Value Microcaps Junior Energy

[CPTMatt]

ATU.V/ATUUF - Thoughts on Altura? Malcolm Shaw at Hydra Capital Partners lays out a pretty bullish case for being long some shares here.

http://hydracapital.ca/hydra-blog.html

With Altura Energy (ATU.V, last at $0.54) fading back into the mid-50’s after surging to over 60 cents on the back of the company’s $28 million asset disposition and Leduc-Woodbend “all-in” moment, I think it’s a good time to revisit the story as the company’s current drilling program at Leduc-Woodbend continues (the first well is complete, the second well is drilling, and there are a total of 8 wells planned this summer). As I’ve mentioned before, I think Altura is the best junior oil growth story I’ve found in a long time… and the broader market is largely overlooking it. I understand that “small cap Canadian energy” isn’t exactly a hot sector right now, but with the oil market tightening by the day as several years of upstream underinvestment/capital deferrals come home to roost, I think that the table is set for crude to continue to move higher and spark a new wave of interest in the sector… all the way down to the Canadian small caps. I maintain that the stock should be trading around 80c today, which means that I think getting stock at anything remotely close to current levels is very attractive for patient money.

To be an Altura bull, I think you first really need to get comfortable with the idea of being long oil for a while, because Altura is the kind of story that should just grind higher quarter after quarter as Leduc-Woodbend (LW) ramps up. Altura says that LW has a $42.55/bbl WTI breakeven price, so there’s a nice buffer on the downside in terms of Altura’s ability to survive at lower prices. The other nice thing is that the “discovery phase” is already behind them, with 400-500 million barrels of oil in place (internal estimate) identified on Altura’s lands… and that is a huge oil pool by Alberta standards. Now comes the development phase… which is where dreams turn into dollars. If you believe in a world where oil is over $60/barrel for a couple/few years, very few stocks can offer self-funded growth potential like Altura, and I think that the market is sure to notice in due course. Overall, most oil stocks aren’t yet discounting anything close to the strip pricing curves and with last week's OPEC meeting out of the way (and with crude rallying in the face of the agreed upon output increase), you have to start wondering if maybe a broader sector move is afoot.

You can look back pretty much as far as you want and you’ll find that global oil demand grows relentlessly at around 1-1.5% per year, which now means that the world needs 1-1.5 million barrels per day of extra supply every year just to keep up with demand. At this point the electric vehicle effect on the oil market is miniscule. There are somewhere around a billion cars in the world and roughly 3 million of them are electric... that’s 0.3%. As a driver of an electric vehicle myself, I understand that “the shift to electric” is coming eventually, but in the meantime, oil isn’t going anywhere and the idea of the oil-crushing self-driving fleets of the future are still a long way off in my view. In reality, oil has plenty of time to take another run at $100+ at which point market observers will lament the high oil prices and consumers will scream for relief at the pumps… and yet there will be nothing that anyone can do about it in the short run as the cards have already been dealt for this cycle.

In talking with a very well read oil market observer I was stunned to learn that a trillion, yes a trillion, dollars of upstream capital investments have either been cancelled or deferred over the last 4 years. That is a massive of amount of money that simply was never spent, which is just starting to show up in the market’s inability to head off a price spike. It’s interesting to note that it takes about 4 years for underinvestment like that to show up in supply growth (or lack thereof), so arguably oil could have a nice multi-year run here… which means that there should be plenty of time for the market to discover Altura as it grows up. OPEC spare capacity is low by historical standards and the oil bull just took OPEC's first quota increase and ate it for breakfast. Throw Venezuelan chaos, Mexico's decline issues, and Iranian sanction potential into the mix, stir in a little Middle East geopolitical risk premium, and you've got a good climate for oil speculators.

