SEVEN GENERATIONS ENERGY LTD VII.
September 09, 2020 - 5:19pm EST by
sediment
| 2020 | 2021 | ||||||
| Price: | 3.85 | EPS | -2.84 | 0 | |||
| Shares Out. (in M): | 333 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 1,252 | P/FCF | 15 | 0 | |||
| Net Debt (in $M): | 2,237 | EBIT | 448 | 0 | |||
| TEV (in $M): | 3,444 | TEV/EBIT | 7.68 | 0 | |||
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Description
Seven Generations Energy (ticker: VII) is a Canadian Oil & Gas producer; specifically, the largest player in condensation (mainly composed of propane, butane, pentane and heavier hydrocarbon fractions) production in the North Western Alberta region in Montney and is a rival to Paramount Resources. The crown jewel for Seven Generations in Montney is their Kakwa River project, in which 1.23B was invested over the past 2 years.
From its humble beginnings, Seven Generations was originally financed by private equity investors and morphed into a listed company— CEO Marty Proctor has exercised great fiscal discipline in comparison to other producers— Paramount Resources, NuVista Energy, Kelt, etc.
Seven Generations has been listed for less than a decade (IPO: November of 2014). Seven Generations lacks Paramount’s mature assets— Seven Generation’s wells have a delineation rate of 45%, which is decreasing every year at a rate of 2-3%. Paramount has mature wells with a 15-20% decline rate, requiring less incremental expenditure. Management is moderating decline rates to make production sustainable.
Liquefied natural gases, such as condensate, is a crucial component for the dilution of bitumen to make dilbit, which enables pipeline transportation of bitumen. Bitumen is the heaviest crude oil used today found in natural oil sands deposits. The oil sands, also known as tar sands, contain a mixture of sand,
water and oily bitumen. In a liquid form, condensate takes up about 1/500th of the volume of conventional natural gas for the same energy output, making pumping and transportation more economical.
A crucial factor in investing in condensate companies in Alberta is supply and demand— Condensate domestic demand (Canada) exceeds supply by more than 250,000 bbl per day, which is why Canada imports condensate from the U.S.
Seven Generations accounts for almost a quarter of all Canadian condensate production. As the largest condensate producer in Canada with strategic pipeline opportunities to sell natural gas at favorable prices to North America, and a promise of greater amount buybacks in the future— should decline rates go down, and Nest 3 prove an important catalyst— Seven Generations has an intrinsic value of at least 14-16 per share or 4-7B in market cap, with an enterprise value of approximately 11-15B (current enterprise value 3.44B), which is 3-5x current worth.
Regions— Nest 1 to 3
With 7G leasing about 800 sections and a total of 500,000 net acres of land (Paramount has 2 million acres); 7G has divided land parcels into 3 nest areas—
1. Nest 1 is an ultra-rich condensate region with 37% IRR and a capital efficiency of $10,700/boe/day. In Q4 2019, there was a land swap that enables an optimized development plant. IP365 is 750 boe/d.
2. Nest 2 is filled with condensate rich locations, especially the north western portion of Nest 2— it was previously considered part of the Wapiti region with 100 reserve locations converted. At 43% IRR and a capital efficiency of $8,000/boe/day, there are favorable trends in condensate recoveries. IP365 is 1000 boe/d.
3. Nest 3 is a high-Deliverability Natural Gas Weighted Region with 63% IRR and a capital efficiency of $5700/boe/day. With the infrastructure and crossing in 2019 completed with a single super pad/hub which employs a spoke and hub build out, with potential to expand boundaries to the southern gas rich region. IP365 is 1400 boe/d.
* All assumptions for IRR depend on a US 40/bbl WTI, $2.5 Hub, at $3 Condensate Differentials
Seven Generations has an excellent production mix consisting of approximately 60% NGLs & Condensate and 40% natural gas.
