Seeking Alpha

No One Cares That Advantage Oil & Gas Discovered Oil

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About: Advantage Oil & Gas Ltd. (AAVVF)
by: Long Player
Long Player
Long/short equity, value, special situations, contrarian
Summary

The oil discovery announcement was basically ignored.

The supporting infrastructure is in place for the transition to a higher percentage of liquids production.

Mr. Market places no value to the transition to more liquids production.

The long-term debt level is very conservative when compared to cash flow.

The discovery will jump start the process to a lot more oil production in the future.

Advantage Oil & Gas (OTC:AAVVF) demonstrated just how out of favor the oil production industry is when management announced an oil discovery and the market basically yawned. This primarily dry gas producer now has a "leg-up" on many dry gas producers when transitioning to more profitable liquids production.

Source: Seeking Alpha Website December 1, 2019

The discovery announcement at the beginning of September caused the stock to recover much of its previous losses at the end of August. Since then the stock has really gone nowhere. Evidently no amount of future oil production can get this stock out of the doghouse.

An obvious way to fund the transition is to use the cash flow from the established dry gas production to drill for much more profitable oil. Then the cash flow increases even when production does not increase. Eventually there will be enough light oil production to ensure both cash flow growth and production growth unless commodity prices sustain a significant collapse for a while. This transition strategy has to be one of the safer upstream long-term strategic moves in the business. Yet Mr. Market clearly has reacted as though there is no strategic change in the works.

The Discovery

Advantage had been acquiring more potentially liquids rich acreage for some time. Then beginning in 2017, management began to evaluate the acreage. Now it appears an optimal or at least highly satisfactory well process has been designed.

Source: Advantage Oil & Gas October 2019 Investor Presentation

The importance of an oil discovery announcement to this dry gas producer is very hard to overstate. Generally liquids represented much less than 10% of total production as reported by the company. A discovery such as this has the potential to materially change the mix towards a far higher percentage of liquids overnight. Management can easily double liquids production from current levels even under a lower capital budget. That production doubling should overwhelm any unfavorable gas pricing news for the foreseeable future.

Source: Advantage Oil & Gas October 2019 Investor Presentation

Before the discovery was announced, management had simply shifted activity to another interval in this stacked play to produce a higher liquids percentage. Over the last year, the production of liquids as a percentage of total production doubled. This increased the profitability per barrel even though production did not increase at historical rates.

Now the announced discovery should ensure some very significant profitability leaps in the future even if the gas market continues to remain at low prices. The competition for capital dollars will depend upon profitability. However, several relatively new intervals appear to be early favorites for the future capital budget.

Future Guidance

The market has left this company in the dry gas producer graveyard. "Everyone" knows that Canadian dry gas producers are as good as dead. Therefore no one is paying attention to any dry gas producer that significantly changes future corporate strategy.

The company can use the dry gas production as a continuing ATM to fund the transition to more profitable liquids. This is an advantage that many smaller competitors (and startups) do not have.

(Canadian Dollars Unless Otherwise Stated)

Source: Advantage Oil & Gas October 2019 Investor Presentation

Management already has a lot of supporting infrastructure in-place with some excess capacity. Generally speaking, supporting infrastructure capacity increases are not a high risk proposition. Nor is the idea of more liquids production high risk after the solid delineation of the property.

(Canadian Dollars Unless Otherwise Stated)

Source: Advantage Oil & Gas Third Quarter 2019, Earnings Press Release

Yet the market is clearly depressed about the future of this company. The current stock price is slightly more than two times adjusted funds flow per share. That adjusted funds flow is comparable to the previous year as management carefully controls costs.

Increasing percentages of liquids production should dominate any negative dry gas pricing comparisons to ensure continued adjusted funds flow growth at a brisk rate. That scenario did not quite play out in the third quarter. But it appears to be holding true for the fiscal year comparison. As liquid production grows as a percentage of production, the growth will yield a rising funds flow per BOE in future quarters.

Yet the enterprise value of the company currently trades around 4 times adjusted cash flow. That is not a multiple one would expect for a company that announced a significant oil discovery which will jump start the transition to more profitable liquids production.

The long-term debt (bank indebtedness) shown above is only slightly higher than the projected cash flow for the year. It will not take too many oil production wells to significantly increase the cash flow in the next fiscal year.

Note that management has slowed the growth of production from historical levels while the transition to a more liquids based production is underway. However, the growth in cash flow is very unlikely to slow from historical levels while the transition to more liquids production is underway. Profitability should continue to significantly increase also.

Summary

Clearly Mr. Market is not expecting much of a future for this company. However the strong balance sheet, the rock bottom costs, and an oil discovery give this company a significant advantage over many competitors in Canada.

This well run Canadian company could be an acquisition candidate if the market does not wise up to the superior future prospects of this stock.

Source: Advantage Oil & Gas October 2019 Investor Presentation

Management has a clearcut plan to increase corporate profits. The plan is actually fairly routine and low risk. Even though the market is disregarding the viability of the plan, investors can probably do very well long term with an out-of-favor stock like this one. No major discoveries are required for significant profit improvement. Management knows the basin very well because this management has long operated in this basin.

The strategy to change towards oil production is actually fairly conservative. The stock clearly has a lot of failure priced in and not much success. A far more usual pricing would be around 10 times current cash flow. Cash flow is very likely to increase by at least 20% annually unless oil prices sustain a sharp price decline from current levels.

The market really has discounted the time needed to complete supporting infrastructure for more liquids production. But such infrastructure is not a material issue because that structure is an add-on to existing gas handling structure. It would be far different to construct the needed infrastructure when no existing processing capability existed in the first place.

The company is in a position to borrow money for expansion should the industry outlook improve materially from current conditions.

There is a lot of talk about small oil and gas company risk. But the low current price, the low corporate debt (compared to cash flow) and the generous cash flow per share all mitigate the risk of long-term investment principal loss. On the other hand, a return to even modest favor in the eyes of Mr. Market should promise at least a doubling of the current stock price.

Fast growing stocks like this one usually become star performers in the eyes of Mr. Market. Cash flow and profitability should show considerable improvement as the production increases are held to modest levels until the strategy transition is complete. Therefore this stock should be worth considering for a wide variety of investors due to its superior long-term prospects with relatively minimal long-term risks for an oil and gas producer. Investors can be sure that management will advertise oil production results as the discovery is exploited.

Disclosure: I am/we are long AAVVF. 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.