Description

HWO is listed on the TSX; all figures are listed in Canadian dollars unless specified otherwise

Summary

High Arctic Energy Services (High Arctic or the Company) is a Canadian-domiciled oilfield services company with its main operations in Papua New Guinea (PNG). In PNG, the main product line is drilling services with high margin adjacent equipment rentals including workforce housing camps, rig mats, cranes, and oilfield related equipment. High Arctic owns and operates two heli-portable drilling rigs (Rigs 115 and 116) along with one workover rig (Rig 102), and operates an additional two drilling rigs (Rigs 103 and 104) that are owned by its principal client Santos (previously Oil Search, which merged into Santos in December 2021). Historically, High Arctic has been the sole major drilling provider in PNG.

From 2013-2019, High Arctic made lots of money providing drilling and ancillary services in PNG. Its three largest clients jointly own the PNG LNG project, which commenced operations in 2014. Natural gas is the largest focus in PNG, but drilling also targets oil and condensate. This all came to a halt in 2020 with Covid completely shutting down operations as well as negotiations regarding the two major new LNG projects being planned in PNG. High Arctic’s share price had begun falling in 2019 as years of weak gas prices finally began to catch up to High Arctic with its clients ramping down drilling activity. Its stock price then plummeted following Covid shutdowns. Nonetheless, the Company has been right about breakeven on a free cash flow basis for the 2020 - H1 2022 period. High Arctic maintained a strong balance sheet with net cash and was able to ride out this period without issuing new shares, taking on material debt or degrading its operating capabilities.

The market environment for natural gas (particularly gas that is accessible to Asia and Europe) has inverted a full 180 degrees. Natural gas is in short supply in the near term and attitudes have shifted about the long-term need for natural gas as part of any energy transition. High Arctic sits in a sweet spot as the major drilling services provider in PNG with one existing major LNG project, a second expected to see an FID made by the end of 2023 and a third also in the very late stages of planning. With one drilling rig now contracted (first drilling expected in December), High Arctic appears to have turned the corner. With historical average EBIT of $29M in 2013-2019* [FN 1], High Arctic offers the potential of very strong profitability in the years to come as the energy environment normalizes. In the event that both LNG projects move forward as anticipated, High Arctic expects to have all of its rigs and much of its ancillary rental products in continued service which would result in higher than historical profits.

Meanwhile, the Company is still priced at Covid-era levels. Following the sale of its Canadian well services division completed on July 28th, the Company has pro forma net cash of $47M, leaving it with an enterprise value of about $20M, materially less than historical average EBIT. With a major long-time non-executive shareholder holding two seats on the board and a history of returning cash to shareholders through dividends and buybacks, High Arctic offers strong prospects for high capital returns through cash flow and significant share price appreciation through multiple expansion in the medium and long term. 

Discussion

As Clay Williams, CEO of NOV, is fond of saying “It takes a while for prosperity to trickle down the oilfield food chain.” Williams is referring to the typical energy recovery cycle which hits energy producers first with the direct impact of higher commodity prices and only runs toward energy service providers once producers are confident enough in the durability of the price recovery to open up their wallets and start spending on growth (with some additional time needed after that to allow for the low-price down-period contract signings to roll off). 

Well, prosperity is running even slower to High Arctic whose three main clients - Santos, Exxon and Total - are huge multinational energy companies planning 20-year LNG projects in the extremely difficult and remote physical environment of PNG. These projects are slower to receive approval and the operators are more deliberate in getting them started. However, once the switch is flipped - and it appears that we are getting very close to this point - and these projects get going, they move inexorably forward to completion with huge contracts locking in energy delivery for decades to come so that projects are not canceled when prices fall. 

Historically, this proved true for High Arctic. The Company spent $90M in 2014 and 2015 purchasing, outfitting and transporting two heli-portable drilling rigs. It was terrible timing with the last energy up-cycle ending in 2014 and service providers hitting the wall soon thereafter. Despite the tough times in the industry, 2015-2018 saw very strong returns for High Arctic. After $80M of aggregate operating cash flow during 2013-2014 ($67M of EBIT), High Arctic brought in a combined $195M in operating cash flow ($147M in EBIT) in the four years 2015-2018. Even during the very weak year of 2019, the Company brought in $15M of operating cash flow (EBIT loss of $9M) and felt confident enough to make an $8M bolt-on acquisition (a bad one as it turned out but not particularly relevant) for its Canadian snubbing division. 

Covid put a complete stop to the Company’s drilling services in PNG. Its largest client Oil Search suspended the drilling of the IDT 26 development well in the middle of drilling and generally put a stop on discretionary expenditures including drilling company-wide. The work halt continued throughout most of 2021 due to pandemic breakouts and travel restrictions placed by neighboring countries which impacted the ability of High Arctic’s clients (and High Arctic itself) to work in the country. Also pushed back were previously launched negotiations between the Company’s clients and the PNG government regarding the two major new LNG projects being planned in PNG. 

Limited activity finally began late last year with discrete abandonment activity utilizing High Arctic’s Rig 115. This year, High Arctic has also been working on a couple of additional abandonment projects for Exxon. High Arctic recently announced the signing of a new 3-year contract covering Rig 103. Preparation of the rig is ongoing with first drilling expected in December and the rig anticipated to operate consistently throughout the 3-year period with the Company’s largest client Santos looking to drill new wells and complete workover activity mainly to maintain natural gas production for the 8.4 million tons of LNG annual production at the existing PNG LNG project as well as additional drilling of oil wells. 

