Description

If you feel like you've missed the energy trade this year - do not fret. There remain a few diamonds in the rough. My current favorite is Parex Resources, PXT CN. Parex is the best risk/reward I've found in energy in a while. Look -- I get it -- there are a lot of cheap energy names out there, why take a look at anything new? Well, Parex actually has two very near-dated, idiosyncratic catalysts that I think can drive upside into the end of the year / in January.

High level attributes:

• Significant net cash balance sheet. No debt - will never have any debt
• Great history of capital allocation
• Two near-dated catalysts:
  • Finalization and clarification of Colombian tax treatment
  • Share repurchases of 15-20% of the volume being Jan 3
• Significant capex reduction in 2023
• Production step-up in 4Q 2022 for Plateau in 2023
• Straight up insane valuation

I realize the first reaction here is going to be -- why would I even LOOK at an oil and gas company with assets in South America, in a country that just elected a leftist leader? And, you would be like every single other person in the market if you have this reaction. But I implore you to hang with me - this is a WAY better situation than Brazil or Argentina or honestly a lot of jurisdictions. I believe the political risk is behind us, the valuation more than bakes things in, and its worth a deeper look. 

Company Summary:

Parex (PXT) is an oil and gas exploration and production company listed in Canada, with assets and production exclusively in Colombia.

They are honest about what they are – they produce oil and gas, unhedged, entirely within Colombia. A few elements of their business:

• Entirely conventional production (vertical wells), onshore – relatively cheap to drill with fast payback periods (6 months at current strip)
• Huge amount of running room in terms of available land for drilling, they secured 4.3m acres of new opportunity in 2021, making them the largest base acreage holder in Col.
• Their incremental capital commitments for this land are low ($25m/year)
• Decade+ of drilling opportunities ahead of them if they want them

The production situation is good - they will run-rate about 60,000bpd at the end of the year and likely hold that production level for the next few years as capex requirements come down - both in 2023 and further in 2024 as the infrastructure for a few of their new fields is laid in. Our view is this production is generally low risk - conventional wells in areas where they have a ton of experience operating. 

Political Situation

The primary reason for the massive valuation discount at PXT is because 100% of its production is in Colombia. Now, Colombia has been a solid and stable jurisdiction for them since they began producing there in the early 2000’s. The last year has been more challenging with the election of Gustavo Petro. The stock chart this year:

PXT has dramatically underperformed its Canadian peers since the beginning of the year (65%+), despite being unhedged to rising oil prices, having increased production, having the highest margins among peers and already being essentially the cheapest stock. Here's a simple chart vs the larger canadian caps (smaller caps its even more stark): 

The facts:

• Petro was elected in June by about 2% of the vote in a run-off election. He barely squeaked through, it was neck and neck with the right/center candidate
• This is a shift for Colombia which historically had more right wing leadership. Petro campaigned on a classic left/center agenda – taxes on wealthy, environmentalism, LGBTQ rights, etc
• Petro has established a coalition but it is relatively shaky (more below). He has 1 four-year term to get things done, then he cannot be President again.
• In August he put out his agenda and bill text for his initial proposals. They were wide ranging – 2% wealth tax, taxes on digital streamers (Netflix, etc), taxes on soft drinks, wide ranging social proposals, and relevant for PTX: a 10% tax on exports above $48 WTI and elimination of base royalty tax deductions
• The tax situation is now finalized, but after going through Colombian Congress is not as bad as was initially proposed. The top line tax became a bottom line tax, where income now gets a 5, 10, or 15% surtax depending on the level of Brent in the market. 

So at this point PXT has underperformed because of the i) fear of Petro, ii) the election of Petro, iii) the announcement of his agenda, and iv) the uncertainty around the implementation of that agenda. My core thesis is that the worst is behind us, and the stock is deeply undervalued, especially as we now essentially have all the information we need to see what the impact of Petro's agenda will be. 

• The bill surcharges / changes last 4 years, the length of Petro's presidency
• The Royalty (8-9.4% to government depending on field) will no longer be tax deductable
• 5% incremental income tax with "international prices" between $67.3-$75/barrel
• 10% incremental income tax with prices between $75-82.2/barrel
• 15% incremental income tax with prices over $82.2/barrel

Parex's income tax rate in Colombia is 35%, although some of this gets deferred into a long-term obligation so historical cash taxes have been closer to 25%. The rates will now increase based on oil prices. Obviously at lower prices there's no impact. For context, the original proposal was a top line hit that started as low as $48.

A few things we do not yet know:

• Is the price triggered off Brent, WTI, the Vasconia Discount price, or the realized price for Parex?
• Does Parex have the ability to shield some of this taxation, which is only applicable to Colombian operations - for example, moving Canadian costs into Colombia, using depreciation on new drilling projects, etc? Their depreciation expense is significantly below their capex but should rise a lot in the coming years. 

The other important element is that Parex will generate more free cash flow next year because of increased production and lowered capex.

Finally, and intriguingly -- EcoPetrol, the state-owned Colombian E&P, made comments just a few days ago that the new tax proposal impact on their cash flow would be "minimal." They have insight into exactly how this is structured, and so there may be more than meets the eye here. EcoPetrol is a challenging stock to own today because they also refine oil for the Colombian market and are controlled by the Colombian executive branch -- so if there are going to be populist shenanigans, I expect they play out in EcoPetrol's income statement more than anywhere else.

