Description

In the past two years, a few formerly high-flying Natural Gas (NG) producers proved to be excellent shorts:  “best-in-class” NG names have mostly been re-priced to better reflect abundance of NG resources and “huge tracts of land” waiting to be developed.  UPL (3/27/2012 VIC write-up) and SWN (3/28/2012) are two notable case-studies:  back in 2009-2011 both were quality names to own for the inevitability of a NG price rally.  Our internal estimate (resulting from DCF analysis of development programs) is that at ~$50/share, UPL was discounting >$5.50/Mcf Henry Hub (HH) Natural Gas (NG) prices in perpetuity on a 2P (P50 basis) while at ~$45/share SWN was discounting >$5.00/Mcf HH on P50 resources.  Even RRC, periodic rumors of an imminent buyout notwithstanding, has materially underperformed the market over the past year and is currently discounting “only” ~$5.00-5.50/Mcf HH according to our estimates.

Introducing Peyto Exploration & Development - PEY CN (PEY) - a mid-cap E&P company holding a concentrated land position in Canada’s Deep Basin with production and reserves ~90% weighted to natural gas.  We believe that at >$24/share, PEY is more richly valued on a NAV basis than the most expensive large- and mid-cap US shale players have ever been over the past two years.  The stock has ~50% downside peer valuations and ~70% downside to our estimate of fair value at normalized commodity prices.  The company sports unusual disclosures and metrics in its investor materials including what appear to us to be factual oversights (we hope entirely un-intentional).  These oversights may leave a reader relying on these materials with an overly optimistic view of company’s financial performance, asset quality, and value.  The apparent inefficiency is also explained by primarily retail and mutual fund investor base that may have relied on the above disclosures and sell-side analysis.  The superficial sell-side coverage in turn largely relies on the company-supplied investor materials and metrics.  Valuation reflecting commodity prices far in excess of the futures curve and the marginal cost of production and limited resource upside virtually eliminate fundamental risk to the short while the roll-off of highly profitable hedges and unsustainable CapEx program provide near- and medium-term catalysts.

Peyto discounts prices in excess of $120 WTI and $7 HH on a pre-tax Proved + Probable (2P) NPV-10 basis and trades at a valuation in excess of SWN, UPL, and CHK at their 2009-2011 peaks.  What’s more, Peyto suffers from Canadian basis differentials.  Cutting through the noise of a non-technical investor presentation rich in unusual profitability and performance metrics,  we surmise that PEY’s resources are not materially more profitable than those of its peers, requiring >$4.00/Mcf HH and >$90/bbl West Texas Intermediate (WTI) prices to generate a 10% IRR.   We believe that in the $4.00/Mcf and $90/bbl WTI price environment and at recent price realizations Peyto’s pace of capital spending is unsustainable.  Finally, all of the sell-side reports we have examined included severe flaws materially overestimating cash flows attainable at projected commodity prices.

In effect, PEY provides an opportunity equivalent to shorting SWN >>$50/sh and UPL >>$45/sh today.  It is an attractive stand-alone short, or paired with just about any going-concern large- or mid-cap NG producer.  As plenty of producers continue to discount sub-$4.00 HH, PEY may be a valuable short to consider even for NG bulls looking to load up on longs while controlling NG price factor exposure.  A discussion of long-term NG price expectations is worthy of its own write-up and is beyond the scope of this note.  VIC’s CHK threads provide a good summary of what we view as sound arguments for a long-term ceiling on North American (NA) NG prices near $4.00/Mcf in real terms with some potential downside below  this level in the continued cost deflation scenario.

Valuation

Relative Valuation

While, this approach is problematic for valuing E&P companies, it does illustrate the disparity between PEY and some well-run NA producers with comparable/superior cost structures, superior market access,  and more meaningful resource exposure to a commodity price recovery as well as some of the recently challenged stories with large resource upside:

Sources:
Estimates: FactSet
PEY CN - 10/2/2012 presentation, p. 19.  Assume booking of all possible locations.
SWN - Internal estimates based on Fayetteville and Marcellus acreage holdings and play typecurves.
UPL - 10/2/2012 presentation, p. 2
BIR-CA - 3/14/2012 NR, 2P+2C
CHK - 3/31/2012 Company estimate of total net resource potential

While we have not adjusted the above income figures for hedges, it is worth noting that ~25% of PEY’s EBITDA and CF is due to the impact of hedging that has provided 38% uplift to natural gas price in 2012 but should turn into a headwind in 2013 on the current futures curve limiting the upside from a medium-term NG price rally.

