Description

High Returns for High Arctic?

High Arctic Energy Services Inc. (TSX: HWO) is an oilfield services, drilling and equipment rental business headquartered Red Deer, Alberta Canada.  While based in western Canada, the company has significant operations in Papua New Guinea (PNG).  High Arctic provides snubbing services, nitrogen services, specialized drilling, drilling management and rental equipment.  Despite several unique characteristics, I believe an investment in High Arctic could provide significant potential upside with important downside protection in its asset base.

High Arctic is currently trading at the following metrics:

The company appears to be quite cheap for the following reasons:

• Many oilfield service and drilling companies don’t appear to be richly valued
• The company had to be restructured during and following the financial crisis and despite not falling into bankruptcy and preserving equity value, it appears to still be sitting in the “penalty box”
• One of the company’s core services, snubbing, has historically been associated with high pressure gas wells (more on that later) and, as everyone knows, due to the current price for natural gas there are not many gas wells being drilled at the moment, especially in Canada
• A significant portion of the company’s revenues and earnings are derived from its operations in PNG, which at first glance is a less than ideal location.  Additionally, a significant portion of the revenue and earnings in PNG is derived from one customer.  (it’s not InterOil Corporation)
• The company is somewhat less liquid, driven in part by a couple significant shareholders, including Cyrus Capital Partners which converted much of the debt it owned in the restructuring to a 44.1% stake and Mr. Jed Wood the former CEO of the company who continues to own 20.4% of the company

Asset and Business Summary

PNG

• 1 owned workover rig
• 2 drilling rig management contracts
• rental business (mats, lighting, cranes, miscellaneous)
• 1 owned oilfield camp (soon to be delivered)

Canada

• 21 snubbing units (15 stand alone, 6 rig assists)
• 3 250K underbalanced rigs
• 5 nitrogen transport trucks
• 10 nitrogen pumpers
• Miscellaneous rental equipment

Papua New Guinea

On a ttm basis 63.6% of the company’s revenue has been derived from operations in PNG.  A significant portion of these revenues came from its relationship with Oil Search Limited (ASX: OSH).  In the first six months of 2012, OSL represented 62% of revenues and in 2011 and 2010 OSL was 48% and 55% of revenues respectively.  Oil Search is a $9.9 billion Australian company with a long history in PNG.  It has operated there since 1929 and the PNG government is currently a 15% shareholder in the company.  It also happens to own a 29% interest in the PNG LNG Project which is currently being constructed with Exxon Mobil as the 33% owner.  You can see their most recent presentation… http://www.oilsearch.com/Investor-Centre/ASX-Releases/Presentations-and-Webcasts.html.  OSL is projecting a more than four-fold increase in PNG production as it begins to deliver gas for the PNG LNG Project between now and 2015.  High Arctic would appear to be a significant, trusted participant in that growth.  High Arctic has several other smaller customers in PNG, including InterOil Corporation.

Obviously PNG and the customer concentration is a significant risk, but it is also a significant opportunity.  The biggest component to the company’s work for OSL is the management and operation of OSL’s drilling rigs in the country.  The two rigs being managed, known as 103 and 104, are heli-portable rigs (the only two in the country).  For the last several years High Arctic has been managing drilling operations for OSL under a semi-long term contract.  The agreements for both rigs currently run through December of 2013 and there was some price consideration given to OSL by High Arctic in the most recent negotiation.  Interestingly, the arrangement calls for the simultaneous operation of both rigs beginning in October of this year for the first time in over a year.  This should provide a significant tailwind. 

PNG is a difficult country in which to do business.  Dealing with a difficult government and local tribal populations are just part of it.  Of course the flipside to that coin is that there are few service operators in the country and several sources have described the very nature of the country as a “barrier to entry.”  High Arctic has operated in PNG for eight years now and has a significant lead on new entrants, entrants which I believe would have difficulty generating the trust needed to win over operators in the country, especially on the eve of LNG gas operations.  In addition to items previously noted, extremely difficult terrain, maddening logistics, government bureaucracy and difficult weather all contribute to this “barrier.”

Recent political headlines have not helped the perception of PNG in the international community, as the recent dispute over who was Prime Minister lead to elections a few months ago.  You can’t make this stuff up!  While it makes for spectacular headlines in the press, it seems to be business as usual in PNG according to long-time residents and business participants in the country.  It appears that this recent episode has been resolved, but this could again become an issue.   Developments over the last 12 months have appeared not to disrupt LNG development operations.

