Description

(Denoted in Canadian $ Unless Otherwise Noted)

(As of 9-23-2016)

COMPANY OVERVIEW

Gear Energy is a junior oil and gas E&P company in Western Canada with a ~95% heavy oil weighting.  Don Gray, co-founder of Peyto Exploration, is Chairman of the Board, while Ingram Gillmore, former VP Engineering at Arc Energy Trust, serves as President and CEO.   The company’s three core areas of focus are currently Wildmere Cummings, Paradise Hill, and Wilson Creek.  With the recent closing of the acquisition of Striker Exploration on July 27, 2016, Gear Energy now gains exposure to the emerging Belly River light oil play in west central Alberta.  The newly combined companies have 450 potential drilling locations in low risk, low cost horizontal oil plays.  

Source:  Gear Energy Company Filings, Internal Estimates

The company grew cash flow per debt adjusted share by 200% in 2014 vs. 2011, while growing production per debt adjusted share by 89% in 2014 vs. 2011.  2P reserves grew by 51% in 2014 compared to 2012.  However, the plunge in oil prices in 2015 had a significant impact on cash flow and production.  2P reserves declined due to lower replacement of production and oil prices.  Despite the persisting low oil price environment, Gear has an inventory of low cost wells that will allow it to spend within cash flow to grow production at the current STRIP and to benefit from significant upside if oil prices recover to USD$60 WTI and above within the next 2-3 years.  

The % change in the average share price appears to move in-line with the % change in cash flow per debt adjusted share.  Cash flow per debt adjusted share should increase 84% in 2017 vs. 2016 based on the current STRIP.  Therefore, the average share price for 2017 could re-rate to $1.16 if the trend holds.  For some additional perspective, the table below shows the EV/DACF multiples that Gear Energy has traded at over the past few years.                                   

Thesis:

Gear Energy trades at just 2.8x 2017E EV/DACF based on the current STRIP and 2.6x 2017E EV/DACF based on a base case price deck of USD$55 WTI for 2017, USD$60 WTI for 2018-2020 and USD$75 WTI thereafter.  Both multiples are a deep discount to the average 7.0x EV/DACF multiple among peer junior oil producers.  Our target price for 2017 using the STRIP and base case price decks are $1.38 and $1.66, respectively, or 98% and 137% above the current share price, respectively.  The base case values Gear Energy at 6.6x 2017E EV/DACF, or ~$48,500 boe/d, which seems fairly reasonable based on Raging River Exploration’s recent purchase of Rock Energy at 6.6x EV/DACF, or $42,750 boe/d, and Gear’s 2013 year end valuation of 6.5x EV/DACF.  Gear Energy offers investors:             

1. The opportunity to invest alongside Don Gray and Neil Roszell, two oil and gas executives on the Board of Directors who both have phenomenal track records of delivering shareholder value

2. Significant torque to higher oil prices.  For example, every USD$5 increase in WTI adds ~$6M in cash flow, or ~13% of our 2017E cash flow at the current STRIP

3. A recapitalized balance sheet with the ability to grow production within cash flow assuming current STRIP pricing

4. An inventory of low cost wells that will continue to lower the company’s cost structure

Why Does This Opportunity Exist?

Gear Energy is primarily focused on drilling for heavy oil, which is currently trading at quite a wide discount to WTI.  The market perceives the company as having relatively poorer quality assets.  Investing in Gear Energy is a bet that management will be able to continue consolidating acreage in its core operating areas and generate returns on par with its current key properties.  For example, Paradise Hill, which generates the highest IRR for Gear, virtually has no other competitors drilling in the area.  Gear could continue consolidating this resource play based on its success to date.  The current market valuation assigns no value to this roll-up strategy.                                                

MANAGEMENT

Don Gray and now Neil Roszell both sit on the Board of Directors for Gear Energy.  Both are highly talented at capital allocation and have a great track record of delivering long term shareholder value.  Following the acquisition of Striker Exploration, insider ownership is now ~17% of shares outstanding.  The three largest shareholders are John O’Connell, Kevin Olson, and Don Gray.  John and Kevin both served on the Board of Striker Exploration and now join Neil on Gear’s Board.             

Don Gray is a co-founder of Peyto Exploration and currently President of Gray Capital Partners.  He owns ~4.3M shares of Gear Energy.   When he first co-founded and ran Peyto Exploration in 1998, he grew production from 0 to over 20,000 boe/d in 2006.  The black line in the chart below illustrates the enormous shareholder returns that Don Gray delivered up until the point when he stepped down as CEO in 2006.  He still serves as Chairman of Peyto’s Board, while his successor Darren Gee continues to deliver exceptional returns.         