Here are 5 reasons why Seven Generations will emerge as a successful producer—
1. Manageable debt and financing with a promise of future buybacks
Seven Generation’s management indicated conservatism in their recent earning’s call with leverage— they have reduced debt levels to a range of 1.0x-1.5x debt to cash flow, versus a previous 2.0x. This allows free cash flow to accrue and we can expect future buybacks via NCIB (normal course issuer bid), which is likely when WTI exceeds usd50/bbl.
With 1.1B available on 1.37B (5 year term) of senior secured credit facility (unsecured notes). Seven Generations doesn’t have any near-term maturities— as of March, Q2, 2020, 298M was drawn on that revolver to repay some of the unsecured 2023 notes with accordion feature from the earlier conversion— which reduced interest rates from 6.8 % to about 2%. Maturity has now been pushed the end of 2024 from mid-2023. 700M at 5.375% is due in 2025.
By avoiding any exposure to maturity issues, and maintaining liquidity on the bank line, Seven Generations will be able to ride through commodity cycles. Seven Generation’s revolving credit facility is covenant based, not reserves based.
2. Maintenance Capex Reduction for Sustainable Production
The desire to reduce debt levels towards the 1.0-1.5x Debt to Cash flow range will naturally diminish maintenance capital expenditures—with an 11% drop in production, this results in Capex down from 1.3-1.7B to 650-800M in 2020; management promises the capex to remain intact even if commodity prices improve. To give you historical reference— capital expenditures were 2012—280M, 2014—920M, 2015— 1.35B. This allows Seven Generations to maintain production in the 180,000 boe/day range.
To protect Seven Generation’s balance sheet and preserve drilling inventory, management reduced capital budget by 41% and deferred the start-up of 11 new wells with 65-70 development wells in 2020.
In Q1, 2020 drill and complete costs were about CAD 7.3 million per well, which is 1 million per well lower than originally budgeted for the year, and 33% below the costs for 2017. Operating costs in Q1 2020 were CAD 4.54/boe, about 20% below 2017 levels. Seven Generations completed the wind-down of its 8 drilling rig and 2 completion spread program in early Q2, and commenced an operational pause. Salary and benefits were also reduced.
CEO Marty Proctor said during a recent podcast interview the company's decline rate would diminish by about 3% every year, which will lower maintenance expenditures by CAD 60 to 80 million per year, or CAD 0.98/boe at the midpoint, assuming production remains near the 200,000 boe/day range.
Seven Generations has also maximized efficiency and output through multi-level stacked pads to improve infrastructure utilization— with a boost of 50% more inventory per section, and 30% increase in NPV per section and a reduction of 85,000 truck-loads of reduced water transportation. These operating cost efficiencies have given Seven Generations Energy much higher netbacks than competitors in the Canadian oil and gas landscape.
3. Decline rate moderation (40% to 30% by 2022) and diverting capital from Nest 1 to Nest 3 with higher IRR leads to sustainability as a low cost producer
Seven Generations has greater than 80Mbbl/day capacity with more than 60Mbbl/day that is wholly owned and operated with optional access to an additional 20Mbbl/day from 3rd parties is and is able to average half-cycle IRRs greater than 50%.
Seven Generation’s business model has pivoted towards a more sustainable decline rate— in an earning’s call, Seven Generation’s management indicated it entered 2020 with approximately a 40% corporate decline rate, with management expecting declines to enter the 30% range by mid-2022 under
its current program. Seven Generations will break-even on a drilling and completion basis at USD 33 per barrel, but declines in to the 30% range could bring it down to USD 29-31 per barrel.
In a low 40s WTI and at a $2.50 per MMBtu price environment— with weaker condensate differentials, Nest 3 is the best returning region in Seven Generation’s portfolio. As prices move into the mid-40s and condensate differentials improve to where we are today (September 2020), all regions start to exhibit favorable well economics.
Seven Generations is currently directing capital away from Nest 1 to Nest 3, which is more gas prone. All development activity for the second half of 2020 will be shifted towards the Nest 3 region to lower initial decline rate. While Nest 1 drilling economics have improved considerably, management should be flexible towards production allocations across wells.
