Canacol Energy Q1 2020: Below Expectations

Summary

• Lower sales, due to lower volumes and price.
• Funds from operations slightly below our estimates.
• FCF generation is good, but still below our estimates.
• COVID-19 will have an impact on its cash flow. However, we expect a stable dividend and ~$40MM of FCF this year vs $60MM in 2021.

Investment Thesis Summary

Founded in 1970, Canacol Energy (OTCQX:CNNEF) is a Canadian company engaged in the exploration and production of oil and gas focused onshore in Colombia and Ecuador. The company has become an industry-leading natural gas supplier to the Caribbean Coast.

Canacol is a key component of regional demand, Caribbean coast gas market, with an estimated ~50% market share. This was expected to increase materially in 2019 and 2020, with management forecasting production to ramp up to ~215 mmscfd by Q1 2020.

Please see our previous article for reference. Overall, Canacol looks focused on executing its solid plan expansion well. At this time, catalysts seem to be materializing, with no price reaction at all.

Q1 Earnings and 2020 outlook

• Sales and production: Canacol has achieved strong sales volumes year on year. They grew sales 65% in terms of production and 48% in terms of revenue:

Source: Company data

Source: Company data

• Operating netback: The Corporation's natural gas and LNG operating netback decreased 11% to $3.60 per Mcf in the three months ended March 31, 2020, compared to $4.03 per Mcf for the same period in 2019.

The decrease is due to lower spot market gas sales prices, net of transportation costs, and an increase in royalties per unit of $0.08 per Mcf due to increased natural gas volumes being produced at the Corporation's VIM-5 block, which is subject to a higher royalty rate.

The decrease is offset by a 27% reduction of operating expenses per Mcf to $0.22 per Mcf for the three months ended March 31, 2020, compared to $0.30 per Mcf for the same period in 2019:

Source: Company data

• Capital Expenditures: The Corporation has experienced approximately a two-month delay in the rig move from the last drilled well of Clarinete 5 to its next scheduled location of Pandereta 8. This delay, and a small delay of the commencement of the Corporation's planned second rig, now anticipated to be operational in July 2020, has led to Canacol now expecting to drill nine wells in 2020, down from its original twelve well guidance. Capital expenditures have been revised to $108 million, down from $114 million, as the Corporation has shifted its near term focus to facilities and flow line construction in preparation for increased gas production.
• Colombian Peso devaluation and G&A expenses. G&A expenses per boe decreased by 32% during the three months ended March 31, 2020, compared to the same period in 2019. The decreased is mainly due to the increase of natural gas production and the devaluation of the COP and Canadian dollar relative to the USD:

Source: Company data

• Debt and interests: Debt is still quite high and expensive. They pay more than $7 million per quarter. EBITDAX was $60 million in the first quarter, but I expect no more than $220 million for the whole year, so that means a net debt to EBITDAX ratio of 1.5x and interest coverage of 7x:

Source: Company data

Source: Company data

COVID-19: As the pointed out in their last MD&A:

"For the months of April, May and June 2020, Canacol has allowed take-or-pay off-takers to defer a maximum of 20% of their contracted volumes to be delivered in the last six months of 2020, with cash collections either occurring in April, May or June or at the time of delivery. Additionally, all parties have agreed that the annual contractual downtime of these contracts shall be taken during the months of April and May, if not already taken earlier in the year. These concessions impacted the month of April 2020 in the following manner: April 2020 nominated volumes totaled 147 MMscfpd, less than 10% of which are allowed to be taken in the latter half of 2020 (up to 20% deferral), and take-or-pay income received, of which the off-taker has lost the right to take its gas, totaled 3 MMscfpd.

These amounts totaled 150 MMscfpd of cash and nominated natural gas sales. An additional average of 13 MMscfpd for the month of April was deemed contractual downtime by seven off-takers, which will have the effect of increasing sales in the latter half of 2020. As a result of the countrywide shutdown imposed in Colombia on March 26, 2020, which remained largely in effect until April 27, 2020, we saw industrial, construction, and commercial demand for gas decrease significantly as workers in these industries remained at home. As a result, there were virtually no interruptible gas sales for the month of April 2020. With the return of manufacturing and construction activities in most of Colombia on April 27, 2020, and the countrywide shutdown scheduled to be lifted completely for all sectors on May 26, 2020, the Corporation expects interruptible demand to continue to increase and stabilize through the summer months of July and August 2020.