Another reason behind the premium valuation appears to be CFPS growth projections that are well in excess of the group:

All the sell-side reports we examined contain substantial errors (discussed below) leading to overestimation of CFPS growth by 10-20 percentage points.  Thus, actual growth is likely to be in the 20-30% range at sell-side assumed 2013 commodity prices (generally in the $3.75-$5.00/Mcf HH range).  Growth will be primarily accomplished by an orgy of CapEx that will increase PP&E by ~1/3:

A 20-30% expected increase in cash flow may sound enticing.  In fact, it is underwhelming when accomplished by investing 29% of the book value of the existing assets.  In addition, the expectations include a 50% recovery in the price of the primary commodity produced by PEY.

Absolute Valuation

A DCF is our preferred method of valuing E&P assets as it captures asset cost structure, capital structure and efficiency, development capital needs, and reserve life.  PEY’s 1P reserves are not particularly conservatively booked with 42% PUDs.  We generally use the after-tax NPV-10 of Proved (1) Reserves (assuming a low PUD ratio) to value E&P assets with Proved + Probably (P50, 2P) NAV appropriate for evaluating portfolios of highly predictable drilling targets.  PEY is significantly overvalued relative to the peers even when using 5% discount rate (comparable to the company’s cost of debt) to estimate the pre-tax NPV of 2P reserves.  We begin with PEY’s YE 2011 reserve report, add the reserves from the Open Range Energy acquisition, reserves added by 2012 YTD CapEx program at historic and advertised F&D costs, and assume 40 bbl/Mcf liquids yields for the entire reserve portfolio.  These are aggressive assumptions as they ignore YTD declines, but the name is so astonishingly expensive that these simplifications do not materially impair the short thesis.  We further assume  40 bbl/Mcf liquids yield.  This is in excess of the Company’s guidance of the impact of deep-cut expansion plans (expansion yielding 35bbl/Mcf average yields, which is already included in the YE 2011 reserve report) and close to the high end achieved but the more liquid-y targets in the portfolio (Cardium).  We ignore BTU loss due to deep cut as well as increase in the proportion of low-value C2 in the liquids stream.  A more thorough analysis accounting for these would have yielded materially lower NAV estimates.  Finally, we assume the following price realizations (relative to WTI and HH), also in excess of the recent history:

The above approach yields the following values assuming $90/bbl WTI and $4.00/Mcf HH:

With the following sensitivities:

We believe PEY shares are worth <$10/sh and current share price discounts roughly $110/bbl WTI, $5.00/Mcf HH, excluding taxes, and using a 5% discount rate.  Even on a pre-tax PV-5 basis PEY shares appear to be worth <<$20.00/sh.

Reasons for the Inefficiency

Our best guess is that this trust-like valuation is primarily due to retail ownership with institutional holders generally consisting of sleepy mutual funds holding PEY as a diversified position as well as the recent move to play NG price recovery.  Interestingly, operationally and financially levered NG producers do not appear to have generally outperformed as one would have expected in a true cyclical commodity upturn.  The performance of PEY appears to have been primarily driven by a search for “safe” ways to play NG by retail and long-only investors rather than energy players.  A review of holder reports appears to support this explanation.  The marginal buyers may not be performing independent due diligence on the name.  Meanwhile, sell-side research on PEY is some of the worst we have seen in the E&P space.  We have been pitched the name as the cheapest NG producer discounting $2.00/Mcf in perpetuity by a supposedly respectable shop, a shockingly flawed model included.  Most of the research we have seen appears to simply re-package the company’s presentation of financial performance, which appears to contain significant flaws as described below.

Presentation vs. Reality

The company has been successful in creating an image of an impeccably run shop achieving industry-leading economics.  We believe this impression is primarily due to an advantageous hedging position, the benefits of which are presented as operating in nature and sustainable.  An additional factor helping to lower the operating costs is high capital intensity (lowering variable costs by increasing capital costs).

