Description

A Differentiated Energy Stock With Growing Profits

Canacol Energy March 13, 2016

All financial numbers are reported in USA Dollars

Company Description:

Canacol Energy has 2P reserves of 80 million barrels of oil equivalent of which 80% is from natural gas in

Columbia that is sold at prices exceeding $5.50/mcf versus $1.81/mcf in the United States.

90% of 2016 EBITDA is from long term natural gas or oil supply contracts at fixed prices.

87% of production is in Columbia and 13% is in Ecuador in 2016.

Investment Thesis:

Investing in energy companies is risky because one is always uncertain about the direction of oil or natural gas prices.  Canacol Energy is a special situation in Columbia, where a natural gas shortage has allowed the company to sign numerous fixed price natural gas contracts for 5-10 years. The company is selling natural gas at prices exceeding $5.00/mcf versus the current $1.81/mcf spot price in the United States.  As a result operating margins exceed 80% and return on investment exceeds 100%. This compares to many American companies that are losing money on their oil or gas production. All of these positive changes at Canacol will begin to be seen in reported financials for the March 2016 Quarter.

As of March 2016 management is guiding to $130 million in EBITDA from natural gas production of 87 mcf/day versus $95 million EBITDA in 2015. Canacol is expecting to increase EBITDA by +37% while nearly all North American E&P firms are budgeting for another large decline in 2016 profits.  Today Canacol trades at 4x EV/EBITDA based on management’s 2016 guidance , while many North American companies trade at valuations exceeding 8x EV/EBITDA for 2016. Thus one could assert that the stock price should double. In fact the outlook is even brighter.  

There are three ways that profits at Canacol could be even higher during 2016-2018 than what you see in sell-side analyst’s models.

1. Success at the OBOE-1 well was not incorporated into management’s 2016 guidance. I am assuming $40 million in EBITDA in 2016 and $80 million in EBITDA in 2017 from Oboe-1 well production of 15 mcf/day and 30 mcf/day in 2016 and 2017.  Natural gas prices should be above $5.60/mcf. Clearly this would lead to  $170 million EBITDA in 2016, or over 30% above management’s guidance. Take a look at the companies recent press releases about OBOE-1.

2. Canacol earned about $65 million in EBITDA from 2015 oil production in Columbia and Ecuador when Brent oil prices exceeded $50/barrel. To be conservative my base case has assumed Brent oil prices of $35/barrel in 2016 and zero profits. If Brent oil prices average $60/barrel in 2016, Canacol can earn $60 million EBITDA with 4,300 BOE/day in production. That would add 47% to management’s EBITDA guidance.  I will discuss my oil price outlook later on.

3. The natural gas shortage in the Carribean coastal region of Columbia is actually expected to get worse over the next 3 years. The largest natural gas fields in Columbia have passed peak production and have seen production declines of 100 mcf/day for two consecutive years. That is why natural gas prices are so high in Columbia. Canacol is the only local company that is rapidly growing their natural gas production. Thus numerous large industrial companies are trying to buy natural gas from Canacol. One of these companies is Reficar,  a large refinery near Cartagena that consumes a huge amount of natural gas. There is a reasonable chance that Canacol and Reficar will sign a long-term fixed price supply agreement for 125 mcf/day of natural gas. At a $5.50/mcf price this could generate over $200 million in annual EBITDA.  That is over a 150% boost to EBITDA from management’s 2016 guidance. The supply contract would not start till early 2018, as first a natural gas pipeline would need to be constructed from the VIM-5 field to Cartagena.

Let’s step back a little. If anyone reading this note is a past Canacol Energy shareholder,  you are wondering what is going on. Before 2015 Canacol generated nearly all of its profits from oil production.

So what happened?  The company made an exceptional acquisition of OGX in December 2014 out of bankruptcy for $40 million.  

