Description

Summary

Calima Energy is an Australia listed low cost oil and gas producer focused on generating free cash flow from the development of its highly economical assets in Western Canada. Their focus is on developing proven and probable reserves within their existing infrastructure. The company has recently initiated a process to maximize the value of its Montney assets (~60k acres of drilling rights in the liquid-rich part of Northeast British Columbia) by disposal, partnering for development or other potential transactions (e.g. exchange for a developed cash flowing asset).  

Calima has taken advantage of the troubled Canadian oil sector in 2020 by acquiring the highly indebted privately held Blackspur Oil at a very attractive valuation of A$22.7 million. This is against over A$200 million invested by Blackspur over the past 7 years to create inventory and infrastructure to accommodate growth to over 10,000boe/d of production. After reducing the assumed debt from C$40 million to C$13 million, the balance sheet of the combined company is significantly de-risked. The acquired assets – Brooks and Thorsby in Alberta Canada – currently produce 3,500boe/d; Calima forecasts an exit rate of 4,500 boe/d for 2021 and 5,500boe/d for 2022 (~70% oil weighted). However, I expect the exit rate for 2022 to be revised up, if oil prices stay at these levels or even continue to increase. The company will be drilling a lot of wells to increase daily production from 3,500boe/d to 5,500boe/d (or more) in the next 18 months or so. With oil prices at US$70 WTI, the payback period for new wells is less than 6 months, IRRs are in the triple digits.  

The experienced Blackspur Oil management team will manage the combined company, which I’m partial to as it creates continuity for Blackspur’s projects and a smooth integration of Blackspur into Calima. As a result of the deal structure (80% stock, 20% cash) and his prior equity interest in Blackspur, Jordan Kevol (Calima CEO) owns close to 4 million shares in Calima – slightly less than 1% of the company. He was recently granted 2.5 million options to further align his incentives. Calima’s Chairman Glenn Whiddon has significantly participated in the equity raise that was executed to fund the acquisition and pay down the majority of Blackspur’s debt. He owns a bit over 2.5% of the company. I generally like higher ownership by key insiders but the fact that Calima’s management was able to identify Blackspur Oil as a target and execute a transformative deal, providing shareholders with a producing asset at a deep discount, says a lot about the quality of the management and their interests to me.   

I believe that Calima Energy is significantly undervalued and the initiation of strategic alternatives for the Montney asset is a clear catalyst to unlock that value within 6 months. With a forecasted production of 5,500 boe/d, Calima trades at ~1.2x 2023e EBITDA at US$60 WTI after adjusting for the value of the Montney assets.

Background and Key Terms of the Blackspur Acquistion

After years of structural challenges in the Canadian energy market, both in terms of equity markets as well as oil and gas prices, COVID-19 was the final nail in the coffin for privately held Blackspur Oil, particularly due to the company’s indebtedness.

For the FY20, Blackspur’s net loss was C$46.9 million and cash from operating activities was C$11.9 million. As at December 31, 2020, Blackspur had a working capital deficit of C$41.7 million, which included bank debt of C$42.1 million. After an amendment to the credit facilities on September 8, 2020, C$30.0 million of debt was coming due on April 30, 2021. 

In light of the pending repayment date, Blackspur initiated a sales process for the company. The company engaged in serious talks with 4 parties. Calima’s proposal emerged as the best course of action. During the period from late November 2020 to early February 2021, the terms of the acquisition were further negotiated.Calima Energy was in a great position during these negotiations, given the depressed demand and price for oil at the time and Blackspur’s looming debt maturity. Although the price for WTI increased from US$40/bbl to US$60/bbl during the negotiations, the final terms of the acquisition remained very attractive.

In the end Calima acquired Blackspur Oil for a total consideration of A$22.7 million, of which A$5.2 million was paid in cash and A$17.5 million in Calima Energy equity. This is against over A$200 million invested by Blackspur over the past 7 years to create inventory and infrastructure to accommodate growth to over 10,000boe/d. Public market valuations for companies with similar production and reserve profiles are multiples larger today as oil prices have roughly doubled since Blackspur’s initiation of the sale process in November 2020. 