The association with PNG may very well be a tailwind.  As mentioned previously, Oil Search has plans to significantly expand its production in the country.  This will no-doubt involve High Arctic.  Additionally, it appears that the PNG LNG operation is being expanded.  Recent results from P’nyang South drilling suggest at least one additional train is feasible for the current two train design for PNG LNG.   While OSL is not the operator here, drilling operations in P’nyang would require heli-portable rigs which OSL owns.  High Arctic was the drilling manager on the initial drilling in the area.

High Artic is currently expanding its operation beyond drilling management in the country, most importantly in the rental and support services areas.  Efforts in this area include matting and miscellaneous rental business and camp management.   

An important conversation with a senior level drilling manager at Oil Search suggested the following:

• The relationship with High Arctic is very much seen as a partnership with significant give and take between the two entities.  Both entities need the other.
• OSL doesn’t fancy itself an operator of the rigs it owns and in many ways would prefer not to own the rigs.
• The recent expansion of the drilling management agreements was not the result of a formal open tender.  It was a negotiated agreement by two partners.
• OSL had a chance to find new relationships when High Arctic was in a dire financial position but chose to work with the company to maintain the relationship.
• Significant additional opportunities exist for the companies to work together outside of PNG, specifically in OSL efforts in Tunisia and Kurdistan.

High Arctic is the largest snubbing operator in Canada and is a significant operator in the independent nitrogen services business.  As noted previously, snubbing has been associated historically with gas well.  Interestingly, in Q1 the company noted that 80% of its snubbing work was directed at oil wells and utilization has remained fairly consistent over the last couple of years despite the ongoing declines in natural gas prices.  The process is used for workover and completion activities and while a competitor so to speak with
coil tubbing, it allows for intervention in the well bore while it is still under pressure.  And while clearly the business would benefit from more activity in the western Canadian gas business, increasing pressure from long horizontal wells and additional drilling demands appear to be driving increased demand from oil well drilling.  Snubbing utilization, which is disclosed separately, has average about 40% over the last several quarters.

The nitrogen business is currently operating under much more favorable conditions.  Utilization over the last several quarters has been approximately 77-80%.  Nitrogen is also used in completion and workovers for a variety of purposes, including well stimulation, pressure testing, EOR, pressure maintenance and gas lift.  The company is investing more heavily in this side of the business.

The company has first call agreements with Encana and Shell in Canada, two of the country’s most active participants.  These agreements speak to the credibility of the Canadian operations.

• Tax losses – While in the most recent quarter the company began the process of recognizing tax assets arising from prior operating losses, the company continues to have significant unrecognized tax assets.  In Q2 2012 the company recognized a $5 mm tax asset due to the expected utilization of $20 mm in available operating losses.  There remains $73 mm in unrecognized tax losses, which would equate to an additional $18.25 mm asset or approximately an additional $.36 per diluted share undiscounted.

• 250K UB rigs – During the restructuring of the business, the company wrote-down the value of its three 250K UB rigs to approximately $5 mm per rig.  Each rack-and-pinion rig cost in excess of $15 mm to construct.  These rigs were primarily built to drill for very deep gas, much of which is uneconomic at the moment, hence the write-down.  These rigs have seen very little if any action over the last couple of years.  However, the company may very well be on the cusp of significant utilization of these rigs.  Recently, the company has been test drilling with one of these rigs for Encana on some extremely deep wells in the Horn River.  The rig appears to be going to depths in excess of 6,300 m where current coil tubbing operations are reaching their limits.  Currently earning approximately $50,000 per day on the Encana test operation, these rigs have the opportunity to potentially generate significant additional earnings for the company.  The company is about to begin a marketing process for the rigs in Canada and in the US where they might be particularly useful, according to management, in the Bakken.  Assuming 60% utilization and a $50,000 day rate, each rig would generate approximately $11 mm in revenues and perhaps $2.8 mm in EBITDA… that might sum to $33 mm in incremental revenue and $8.4 mm in incremental EBITDA compared to ttm revenue of $138 mm and ttm EBITDA of $36 mm.  Clearly if this business develops these rigs would be worth more than $5 mm each.