Even if/when OPEC and/or Russia decide to open the spigots again and add more production to the market, our view is that any effects on the crude price will be transitory as there just isn’t enough ammunition (in the form of spare capacity) to stop this charging bull in its tracks. Meanwhile, a lot of portfolio managers are underweight energy right now after having sold en masse in the wake of the “glut” of 2015-2016 and they are only just starting to add energy back to their portfolios that are currently heavy in FANGs and blue-chips that are trading at valuations ranging anywhere from “historically high” to ludicrous. To me, it’s insane that a person can go out and buy a company like Vermillion Energy (VET.TO, last at $46.45) with a 6% dividend yield today. Vermillon is a best-in-class $7 billion market cap energy company that has never, ever, cut its dividend and has just pulled off a coup in stealing Spartan Energy at a trough valuation, boosting its own production, cash flow, and growth profile. When I see a set up like this (little to hold oil prices down and money mostly still on the sidelines), it tells me that the move in oil stocks hasn’t even started yet… and when the money comes in, those people who are positioned properly will be reminded of just how lucrative the energy sector can be.

At times like this, when I find a stock that looks cheap, I start looking for the fundamental reason(s) for it. Often it’s a balance sheet issue, asset flaw, management discount, capex/cash flow mismatch, or any number of other factors. In Altura’s case, I think the reason that it’s cheap (~2x 2019 EV/DACF versus peers at anywhere from 3-5x) has nothing to do with the management team, the balance sheet, or the assets, but more to do with the company’s market cap, market visibility, and modest current production… after all, who cares about a company that’s doing 550 boepd going to 1,900 boepd by the end of the year, right?

But what if (i.e., when) the market starts to clue into the fact that while Altura plans to exit 2018 at 1,900 boepd, there’s good visibility on a self-funded case where the company exits 2019 at around 3,000 boepd with its sights on ~4,000 boepd by the end of 2020? Now, imagine that it’s January 1, 2019 (6 months from now) and the analysts that do cover the story (GMP, Beacon, and Mackie) have rolled their 12-month price targets forward to run off of 2020 cash flows. At that point, the market is going to be looking at a company that’s going to average around 3,500 boepd in 2020, with 4,500 likely in sight the following year (for those paying attention that’s a multi-year >30% CAGR… internally funded in my modeling).

Figure 1: Full field model through to the end of 2021. The model assumes 50 wells drilled in that time and all drilling is internally funded based on my cash flow model. Note that these are just my own projections. This is the model that I will use to evaluate Altura’s performance over several quarters relative to my estimates.

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At current oil prices, cash flow on 3,500 boepd in 2020 (average) should come in around $35-40 millon, which even at 2x EV/DACF, would equate to a 70-80 cent share price. At 3x, that’s a $1.05-1.20 share price. At a more reasonable (and still cheap in my view) 4x EV/DACF multiple, ATU could trade to $1.40-1.60… and I think that’s possible 6-8 months from now. Come next January, the market will be digesting the production adds from the company’s current 8-well drilling program and looking forward to the 2019 capital program, guidance, and reserves. Those are all big catalysts at that time of year for energy stocks and Altura should show well as an emerging junior to take seriously. At that point, the company will also have crossed the $100 million market cap threshold, which means that a whole new swath of institutions become potential buyers. Given that I see limited technical risk on the project given the initial well performance and abundance of well log data that has led to the definition of this pool, all I have to do is wait and see if I’m right.

To back up a little, I like Altura a lot in part because it’s such a simple story to understand. Much of what defines Altura’s business can be summed up in just a few slides. I’ve included the slides here below:

The Leduc-Woodbend pool is huge (400-500 million barrel OOIP) and is defined by hundreds of historical well penetrations that were drilled for deeper targets. The pool is only at the very beginning of its development. Based on detailed mapping, everything within the green outline appears to be fair game for drilling. There are 160 well locations in the play as defined. That number could double if 8-well per section spacing is found to be appropriate in the future.
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Altura is well positioned in terms of the infrastructure needed to fully develop the pool. That includes existing and planned in-field gas and fluid pipes, oil batteries, gas plant access, and disposal wells. The expansion of the infrastructure can be scaled to follow the production ramp-up in this easily accessed area south of the town of Leduc, near the Edmonton International Airport.
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?The economics look very, very good. With F&D costs of around $10/boe and $35/boe operating netbacks at $65 WTI, Leduc-Woodbend is a cash generating machine just waiting to be turned on. Wells reach payback in just over a year, allowing for quick recycling of capital at very attractive well costs. At $80 or $100 oil, things would get silly.
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?As it is right now, Altura lives in a weird part of the market where it is currently “too small” for most institutions and too “boring” for (typically) fast money retail traders for whom 6 months of holding a stock would feel like an agonizing eternity. My read of the market on this one is that the kind of money that is attracted to Altura is “small cap value” money, because anyone who knows how to truly define value creation will find little fault with Altura’s asset base, business plan, and capability. That’s an ideal situation for sustained share price strength as longs typically won’t be waiting for any particular event to unload stock and still might actually be more prone to adding to positions if the company delivers on the production and cash flow growth profile that I think it can.