Initiation of Strategic Alternatives for Montney Assets

“The Montney is estimated as the third largest natural gas basin in the world and remains a strategic source for oil & gas for Western Canada. With the focus on low GHG emissions and world leading ESG compliance, the Montney will be a leading energy supplier to LNG Canada and the North American market. “(Calima’s Reports)

Calima position in the Montney consists of 100% working interest across ~62,400 acres of Montney rights with 195.6mmboe of undeveloped 2C resources (44mmbbl of liquids and 890bcf of gas). This includes 33,643 acres held under a 10-year continuation lease awarded following a successful drilling program in 2019. All the contingent resources are within this core acreage. The remainder of the acreage is held by drilling licenses that require validation before their scheduled expiry in 2022. In addition, the company owns the Tommy Lakes infrastructure, which includes tankage, electrical generation, metering and a control center. According to management the Tommy Lakes facilities have a replacement value of A$85 million. Calima is carrying a little over A$60 million on the books relating to the Montney assets.

Calima considers a significant portion of its Montney acreage as development ready. Once it secures funding to construct a tie-in pipeline from the Calima well-pad to the Tommy Lakes processing infrastructure, the development pending resources could be classified as 2P reserves. An approval to construct and operate a multi-well production facility has been granted by the BC Oil and Gas Commission; this includes a permit to construct a 19.5km pipeline.  

Interest in the Montney has been picking up with a wave of recent M&A activity. Tourmaline Oil in particular has made several large acquisitions of acreage near Calima’s position in the Northern Montney in the last 2 years. Here’s an overview of the recent transactions in the Montney: 

-       Tourmaline buys Black Swan Energy for C$1.1bn in June 2021. Under the deal, Tourmaline purchased 2P reserves of 491.9 mmboe, 1,600 Montney horizontal drilling locations, and 230,000 net acres of Montney rights. 

-       In April 2021, Tourmaline acquired 50% of the assets of Saguaro Resources for C$205 million and entered into a joint venture agreement to develop these assets. The acquired assets consist of net average production of 9,000 boe/d, 2P reserves of 187.1 mmboe and 645 gross future Montney horizontal locations.

-       ARC Resources and Seven Generations Energy C$8.1 billion merger announced in April 2021.

-       Canadian Natural Resources C$461 million purchase of Painted Pony Energy in October 2020.

-       ConocoPhillips C$550 million acquisition of Montney acreage from Kelt Exploration announced in July 2020. This acquisition is 140,000 net acres with 15.000 boe/d of production and over 1,000 mmboe of reserves.

-       Chinook Energy acquisition by Tourmaline for C$30 million announced in February 2020. The Chinook assets include 3,500 boe/d or production, 35.6 mmboe of 2P reserves and 54,000 acres of Montney lands.  

-       Tourmaline acquired Polar Star Canadian Oil and Gas Inc. in February 2020 for C$11 million. The acquired assets include 2,500 boe/d of production, 2P reserves of 80.7 mmboe and 106,000 acres of Montney lands.

-       Painted Pony Energy sold 75% working interest in 8,460 net acres of Montney lands to Tourmaline for C$56 million in November 2019.

Source: Calima Energy Investor Presentation

On September 16, 2021, Calima has initiated a process to identify value maximizing alternatives for the Montney assets via engagement of Canadian investment bank, Peters & Co, who have executed on a majority of transactions in the Montney and know the value of the opportunity. Such potential alternatives include an asset sale, joint venture, asset exchange, or other potential transactions. Calima will not provide further updates on the process until a binding agreement is executed, which could take up to 6 months.

I think an outright sale is the most likely outcome given recent M&A activity in the area and Calima’s focus on generating free cash flow from the development of its oil assets. So, what could the Montney assets go for in sale? It’s difficult to arrive at a valuation based on the recent M&A transactions because they all include existing production/ PDP reserves.  

