Headwater Exploration: The Hottest Canadian Small-Cap Oil Stock You Don't Want To Miss Out

Feb. 18, 2022 4:19 AM ETHeadwater Exploration Inc. (CDDRF), HWX:CA36 Comments14 Likes


  • Headwater Exploration is the fourth start-up founded by a serially-successful team led by Neil Roszell.
  • Its land position in the emerging Clearwater play in the Western Canadian Sedimentary Basin exposes the company to upside of profitable growth through organic development as well as consolidation.
  • However, the critical question is whether the high quality assets and the enormous growth prospect have been priced in. To buy or not to buy?
  • I do much more than just articles at The Natural Resources Hub: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
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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:

  • [EV] = [EV/EBITDA] X {[Realized price - Unit all-in cost] X [Production] X [1 + Growth rate]},

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 play

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).

Maps showing the Clearwater heavy oil play and the Peace River, Athabasca, and Cold Lake oilsands play in the Western Canadian Sedimentary Basin

Fig. 1. Maps showing the Clearwater heavy oil play in relation to the Peace River, Athabasca, and Cold Lake oilsands play in the Western Canadian Sedimentary Basin. (BOE Report)

The team

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.

  • The board of directors includes Chandra Henry (CFO of Longbow Capital), Kevin Olson (President of Camber Capital and long-time director of the fluvial series of companies), Stephen Larke (director of Vermilion Energy (VET) and Topaz Energy (OTCPK:TPZEF)), Dave Pearce (deputy managing partner at Azimuth Capital Management, formerly director of Raging River Exploration), Phillip Knoll (ex-CEO of Corridor), and Kam Sandhar (EVP-strategy and corporate development at Cenovus Energy), besides Roszell and Jaskela.

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.

Becoming Headwater

Corridor Resources

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.

The competitive landscape in the Clearwater play in the Western Canadian Sedimentary Basin.

Fig. 2. The competitive landscape in the Clearwater play. (Headwater Exploration)


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 total consideration consists of C$35 million in cash, and 50 million shares of Headwater and 15 million warrants exercisable at C$2.00 apiece within three years, making Cenovus a ~26% shareholder of Headwater.
  • Cenovus retains a gross overriding royalty on the lands, while Headwater committed to spend C$100 million on the acquired land before the end of 2022.

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.

Operations: growth, cost, and free cash flow

Headwater launched an aggressive exploration and development program in the Clearwater play since the completion of the Marten Hill acquisition (Fig. 3).

The Clearwater land holding of Headwater and adjacent peers, divided into the core area and five exploration areas with seasonal access.

Fig. 3. The Clearwater land holding of Headwater and adjacent peers, divided into the core area and five exploration areas with seasonal access. Note access to some areas is possible either in the falls or winters. (Headwater Exploration)

2021 program

Headwater had an C$85-90 million capital program in the Marten Hills area for 2021 but the company quickly accelerated to C$130-140 million, encouraged by initial results.

  • In the 1Q2021, Headwater deployed C$37.3 million in the Marten Hills area, drilling 12, 8-leg multi-lateral producing wells, 5 horizontal injection wells, 2 source water wells, and 1 stratigraphic test well. It started to build a gas processing facility jointly with an area operator.
  • Since the 2021 spring break-up, Headwater successfully rig released 13, 6-leg producing wells, of which 7 have been placed on production. Thanks to the optimized drilling strategy, the company reduced drilling costs by 10% from the 1Q2021. Headwater commenced water injection into the first of four, 4-leg horizontal injector, with extremely encouraging results (Fig. 4).
The performance of waterflood wells of Headwater in the core area of Marten Hills

Fig. 4. The performance of waterflood wells of Headwater in the core area of Marten Hills. (Headwater Exploration)