Two wells were drilled in 2015 on this 785,000 acre OGX property that is called VIM-5. Here are the results from the first two wells. The wells were named Clarinette-1 and Clarinette-2. These two wells each had initial production exceed 25mcf/day or the equivalent of 4,400 barrels of oil/day with drilling costs of $11 million. Expected returns on investment are far above 100%.  This past week, Canacol reported production results on the 3rd well, OBOE-1 with a final test rate of 11,000 BOE/day equivalent equal to 66 mcf/day for this natural gas well.  This OBOE-1 well may generate over $100 million in annual cash flow if one assumes 45 mcf/day production (8,000 BOE/day) and a $26/barrel net-back. Not bad for a well that cost $5 million to drill. I am assuming that Canacol can find customers for OBOE-1, so that production from this well reaches 15mcf/day in 2016 and 30 mcf/day in 2017.

If Canacol can discover additional wells with similar economics on the VIM-5 property, the results will further transform the company.

Most portfolio managers are underweight the energy sector as they are fearful that oil prices will continue to decline. I recommend that they buy Canacol Energy. An investment in Canacol bypasses most of the commodity price risk as in 2016 Canacol will generate 85% of EBITDA from ten year fixed price natural gas and oil contracts. Unlike global oil prices, natural gas prices in Columbia are rising due to an existing shortage of natural gas that may not be solved for several years. In summary Canacol is the total anti-thesis of a North American energy company. Natural gas prices are rising, production is rising, return on invest is rising, but the stock price has yet to reflect all this good news.

Below is an abbreviated income statement that shows how EBITDA growth at Canacol is being driven by natural gas production growth at elevated gas prices. Sell-side forecasts are very conservative as they are not willing to assume that Canacol continues to have strong drilling results on their natural gas and oil acreage.

Below are additional positive and negative comments about Canacol Energy.

POSITIVES:

UnderValued at under 4x EV/EBITDA for year ended Dec 2016

In 2014 Canacol Energy traded at 8x EV/EBITDA when most of the profits were generated from oil. Today the stock is being given away at a 4x EV/EBITDA on 2016 estimates.  Meanwhile many North American E&P firms trade at 8x EV/EBITDA on 2016 estimates.

Clearly Canacol’s shares can easily double. In fact, if Canacol was valued at 8x EV/EBITDA again, the stock would appreciate over 200% as seen in the table below.

The key assumption below is 2016 EBITDA of $170 million that includes initial production from OBOE-1 and an 8x EBITDA multiple.

Among The Best 2016 Growth Profiles Of All Energy Stocks

EBITDA will grow 37% in 2016 based on management’s guidance as a new gas pipeline connects Canacol to its customers in March 2016.  This exceptional growth compares favorably with a forecasted 2016 profit decline for the entire North American energy sector.

Successful natural gas drilling could add another 205 mcf/day or  $200 mil in EBITDA by Dec 2018 and thus have total EBITDA double over three years (from 2016  → 2019) to over $400 million.

2016 Estimates Will Rise As The Fiscal Year Shifts From June to December

Quantitative and momentum investors will also be attracted to Canacol as 2016 estimates will rise about 50% in the next few months. Canacol is in the process of converting from a June to a December Fiscal year end. The new natural gas contracts are adding over $100 million in EBITDA/year starting in January 2016. By shifting fiscal year ends Canacol will add $100 million or 12 months of EBITDA instead of $50 million and 6 months of EBITDA.  The sell-side will also be revising 2016 estimates higher as many firms are still publishing brokerage reports with a Fiscal year that ends in June.

Rising oil prices in 2016 will lift valuation multiples for the energy sector

Valuations for most energy stocks have collapsed in 2015 along with the fall in oil prices. As oil prices recover in 2016 valuations should rebound as well which will help Canacol. At $40 Brent oil prices,  drilling budgets have been cut 50% by many firms for 2016.  This will result in declining global oil production.  

Right now the oil market may be oversupplied by 1.5 million barrels/day out of a market that consumes 96 million barrels per day. Global production will likely decline by 1.0 million BOE/day in 2016, and demand could grow by 1.5-2.0 million barrels per day. This combined 2.5-3.0 million barrel tightening in the supply demand balance will lead to an oil shortage and much higher oil prices later in 2016.

This week the (IEA) International Energy Agency published a report stating that global oil prices may have bottomed.

Northern Columbia – An Attractive Natural Gas Market

Unlike oil, natural gas prices are influenced more by the local supply & demand balance.

