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Baytex: One Way To Benefit From The Coming Inflection In Oil Markets

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About: Baytex Energy Corp. (BTE)
by: Prime Value
Prime Value
Hedge fund manager, contrarian
Summary

The oil market is at an inflection point.

Canadian E&P sector offers a unique valuation proposition based on FCF yields.

Baytex is a winner in a >$60WTI environment.

An update on oil market: the inflection point

The oil market is at an inflection point. Sometime in the next six to 12 months we will flip from a long period of over-supply to being under-supplied. As a result, we are on the cusp of entering what could be a multi-year bull market. Why do we think this? Here are some reasons:

  • 2015-2019 saw the largest E&P capex cuts in history due to the drop in oil prices. The challenge for global oil supply is simple – global decline rate is increasing, which means more and more oil needs to be produced every year just to stay flat.
  • With OPEC spare capacity tapped out, any disruptions that reduce global oil supply can lead to higher oil prices.

  • To support Saudi Aramco value around the $2 trillion level, Saudi Arabia will continue with a “do what it takes” approach to supporting oil prices.

  • Demand fears are less of a concern with US-China trade deal.

  • The main source of growth in the oil market is slowing. US shale growth deceleration is both geological and structural. Oil rig count and frac spreads are dropping and DUC’s will not be enough to offset declines:

Source: Bloomberg

Source: Bloomberg

This is probably going to lead US core petroleum inventories lower in 2020, a trend has been consistent since 2017:

Source: Author based on EIA data

Energy equities' weight in the S&P 500 is at extremely low historical levels of around 4.23%, while the average in the last few decades has been over 9%:

Source: Bloomberg

Given the extreme disconnect with valuations, there currently exists an unprecedented opportunity for oil stocks:

Source: Bloomberg

Baytex Energy: Solid Asset Base Generating Strong FCF

Baytex Energy Corp. is an oil and gas corporation based in Calgary, Alberta. The company is engaged in the acquisition, development and production of crude oil and natural gas in the Western Canadian Basin and in the Eagle Ford in the United States.

Baytex has an asset base that is well diversified by geography and hydrocarbon mix. Geographically, the company is in four key plays (Eagle Ford, Viking, Peace River, Lloydminster), as well as earlier stage liquids exploration development (the Duvernay). Duvernay asset offers potential future growth and development upside in an emerging play where BTE has seen promising initial results.

Production is split approximately 40% US/60% Canada, with the Canadian production split between Alberta and Saskatchewan. By hydrocarbon, the company' exposure to oil/bitumen is 71%, NGLs 11% with natural gas the remaining 18%.

Debt outlook: Improving their financial position

BTE has elevated but manageable refinancing risk. This includes USD400 million of 5.125% senior unsecured bonds due June 1, 2021, and CAD300 million in 6.625% senior unsecured bonds due July 19, 2022.

Source: 2019 December presentation

Separately, the company funded an early redemption of its USD150 million of 6.75% 2021 senior unsecured bonds this past September out of cash on hand. They probably end the year at 2.2x net debt to funds from operaitons. Although their target is 1.5x:

Source: 2019 December presentation

Paying down debt to 1.5x remains a key priority. That probably requires another year of oil prices at >$60 and WCS-WTI differentials at <$18. Although there is no assurance that oil prices will stay there for that long, I would say, 2020 outlook looks more favourable than 2019.

Fitch thinks Baytex will be able to re-finance or pay off 2021 maturities within the first six-months of 2020. Obviously, a pretty big catalyst if this turns out favourable:

"Under our base case conditions, Fitch anticipates the company will meet the repayment test with a reasonable amount of headroom. At Sept. 302019, there was approximately CAD271million outstanding on the revolver. Fitch would note that unlike a number of peers, Baytex' revolver is secured by a first priority interest in the company's assets and properties, and not by a borrowing base, which eliminates the risk of an unfavorable borrowing base redetermination."

Free Cash Generation and Valuation

Baytex currently offers one of the highest FCF yields amongst energy names in North America and should screen well for those investors prioritizing capital discipline and free cash flow generation in order to deliver shareholder returns via debt reduction or share buybacks.

We model BTE generating FCF of 180MM CAD 2019 or 295Mm CAD excluding changes in working capital and asset retirement obligation. For 2020, Baytex could make more than 200MM CAD of FFO per quarter with current prices. In 2019, BTE’s capital program has been directed ~80% to their high netback light oil assets the Eagle Ford and Viking , with 2020 guidance calling for the budget to again be focused 80% towards these two plays:

Source: 2019 December presentation

So Baytex could make as much as ~290MM CAD of free cash flow in 2020. That should be enough to pay down 2022 maturity and refinance the 2021 bond, although with higher interest (probably in the range of ~7%-9%):

2019
Q1 Q2 Q3 Q4
Brent 63.10 66.16 62.00 62.42
WTI 54.82 59.88 56.26 56.87
WCS 44.48 47.39 43.59 37.85
Differential WTI-WCS -10.34 -12.49 -12.83 -19.02
Average B-WTI-WCS 54.13 57.81 53.95 52.38
Baytex Boe Price C$/boe 47.98 51.49 47.14 45.57
Difference -6.15 -6.32 -6.81 -6.81

Source: Author based on Company data

Final thoughts

Baytex has pronouncedly disappointed investors for several years due to low prices. However, the new strategy are likely to show up in the near future, as it takes some time for delevering and begin generating material free cash flows. With ~$60WTI and ~$18 WCS-WTI differentials, Baytex could make more than $800MM in FFO.

However we need some time to see how fast they delever their balance sheet while returning cash to shareholders. If the narrative changes and we see the inflection point this year, Baytex should benefit from it, as they could make 20% FCF yield with reasonable and manageable debt levels.

Disclosure: I am/we are long BTE. 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.