One sell-side report estimates that acreage valuations have been done at around C$1,500-2,000/acre when excluding the value of production. That implies a C$50-67 million valuation for Calima’s core acreage of 33,643 acres or C$94-125 million on its total ~62,400 acres.

As a sanity check I have done a comparable valuation based on 2P reserves. Since Calima’s 2C resources will only be converted to 2P reserves once funding is secured to build the tie-in pipeline from the well pad into Tommy Lakes, and there’s a capacity limit to the existing infrastructure, I have done a couple of adjustments to arrive at hypothetical 2P reserves: 1) I only classify volume processable with Tommy Lakes infrastructure of 125mmboe as 2P, 2) adjustment for geological chance of success of 90% and 3) deduct CapEx for tie-in pipeline of C$50 million (in reality only C$25 million according to management) from the valuation. So, here’s what I come up with: 

Notice that 3 of the 5 transactions have been done in 2020 when gas prices were much lower. Still, the resulting NAV of C$65.6 million is not too far of the carrying value on Calima’s books and the best estimate from sell-side reports. In the spirit of “It’s better to be approximately right than precisely wrong", I will assume a nice round NAV of C$50 million for the Montney assets going forward. 

Valuation

Let’s look at a couple of different scenarios. The first scenario shows 2023 price targets for varying EV/EBITDA multiples and oil prices and 5,500boe/d of production. The price targets include C$50 million of NAV for the Montney assets.  

The production level is likely going to be revised up as the 2021 year-end guidance was raised from 3,400boe/d to 4,500boe/d, but the 2022 year-end guidance remained unchanged. During a shareholder webinar in July, Jordan Kevol already indicated as much: 
“I think that’s entirely likely. As all the shareholders will recall, our exit 2021 guidance went from 3,400boe/d to 4,500boe/d. That was based on higher oil prices resulting in more cash flow than had originally been modelled, as well as the existing production doing better than previously modelled. So, we upped our 2021 guidance to 4,500boe/d, however, we didn’t touch our 2022 guidance, it still remains at 5,500boe/d. So, I think it’s quite likely that we will revisit that guidance level […]” 

So, here’s the scenario assuming 6,500boe/d production by year-end 2022.

Over 100% upside even at the lower end of the valuation range is not too bad, but what happens, if the Montney assets can be sold for a net C$50 million and the capital is allocated towards share repurchases and/or further production expansion? 

In the next scenario the entire proceeds are used to repurchase shares at an average share price of A$0.42. I somewhat arbitrarily chose the lower end of my valuation range at 5,500boe/d as the average purchase price. I can’t see the share price being lower than that, if the company sells the Montney assets and announces a huge share buyback; of course, the lower the share price, the more value the buybacks create. 

But with oil prices at current levels it would be even better to drill more wells. So, in the following scenario I assume that C$29 million is invested towards increasing production to 10,000boe/d and the rest is used to repurchase shares at an average price of A$0.42 per share. My CapEx estimate for a production increase of 3,500boe/d is based on recent drilling programs at Brooks and Thorsby. I stop at 10,000boe/d because I’m not sure how much more production the current infrastructure can support (“>10,000 boe/d” according to management).

So, what do you have to believe for these valuations ranges to be reasonable: a) oil prices will be above US$60/bbl for a while, b) 3-4(5)x EV/EBITDA is a reasonable multiple, c) Montney is worth C$50 million and d) for the most bullish case, Montney assets will be sold for C$50 million and the capital will be used to increase production and repurchase shares. 
If you believe that oil prices are headed even higher for a prolonged period of time, none of the rest even really matters. 

