NuVista Energy: Limited Capital Allocation Decisions

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About: NuVista Energy Ltd. (NUVSF)
by: Hervé Blandin
Summary

NuVista Energy published Q2 earnings with no surprise, and management confirmed the guidance.

I realized I had overlooked an issue that may explain the negative market reaction.

The valuation is attractive but there are better opportunities in the current Canadian oil environment.

After the release of NuVista Energy's (OTCPK:NUVSF) Q2 earnings yesterday, I realized I had missed an important aspect of the company in my previous articles.

The results didn't bring any surprise and management confirmed the guidance. The issue I had overlooked may explain the 13.51% drop in the stock price.

The company was already underperforming its peers since the beginning of the year. And the increase in the Canadian Crude index by 26.76% contrasts with the drop in the stock prices of Canadian oil and gas producers.

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Yet, I still think NuVista is an attractive investment proposition. But, considering the valuations of Canadian oil and gas producers in the current context, there are better opportunities.

But before getting into the valuation, I'll have a look at the Q2 results and I'll discuss the issue I overlooked.

Oil gas rig Image source: Anita_starzycka via Pixabay

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

Q2 results with no surprise

The Q2 production of 50.391 boe/d reached the top end of the guidance range of 48,000 boe/d to 51,000 boe/d.

NuVista Energy Q2 earnings: production

Source: Q2 2019 MD&A

But the year-over-year lower benchmark liquids and gas prices impacted revenue. For instance, NGL prices dropped 81% to C$7.21/boe.

NuVista Energy A2 earnings: benchmark prices

Source: Q2 2019 MD&A

Thus, despite a 40% production volume increase compared to last year, revenue stayed stable at approximately C$137.7 million.

NuVista Energy Q2 earnings: revenue

Source: Q2 2019 MD&A

With no surprise, per-unit costs stayed stable compared to the previous quarters. I also listed the costs of Kelt Exploration (OTC:KELTF) and Paramount Resources (OTCPK:PRMRF) as they produce similar portions of liquids and gas. Despite its higher portion of liquids, I also include Seven Generations (OTC:SVRGF) in the comparison as it's also a condensate-oriented producer in the Montney area.

NuVista Energy Q2 earnings: costs and netbacks

Source: Author, based on company reports

I updated my sustaining costs estimates from C$10.29/boe to C$12.09/boe. In a previous article, I had estimated the sustaining costs based on the 3-year average proved FD&A costs.

But, in its latest presentation, management forecasted sustaining costs would amount to about C$300 million when production reaches 68,000 boe/d. The corresponding per-unit cost is C$300 million/(68,000 boe/d/365 days) = C$12.09 boe/d. As I always prefer to stay on the conservative side, I now consider the sustaining costs of C$12.09/boe.

Even with the higher sustaining costs estimate, the company generated an average total netback of C$4.2/boe over the last three quarters, in a challenging commodity price environment.

Because of lower natural gas and NGL prices, and despite higher production volume, adjusted funds flow decreased to C$64.3 million compared to C$71.6 million during the previous quarter.

And with a capex of C$89.2 million, the free cash flow was negative and the net debt increased.

Net debt to annualized current quarter adjusted funds flow ratio increased to 2.2x from 1.9x at the end of last year. But production is expected to increase. And if commodity prices don't further deteriorate, funds flow will increase and the leverage ratio will decline.

The price of commitments

Management confirmed the production guidance of 51,000 boe/d to 54,000 boe/d. But it also indicated that, with a capital program in the low end of the guidance of C$300 million to C$325 million, the production volume would also be close to the low end of the expected range.

With C$136 million of adjusted funds flow during H1, the Montney producer will generate negative free cash flow in 2019 to grow its production. And management expects this trend to continue in 2020.

This strategy contrasts with the shift to flat production from many Canadian producers. With the volatility of liquids and gas prices, the egress limitations, and the levels of debt, their priority is now to generate free cash flow.

But following its Pipestone acquisition last year, NuVista Energy negotiated take-or-pay commitments for a production of 68,000 boe/d by 2021.