In 2019, Seven Generations completed a 120 million pipeline network that connects the southern part, the Nest 3 area, to the core. The lower Montney well on the 10-16-62-4 pad in Nest 3 continues to exceed expectations, with the well continuing to be the best condensate producer on the pad. Overall IP270 volumes of 1,934 boe/d are 12% above the average upper/middle Montney locations on the pad, and condensate rates over the same time frame averaged 506 bbl/d, 39% above the average upper/middle Montney location on the pad.
The encouraging results from the first Nest 3 lower Montney well prompted Seven Generations to add two additional lower Montney wells in the area in 2020— improving the capital efficiency mix due to the high deliverability. Over the next 24 months, further benefits from decline rate moderation will result in another 6% to 12% decrease in total maintenance capex.
When condensate prices are stronger, Seven Generations can always consider Nest 1. Although not as lucrative as Nest 3, Nest 1’s well economics still compare favorably to wells operated by the majority of Montney producers. These wells have an IRR of about 15% and a payback of 3 years at current prices.
As oil prices firm up, the ability to blend more production from the Nest 1 region into Seven Generation’s total production profile is likely to put condensate yields back on track— similar to 2018.
Revenue from condensate reached 70% of Seven Generation’s total revenue in Q1 2020 with 69,000 barrels of condensate per day. Given the same equivalent volume, due to higher prices, condensate production brings in higher revenues than natural gas.
In terms of Seven Generation’s internal rate of return for its projects, Nest 2 Wells have an IRR of roughly 40-60% at USD 40-50 WTI and USD 1.8-2.80 NYMEX gas, representing a payback period of 12-15 months. At a discount rate of 10%, the net present value of these wells is approximately 20-35 million.
4. Differentiated pipelines for Natural Gas brings pricing options
Seven Generations has more than enough processing capacity with 3 owned plants, with additional access to third-party processing. When it comes to pipeline capacity, they have more than enough egress for gas.
Seven Generations has egress of about 700 million cubic feet per day— mostly to the Midwest, some of it to Henry Hub, some to Eastern Canada, some to Malin.
As of 2020, with dire conditions, Seven Generations has reduced to 500 million cubic feet per day. There is a lot of additional room to grow gas production over other liquids.
Seven Generations sells oil & gas via domestic (Alberta) and exports (80% of natural gas is outside Alberta) to the U.S— with 90% of Seven Generation’s natural gas sales in the U.S Midwest, the US Gulf Coast, and Eastern Canada with a realized price of $3.41/Mcf for 2019, with the local AECO benchmark price averaged at $1.67/GJ. Seven Generations is far from reaching its total capacity of 1 Bcf/d. With Cutbank/Lator/Gold Creek alone— the capacity is 760MMcf/d.
These main pipelines which transfers Seven Generation’s produce—
- GTN at 90-92 MMcf/d
- Alliance at 500 MMcf/d to Chicago and the mid-west market
- NGPL at 100MMcf/d for Henry Hub (Henry Hub has been selling to Cheniere— the gas is then placed on the water for LNG)
- TCPL at 77 MMcf/d to eastern Canada
This means that for natural gas, 700MMcf/d of pricing optionality is available due to diversified market access.
Alliance provides Seven Generations with over 500Mcf per day, nearly 2/3 of pipeline capacity, but is currently slightly out of the money. Alliance provides access to the Midwest market and enables transportation of gas through Kinder Morgan's NGPL line directly to the Gulf Coast. The Alliance partnership also provides tremendous amount of flexibility, particularly with regards to renewal options.
The primary term of Seven Generation’s current Alliance contract expires in the Q4 of 2022 with option for renewal or termination of transportation capacity completely—if terminated, Seven Generations will market their gas in Alberta or on TC Energy connected systems.
In the long term, through projects in British Columbia, Kitimat, Jordan Cove LNG Terminal, natural gas take-away capacity will improve.
5. Reserves
With approximately 1.6B boe of gross proved plus probable reserves, this is enough to last 20 years of domestic Canadian energy supplies and exports.