Peyto Exploration Share Price and Production Growth per Share

Source:  Peyto Exploration August 2016 Investor Presentation

Neil Roszell is founder/CEO of Raging River Exploration and served on the Board of Striker Exploration.  He owns ~2.3M shares of Gear.  Neil grew production at Raging River from 1,000 boe/d in 2012 to 18,000 boe/d today.  Raging River’s share price has compounded at ~50% per year to ~$11/share from just $2/share in 2012 and is now at its previous peak in 2014.  Similar to Gear Energy, Raging River eschews high cost, high productivity wells for low risk, low cost wells.  A typical well in Raging River’s core Viking play costs ~$650K and has an EUR of ~50mbbl.  Neil also maintains low leverage in the range of 0.6x-0.9x Net Debt/CF.   We believe that Gear will also maintain a Net Debt/CF below 1.0x with Neil now on the Board.  

Raging River Exploration Production and Share Price History

Source:  Raging River Exploration August 2016 Investor Presentation

Ingram Gillmore serves as President and CEO and formerly worked at ARC Energy Trust as VP Engineering.  He owns ~950K shares.  We certainly appreciate Ingram’s transparency and non-promotional character and his philosophy of maximizing return on capital rather than just chasing after a specific play.                        

DE-LEVERED BALANCE SHEET AND STRIKER EXPLORATION ACQUISITION SUPPORTS FUTURE GROWTH

Gear Energy certainly experienced substantial stress over its $130M syndicated demand credit facilities over the past year due to the plunge in commodity prices.  A demand facility allows the lender to call on the entire loan amount at any time.  Lenders reduced the borrowing limit from $130M to $90M on June 30, 2015, leaving Gear with very little breathing room on the $81.1M already drawn against its credit line.  However, lenders then dropped another axe on the company at the next redetermination by reducing the bank line to $60M on November 30, 3015.  This left management with no other choice but to issue $11M in equity (14.667M shares at $0.75/share) and $14.8M in convertible debt with a conversion price of $0.87/share for every $1,000 principal amount in order to pay down the non-conforming piece of the bank line.  

Given the risk of the banking syndicate calling on the entire demand loan at any time and only ~$6.8M in remaining borrowing capacity following the $25.8M equity and convertible debenture financing, Gear had very little flexibility to fund its capital program if oil prices rebounded.  Therefore, management announced on June 7, 2016 that it entered into an arrangement where it would:

1. Sell an additional 28.75M shares for gross proceeds of $20.125M through a bought deal financing

2. Acquire Striker Exploration for ~$53M in Gear Energy stock (76.2M shares) and the assumption of ~$9M in Striker Exploration net debt by the end of July 2016

3. Replace its $60M demand facilities with $50M committed term facilities since lenders cannot request repayment on demand unless agreed upon covenants have been breached

The Striker acquisition provides Gear with ~90 net sections of undeveloped land in the Belly River light oil resource play as well as ~2,000 boe/d of additional production.  The new committed term facility and bought deal financing affords Gear more financial flexibility to fund its capital program as the new committed term facilities have  ~$17M in undrawn capacity, which is even more than the $12.5M capital program for 2016.  Based on the current STRIP, Gear should be able to spend within cash flow to grow production to 7,200 boe/d in 2017.  Net Debt/CF should be ~1.6x and only ~0.1x for 2016 and 2017, respectively.  Our 2017 estimate assumes the entire $14.8M in convertible bonds are exercised and all proceeds are used to pay down debt.  Note that if none of the convertible debentures are converted, then 2017E Net Debt/CF is still a very manageable 0.8x.  Either way, Gear’s decline in Net Debt/CF should further support the case for shares to re-rate closer to the peer average of 7.0x EV/DACF.       

