The Canadian oil industry is facing challenges that created misery for producers and investors.
2020 is a year to tread water and try to grow stronger.
A new joint venture may be an indicator of things to come as producers try to grow in a capital constrained environment.
Is this the time to sell or wait for better days.
The Canadian energy sector has been a very difficult space to operate in for quite some time. Pressures from environmental activists, both within and outside of the country, have hurt producers taking away their ability to move product to market and choking off needed pipeline expansion. Highly leveraged operators have been forced out of business as prices have continued to drift lower in an industry that just can't seem to catch a break. However, within this sector, there are a few shining lights. Companies that have taken advantage of opportunities that have come their way, producing solid cash flows while paying down debt and rewarding shareholders. Companies like Whitecap Resources (OTCPK:SPGYF).
There is more to Canadian oil than just the oil sands
The Canadian oil and gas industry is dominated by heavy oil producers, however, about 20% of Canada's oil production is conventional light oil. In this space, there are many players but the one I follow is Whitecap Resources who have quietly went about building capacity, strengthening their balance sheet and growing their dividend in what can only be described as a tumultuous time.
In their most recent investor presentation, Whitecap highlighted their financial target to generate total shareholder returns of between 10-15%. Although it's nice to pull out numbers like this, I think it is more important to evaluate their strategy to determine how they intend to achieve this goal. In the case of Whitecap, their plan centers on maintaining a strong balance sheet, paying a sustainable dividend and moderating their growth profile in order to operate profitably and support their ability to ramp up production when opportunity returns to the market.
In the oil and gas industry, you achieve profitability through a combination of productivity, price, and transportation as you remove the resource from the ground and ship it to refiners predominantly located in the USA. At times producers push to produce as much product as they can in order to increase cash flows and profitability based on the netbacks they receive from every barrel of oil. As prices fall and netback shrink, many producers increase production to generate additional cash flows. Unfortunately, this approach increases capital expenditures while flooding the market, creating additional pricing pressure as supply overwhelms the system.
With limited takeaway capacity coming online and the differentials between WCS and WTI growing significantly, in 2018, the Alberta Government chose to mandate production cuts as the differential between WCS and WTI approached $50 per barrel. That had ripple down effects across the industry, however, the move stabilized the price and narrowed the gap that existed between WCS and WTI. With a newly elected Conservative government in place, restrictions have begun to ease but the bulk are still in place.
These production cuts are looked at as a negative by many who wish to have the market determine efficiencies, but a combination of better pricing and a reduced need to invest in additional capex helped many producers. Currently, the differential is at $5 for MSW and $20 for WCS compared to WTI and is expected to remain in the $15-20 range for the coming year.
For Whitecap the restrictions have seen them take a more conservative approach. Rather than pumping money into their capex program to grow production, they are investing only enough to grow existing production levels modestly. Although this is anticipated to cut cash flows by 5%, a decrease of 8% in capex spending will mean that total free funds flow will remain fairly constant in 2020. Using this level of FFF, Whitecap was able to direct $100 million towards debt reduction in 2019 as well as contributing to share repurchases and increasing their dividend by 6%. Currently, the company has a debt to EBITDA ratio of 1.7x which is below their targeted 2x.
Designing their capital program for modest growth, funding the dividend within funds flow and providing substantial levels of free funds flow, the company expects to direct an additional $100 million to debt repayment, strengthening their balance sheet further while continuing to look at further share repurchases.
Participating in a new joint venture
Whitecap has also announced that they have entered into a joint venture with a private company to develop oil reserves in the Alberta deep basin. This project which has seen them complete a first new well will provide them the opportunity to expand drilling into further territory with the completion of 2 additional wells over the next 2 years.
This development is a creative way for the company to expand into new territory without the need to outlay significant new capital for additional land in a capital constrained environment. Whitecap expects to invest $14-15 million in the project in 2020 with the potential to ramp up production further in 2021. This investment in a highly productive part of Alberta has the potential to produce an additional 20-30 thousand barrels of oil per year. The investment came about after approaching their private partner earlier this year with a proposal to drill and earn sharing technology and capabilities at a reduced cost.
As a retiree all of this sounds good from a company health perspective but for me, the important part still remains the dividend and more importantly, will they be able to grow the dividend going forward. Since cutting their dividend in 2016 after the floor dropped out from under the price of oil, Whitecap has been steadily increasing their monthly dividend payout. This increase has followed their cash flow position, recognizing the importance of balance sheet health.