Seven Generations possesses one of the best liquefied natural gas land in the entire Montney. Covering approximately 500,000 acres— Seven Generations owns a vast amount of land and over 1100 undeveloped locations with 2P reserves of 1.6B Boe and 1P reserves of 842 Boe.
Of these 1100 locations, approximately 55% lie within the company's primary development block, termed Nest 2. The liquid-rich natural gas produced in Nest 2 is “sweeter” than other natural gases found in the region (less than 100 ppm H2S), allowing for minimal investment requirements in sour gas processing facilities. As such, the cost of producing one MMbtu of gas is only US$0.94, ranking the company as one of the most competitive suppliers of gas in North America. Assuming WTI of $40, gas at $2.50 and a minus $8 condensate differential.
Approximately 1,300 Nest-quality locations in the Upper Montney have attractive well economics on a half cycle and a full cycle basis. Nest locations imply -- with 1,316 Nest locations in the Upper Montney alone; implying about 19 years of top-tier drilling inventory, assuming about 70 locations are drilled per year.
Risks—
Specific risks include unplanned facility downtime, not delivering on production targets, deploying
capital ahead of time for additional production, and higher than expected decline rates.
Sector risks include a decline in commodity prices and rising industry costs.
Here are 3 risks to consider—
1. Depth of Inventory/ Adequate Reserves & inability to improve decline/depletion rate
Seven Generation claims to have 15-20 years of inventory—2P reserves are 1.6 billion barrels equivalent. Divide 1.6B by 200k boe/d, and you get 22 years (8000/365days) of inventory.
Shale plays or “resource plays” have an average well profile different from conventional wells. Horizontal and multistage fracking are used to create more contact between the well bore and the oil & gas formation. This gives wells very high IP 30 rates, but eventually diminishes the yield. Seven Generations is now trying to moderate their growth rate after years of hyper growth. Their decline rate is about 45% a year after being at 50%, and is being reduced by 2-3% a year. High decline rates with new horizontal shale wells as reserves require more active drilling and a higher replacement requirement.
On average, Nest 2 wells loses 30-40% of production yields after 250 days, and 80% of yields after 2 years, due to over pumping and the spread of contamination and land subsidence. Although Seven Generation's unconventional plays are not as stable long term as peers, at current low oil prices— it is still the preferred method of production, since it leads to a faster payout.
2. Out of the Money Prices
While oil and gas are at an all-time low, prices are still unpredictable with many variables affecting commodity prices. There is a misconception that Seven Generation gets Chicago pricing instead of low AECO prices— Seven Generation has a premium on their NGLs, but the gas is still in Alberta. For the bulk of the rest of the year, AECO prices may US$1.00/MMBtu below Henry Hub. When the Alberta price exceeds Henry Hub, exports have lagged.
To adapt to the new commodity price uncertainties brought about by supply and demand impacts resulting from OPEC decision-making and the COVID-19 pandemic— for 2021, Nest regions will have a more balanced mix. With resumed activity and recovery to higher liquids prices, Nest 1 will resume.
Ultimately, all decisions are based on well economics and maintaining flexibility to changes in commodity prices.
3. Increasing Transportation Costs and other costs
One major increasing expense is transportation costs—Seven Generation’s costs are higher at 7.5-8.25/boe while Paramount is at 3-3.5/boe. Transportation costs (per BOE) are expected to grow 3% a year, as a result of the increasing cost of fuel less any cost savings attributed to bundling of large lots of production.
Valuation (reserves and cash flow)
1. Cash flow and Production
If production is maintained at 180-200k boe/day and improves to 200-250k boe/day due to lower capital expenditures, at WTI $45-50 for oil and $3-6 condensate differentials, I expect the bear case for EBITDA to be at least 150-180M with 65-70 wells on production, and the bull case to be near 220-290M with 80-95 wells.
In 2019, with operating cash flow of approximately 1.4B and capital investments of about 1.23B, Seven Generations had free cash flow of about 160M. Even in Q1 of 2020, Seven Generations generated a modest amount of free cash flow.