THREE KEY ASSET PLAYS IN PORTFOLIO DELIVER ATTRACTIVE RATES OF RETURN

Following the closing of the Striker Exploration acquisition, there are 450 potential well locations–roughly 33% are booked as 2P reserves.  The Lloydminster formation in Wildmere has been the most exploited interval to date and accounted for 31% of corporate production in 2014.  However, the Cummings, Sparky, and Colony formations have all proven to be successful development targets for heavy oil.  The 3 core areas that Gear Energy is currently focused on are Wildmere Cummings, Paradise Hill, and Wilson Creek.  Further development of these areas will support future low cost growth.                                                            

Wildmere Cummings

The Wildmere Cummings is an oil pool southeast and northwest of Gear Energy’s Wildmere Lloyd pool and accounts for about 9% of overall production, excluding production acquired from Striker Exploration.  Gear Energy has 10 sections of crown land, or about 40 multi-lateral wells in inventory (7 proven, 6 probable).  This area had previously been vertically drilled by other companies with limited success.  However, the company identified that a large oil pool existed in the area and purchased numerous sections of undeveloped crown land in 2012 for ~$1M.  Through 2014, Gear drilled 18 single leg horizontal wells with slotted steel lingers installed at an average cost of $1.1 million per well.  

A testament to the company’s focus on cost reduction, the company noticed that oil from the Cummings formation produced much lower sand relative to other areas, which motivated a switch in 2015 to drilling the first quad lateral horizontal well without any expensive slotted liners for an all-in cost of $1.1M.  For the same cost as previously drilled single leg horizontal wells, the quad lateral well delivers over 2.5x the production and reserves.  The higher oil production rate also lowers operating costs, which should average below $10/boe over the lifetime of the well.  The cumulative horizontal well length also qualifies for an Alberta crown royalty holiday of 5% for the first 3.5 years or 90,000 bbls.  As of September 2016, three more quad lateral, unlined horizontal wells have been drilled, with IP30 rates averaging 40% more than the first quad lateral well.  The higher IP rates are partially driven by increased lengths, which has also resulted in an average well cost of $966K–14% higher than the current risked type curve.  Our model assumes this new cost per well.  Below are the economics for the current risked type curve for the Wildmere Cummings play.  Note that the new well cost has not been updated in the chart below.                               

Source:  Gear Energy Investor Presentation (August 2016)

Paradise Hill

Paradise Hill, Saskatchewan is another great example of an area where the company identified a large oil reservoir that was being unsuccessfully drilled with vertical wells.  It then acquired 6.5 sections of land, which have an estimated 65 potential well locations (12 proven, 6 probable), in 2014 for just a little over $2 million.  Results from the first 5 horizontal wells drilled this year managed to far outperform the company’s initial type curve expectations by about 50%.  The risked type curve for future wells has now been revised higher but is still below actual well results as shown in the chart below.   Management initially planned six lined horizontal wells to be drilled this year but just expanded the program by 2 wells due to costs coming in 21% below original estimates.  Paradise Hill has the highest IRR in Gear’s portfolio and wells are eligible for a Saskatchewan Crown royalty holiday of 2.5% for the first 38,000 bbls of oil.  

Source:  Gear Energy Investor Presentation (September 2016)

Wilson Creek

Gear acquired 25 net full section Basal Belly River wells in the Wilson Creek area from Striker.  Wilson Creek provides Gear with exposure to the emerging Belly River light oil play.  These wells are also gassier than Gear’s other plays with a ~23% natural gas weighting.  Gear’s average working interest in this area is ~70% and operating costs are around $16.80/boe.  We would not be surprised at all if management reduces the costs of developing this play and buys out additional working interests from its JV partners.  However, we have not modeled any cost reductions or JV partner buyouts.  Two full section Basal Belly River wells are currently budgeted for Q4 2016.                   

Source:  Gear Energy Investor Presentation (September 2016)

As the company continues to exploit its inventory of low cost wells, Opex/boe, G&A/boe, and the average royalty rate will also continue to decline.  Below are our base case estimates for future expenses over the next 5 years.        

Below are our assumptions for individual well economics.  Note that the well cost, royalty rate, and operating expense assumptions are only for 2016.  These inputs then escalate depending on the price deck being used.  For example, it is assumed that every 1% increase in the WTI price results in a 0.5% increase in well costs and operating expense/boe since service provider costs will need to increase.  Also, the assumptions for Wilson Creek are on a gross basis.  Therefore, 70% of the capital cost per well, EUR, and production should be attributed to Gear Energy based on Gear’s average working interest in Wilson Creek.        