On the plausibility of the multiple range of 3-4(5)x EV/EBITDA: Decline rates matter, so let’s look at FCF (here EBITDA – CapEx). The decline rates for Brooks and Thorsby are ~22% and ~17%. Total maintenance capital at 5,500boe/d is around C$23 million according to management (that’s including CapEx to keep production levels stable), i.e. 3x EV/EBITDA translates to ~5.3x EV/FCF at US$60/bbl WTI, ~4.5x EV/FCF at US$70 and ~4.2x EV/FCF at US$80/bbl; 4x EV/EBITDA translates to 7.1x EV/FCF at US$60/bbl, 6x EV/FCF at US$70/bbl and 5.5x EV/FCF at US$80/bbl. That’s cheap in an absolute sense and sets up potentially high returns from dividends and buybacks, which matters a lot here, because I don’t see the market falling in love with O&G stocks any time soon. 

Risks

-       Oil and gas prices 

I’d love to say that I have no view on oil and that Calima Energy is just an incredible idiosyncratic opportunity that I would’ve invested in regardless of my view on oil, but I’d be lying. Yes, I like the circumstances of the Blackspur Oil acquisition, I like that there is a catalyst in the form of strategic alternatives for the Montney assets and I certainly love that it’s cheap, but if oil prices collapse tomorrow and stay low for long, this will not be a great investment. 

Although there a few things I’m as confident about as our inability to predict the future, and the fact that JPM and GS believe that we’re in an oil super cycle makes me more skeptical and hesitant than excited, I do think there are compelling arguments why oil prices will stay high for longer. 

I share the believe that oil supply will remain constraint for years to come, because of declining investments in production and exploration, as a consequence of O&G companies’ high costs of capital in today’s anti fossil fuel environment. Environmental issues are increasingly at the forefront of political discourse, but the vocal calls to stop investing in hydrocarbon supply are only addressing one side of the problem. We can’t simply cut hydrocarbon supply without replacing it with clean energy. However, the transition from hydrocarbons to clean energy has proven to take time, yet people want to see oil production gone today. As energy demand rebounds with global economies reopening fully, and oil supply stays tight, oil prices will likely continue to rise/ stay high. 

-       Execution

“How do you get comfortable betting on the same management that essentially went bankrupt with Blackspur Oil?” The near bankruptcy was brought on by structural challenges in the energy markets, both in terms of equity markets as well as oil and gas prices, and ultimately by the demand destruction caused by COVID. I don’t think you can infer a lack of executional prowess from those circumstances. Actually, I’d be much more worried about operational risk, if former Blackspur management, who are the most familiar with the Brooks and Thorsby assets, weren’t at the helm of the combined company. 

-       Capital Allocation 

The company is committed to return 30% of FCF to shareholders in the form of dividends and/or share repurchases. I believe that dividends and share repurchases will be the key to any O&G company’s shareholder returns because those companies will likely remain out of favor in today’s market regardless of their results. I know that perception can change quickly, and high returns will ultimately always attract capital, but I don’t expect the market to fall in love with oil and gas stocks for this investment to work out.

Calima’s management has recently shown great capital allocation with the opportunistic acquisition of Blackspur Oil. The timing, circumstances and price of that transaction say a lot in my opinion. Similarly, the timing of strategic alternatives for the Montney assets is another opportunistic move that confirms management’s capital allocation prowess; the market for gas assets in the area is red hot and gas prices are at levels not seen in a long time. 

Of course, if oil prices stay high, they will do what’s most natural for any O&G producer and drill more wells, which, if oil prices stay high, is not such a bad thing at all. Unless they raise expensive (equity) capital to do so, but that would not be characteristic of management considering their capital allocation decisions thus far.

-       No interest for Montney assets  

I find this highly unlikely given the recent transaction activity in the area and current energy prices. I’m also confident that the company will not agree to a bad deal for the reasons mentioned in the Capital Allocation section, i.e. these guys are opportunists that make good deals. That aside, most equity research reports on the company ascribe no value to the Montney assets and still come up with price targets of >3x the current price. Although I don’t put much weight on these reports, I do think there are multiple ways to win here.

Catalyst

Results for Montney strategic alternatives process 

Oil prices higher for longer

Dividends and share repurchases