Single-factor investors are to oil and gas equity investing as single-issue voters are to elections. It is okay to focus on one factor, except single-factor decision making works not so well in confirming an investment idea as in screening out one. For example, if you have verified that a CEO tends to enrich himself at the expense of the shareholders, then the stock under consideration is definitely a no-no. However, buying a random oil stock upon rising crude prices will probably not pan out.
That is because multiple factors have to align to lead to a desirable outcome: a stock idea ends up being profitable. The value of an oil stock, e.g., can be described as follows:
where the realized price is determined by benchmark oil price adjusted for the quality of the specific commodities produced; the unit all-in cost mainly depends on the fiscal regime of the jurisdiction, reservoir characteristics, reserve replacement, infrastructure accessibility, commodity price hedging, interest payment, and corporate overhead; the production growth rate is related to the reserves, available capital, and accessible oilfield services; and the EV/EBITDA multiple in itself is a function of the profit margin and growth outlook of the underlying oil fields, adjusted for the idiosyncratic risk associated with the assets.
To make it easy, I outlined in a recent interview three criteria that can be used in picking winning oil stocks, namely, high-quality assets, a technically-competent and shareholder-friendly management, and an adequate margin of safety.
Below, I'd like to demonstrate Headwater Exploration Inc. (HWX.TSX)(OTCPK:CDDRF), an emerging oil producer in the Clearwater heavy oil play in Canada, checks the above boxes. Headwater trades with adequate liquidity on the TSX main board, averaging 1.5 million shares per day, and on OTC-Pink, averaging 47,000 shares per day.
The Clearwater heavy oil play emerged in the last few years as one of the top oil plays in the Western Canadian Sedimentary Basin. Clearwater includes three main areas, i.e., Marten Hills, Nipisi and Jarvie-Newbrook, along the southwestern margin of the Peace River-Athabasca oil sands areas (Fig. 1).
The management team at Headwater Exploration is led by Chairman and CEO Neil Roszell and President and COO Jason Jaskela, who are supported by CFO Ali Horvath, VP-Engineering Terry Danku, VP-Exploration Jonathan Grimwood, and VP-Land Scott Rideout.
Headwater is the fourth company started up by the team. With an envious track record of being serially successful across ups and downs of the commodity cycles, they are known for creating enormous value by growing oil and gas businesses through disciplined acquisition and organic expansion.
On January 13, 2020, Roszell, Jaskela, Horvath, Grimwood and Danku took over Corridor Resources Inc. by investing C$20 million in it. They changed the company name to Headwater Exploration Inc., continuing the penchant of naming their start-ups in young rivers. Concurrent with the C$20 million capital injection by the Roszell gang, they raised C$30.0 million of equity in a private placement.
Roszell commented on the occasion of the transaction,
“This is an exceptional opportunity to invest in a company with a material cash position and strategic assets that provide significant free cash flow at current commodity prices. The Headwater management team is energized and truly believes that the Corridor platform can lead us into becoming a leading Canadian energy producer”.
Seeing an ideal entry point into the Canadian energy sector, the team used Corridor’s anticipated adjusted working capital of C$110 million and the C$7-9 million per-year stable field-based cash flow from the McCully gas field in New Brunswick to acquire massively mis-priced assets, and unlock the value of the assets through disciplined capital allocation and greenfield development.
On November 9, 2020, Headwater announced it has entered into a definitive agreement with Cenovus Energy Inc. (CVE) to acquire a 100% interest in the latter's clearwater properties in the Marten Hills area of Alberta for C$100 million, thus becoming a publicly-traded company that gives investors pure-play exposure to the Clearwater play (Fig. 2).
The Marten Hills property includes a 100% working interest in ~2,800 b/d of medium oil (22˚API) and 189,000 acres of total land, including 172,800 acres of Clearwater rights. The property includes 8.3 MMbo of proven and probable reserves as of end-2020 and un-discounted asset retirement obligation of C$3.5 million at the time.
Headwater launched an aggressive exploration and development program in the Clearwater play since the completion of the Marten Hill acquisition (Fig. 3).
Thanks to rapid production growth and rising commodity prices, Headwater pulled in sequentially increasing quarterly revenue, with a 7.4X increase of revenue from the 4Q2020 to 3Q2021 (Fig. 6).