A natural gas shortage exists in Northern Columbia on the Carribean coast as the three primary natural gas fields (Ballena, Chuchupa, & La Creciente) are mature and have seen production decline by 100 MMcf/day in 2014 and 2015. Production is forecast is decline another 170 mcf/day over the next three years (2016-2018).  This is a huge opportunity for Canacol Energy as their natural gas production was only 20 mcf/day in 2015 and is forecast to rise to 87 mcf/day in 2016.  This natural gas shortage is allowing Canacol is sign long term supply contracts at high fixed prices and potentially grow production to over 200 mcf/day if Canacol continues to expand its natural gas reserves.  Canacol has 362 BCF in 2P reserves with 3 TCF in unrisked  resources. Thus successful drilling could increase reserves by nearly ten-fold. The two most recent Clarinette wells drilled produced over 25 mcf/day for each well.  The OBOE-1 well was the most successful well so far with a final test production rate of 66 mcf/day.

Return On Equity is Going to Rise Dramatically

Canacol management is forecasting that pre-tax return on investment is going to exceed 100% per year in the Columbia natural gas market.    This compares to a negative return on investment for many energy companies in the USA with WTI oil prices at $38/barrel.

The two most recent Clarinette wells drilled on the VIM-5 properties cost $11 million each. At $5.25/mcf natural gas prices and production of 25 mcf/well,  each well can generate over $30 million in year 1 EBITDA.  These are exceptional numbers!!!!

Drilling to Lead to New Natural Gas Contracts:

Columbia’s largest natural gas pipeline company, PromiGas, has plans to build a new 180 mcf/day pipeline for completion in 2018 that would run north south to Cartagena. The Cartegena region is expecting a natural gas shortage which is why they are seeking to build a new pipeline to transport gas from other areas in Columbia.

Canacol already has a preliminary 60 mcf/day natural gas contract to supply the REFICAR oil refinery.

Eight additional successful Clarinette wells drilled in 2016-2017 could add another 120 mcf/day in production for Canacol that starts in 2018. Right now investors attribute zero value to this scenario that could add over $200 million in annual EBITDA.

NEGATIVES:

Management has hurt equity shareholders by issuing new shares at low prices.

Management panicked in 2015 and issued 30 million new shares at C$2.50/share to reduce debt. This was a 23% dilution of existing shareholders. There were cheaper ways to raise capital from sources such as Apollo. Thus I am disappointed with management’s treatment of shareholders.

Not Enough Free Cash Flow:

Historically, Canacol has not generated free cash flow as they have aggressively invested in exploration and development.

Limited natural gas pipeline network prevents Canacol from growing faster

Columbia is a less developed economy that lacks an adequate natural gas pipeline network to transport gas from the well site to the point of consumption. Thus Canacol has stranded natural gas discoveries where there can be a 1 or 2 year delay from the time natural gas is discovered till the time Canacol can monetize the reserves.

Balance Sheet Risk

Free cash flow is reduced as the company must pay $40 million in principal every year to repay its BNP Paribas bank debt that matures in 2019. A larger company would have more financial flexibility and not need to repay principal till the actual maturity date.

Foreign Currency Is Always a Risk When Investing Outside the USA

Over the past year the Columbian  Peso has depreciated by 23% versus the US dollar.

This has clearly helped Canacol since local labor costs have fallen. Nevertheless, there is always the risk that the Peso could appreciate versus the dollar.

Additional Information About Canacol Energy:

Key Properties:

1) The most important asset is VIM-5, a natural gas property with 785,0000 acresslocated in Columbia.

Three wells have been drilled on this property with over 50 attractive drilling locations.

2) LLA-23 is an oil play in Columbia that was the firm's key source of profits from 2012-2015, until oil prices plummeted.

3) Canacol also has 750,000 acres of shale oil in Columbia that would be economical to develop when oil prices are above $50/barrel.

Catalyst

1) Announcement Of Additional Long-Term Natural Gas Supply Contracts At High Prices

2) Additional Success Finding Natural Gas in Columbia

3) Rising Oil Prices Will Lead To A More Bullish Investor Attitude Towards Energy Stocks