NuVista Energy A2 earnings: commitments

Source: Presentation August 2019

Management highlighted the company's flexibility once production reaches 68,000 boe/d:

In 2021, we are fortunate to have the option to moderate growth or flatten production near 68,000 Boe/d, corresponding to our future minimum take-or-pay volume commitments. Continued growth beyond 68,000 Boe/d toward our existing firm infrastructure access of 90,000 Boe/d is an option which will be carefully weighed alongside other uses of the forecast free funds flow based on the best shareholder return scenario available at the time." - Source: Press release Q2 2019

But the issue I missed in my previous articles is the company doesn't have many options besides growing to meet its medium-term commitments. Despite the volatility around Canadian liquids and gas prices, and with higher leverage, the company plans to outspend its adjusted funds flow. The goal is to increase its production by 10% to 15% per year until it reaches 68,000 boe/d by 2021.

At current strip prices, the situation isn't desperate, though. With a WTI price of US$55/bbl, the company will keep its leverage ratio at about 2x.

NuVista Energy Q2 earnings: forecasted leverage ratios

Source: Presentation August 2019

But if WTI prices drop below US$55, the company will be in a difficult situation. Either the leverage will increase, or transport commitments won't be met, which will impact profitability.

Thus, the market doesn't seem to appreciate the lack of flexibility and the potential negative free cash flow over the next few years.

Valuation

I discussed above my total netback estimate of C$4.2/boe over the last three quarters. This calculation takes into account my higher sustaining capex assumptions. Also, liquids and gas prices weren't favorable during that time.

I apply a 12x multiple to the estimated profits corresponding to a flat production. I also took into account the low end of the 2019 production guidance.

NuVista Energy Q2 earnings: intrinsic valuation

Source: Author, based on company reports

With these conservative assumptions, the stock price is 47% below my fair value estimate.

The flowing barrel valuation indicates the company isn't overvalued compared to some of its peers. The market even values NuVista at a discount to Paramount Resources despite NuVista's higher portion of liquids production and higher total netbacks.

NuVista Energy Q2 earnings: Flowing barrel valuation

Source: Author, based on company reports

The discount to Seven Generations is justified, though. Seven Generations' capital structure is much safer and it produces a higher portion of liquids. Also, the company has much more flexibility than NuVista. Seven Generations already reached a reasonable scale with production above 200,000 boe/d and it doesn't depend on higher commitments.

With the information NuVista provided in its latest presentation, we can assess the free cash flow yield, based on a flat production of 68,000 boe/d by 2021/2022.

NuVista Energy: free cash flow potential

Source: Presentation August 2019

I have highlighted in red the important assumptions. At a WTI price of US$55/bbl, the company expects to generate approximately C$50 million of free cash flow to hold its production flat at 68,000 boe/d by 2021/2022. With a WTI price at US$65/bbl, the free cash flow estimate increases to C$150 million.

Considering the stock price currently at C$2.24, the market capitalization corresponds to a free cash flow yield between 10% and 30% at a WTI price of US$55/bbl and US$65/bbl, respectively.

If we assume the same total netback as during the last three quarters, the free cash flow will amount to C$4.2/boe * 68,000 boe/d * 365 days = C$104 million. The corresponding 20% free cash flow yield is attractive.

Thus, at a stock price of C$2.24, NuVista Energy is an attractive investment proposition. But, at an equivalent valuation, Seven Generations is a much safer investment with lower leverage and more flexibility.

Conclusion

Despite Q2 results with no surprise, the stock price dropped by 13.51%. With these earnings, I realized NuVista lacked flexibility over the next couple of years because of its important take-or-pay commitments.

To meet its obligations, the company must increase its production in a challenging oil and gas environment. Despite positive total netbacks, the market doesn't seem to appreciate the increase of the net debt that corresponds to the production growth.

The lower stock price represents an investment opportunity, though. But considering the depressed valuations in the Canadian oil and gas industry, safer investment propositions exist. For instance, the market values Seven Generations, another condensate producer in the Montney area, at about the same price as NuVista. Yet, with lower leverage, Seven Generations reached a higher scale and has much more flexibility to allocate its capital.

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Disclosure: I am/we are long SVRGF. 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.