Peyto realizes 140% of the benchmark NG price due to NGL and heat content uplift

 (10/2/2012 presentation, p. 10):

“2011A Sales Price of $5.47/mcfe = $3.91/GJ x 140%* = %5.47/mcfe”
“* 2011 uplift for NGLs and heat content from unhedged natural gas price ($/GJ) to realized effective price ($/mcfe)”

Reality:  

The uplift is due to NGL content as well as hedging benefits.  2011 A oil and gas sales ($/mmcfe) were 4.98 while realized gains on hedges were 0.48.  So the uplift for NGLs and heat content in 2011 was 27% vs. 40% indicated.  While the presentation appears factually incorrect, 2011 NGL price realizations are a pleasant memory for NG producers these days.  Arguably, including 2011 liquids realizations in an October 2012 presentation is an even more severe oversight than claiming 40% heat and liquids content uplift instead of the 27% actual plus 13% hedging gain.  The Q2 2012 reality is oil and NGL price realization at 76% of WTI vs. 86% in 2011 and NG price realization at 83% of HH vs. 97% in 2011.  At differentials slightly improved from the recent levels (to 80% NGLs, 90% NG) and at $90/bbl WTI and $4.00/mcf HH benchmarks PEY would realize ~$4.50/Mcfe.

Peyto is a low-cost producer that is profitable in a $4/Mcf NG price environment

 (10/2/2012 presentation, p. 10):

“Costs = PDP FD&A + Cash Costs”
PEY represents total costs, including capital, as $3.47/Mcfe.  The implication is that the company is profitable >$3.47/Mcfe realized prices.

Reality: 

PEY has 9 year producing reserve RLI (10/2/2011 presentation, p. 24).  The present value of gross revenue from 1Mcf of NG realizing $4.00 and produced uniformly over 9 years discounted at 10% is $2.56 and discounted at 5% is $3.16.  PEY’s latest debt raise had ~5% coupon so discount rate >>5% seems appropriate.  Using data from the presentation, at $4.00/Mcf HH price environment the pre-tax economics is breakeven at best and not particularly different from a typical liquid-y Deep Basin well or Montney, Marcellus, Fayetteville, and Woodford wells:

The above model is intentionally simplistic.  It ignores taxes since this makes comparisons to peers who generally tend to ignore taxes in their presentations easier.  It also understates the effect of discounting due to steeper initial decline of tight wells and actual production extending well beyond the 9-year RLI in practice.  We have built DCF models for PEY’s individual areas of activity (Cardium and Wilrich) and own some producers active in those areas and the above breakeven is approximately representative.  It is interesting that PEY’s is the only peer presentation without reference to production rates, typecurves, and IRRs.  Perhaps these would have more difficulty showing $2.00/GJ profit at $3.91/GJ NG pricing…

The above analysis suggests that there should be no meaningful value creation by the company in the $4-5/Mcf environment.  This is supported by the reserve report:  As of 12/31/2011 the company recorded $1,629,220K of PP&E.  Running the YE 2011 reserve report at various benchmark prices (and using the aggressive assumptions of 100% of HH NG and 90% of WTI liquids price realizations so as to reconcile more closely to the report), one gets the following NPV-10 sensitivities  The company likely needs to see >$4.00/Mcf HH to earn 10% return on invested capital, broadly consistent with the above conclusion of economic break-even around $4.00/Mcf HH price level:

NAV is Before Tax Net Present Value, discounted at 5%, at an unspecified commodity price deck
(10/2/2012 presentation, p. 34):

“P+P NAV is PV5 DA/share.  PV5 DA/share is Before Tax Net Present Value, discounted at 5%, less debt divided by the number of shares/units outstanding”

Reality:

Given the 4.4% coupon on company’s term loan and 4.9% coupon on the recently-issued notes, yields on peer debt, and on dividend-paying peers, we need a few more rounds of QE before the pre-tax P+P PV5 becomes the appropriate metric for valuing commodity assets.  Though no information is provided on the commodity prices and realizations assumed, to get to ~$35/sh NAV, the company appears to be relying on the 12/31/2011 price deck of the independent reserve evaluator (InSite) which includes 2012 estimates of $98/bbl Edmonton Par / $3.45/MMbtu AECO and 2020 estimates of $110/bbl / $7.12/MMbtu.  These could be characterized as aggressive given the 2020 futures prices of ~$86/bbl WTI and $5.50/MMbtu HH.  Management’s value metric is worthy of recognition among the best promotions we have seen in this industry.

