Description

Southern Pacific Resources (STP CN) is a dirt cheap (0.44X NAV) early stage oil sands company based in Alberta, Canada with 208 mmbbl of 3P reserves and 667 mmbbl of 2P+2C resources, a debt-free, cash-rich balance sheet, and a very near-term high probability catalyst: regulatory approval and financing for Phase I of its crown jewel McKay project, expected within a few weeks.  I believe this idea is off the radar screen in the hedge fund community, and it is not well followed on the Street.  While difficult to gauge timing on regulatory approvals, the company has received good feedback that their target of 9/30/10 is in the right ballpark.  The company is particularly confident because 100% of Canadian oil sands projects have gone on to receive approval once they have reached this stage.  

As for the financing, they are looking to launch a high yield debt offering in the C$300M range immediately following regulatory approval, which should comfortably close the funding gap for the project.  Given the strength (bordering on frothiness) of the high yield market right now, I have high conviction that there will be good appetite for the paper.  The 4 banks in the syndicate (RBC, TD, BMO, Credit Suisse) are all pretty bullish on STP CN, looking for the low end of their 9-11% target yield.  A good comp is Connacher Oil and Gas (CLL CN) 10.25% bonds due '15, trading at par for a 10% yield.  This should provide a strong derisking catalyst for the stock, and I think the discount to NAV should narrow considerably.  My price target is C$2.00, which equals 0.9X NAV and provides 80% upside.  With roughly $50M per year in highly visible free cash flow (FCF) at $80/bbl WTI and $6/mcf natural gas from the currently operating Senlac asset (reserve life of 11 yrs), I believe downside at the current enterprise value of C$300M is quite limited. 

Senlac Project:

In November 2009, Calgary-based Southern Pacific acquired the Senlac SAGD (steam assisted gravity drainage) project from Encana (ECA CN) for C$95M, net of working capital.  The project had been operating for over a decade and was primarily used by Encana to develop new technologies and best practices that could be applied to its more significant projects like Foster Creek and Christina Lake (which are now considered among the best commercial SAGD projects in the industry).  All of the 20 key field employees who worked on Senlac were retained, providing a wealth of transferable knowledge and experience that are now being applied to the McKay project. 

What's more, as this project was run as an R&D center, its full economic potential was never realized.  Southern Pacific is now running it for cash flow.  It is producing about 4.5 mbpd at an average operating netback (after royalties, opex, etc) of $41/bbl, which equates to about C$65M in cash flow per year.  It has about 11 mmbbls of 2P and 20 mmbbls of 3P reserves.  Not bad for a C$95M acquisition.  With C$25M of capex earmarked for Senlac, and average production of 4.75 mbpd, free cash flow from this project should be about C$50M (see assumptions below), which will be used to help finance the McKay project.  The enterprise value of STP CN is about C$300M (net of C$90M in net cash post equity offering).  One could argue that the company is cheap on Senlac's free cash flow generation alone, which should last at least 10 years. 

McKay Project:

STP-McKay will be Southern Pacific's first commercial project in the Athabasca oil sands region.  The company in May 2009 submitted an application to the Alberta Energy Resources Conservation Board (ERCB) and Alberta Environment for the development of its first 12 mbopd phase and is expecting regulatory approval by the end of 3Q10 (announcement is expected any day).  Typically these approvals (of which there has been plenty of precedent, not just by Southern Pacific but by Suncor and Petro-Canada, which was acquired by Suncor, among others) typically take 14-16 months and we are now at month 17 so it really should be any day. 

Phase I's total project capital cost estimate is C$430M.  In April 2010, STP issued 84M shares of stock at C$1.20 per share, raising C$101M in gross proceeds (ultimately enabling STP to graduate from the TSX-V to the TSX in June 2010).  This removed the equity overhang related to the McKay Phase I financing, and STP plans to finance the remaining portion through cash on hand, free cash flow from the Senlac project, and a debt financing to be completed immediately following regulatory approval.  Bid packages on major drilling equipment and supporting infrastructure are currently being issued, so the company should be able to move quickly upon receiving financing.  The current timeline envisions application approval in September 2010, civil construction starting in October 2010, plant construction in December 2010, commissioning in October 2011, and first steam in Jan/Feb 2012. 