• The company unfortunately does not break out margins between the Canadian business and the PNG business.  While I can understand management’s reluctance given the customer concentration in PNG, it makes an analysis of the two streams of income more difficult.  Assuming a 27.5% EBITDA margin in the Canadian business (which I believe approximates many drilling and services business in Canada) the Canadian business would have generated approximately $13.8 mm or 38% of the EBITDA of the company over the past 12 months.  On an adjusted enterprise value of $75 mm, I believe the Canadian operations alone (at an EV/EBITDA multiple of 5.7x) provide support for the current valuation of the entire business.  Yes it can be argued that there are plenty of drillers and services companies trading at 3-5x EV/EBITDA at the moment, but the slack in the snubbing business and the recent paucity of 250K UB work that might be changing lead me to conclude that we are not at peak earnings for this business and therefore a 5.7x EV/EBITDA multiple is approximately a fair multiple for the Canadian business over time.

• According to management, approximately 50% of the cash is in the PNG operation.  The PNG operation is mostly transacted in USD.  There is a 17% withholding tax from PNG.  In terms of modeling out a PV on the tax value, the company’s PNG operation currently pay the Canadian operation a 6% of revenue management fee.  At a discount rate of 10% I model approximately $.27 per share in NPV for the tax assets.

• The company pays a dividend which approximates a 7% yield at current prices.  Oddly, the company pays the dividend at $.01 per month, perhaps a vestige of its days as an income trust.  The company is attempting to force the valuation question by paying a dividend which can’t be ignored.  While there is clearly room for this payout to expand, the company has to manage significant reinvestment opportunities both in PNG and elsewhere.

• High Arctic also has a NCIB that it received approval for in late March of this year.  Again it is attempting to manage investment opportunities in addition to the limited liquidity available in these efforts.  The company repurchased approximately 80,000 shares through the end of Q2.  According to SEDI it has continued to repurchase a small number of shares, approximately 35,000 shares since the close of Q2.

• Cyrus Capital Partners, the company’s largest shareholder, is a stressed and distressed credit investment management organization.  While it has a representative on the board, it likely will seek an exit at some point.  Cyrus has over $2.1 billion under management and the High Arctic position seemingly is quite small.  I don’t necessarily foresee a sale of the business (though would certainly welcome one), but added liquidity from of sale of these shares would likely help the valuation.   

• Clearly the company would benefit from any pick-up in gas drilling in western Canada.  While I won’t venture a guess as to when that might be, I like the option of owning assets cheaply that would benefit from an improvement in that market.

• Western Canadian drilling activity is clearly slowing, surprisingly also for oil operations.  It remains to be seen how this will play out over the winter season and into next year.  According to Baker Hughes, in July the total rig count in Canada was down 11.5% and in August it was down 32.9%.  Gas was down 27.2% and 43.6% in those two months respectively and surprisingly, oil rigs were down 5.3% in July and 28.2% in August.  Overall, utilization at the end of August was down to 41.4% from 64.3% last year.  This will clearly have an impact on the Canadian business if it continues.

• Despite what I believe to be a unique relationship between High Arctic and OSL in PNG, this is a risk.  The company’s may not be as friendly to each other as time goes on (though resent indications are that the relationship is strengthening).  Agreements may not be renewed or if they are renewed may be at terms which are disadvantageous to High Arctic.  In fact, I would expect some price pressure going forward on all business in PNG.

• New capital commitments to PNG are currently accompanied by a contract that allows for the payback of High Arctic’s investment in as little at 18 months.  Subsequent agreements typically provide pricing concessions to the customer base.  Either the payback provided to High Arctic or the subsequent renewal pricing could turn out to be less favorable in the future.

• PNG.  Despite major capital commitments by very large international oil and gas companies that are redefining the country, strange things could still happen in PNG.

• Acquisitons.  The company has looked at acquisitions, though none have been consummated.  While now may be a fine opportunity to make an acquisition as multiples for private companies in Canada are on the order of 2-3x EV/EBITDA, the company could make a mistake if it were to acquire a company.  I believe management and the company have an interest in the coil tubbing business and would expect an acquisition or significant capital expenditures toward that end over the next several years.

Final Comment on Valuation

I’ve chosen not to present a very formal presentation on valuation.  My argument is that with the metrics currently present and the potential tailwinds in North America and PNG, the valuation at these prices appears to be mistaken.  I consider it a one foot hurdle.  It doesn’t take very large multiples to generate substantial returns for an investor at current prices.  For reference, a 5x multiple on fully diluted ttm NI per share gets you to $2.67 (54% return) and a 7x multiple gets you to $3.74 (116% return).  Of course the ttm NI figure used in that calculation is mostly not burdened by taxes, as it will be for several years.  With management (current and former) and a large controlling shareholder clearly incentivized alongside me, I like the chances of success at these prices.

Catalyst