Should this interruptible demand not return to the Colombian gas market, the period of July forward (once the off-taker deferral period expires, as described above) is anticipated to have contracts of approximately 162 MMscfpd, with 2020 annual sales thus being approximately 170 MMscfpd. The Corporation's best estimate is that demand will begin to increase once the quarantine measures are lifted, and under that scenario, our full-year 2020 guidance remains relatively intact. Full-year 2020 production guidance would be 197 MMscfpd, with the assumption that interruptible sales return by August 2020. It is management's belief that average sales volumes for 2020 will be closer to this level than a low case sales of 170 MMscfpd implied by only selling into the take or pay contracts for the remainder of 2020."

Source: Company data

Macroeconomics: Canacol expects Colombian demand for its natural gas to increase in the near term related to the current 20-year low level of the hydroelectric reservoirs due to an unusually dry winter in Colombia, and in the medium to long term related to the continued decline of Colombia's main gas producing fields. Colombia's hydroelectric reservoirs are currently at a 20-year low due to the unusually dry winter.

In May of 2016, during the last El Niño Phenomenon, the level of the reservoirs was 41%. Currently, the aggregate level of electric power generation reservoirs is 32%. The months of June and July are forecasted to have rainfall well below the historical averages, and there is further uncertainty with respect to the levels of rainfall in the following months. This will result in the need for a higher than normal usage of gas to power the thermoelectric plants to ensure that adequate electricity is supplied to the country, most particularly to the Caribbean coast.

Meanwhile, Colombia's total gas production continues to decline. In April of 2020, the Ministry of Mines and Energy reported that proven gas reserves in Colombia decreased by approximately 18%, from 3.8 Tcf at the end of 2018, to 3.1 Tcf at the end of 2019. This decrease in reserves was partially related to the production of approximately 0.4 Tcf during 2019. Conversely, Canacol's gas reserves and production increased significantly. Given these natural gas market fundamentals of declining gas supply, excluding Canacol, and stressed and uncertain hydroelectric production, Canacol remains very well positioned to capture any increasing demand once the Colombian economy begins to normalize post the lifting of quarantine.

Risks and Valuation

As we mentioned before, there are risks to take into account:

• Canacol is reliant on the Promigas pipeline infrastructure to transport its gas to end-users.
• Other key risks include Colombian geopolitical risk.
• Exploration success rates.

With a steady and predictable free cash flow to the firm of around $80 million, and huge 2P reserves value, this company could have an upside of more than 200% in the next 3 or 4 years:

Source: Author based on Company data

Source: Author based on Company data

Source: Author based on Company data

Conclusion

The market will pay attention to fundamentals: predictable revenue and strong free cash flow generation. Canacol Energy is undervalued because it is associated with oil companies. However, we remain optimistic for now, as we expect: 1) a significant increase in free cash flow generation 2) the drilling of 9 wells as a result of its exploration program; 3) the Medellin project, which may add 100 mmcfpd by 2023; and 4) recurrent quarterly dividend payment.

Analyst’s Disclosure: I am/we are long CNNEF. 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.

Comments

[dumpsterdiva]

Bottom line They take there options in cash. They use to inflate their reserves to industry people via Sproule International Limited until they were caught.
Somewhere between Revolutionary Armed Forces of Colombia (Farc),United Self-Defense Forces of Colombia (AUC), Bacrims or criminal bands, National Liberation Army (ELN) you can begin your Colombia's armed groups risk.
Safeguarding your portfolio health in conflict coalition for a small energy company from Canada that all the above groups loath and think nothing of bombing your pipeline you also have media and pueblos indigenas backlash.
This management have a long history of destroying shareholders wealth a couple of them have a cease trade order against a company they raised money for and failed to report earnings.
If you goto sedar and pull their first year you will see a pattern of what they charge even for monthly for rents before you see their subsidiaries. Radial Energy/Benchmark Energy Corp vs Rancho Hermoso S.A.and inflating reserves via Sproule International Limited.
After you read their sedar info read Petyo,Vermillion, and Tourmaline financials .......

Disclosure
Their unregistered debt that is secured to assets that have no jurisdiction to stake claim is priceless