Seven Generation’s enormous infrastructure provides economies of scale which generates a high cash flow netback at $18-20/boe. Rising production of oil sands creates a strong demand for condensate. Condensate enjoys a price on par with WTI, which lends Seven Generations a stable and high operating netback. While Paramount and Seven Generation have different profiles in Natural Gas and Condensate, Seven Generations has more pricing flexibility due to additional pipeline options.
Average realized prices range from $10-70/boe depending on the condensate in the production mix. C5+ LNGS (condensates) go for as high as $70/boe while C3 and C4 gases (propane and butane have dropped to as low as $10-20/boe since the energy crash). Seven Generations Energy's 150bbl/MMcf liquids to gas
ratio is significantly higher than the 40bbl/MMcf average in western Canada, giving Seven Generations as high as $6/MMcf in savings.
With 2.2B net debt, and a 1.4B market cap, with 333M shares outstanding, assuming 500M EBITDA, Seven Generations has a EV of 3.6B, and is trading 3x LTM EBITDA. Book value is 4-5B, or $12/ share. Shares are currently (September 10, 2020) 3.8/share.
Paramount Resources is uncertain to produce FCF in 2021, but Seven Generations surely will. A bird in hand is worth two in the bush— despite Seven Generations having almost double the enterprise value of Paramount Resources— CEO Marty has not over leveraged Seven Generation’s balance sheet nor over produced at inopportune moments. Paramount previously had to sell off assets due to overly aggressive production to cover basic liquidity assets needs during bad times.
Seven Generations (43% natural gas, 35% condensate, 22% other NGLs):
Q2 2020 Production: 183,200 boe/d
Enterprise Value: 3.56B
1P Reserves: 842 MMBoe
2P Reserves: 1600 MMBoe
EV/2P= 3.44B/1.6B Barrels = 2.23x
EV/1P = 3.44B/ 842M Barrels = 4.22x
Seven Generations is valued at 2.23 times its enterprise value to 2P reserves
EV/ LTM EBITDA =3.56B/ 1.3B = 2.72x
Paramount Resources (47% liquids):
Q2 2020 Production: 68,839 Boe/d (39% liquids)
Enterprise Value: 1.15B
1P Reserves: 335 MMBoe
2P Reserves: 632 MMBoe (47% liquids)
EV/2P= 1.15B/632M Barrels = 1.8x
EV/1P = 1.15B/ 335M Barrels = 3.43x
Paramount is valued at 1.8 times its enterprise value to 2P reserves
EV/ LTM EBITDA =1.15B/ 421M = 2.73x
2. Reserves
The 2P reserves for Seven Generations don’t paint a complete picture, since it only includes about 975 locations or 3/4 of the Upper Montney in the Nest. Seven Generations has more areas for development, including the lower Montney, Wapiti, etc.
Pre-Covid-19, Seven Generations was selling 200kboe/d, whereas Paramount was selling 90-100kboe/day, with nearly 500MMcf/d of natural gas sales. In addition to this, Seven Generations has 842 MMBoe in 1P reserves, whereas Paramount has 335 MMBoe. Paramount has 2 million net acres of land, yet despite a lower decline rate and longer operating history, their production isn’t as prolific as Seven Generation (500k acres), and reserves are less. 2P reserves for Seven Generations is 1600 MMBoe, while Paramount is 632 MMBoe. Despite Seven Generations having an enterprise value double of Paramount, the probable reserves still make Seven Generations a justified purchase.
Oil and gas is a sector where you think you know enough to be right, but there will always be macro-economic factors such as Covid-19 and the banter between the middle-east and Russia. You can never know enough to predict where you're wrong— there are always external factors out of an investor’s control. This makes me conservative and I would sell immediately when the stock price exceeds intrinsic value.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
- Focus on Nest 3 and wells with higher IRR with Nest 1 as optional upside
- Natural Gas pipeline capacity at Henry Hub, Alliance, and the Mid-West is currently out of the money and will revert
- 45% decline rates being reduced 2-3% a year to a 30% rate by 2022
- Maintenance capex reduced
- Prices improving with condensate production going up
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