But on PXT, let's do the math. All in USD: 

When I bake in the higher tax rate (we will see exactly how it gets implemented, some deferred tax assumptions in there but small), the royalty tax change, and the capex reductions that the company has guided to, we get to a very nice result. I assume they continue to repurchase 10% of the shares as they have every year for the past 4 years around current prices (maybe that's aggressive but if prices go up its a good problem to have). 

Catalysts:

Three things that I think will happen in the near-term to unlock value here:

1) Parex is having an analyst day in early December. I believe we will get multiple pieces of clarifying information.

• We will get clarity on Parex's budget and capital allocation for 2023, including share repurchases and lowered capex. Capex then can come down further in 2024 given some one-time infrastructure projects in 2023. 
• We should get clarity on the impact of the change in the tax regime and strategies Parex can use to shield the tax. Strangely, the tax issue can be helpful fore shareholders as Parex may choose to return more capital in lieu of new capital projects given the higher tax rate

2) Parex will begin buying shares again in the market on Jan 3. They buy 10% of their shares every year - but this year they exhausted their authority at the end of the third quarter. They just thought they were getting too good of a deal on the stock and accelerated to buy as many shares as they could. They now have this one quarter period where they can't buy -- due to Canadian law (they'd be buying if they could, they have assured me) - and can restart purchases on Jan 2. That said, at these prices I believe they will be even more aggressive, and should be purchasing 15-20% of Parex's volume in shares for the first 6 months of 2023. 

3) After they exhaust their buyback (or perhaps even sooner), I think the company will engage in a Substantial Issuer Bid to repurchase additional shares. Effectively a tender offer -- Imperial Oil just announced one of these a few days ago. They just have too much cash and structurally this is the way to do it.

They upset shareholders with their Q3 earnings by NOT announcing an SIB. They didn't do it because it can be tax inefficient - although I am dubious of this claim and honestly I think the real reason is they want to buy their shares cheaper in January. There is a ton of pressure on them now to do more, and I think they will. 

4) If this stock doesn't work in 23 I think they are selling to private equity given CEO Imad's background. I think the lack of outperformance even given great capital allocation and low debt has them re-thinking the public market life. 

Risks and Mitigants:

1) Oil and gas management team -- I am always skeptical. I grew up in E&P land and every management team is excited to spend money to drill 100% IRR projects that never pan out, love to be long oil all the time, etc. These guys have one of the better capital allocation frameworks I've seen in the oil and gas space and a history of sticking to it. They also have a crystal clean balance sheet -- something that used to be rewarded with a premium multiple!

2) Colombia "nationalization" risk -- I have heard this pushback many times, and I think it explains some of the valuation disconnect here. My view is that the nationalization of assets in Colombia is very low risk, a few reasons:

• One of the main political arguments against Petro during the campaign was that he was going to radicalize the country and start nationalizing assets. He even had a big press event where he sat down and signed a pledge that the government would nationalize nothing to rebut this claim. His leftist ideas are traditional, honestly wouldn't be out of place in the democratic party in the US today. I doubt he goes back on the public commitment
• He's not that popular -- he barely got into power with 52% of the vote. He does not have a mandate to overhaul the country in a radical way
• The Congress is more right-leaning and would stop him if he  tried to do this via passing a bill
• The Courts are even more right leaning -- all judges were put into place under Uribe and other conservative administrations. This type of nationalization is explicitly against the constitution in Colombia -- which enshrines private property rights -- it would not survive a court challenge
• The army dislikes Petro. The main general even campaigned against him during the run up to his election. There is no way he could do this extra-judicially by taking over the country as some sort of dictator. 

3) Further negative oil and gas legislation -- Given this legislation was negotiated back closer to what the oil and gas companies wanted after announcement its hard to imagine there is more coming. If anything I would expect we might move the other way. He is now beyond the taxation portion of his agenda and moving on to spending the money. There is some concern with respect to further issuances of oil and gas drilling licenses, but PXT basically swept the board in 2021 (pre-Petro) and has enough acreage to drill for a decade+ and doesn't need any new licenses. 

4) Political interruptions - the third quarter was modestly challenging operationally for Parex because, in conjunction with elections, local work leaders went on strike in a few places which hampered production for a few weeks. This wasn't a huge impact, but was an annoying one. These types of things happen basically every 4 years in Colombia and PXT has now "settled" the wage relationships in all of their key drilling zones. So while brush fires can still jump up, I think most of this risk is also behind the company. 

Disclaimer

This document is for informational purposes only. All content in this report represents the author's opinion. The author obtained all information herein from sources believed to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind — whether express or implied. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any information contained herein. This report is not a recommendation to purchase the shares of any company. The information included in this document reflects prevailing conditions and the author’s views as of the date submitted, all of which are accordingly subject to change. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity. Any or all forward-looking statements, assumptions, expectations, projections, intentions or beliefs about future events included in this document may turn out to be incorrect. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment prior to making any investment decision.

The author does not hold a position with the issuer such as employment, directorship, or consultancy.
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Catalyst

• Analyst day in December - Clarity on Colombian tax implications
• Buying 15-20% of volume of shares starting Jan 3