From the 1Q via 2Q to 3Q2021, production cost declined from C$5.62/boe via C$4.89/boe to C$4.42/boe but the transportation cost remained as high as C$6.04-8.68/boe. The wholly-owned oil processing facility in the Marten Hills core area, which ties-in directly to the Rangeland pipeline system, was completed on January 14, 2022, resulting in an immediate C$2.00/bo reduction in transportation costs. An additional C$2.00/boe of reduction in transportation costs is expected by March 1, 2022, when 90% of the company’s volumes will be pipeline connected. By then, the production and transportation costs will drop to around C$9/boe (Fig. 7).
The accelerated capital program in 2021 will result in C$20 million of negative free cash flow (or FCF). However, beginning 2022, just a little over one year after taking over the Clearwater operations, Headwater is expected to generate positive FCF, which is projected to rapidly increase as less and less capital spending will be needed in the Marten Hills core area (Fig. 8). I believe Headwater will continue to deploy a portion of this FCF toward the delineation and development of Marten Hills West for continued production growth, as it did in the 2H2021.
The initial capital budget for 2022 is at C$120 million, including C$78 million for further development of the Marten Hills core area and C$42 million for the delineation and development of the Marten Hills west acreage, incorporating a 5% increase in drilling, completions and infrastructure costs to account for inflationary pressures in materials and manpower.
Headwater aims for 2022 annual average production of 12,500 boe/d (11,500 b/d of heavy oil and 6.2 MMcf/d of natural gas), with the 4Q2022 average production expected to be 15,000 boe/d (13,770 b/d of heavy oil and 7.4 MMcf/d of natural gas), implying a 70% per-share production growth.
Headwater is at the inflection point of a transformation to a free cash flow cow. Although it will report a negative FCF of C$20 million in the first full year of Marten Hills operations, Headwater forecasts a FCF of C$118 million in 2022, C$125 million in 2023, C$139 million in 2024, C$191 million in 2025 from the Marten Hills core area alone, at US$75/bo WTI (Fig. 8).
Headwater is valued at 13.3X of 2022 forecast FCF. The stock has an EV/EBITDA multiple of 11.9X on a 3Q2021 run-rate bases. These multiples suggest that Headwater is richly valued relative to its industry peers. From its forecast 2025 P/FCF multiple of 8.5X, the current share price has priced in a lot of growth in the next three years, which the company indeed anticipates (Fig. 5; Fig. 8).
Headwater's year-end 2021 reserve report may shine some definite light on whether its valuation is justified. It is not unreasonable to expect the company to book much-expanded 2P reserves in its end-2021 reserve report, possibly including no less than 15 MMbbl of PDP reserves, which if true will more than justify the current valuation.
In spite of the above positive progress, the primary risk associated with Headwater remains to be with the EOR program and the delineation of Marten Hills West. The dilemma is once the Clearwater project is fully de-risked, the full value will have already been priced in. So, we have to make an investment decision based on emerging lines of evidence.
Headwater checks the important boxes of asset quality and the management.
The critical question is whether the stock gives investors an adequate margin of safety on the way in at this time. Initial data from the waterflood program and Marten Hills West drilling appear to suggest the asset value and growth prospect are much greater than previously perceived. I believe the upcoming reserve report will likely assure investors there is indeed a margin of safety at the current share price, and going forward, it may not be a bad idea to add on dips (Fig. 9). The upside from the EOR program and Marten Hills West is simply too great to ignore.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
This article was written by
As a natural resources industry expert with years of successful investing experience, I conduct in-depth research to generate alpha-rich, low-risk ideas for the member of The Natural Resources Hub (TNRH). I focus on identifying high-quality deep values in the natural resources sector and undervalued wide-moat businesses, an investment approach that has proven to be extremely rewarding over the years.
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Disclosure: Besides myself, TNRH is fortunate enough to have multiple other contributing authors who post articles for and share their views with our thriving community. These authors include Silver Coast Research, ..., among others. I'd like to emphasize that the articles contributed by these authors are the product of their respective independent research and analysis.
Disclosure: I/we have a beneficial long position in the shares of CDDRF either through stock ownership, options, or other derivatives. 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.