acordeon‐1, their first exploration well of the year. Acordeon‐1 is close to the Clarinete field. The well will take approximately five weeks to drill, complete and test and has the potential for a significant increase in reserves, up to 100bcf. As per the last conference call:

"... going to the forecast for a potential unrisked prospective resources at Acordeon, we're looking at a pre-drill estimate for the entire Acordeon accumulation of up to 100 Bcf of unrisked recoverable gas resource in Acordeon.

So it's a material prospect. It's on trend with Clarinete, which of course is a 200 Bcf discovery that we made in 2014. So, we're very excited and it's a high impact exploration well for us, the first well for us this year."

Canacol expects to produce 65Bcf of natural gas this year with an average production of ~180mmcfpd. A 100Bcf discovery would mean a net increase of 35Bcf, or a ~6% increase in 2P reserves, just with Acordeon itself.

Financials

The key point of Canacol is that they expect to produce 200-215mmcfpd of natural gas production probably by end of June.

With revenues already fixed at ~$4.96/Mcf, netback of ~$4/Mcf that is about ~$270MM ebitda and $190MM cash flow from operations (in the last years they have a cash flow from operations to revenue ratio of about ~45%-~50%, lately at 58.7%, funds from operations/revenue).

The average this year will be lower at ~170MMcfpd-180MMcfpd, so we should expect ~$310MM of revenue, ~$215MM ebitda and ~$160MM of operating cash flow.

• Debt

Net debt is ~$343MM with a one bullet maturity in 2025.

There is plenty of room to pay down debt as free cash flow generation should be very strong from 2020 onwards.

However interest expenses are burdensome and I do not like to see ~$30MM every year until 2025. Management seems to prefer exploring and adding reserves rather than paying down principal and reducing interest expenses.

I am fine with a 83% success rate, but what if this rate drops to 50%? Debt is a risk. If Canacol is going to make tons of free cash flow as they should, they must repay some debt at least.

"Source: Company"

• Capex

Capital expenditures should be around ~$100MM-$120MM. Jason Bernad, CFO of the company said this just few days ago:

" But of course, every year we have – we drill exploration wells and we intend to continue that activity. So we drill on average 8 to 10 wells per year. So if three of those are maintenance development wells, seven will be other wells, seven or – six or seven will be other wells, plus we continue to acquire 3D seismic over our exploration acreage to firm up our portfolio with future drilling. So I think we can realistically say that in terms of CapEx going forward, we're probably in the range of up to $100 million of CapEx per year for all of those activities. "

• Net cash generation

Let´s take this year as an example:

1. Production: 170MMcfpd
2. CFO to Revenue ratio: ~50%
3. Success rate: 80%
4. Cash flow from operations: $160MM
5. Total Capex: $120MM
6. FCF: $40MM
7. Interest:$30MM

*Note: I treat operating cash flow and FCF as if they were independent of financing and nonoperating items. Instead, interest expenses are treated as a financing cash flow.

Estimated FCF of about $35MM-$40MM will have to serve interest expenses and debt principal. As there is no maturities until 2025, but ~$30MM of interest expenses every year, FCFE will be close to zero or slightly positive, so no food (cash) for shareholders this year, other than a net increase in reserves.

The story is completely different once they average ~215mmcfpd in 2020 and ~300mmcfpd in 2023:

"Source: Author based on Company data"

"Source: Author based on Company data"

"Source: Author based on Company data"

With the following assumptions, a DCF valuation shows there is enough upside to wait patiently until cash arrives:

1. Price per MCF at $4.96 every year until 2025. Canacol uses higher forecast (page 24).
2. CFO to Revenue ratio at ~50%.
3. Lower production than their forecasts. Canacol see production at 315mmcfpd in 2022 (page 7) and an average of 179mmcfpd this year. I do not see that until 2023-2024.
4. Total capex at $120MM every year until 2025.
5. 2P reserves CAGR at ~5% to 2025."Source: Author based on Company data"

Risks

Among others:

1. Execution and delays risks until pipelines are completed.
2. New regasification plant. Second regasification plant in the country, located in the Pacific, has been considered, which would represent a risk since it would be direct competition for Canacol Energy. However, prices of natural gas offered by the Pacific regasification plant would be much higher than $5 per Mcf.
3. Overspend in capex and a sharp drop in success rate.

Conclusion

Canacol is a company with a clear competitive advantage, management with ~25% share, limited competition, fixed revenues, massive reserves and a solid plan to expand its footprint along with a strong and predictable free cash flow generation. The execution so far has been good, and we should see a strong cash stream coming for the next years.

From our point of view, this company is greatly undervalued at these prices.

Disclosure: I am/we are long CNNEF. 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.