In June 2010, the company bought out Bounty Development's (its partner's) 20% working interest in McKay for C$33M giving STP a full 100% working interest in the McKay project (Phase I and surrounding phase expansion lands). 

Management believes that the STP-McKay project is analogous to Suncor's (SU) currently producing, and highly successful Mackay River project, which has steam-to-oil ratios (SORs) that are among the lowest in the industry, averaging 2.5.  Both projects target the same bitumen deposit - the McMurray formation.  As shown below, STP-McKay stacks up well compared to other currently producing SAGD projects that have been deemed to be quite successful. 

Valuation:

With guidance from the company and directly relevant experience from Suncor and Connacher Oil and Gas, I have done what I consider a conservative, but realistic NAV model for STP which aggregates production from Senlac and McKay (Phase I and future expansions), and I come up with an NAV per share of C$2.64.  This compares with Tudor Pickering's NAV of C$3.00, Raymond James' $2.47 and TD Newcrest's C$1.66 (the only 3 estimates I've been able to find).  I assume McKay ramps up to a max of about 40 mbpd by 2018 and Senlac peaks at 4.8 mbpd by 2012.  Overall operating netback assuming $80/bbl WTI crude and $6/mcf natural gas works out to about C$33/bbl, with F&D $3.30/bbl and maintenance capex of C$40M.  Sensitivities are shown below - clearly the price of crude is a huge swing factor here given the steep differentials and high operating costs of oil sands, so if you are not a bull on crude, this is not the investment for you. 

I've compared STP to its 2 closest comps, Opti Canada (OPC CN) and Connacher Oil and Gas (CLL CN), and on an EV/recoverable resource basis, the contrast is stark.  The market is clearly applying little to no value for the McKay project despite all the positive reserve updates (on 8/19/10 the company upped its Best Estimate Contingent Resource from 256 mmbbl to 489 mmbbl.  Total recoverable resources increased 62% from the prior estimate to 667 mmbbl).

Applying the peer group average EV/recoverable resource we get a fair value for the stock of C$3.47.

One key concern regarding my valuation work is why Bounty Development sold its 20% interest in McKay for so little.  I did some digging and found that the reserves in question at the time of sale (which was finalized in March 2010) were much lower than today's figures.  As shown in the following press release, http://www.marketwire.com/press-release/Southern-Pacific-Acquires-Remaining-20-Interest-McKay-Additional-Oil-Sands-Interests-TSX-VENTURE-STP-1134670.htm McKay 2P reserves were 13.5 mmbbl, suggesting a 100% interest would be 68 mmbbl.  Today those reserves are marked at 168 mmbbl (out of the 179 mmbbl in the company's most recent presentation) http://www.shpacific.com/wp-files/Presentation/STP-Presentation-2010-08.pdf .  The company also acquired some more speculative resources (Ells) which I would assume were given little value.  Assuming C$30M out of the C$33M were for the McKay assets, let's do the math, and apply to today's resource estimates. 168 / 68 * 30 = C$74M for the 20% interest.  75 * 5 = C$371M for the implied book value.  Add that to Senlac at C$95M (which we already know is a bargain) plus the C$90M in net cash and we get C$556M in book value for the company.  That's C$1.63 per share. 

I spoke with the CEO Byron Lutes (who by the way is a rock star) http://www.shpacific.com/wp-files/Presentation/STP-Oilweek-2010-09.pdf  about this sale to Bounty and he said they are a private family-owned exploration company and they sold because they were not in a position to finance their share of the project.  Given that there were no other logical buyers of the 20% interest they were also in a weak bargaining position.  Finally he confirmed that the resource estimates at that time were quite low.  That said, it was still quite opportunistic for STP!

Catalyst