  • As of September 30, 2021, Headwater had drilled 30 multi-lateral horizontal wells in the core development area, growing production from 3,385 bo/d in the 1Q2021 to >9,000 bo/d (Fig. 5). Capital efficiency continued to improve since the start of operations in Marten Hills in 1Q2021, up by 33%. Waterflood pilot operations expanded, with 2 additional injection wells placed on injection in mid-October (Fig. 4).
  • During the 3Q2021, Headwater spudded its first 3 exploration wells in Marten Hills West, with encouraging results. These wells were completed, and brought on production during the 4Q2021, with results exceeding expectations (155-275 bo/d, on par with core Marten Hills), thus confirming a substantial new pool discovery in the Clearwater A formation and unlocking a significant Clearwater B resource. Five wells are scheduled for the 1Q2022. Since October 1, 2021, Headwater has added 75 net sections of unburdened exploration lands, where five new exploration prospects have been identified, increasing the total exploration land holdings to >350 net sections.
  • During the 4Q2021, production averaged 10,400 boe/d (9,400 b/d of heavy oil and 6 MMcf/d of natural gas). By February 2022, production rose further to 12,400 boe/d, with core area heavy oil production exceeding 10,000 bbls/d.
Production of Corridor Resources/Headwater Exploration, actual and expected

Fig. 5. Production of Corridor Resources/Headwater Exploration, actual and expected, for McCully and Marten Hills core area only. (Laurentian Research for The Natural Resources Hub)

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).

Revenue of Corridor Resources/Headwater Exploration

Fig. 6. Revenue of Corridor Resources/Headwater Exploration. (Laurentian Research for The Natural Resources Hub)

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 unit cost profile of Corridor Resources/Headwater Exploration

Fig. 7. The unit cost profile of Corridor Resources/Headwater Exploration. (Laurentian Research for The Natural Resources Hub)

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.

Free cash flow of Corridor Resources/Headwater Exploration, actual and expected.

Fig. 8. Free cash flow of Corridor Resources/Headwater Exploration, actual and expected, for McCully and Marten Hills core area only. (Laurentian Research for The Natural Resources Hub)

2022 budget

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.

  • In the Marten Hills core area, Headwater plans to drill 19 multi-lateral producing wells, 24 injection wells, and 6 water source wells / stratigraphic tests. Commissioning of the water injection facilities is expected to occur in March 2022, with 6 additional injection wells placed on injection prior to April 1, 2022. A total of 14 4-leg lateral injectors will be put on injection by the end of 1Q2022, an additional 13 4-leg lateral injectors will be put on injection in the 3Q2022, and ~30% of the core area will be under waterflood by end-2022.
  • In Marten Hills West, Headwater will drill 7 exploration wells, 15 development wells, and 3 stratigraphic wells, besides infrastructure upgrades, seismic and additional land purchases.

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).

Valuation, downside, and risk

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).

  • Recognizing its superior asset quality, the market is willing to pay a premium to gain exposure to the Clearwater play. Headwater does stand out as a rarity among the Clearwater participants because it is publicly-traded, and is a Clearwater pure-play (Fig. 2).
  • It also helps to have a serially successful management, which brings to the table access to low-cost capital, technical capability, flawless execution, and consequently lower risk for shareholders.

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.

  • As of end-2020, the Marten Hills project held 8.332 MMbbl of 2P heavy oil reserves, including 2.181 MMbbl of PDP reserves producing ~2,800 bo/d, for which Headwater paid C$100 million. By the 3Q2021, Headwater had 30 new wells producing >9,000 bo/d.
  • Further value will be realized through the extremely encouraging pilot EOR program (Fig. 4). The recovery factor may be enhanced from 3-6% in primary recovery to 12-15% through waterflood, while the decline rate may be reduced from ~25% to 10-12%, thus multiply the asset value.
  • An additional value driver is the delineation and development of the Marten Hills West acreage. Initial drilling of Marten Hills West in the last few months returned extremely encouraging results, pointing to substantial de-risking of the area in 2022 (see above).

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 is debt free. As of end-2021, it had C$93 million of working capital. The McCully gas field, which I reckon is worth approximately C$70 million, provides small but stable cash flow, furthering strengthening its financial position.

Investor takeaways

Headwater checks the important boxes of asset quality and the management.

  • Its Clearwater properties have truly top-tier economics and boast envious growth potential through organic exploration, development, and especially waterflood EOR. Expanding production and infrastructure construction are poised to drive down the operating costs due to economies of scale, thus making the project even more profitable.
  • The management team is technically capable, has made shareholders rich in multiple ventures in the past, and seems to be executing flawlessly at Marten Hills.

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.

Stock chart of Headwater Exploration, as compared with the WTI benchmark oil price.

Fig. 9. Stock chart of Headwater Exploration, as compared with the WTI benchmark oil price. (Barchart)

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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.

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