Reconciliation of sell-side targets to reality

Pricing NGLs on par with oil (Morningstar, some others)

Short of the various .com / social media / cloud pumps, research on PEY has seen some of the most spectacular errors and inefficiencies we have ever encountered in a mid-cap company.  Some of the gems include: “… For oil, we use $104.67 per barrel in 2012, $104.43 in 2013, and $99.07 in 2014. … we assume a 15% discount to WTI when computing realized selling prices of natural gas liquids.” We have few relationships with sell-side shops but one of the more respectable ones’ models simply used the projected WTI price for NGL realization in perpetuity in the DCF model.  In fact, in 2011 and Q2 2012 PEY has been realizing ~78% and ~66% of WTI on NGL production.  Depending on the shop, the treatment of liquids realization yields 10-30% error in NAV estimation.

Hedging impact (UBS 10/1/2012 report and most others)

UBS has one of the best reports on the name (10/1/2012) providing NAV estimates that generally reconcile to ours after accounting for taxes and SG&A.  However, even their report contains substantial errors in forward cash flow and balance sheet forecasts.  For instance, for 2013 UBS projects $60m in hedging gains (presumably copying over the number from 2012).  In reality, the company’s 2013 hedges are generally below the 2013 prices assumed in the model and PEY should realize losses instead.  This leads to >10% overestimation of 2013 CFs, and misleading liquidity picture, among other issues.

Failure to account for taxes (UBS 10/1/2012 report and most others)

Sell-side frequently values PEY CN and peers on a before tax (BT) basis.  This is somewhat defensible for a tiny name that may be able to defer taxes for so long that their present value is materially ~0, but is questionable for one of the largest producers in a basin.  In practice, PEY CN paid ~3% cash tax rate in 2011 and accrued deferred taxes at an additional 21%.  At best, assuming PEY CN grows at the current rate indefinitely, this oversight leads to an ~3% higher estimated EV.  In practice, a slowdown in CapEx that may be required given the balance sheet deterioration should lead to a maturing of the liability and an ~20% lower value estimate at high commodity prices.  There is no meaningful difference at lower commodity prices (<=$4.00/Mcf HH) where PEY CN is not meaningfully profitable.

Failure to account for SG&A (every report studied)

Given the discourse on the EQU post about the appropriate value and multiple for the recurring SG&A expense, it is interesting to note that SG&A is completely ignored in the reports of PEY CN that we have seen.  Once again, this treatment may make some sense for a small-cap that one expects to transact in the short-term but is not defensible here.  PEY’s SG&A (net of overhead recoveries from operated properties) was $26.4m for 2011 and $5.6m for H1 2012.  The average value for the past 3 years is ~$27m.  Capitalizing this at a (likely too low) 5 multiple yields $135m, ~$1/sh, or ~4% lower value estimate.

Combined (for ~50% downside), the above sources of error account for most of the delta between our and the consensus/sell-side models.  Of these, the first one is most significant and will be most vividly demonstrated as the hedges currently masking the true price realization picture roll off.  The above are some but by no means all issues with the consensus.  Generous discounting or asset performance assumptions are widespread.

Risks to the Short

Low-cost NG supply story is a giant conspiracy:   All the independent research suggesting the production-weighted average cost of recent new supply in the $3-5/Mcf range is flawed.  Markets begin to discount long-term NG prices >$7/Mcf.  We view this as an increasingly remote possibility with each new quarter of consistent data on the economics and size of tight gas resources.

Evolution of PEY to a roll-up/trust/dividend Ponzi story:  It is not a coincidence that this year saw the first acquisition in the company’s (13 year) history.  PEY should use its stock to buy-up cheap Canadian juniors.  Every issuance of shares at $24/sh to buy a fairly valued or even most overvalued assets helps back-fill the valuation pocket.  We view this as the main risk to the short.  Still, we doubt the company will embark on a multi-billion dollar spending spree that will be needed to bridge the valuation gap.  Doing so would also conflict with the story that has been sold to investors over the years and may alarm the holders.

Big new play backfills the valuation:  Concentrated acreage makes $1bn+ exploration value creation unlikely.  The current valuation at >$10K/net acre already prices-in core-Marcellus-like performance on the entire asset portfolio.

Disclosure:  We and/or parties we advise hold short positions in the issuer’s securities and may take long and short positions in any of the securities discussed in this report.  Our positions and outlook may change without notice with respect to the securities mentioned herein.  The author does not warrant the accuracy of any information or perspectives herein.

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