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Advantage Oil & Gas: Not An Investment Opportunity Anymore

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About: Advantage Oil & Gas Ltd. (AAVVF)
by: Hervé Blandin
Hervé Blandin
Long only, value, long-term horizon
Summary

Advantage Oil & Gas' 2020 capital program seems disappointing when compared to the company's three-year plan.

Despite a strong increase in liquids production, positive free cash flow remains unlikely in 2020.

Because of its higher stock price and its weak guidance, I don't consider Advantage Oil & Gas as an investment opportunity anymore.

A few days ago, Advantage Oil & Gas (OTC:AAVVF) announced a disappointing 2020 capital program when compared to its three-year plan. That multi-year plan, communicated at the end of 2018, envisioned an increase in the company's liquids production to improve its profitability and reduce its debt load.

But despite a recent oil discovery in its Progress area, the company's forecasted 2020 production and its liquids portion should be lower than previously anticipated. Also, management doesn't expect the company's net debt-to-adjusted funds flow ratio to decrease anymore.

In my previous article, I had described Advantage Oil & Gas as an investment opportunity over the long term. Since then, its stock price increased by 30%. And given the company's weak guidance for this year, the margin of safety diminished. Investing in this Canadian oil and gas producer has become riskier.

Gas rig

Image source: Anita_starzycka via Pixabay

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

Advantage Oil & Gas' three-year plan vs. its 2020 capital program

Before getting into Advantage Oil & Gas' 2020 capital program, let's have a look at some of the most important aspects of its three-year plan.

The chart below shows the company foresaw to increase its production to a range of 46,000 boe/d (barrels or equivalent per day) to 48,000 boe/d in 2020. And liquids production was planned to increase from 7% of total production in 2019 to 15% in 2020.

Advantage Oil & Gas

Source: Investor presentation May 2019

Management had estimated a capital program of C$225 million in 2020 would deliver this expected production growth. It also ensured this capital program would remain below its expected adjusted funds flow of C$235 million to generate positive free cash flow and decrease the company's net debt-to-adjusted funds flow ratio to 1.2.

Advantage Oil & Gas

Source: Press release November 2018

In contrast with those numbers, the 2020 guidance indicates Advantage Oil & Gas will not deliver according to its three-year plan.

The company's 2020 capital program in the range of C$170 million to C$200 million stays below the estimated three-year plan's capital program of C$225 million. And because of this reduced capital program, the expected total production dropped to a range of 45,000 boe/d to 47,500 boe/d.

Also, the midpoint of the 2020 guidance range implies liquids will represent 13.7% of total production, which is well below the previous goal of 15%.

Advantage Oil & Gas

Source: Investor presentation January 2020

With its growing liquids production, the company is increasing its exposure to Canadian NGL, condensate, and oil prices (revenue from "Oil/Liquids" in the chart below) that usually vary along with WTI prices.

Advantage Oil & Gas

Source: Investor presentation January 2020

Management didn't communicate the reasons for its reduced 2020 capital program compared to its three-year plan, but lower-than-forecasted commodity prices may explain this weak guidance.

You can see in the table below the company had forecasted a WTI price above US$66 per barrel in 2019 and 2020.

Advantage Oil & Gas price assumptions in its initial three-year plan.

Source: Investor presentation May 2018

But spot and futures WTI prices below US$60 per barrel on Jan, 9 don't meet management's previous forecasts.

WTI spot and futures prices

Source: The petroleum services association of Canada

As a result, management now assumes an average WTI price of US$56.58 per barrel in 2020, which corresponds to lower adjusted funds flow.

The net debt-to-adjusted funds flow ratio of 1.8 at the end of last quarter remained reasonable. But management stays prudent, avoiding this debt ratio to exceed 2. For this reason, it had already decreased its 2019 capital program by C$10 million last year because of lower oil and gas prices.

Since the company's 2020 capital program should remain at or below expected lower adjusted funds flow, the company's net debt won't increase. But the consequence is production in 2020 should stay below the company's three-year plan estimates.

Advantage Oil & Gas has become a riskier investment

With its lower oil price assumptions, management didn't communicate its adjusted funds flow forecast. But the goal of keeping the company's net debt-to-adjusted funds flow ratio at or below 2, which is above the debt ratio of 1.8 at the end of Q3, suggests the company will not generate any free cash flow at management's commodity price assumptions (WTI US$56.58/bbl, AECO $1.88/GJ, and NYMEX US$2.42/mmbtu).

And taking into account the midpoint of 2020 production guidance and assuming production will reach 45,000 boe/d in 2019, the 2020 capital program corresponds to a modest year-over-year 2.8% increase in production.

In contrast, I discussed in another article that Peyto Exploration & Development (OTCPK:PEYUF), which is expected to produce a similar mix of liquids in 2020 compared to Advantage Oil & Gas, should grow its production by 11% in 2020 with a capital program that should not exceed its adjusted funds flow.

Advantage Oil & Gas' lower forecasted production growth is due to its higher costs compared to Peyto, as shown in the table below. Advantage Oil & Gas' total costs of about C$18/boe far exceed Peyto's total costs below C$12.5/boe.

Advantage Oil & Gas costs compared to Peyto

Source: Author, based on company reports

I calculated Advantage Oil & Gas' sustaining costs based on its 2020 capital program. Assuming the company will hold its production of 45,000 boe/d flat with the low end of its capital program of C$170 million, its per-barrel sustaining costs should reach C$170 million / (45,000 boe/d * 365 days) = C$10.35/boe.

In addition, Peyto's realized price of C$12.78/boe before hedges during the third quarter exceeded Advantage Oil & Gas' realized price of C$11.98/boe. Going forward, there will be many moving parts in the companies' realized prices depending on their liquids production and marketing diversification, but Peyto's cost advantage should remain significant.

Despite Advantage Oil & Gas' lower profitability, the market doesn't seem to value the company at a discount compared to Peyto. As shown in the table below, the market even values Advantage Oil & Gas at a premium based on market capitalization valuation ratios. But taking into account their enterprise value, both companies' valuations become similar because of Peyto's higher debt load.

Source: Author, based on company reports

Besides, because of the lower-than-expected commodity prices in 2020, the goal of decreasing Advantage Oil & Gas' net debt-to-adjusted funds flow ratio to 1.2 in 2020 seems far away. Management now plans to have this ratio at 2.

Thus, Advantage Oil & Gas needs flawless execution over the medium term to increase its liquids production in a significant way and improve its profitability. Besides, the company also needs higher commodity prices to reduce its debt load.

In addition, since I described Advantage Oil & Gas as a long-term investment opportunity in May 2019, its stock price increased by 30%. Coincidentally, Peyto's stock price decreased by 30% over the same period of time.

ChartData by YCharts

Thus, given the increase in its stock price and its weak guidance, Advantage Oil & Gas has become a riskier investment and I don't consider the company constitutes an investment opportunity anymore.

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Disclosure: I am/we are long PEYUF. 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.

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