In time, I think that Leduc-Woodbend is capable of being a 8,000-10,000 boepd asset (that’s an 11 to 27 year RLI based on 10-20% recovery factor on 400 million barrels of oil in place, give or take) and this management team seems to have the task of developing it well in hand. The pedigree of Altura’s board and management (Peyto, Storm, Vermillion, Renaissance) tells me that the company’s growth will be largely internally funded with a laser-sharp focus on growing reserves, production, and cash flow per share. To some people this might seem boring, but to me this is the kind of small cap situation that I dream of finding. Once my position is established, I can just watch for road markers along the way (production and reserve adds), read quarterly reports and let management do their job. If Altura delivers what it says it can over the next two quarters, I’m confident that more eyes will turn Altura’s way and the company will start to get the attention that it deserves as the road ahead becomes more plain to see. If Leduc-Woodbend is what it looks like it is, one day Altura could ultimately bookend some 40-50 million barrels of reserves that I suspect would be worth some $400-500 million as a start. If the pool can be waterflooded, up to an additional 40-50 million barrels are also on the table. The share count probably won’t be far from where it is now at that point (109 million), so I see this as a legitimate shot at a 500-1000% gain for patient money over a multi-year period.

Maybe the bigger question is not just where Leduc-Woodbend will take Altura’s share price in time, but what management will turn this company into over the coming years. When I met with management recently I asked, flat out, “Are you a “build it and sell it” situation or do you want to build a much bigger company here?” The answer was exactly what I hoped to hear, which was that management views Altura as the beginning of a company that they intend to build to mid-cap size (think Whitecap, WCP.TO). Now that’s a long term play to be sure, but for real small cap value investors it’s a tantalizing concept, and Leduc-Woodbend is a very good place to launch from. Altura is methodical and disciplined when it comes to asset and exploration evaluation, which are traits that should serve it and investors well along the way. I remember when Whitecap was formed, but I don’t think anyone (including me) realized how big it would become, but it’s now widely held by institutions and retail investors alike. It was management that did that. Great management. While I’m sure Altura would be willing to sell at a price, that’s not the plan. The plan is to build a much bigger company over time through disciplined and effective management. Time will tell, but my cash flow model says that they’ll have lots of money to work with.

Perhaps the first big test for Altura is showing the market that it can hit its targeted 1,900 boepd exit rate this year. To be fair, it is early days at Leduc-Woodbend with only 5 horizontal wells (3 of which are ERH) drilled and, while the well performance to date appears to be exceeding initial type curve expectations, the market does tend to like to see a track record of delivery over at least a couple of quarters (and a larger number of wells) in new plays. This is one of those situations where I think I have a reasonable understanding potential outcomes, so I’ve put on an overweight position at what I believe to be a very good level. Really, the two main risks I see here are a total market implosion (in which case nothing will be safe in the short term) or an implosion in the oil price. Even though Altura can break-even way down at US$42.55/bbl WTI, part of my thesis here is that all of my numbers here are based on $65 oil… but what if oil is $80/barrel in a year or two? What if it’s $100/barrel? It’s worth remembering that there are such things as oil bull markets… dare to dream.

The combination of first-class management, a first class-asset, a pristine balance sheet, and self-funded multi-year aggressive production and reserves growth potential is like hitting the super trifecta of junior energy companies. Don’t get me wrong; I don’t think that my investment in Altura is without risk. WCS spreads, well performance, and all of the usual things that can happen to an energy company are still things that I think about, but on balance Altura checks all of the boxes for me. At the end of the day, investments in junior companies are always speculative, but in this case I think the odds are grossly in my favour at current levels and the drilling program currently underway will likely be pivotal with respect to the market's view of the growth potential here. For now, Altura is flying under the radar, but that’s always the case until it isn’t... in the meantime, I can wait.

Happy hunting.