Whitecap is currently paying an 8% dividend to shareholders after a 6% increase earlier this year. Although this is generous, I do have concerns that it may stall until they can start moving their cash flows in the right direction. With the low current valuation on the stock, they may be more inclined to purchase shares as a way of rewarding shareholders.
I would like to believe that they will be able to continue raising their dividend once the price of oil starts to rise and production expands. However, based on their projected $55 price for oil in 2020 that may not be the case. A look at the chart below shows a slight drop in their dividend payout for 2020 which may be from the reduced share count, but not an increase as in 2018-19. The company has also indicated that they are capable of fully funding the dividend from existing cash flows provided the price of oil does not drop below $45.
Outlook for Oil
Despite efforts to transition to a greener world, the reality is that our dependence on carbon based energy is growing and not shrinking. The demand for oil and gas has never been greater but at the same time the supply of oil and gas has never been so fluid. The introduction of new technologies that have allowed tight oil to be accessed and brought online quickly and efficiently has changed the way the world has developed oil reserves.
As a net exporter of oil, the US has changed the landscape of the oil industry, reducing dependence on OPEC suppliers domestically while competing with them internationally. This increase in US production has kept the price of oil low, as efforts to bolster pricing, through OPEC cutbacks in production, are quickly met with increased outputs by US producers.
Although OPEC countries do enjoy a cost advantage over US producers, they are forced to choose between flooding the market to drive out US competition at lower prices and cutting back production to stabilize prices but seeing more supply come online. Either way, this is causing a ceiling for oil prices not experienced in the past.
Whitecap is well positioned to compete in the North American Market
Tight oil production is different than conventional oil in that the initial capital cost is lower but the decline rates are much higher. In addition, it is not uncommon for tight oil sites to deplete 2/3 of their output from a well in the first 2 years of its production then depleting the remaining 1/3 over the remaining life of the well which may be 10 years. That means that as the price of oil drops, the payout period to break even on a well goes up. If the payout period extends too far, then it becomes uneconomical for producers to break even. Currently, the median payout period is 1.6 years so drilling these wells can be very price sensitive.
Whitecap is very well positioned in the tight oil industry as evidenced by the chart above. The half cycle payout period for most of their wells is well below the North American median, allowing them the ability to operate profitably in a sensitive pricing market. In addition, their decline rates are among the best in North America meaning their investments continue producing at a higher output for much longer than the norm. This also allows them to invest less capital to maintain production than many of their competitors.
In the current market environment, Whitecap has operating expenses of $12.56/boe and has indicated they are fully capable of implementing their strategic plans even if the price of oil drops as low as $45 WTI. At this price, many US producers could not function due to their higher costs of production and faster decline rates.
Warren Buffett once said that when investing, "the rear view mirror is always a lot clearer than the front windshield", and that is surely the case with Whitecap. I invested in Whitecap several years ago because I liked the way they ran their business using a more cautious balance sheet focused approach. I liked their dividend and their future prospects looked good. In some regards that has not changed, but in others it has.
Getting caught up in the oil price collapse over the past 5 years, their cautious approach and focus on the balance sheet have meant that they have been able to weather the storm better than a lot of their peers. That is of little solace to investors who have seen their investment fall by 75% but the focus of an investor should be on the front windshield, not the rear view mirror. The current price of the stock reflects the industry as a whole and has been beaten down to record lows. Can it go lower, possibly? Can it go higher, definitely? I am of the mindset that the stock will rebound but this puts me in an uncomfortable place.
I am an investor, not a trader. I didn't retire to take on another full time job trading stocks and I fear that Whitecap is moving into the realm of the trader. Having followed the company closely for several years, I have watched the price fluctuate wildly based on macro events that have impacted the price of oil and pipeline capacity. This will continue creating opportunities for some and risks for others.
Personally, I do believe there is short-term upside to the stock based on current valuations and steps the company is taking to strengthen their financial position. For this reason, I will be holding on to what I have but will be looking for an exit point into something more in line with my buy and hold forever approach to investing, if that's possible. In a de-carbonizing world, companies like Whitecap present many questions for investors and face many challenges in the years ahead.
Disclosure: I am/we are long SPGYF. 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.