Santos, Exxon and Total also recently announced the launch of FEED studies for the next major LNG project, Papua LNG, and expect a final investment decision by the end of 2023. Papua LNG would involve production from the onshore Elk-Antelope gas field, and provide an additional 5.4 million tons per annum of LNG. Further down the line, the same parties are working on the P’nyang LNG project. In February 2022, Exxon announced the signing of an agreement with the PNG government providing a clear framework for the future development of the P’nyang LNG project. The P’nyang field is estimated to have 4.36 trillion cubic feet of gas. 

Additionally, there are other smaller projects in PNG including Arran Energy’s Stanley Gas Condensate Development (stated intention to announce an FID shortly but this has been delayed in the past). With the current global environment broadly supporting energy - particularly LNG and particularly near Asia - High Arctic could be facing a long period of very profitable drilling work and associated rental services.  

This is a business that generated annual EBIT ranging from $24M to $46M per year from 2013 - 2018 for an aggregate total of $214M during that period. Looking out to late 2023 and 2024, with the possibility of having most of the Company’s rigs back in full-time operation, regaining similar and potentially higher levels of profitability seems very achievable. 

Valuation

While the Company’s position in PNG and future profitability are very attractive, the real driver of future returns is the current valuation. 

As stated above, High Arctic brought in average EBIT of $29M during the 2013 - 2019 period (which included a $9M EBIT loss in 2019 and highs of about $45M EBIT in 2015 and 2016). During this period, the Company paid $68.4M of dividends ($1.40 per share on the current share-count), repaid a net $36M in debt and spent $59M on acquisitions. 

While High Arctic has never traded at a high multiple of its earnings, a return to average historical levels of profitability upon the anticipated resumption of PNG energy activity would allow the Company to pay significant dividends and result in a significant share price increase. Prior to the Covid shutdowns, High Arctic paid $0.20 ($10M-$11M per year with a slightly declining share count) in annual dividends from 2015 through 2019. Additionally, at a 5x EV:EBIT ratio (not a reach in the early stages of an industry upturn), High Arctic would sport an enterprise value of $145M. In the event that both of the planned LNG projects go through, the company anticipates that all its drilling rigs and rental equipment would be required (which did not occur even during its most profitable period in 2015-2016) and record profits should result, leading to a significantly higher than historical dividend level and share price.  

Meanwhile, the company is priced as though it were April 2020. In July, High Arctic announced and closed the sale of its Canadian well servicing business to Precision Drilling for $38M* [FN 2]. High Arctic received $10M cash on closing and will receive an additional $28M in January. Including the $6M net cash on the balance sheet as of July 28 ($14M cash and $8M of mortgage debt) and $3M of retained working capital to be collected within 75 days of closing, High Arctic has pro forma net cash of $47M, leaving an enterprise value that is currently about $20M. 

Additionally, with the sale structured as an asset sale, the Company kept $130M of Canadian tax loss carry-forwards which are held at the parent company level. These losses would be usable by other oilfield service companies if acquired in a future acquisition. While Canadian OFS companies have no shortage of tax losses to use at the moment, that picture could change materially over the next couple of years. Canadian E&Ps were in a similar position in 2020 swimming in tax losses but will have largely exhausted these by the end of 2022 or 2023. While early, the Company is thinking about how to monetize these tax losses. 

All in all, I believe an investment in High Arctic at anywhere near current levels provides the opportunity for very large returns over the next six months to two year period with strong downside protection based on the Company’s net cash, net tangible assets of $127M, and tax loss carry-forwards.

Catalysts

The Company’s Q3 release will include the first $10M of the cash received in the recent sale which, along with the receivable for the next $28M, should result in net current assets (current assets minus all liabilities) equal to the current market cap. This will show up on quantitative screens for the first time and should move the Company’s share price off the current very low level.

Drilling is scheduled to begin in December which should highlight the upcoming change in profitability. With the remaining sale proceeds arriving in early January, the Company’s board will likely announce the use of the sale proceeds which may include capital returns to shareholders or other attractive use of the proceeds. Notably, the company has stated that the cost of bringing its two principal owned drilling rigs back into regular service should only be about $2M - $4M USD per rig.

Further announcements regarding the going forward of the Papua LNG and P’nyang LNG projects and associated drilling and rental contracts should be forthcoming next year.

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Footnote 1

During late 2016, High Arctic used the cash flow from its PNG business to acquire a Canadian well servicing division (Concord) for $43M. The thinking at the time was that this was a value purchase at a cyclical low point in the industry and the stock price increased sharply following the purchase. As it turned out, the industry downturn continued far longer than expected and the acquisition did not work out. High Arctic announced the sale of this division in July for $38M. While the Company does not break out operating earnings between its Canadian and PNG operations, it does not seem like Concord ever provided the company with significant earnings or cash flow and the vast majority of the positive results listed above relate to the remaining PNG business.

Footnote 2

At the same time, the Company also sold its Canadian snubbing assets in exchange for a 42%-ownership interest in the acquirer along with a $3.4M note. While High Arctic contributed significantly more equipment than the acquirer, the Company’s motivation was to place its assets in the hands of a motivated and hungry entrepreneur who had worked in their snubbing division before starting his own snubbing specialist and freeing management’s attention to focus on PNG. While I attribute no specific value to the snubbing interest, this division did provide material cash flow earlier in the Company’s history when Canadian natural gas drilling was strong. The Company also still owns some pressure control rental equipment in Canada that provides about $1.2M in revenue per quarter and a nitrogen pumping business.

Catalyst

Release of Q3 financial statements including the impact of the recent sale on the Company Balance Sheet

Upcoming start of drilling operations

Future announcement regarding use of funds including potential capital return to shareholders

PNG project updates and associated service contracts