- Baytex is highly leveraged to rising oil prices.
- Free cash flow at $65 WTI is tremendous.
- Consensus is playing catchup to increasing oil and stock prices.
Baytex (BTEGF) is an oil focused E&P with diversified assets both from a geographical and product standpoint. They have production in Texas, Alberta and Saskatchewan, which is composed of heavy oil, light oil, natural gas and NGLs. Baytex expects to produce between 73-77,000 BOE per day in 2021. Oil prices have materially increased since November, completely changing the fortunes of this indebted company. The difference between $45 WTI to $65 WTI is not a steady consistent increase to cash flows, but rather a hockey stick-like inflection that's a true game changer not only for survivability but for profitability as well.
Baytex is a highly leveraged oil company with $1.85 billion in net debt and a current market cap of $840 million. For comparison purposes, Whitecap Resources (OTCPK:SPGYF) has $1.08 billion in net debt and a market cap of $3.15 billion. The upside-down nature of Baytex’s capital structure, net debt being greater than equity value, is a double-edged sword. In bad times, it’s a killer, but in boom times, it acts like a rocket ship for the equity value. With WTI rallying substantially over the past several months, the concern from investors is, is this sustainable? We believe that WTI prices over $60 per barrel are here to stay. The bull thesis for oil is as follows:
- Limited capital spending from E&Ps since the 2016 price collapse, exacerbated by the 2020 pandemic
- Lack of major conventional projects coming online to arrest natural declines in conventional production
- Scarred management teams that so far are demonstrating capital discipline
- Shale Tier 1 inventory being depleted
- Green initiatives + prior poor performance restricting capital from funding future oil projects, increasing the hurdle rate
- A disciplined + aligned OPEC
Given the circumstances, a sustained oil price recovery appears to be real, with $70 WTI in 2021 a distinct possibility as we continue to reopen and look forward to the summer months. Baytex is an optimal company to express this sustainable higher oil price theme. To demonstrate the benefits of being highly leveraged, the current enterprise value of Baytex is $2.7B. If one assumes the EV has 50% upside, implying a $4.05B EV, the market cap will go from $840M to $2.2B, a 155% increase. Let’s compare this with a commensurate increase in EV with Whitecap. Whitecap’s enterprise value would increase from $4.25B to $6.35B and thus the market cap would rise to $5.25B. A 66% increase in market cap is certainly strong performance but materially below the 155% increase that’d be realized with Baytex.
The 50% increase in EV is more a thought experiment to demonstrate the benefits of investing in a leveraged entity during a bull market. Having said that, we believe these results are achievable in the next 6-12 months and can be justified from a valuation perspective.
At $65 WTI (current oil prices), free cash flow is estimated to be approximately $375 million. $375 million of free cash flow can certainly justify a market cap of $2.15B as that implies a free cash flow yield of 17%. A reasonable valuation metric with all things being considered.
The stock price has increased tremendously since the beginning of the year, and it’s natural to wonder if one has missed the rally. Our belief is that we are in the early innings of a sustained bull run in oil equities as the rapid price appreciation in oil is still being digested by market participants. The difference between $45 WTI which was reality in early December and $65 WTI is truly astronomical for a company like Baytex. The entire business completely changes from its cash flow metrics to reserve life additions. It takes the market time to adjust to such a rapid change in a company’s prospects. The clearest example I can see of this cautious and rather slow acceptance to the new oil price paradigm is with bank analyst reports.
Why the Mispricing
In TD’s research update following Baytex’s Q4/20 results, they provided a price target of $1.30/share. On the surface that would appear to be a bearish piece of evidence as the current share price is sitting at $1.50, implying 13% downside. The analysts arrive at their price target based on a combination of utilizing a NAV calculation and applying a target multiple to a projected EV/DACF. What one has to notice is that the $1.30 price target was arrived at by inputting a WTI price of $48 for 2021 and a $47 price for 2022. It is clear banks will be revising those WTI prices meaningfully upwards over the coming months, leading to a re-rating of price targets. Analyst price revisions and upgrades will be coming which will lead to institutional flows of capital into the sector. Our belief is many institutions need the comfort of the herd telling them it’s okay to begin investing in oil E&Ps again.
(Source: TD Securities Inc. Action Note)
The biggest risk to a recovery in the stock price is naturally further lockdown measures due to coronavirus and variant concerns. This would hurt oil demand and investor psychology. While we believe this risk is low due to the proven results from the vaccines and the rapid deployment of them, we still must be mindful that things can take a turn for the worse. Baytex has hedged nearly 50% of 2021 production at prices below current WTI prices. While hedging is generally seen as mitigating risk, we do recognize they are losing out on some of the current strong pricing which is limiting their ability to accumulate the full potential of their cash flows today. However, this should only be a temporary issue as we move through the year and work off the lower hedges.
We are optimistic on this oil price recovery and believe this isn’t a flash in the pan but a sustained oil price increase. We believe the best way to play this is by buying companies like Baytex that have meaningful leverage and upside to this recovery. It is time to play offense rather than defense when it comes to stock picking in the oil and gas sector.
This article was written by
Analyst’s Disclosure: I am/we are long BTEGF. 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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