Source:  Internal Estimates, Gear Energy

GEAR ENERGY CAN CONTINUE TO CONSOLIDATE ACREAGE IN ITS CORE OPERATING AREAS

Management’s track record to date demonstrates that it can consolidate undeveloped crown land in its core operating areas and develop these assets to generate attractive rates of return.  As mentioned earlier, Gear Energy first acquired land in Wildmere Cummings for ~$1M in 2012 and paid ~$2M for 6.5 sections of Paradise Hill acreage in 2014.  As mentioned in the previous section, Gear’s first 5 horizontal wells drilled in Paradise Hill have already yielded very promising results.  There is also virtually no competition in Paradise Hill, thus the company can continue to purchase crown land in the area if it chooses to do so.  The company also purchased over 20 sections of undeveloped crown land in 2015 for just ~$1M.  There are 170 unbooked potential well locations in these 20 sections of land, and the company is already working to de-risk some of this land by drilling one exploration well as part of its 2016 drilling program.  

In order to account for management’s ability to continue to acquire and consolidate land in its main operating areas, we have extrapolated the estimated cost to acquire 700 risked well locations and assume these wells will have similar economics to Wildmere Cummings.  We assume a risked well % of 85% of potential well locations, which should be attainable since Gear’s drilling success rate has consistently been over 90%.  We understand this may not be the most exact methodology for modeling purposes, but it should be reasonable based on management’s track record of cost reductions and maximizing the return on capital of recent plays, such as Wildmere Cummings and Paradise Hill.  Below we show that it would cost ~$41M to acquire over 200 sections of land with 700 risked well locations using Wildmere Cummings as a benchmark.  We have actually baked in $50M into our base 2016-2025 base case capex projections to be a bit more conservative.                

Also, Twin Butte Energy’s recent bankruptcy is another opportunity for Gear to further consolidate the Wildmere Lloydminster area where Twin Butte currently has operations.  

CAPITAL EFFICIENCY ASSUMPTIONS

Below is the line item detail for our base case capital expenditure projections.  Although Gear’s capital efficiency has been in the $12,500-$13,500 boe /d range for 2015-2016 due to service provider cost reductions and drilling efficiencies, a normalized capital efficiency will likely range from $19,500-$21,000 boe/d once Gear ramps up purchases of undeveloped land and infrastructure to facilitate more production growth.  

The table below lays out the All-In IP365 Capital Efficiency for each price deck scenario.  Each scenario has different capital efficiencies because it is driven by the oil price deck being used, which then drives our assumptions for service provider costs and land costs.     

VALUATION

Gear Energy trades at just 2.8x 2017E EV/DACF using STRIP pricing.   This is a substantial discount to the average peer multiple of 7.0x EV/DACF for junior oil producers, particularly with Gear’s de-levered balance sheet.  Raging River Exploration recently acquired Rock Energy, a junior oil producer for 6.6x CF assuming USD$50 WTI.  This transaction provides a useful comp and further supports the case for Gear Energy to re-rate to at least 6.0x 2017E EV/DACF.  As a reminder, my NAV methodology assumes that Gear Energy will continue to further acquire and consolidate land in its core areas of operation.  I assume a WTI/WCS differential of 30% in 2017 and then a normalized 25% thereafter.  My assumption for Gear’s differential to WCS is $4.50/bbl.    

Assuming current STRIP pricing and a 10% discount rate, Gear Energy’s 2017E NAV is $1.38/share, or 6.0x 2017E EV/DACF, 98% upside to the current share price.  Our base case scenario, which assumes USD$55 WTI for 2017, USD$60 WTI for 2018-2020, and USD$75 WTI thereafter, yields a 2017E NAV of $1.66/share, or 6.6x 2017E EV/DACF, 137% upside to the current share price.  If we take the price deck used by Sproule in Gear’s most recent reserves evaluation, Gear Energy’s 2017E NAV is $1.95/share, an upside of 179%.  If Rystad Energy’s price deck, by far the most aggressive, were to materialize then Gear Energy should trade at $2.68/share, or 9.0x 2017E EV/DACF.  Below is a detailed summary of each price deck scenario.     

Valuation Summary

SUMMARY FINANCIALS

Risks:

1. Oil and gas prices remain lower for a sustained period of time

2. Heavy oil differential remains at 30% or higher, above the 5-year average, for longer than anticipated

3. Future horizontal wells yield results below risked type curves

4. Roll-up strategy fails to yield economic plays

5. Biggest insider shareholders liquidate position

6. Management decides only to hedge a small portion of production if oil prices rebound to higher levels, thus exposing Gear Energy to greater potential downside price volatility

Catalyst

• Q3 earnings report.
• 2017 Guidance update in November.
• Oil prices heading back up.
• Drilling results from Wilson Creek.