This is one of those articles where I take no pleasure in being "right". That said, my hope is you took my advice and hedged your downside risk. As was expected, Canada's energy sector sold off, some producers by double digits, when OPEC announced there would be no cut in production. WTI plunged by over 6% to close at $69.04. By many accounts, there is much more downside before things will settle. With supply exceeding demand, it will take many quarters for WTI to stabilize at a price where supply equals demand. There is a great deal of speculation what that price is.
It's important to remember that the market is likely oversupplied by 1.5 to 2.5 million barrels a day. The world is still consuming 92 million barrels per day with modest growth projections for 2015. In other words, I continue to maintain WTI is not heading to something drastic like $10-$35 a barrel. (Contrary to Mr. Wonderful - Kevin O'Leary - who is predicting $35 WTI which is somewhat misguided). It simply would not serve OPEC to have prices fall that low over the long term. Low prices means lower revenue. Lower prices costs everyone, including Saudi Arabia and other OPEC members. Having secured market share at a fraction of realized prices defeats the purpose of maximizing revenues for cartel members. OPEC simply needs to have prices fall low enough to take out the excess supply (at the expense of US Shale producers).
OPEC made it clear they will let the "market" decide the prices for oil instead of ceding market share as the swing producer. Put another way, they will let the price of oil sufficiently fall to squeeze US shale plays out of the market to re-establish dominance in the global oil market. OPEC is prepared to go the distance, so I do not anticipate any intervention in June 2015 when they next meet or later in 2015. It won't be long before the high cost, levered producers fall off the radar. At $80 WTI, many of the US Shale plays were barely scraping by. At $60 WTI, they won't survive. OPEC knows many producers hedged through the middle of 2015, so they will likely intervene in 2016 after US supply has been taken out of the market, if that is even required at that time. So what is the trajectory for WTI oil prices in my humble opinion?
· WTI hovers around $60 per share through Q2 2015 as supply continues to exceed demand.
· WTI moves up to $65 per share by Q3 2015 as it becomes apparent US Shale and global supply is shrinking with lower prices taking effect.
· WTI inches up to $70/barrel by Q4 2015 as the marginal producers have been taken out of the market, and supply has likely overcorrected on the downside.
· As we move into Q1 2016, demand starts to exceed supply, and WTI moves up to $75/barrel
· As is typically the case, prices move to $80 and $85/barrel in Q2 and Q3 respectively, as price overshoots on the upside.
· Finally, prices stabilize at around $80/barrel in Q4 2016
So by my estimation, we are two years away from a stable oil market. I've intentionally modeled a stressed scenario for an extended duration. The analysis excludes any demand uptick over the next two years as a result of lower energy (which in my opinion makes this analysis even more conservative than necessary). However, I always prefer to see how a company performs should things get really bad versus painting a rosy forecast. OPEC will sit on the sidelines and protect market share over the long-term. As I articulated in a previous article, all Saudi Arabia did was exploit their marginal cost advantage over the competition which was a logical decision.
To restate the obvious, not all Canadian producers are created equally. Some producers in Canada will not emerge unscathed.
Setting The Context
It's always a red fleg when management bases a capital budget on grossly overestimated planning assumptions. Lightstream and Penn West were no exceptions. Extrapolating the data from analyst reports, it's about to get really ugly for these names in the energy patch. Assuming WTI averages $63.5 USD in 2015.
(Pre OPEC) to (Post OPEC)
Lighstream
- D/CF - 3.07x to 8x
- Payout Ratio - 113% to 293%
- WTI - $90 to $63.50
- CF/BOE - $38.07 to $14.37 (assuming royalties, hedges, opex, transportation, G&A, interest held constant)
Assumptions
- CAPEX @ $475M
- Dividends @ $96.3M
- Revised Cash Flow @ $194M
- Net Debt @ $1.558 Billion
Penn West
- D/CF - 2.51 to 9.91
- Payout Ratio - 113% to 446%
- WTI - $95 to $63.50
- CF/BOE - $26.46 to $6.74 (assuming royalties, hedges, opex, transportation, G&A, interest held constant)
Assumptions
- CAPEX @ $820M
- Dividends @ $278M
- Revised Cash Flow @ $245.9M
- Net Debt @ $2.43 Billion
SOURCE: (Assumptions extrapolated from CIBC and TD Equity Research as of September 2014)
However, the tendency is to pull the trigger on an entire sector before investors realize there are some great bargains for those who can withstand the "new normal" in oil pricing. I've also argued that Twin Butte energy is one of those companies that will go through some "tolerable" pain in 2015 before emerging as a stronger company in 2016. It will come down to management and how they decide to navigate the storm.
Scenario 1 - "Stay The Course"
· Management decides to maintain the dividend
· CAPEX remains unchanged at $160M
· Production remains flat at approximately 21,500 boepd
Before we begin, a few notes on the summary analysis
- Analysis assumes operating costs and royalties decline with shift to medium oil.
- Assumes no hedging for 2016 (I'm assuming management will not want to incur potential losses by locking in derivative contracts at prices lower than $60 WTI. This assumes that prices will eventually increase over time)
(click to enlarge)
Observations
· Year-end metrics in 2015 become somewhat stretched, but nothing that can't be managed, and certainly nothing compared to what other producers will likely face (ie. LTS, PWT).
o D/CF = 1.8 to 2.28
o Total Payout (Post DRIP) = 100% to 148%
o WTI = $80 to $63.50
o Year-End Cash Flow - $225M to $156M
o Production - 21,516 boepd (no change)
o CF/BOE - $28.21 to $19.90 (Of which $11.63 represents thier lucrative hedge contracts)
· If prices recover in 2016 as forecasted, Twin Butte fully recovers a stronger producer assuming a marginal bump in CAPEX for 2016.
o D/CF = 1.41
o Total Payout (Post DRIP) = 92%
o Year-End Cash Flow - $251M
o CAPEX - $170M
o Production - 22,663 boepd
No doubt, the market will penalize Twin Butte for missing their current cash flow forecast of $225M in 2015, but current prices are nearing a floor to reflect new commodity price assumptions after falling 50% from its peak. If management maintains the dividend, investors walk away with a very sustainable 15%+ yield for 2015 at current prices while waiting for the stock to recover.
Scenario 2 - "Cut CAPEX By 50%"
· Management maintains the dividend but slashes CAPEX by $80M under the lower price environment.
(click to enlarge)
Observations
· Year-end payout for 2015 become more manageable, but cash flow, debt to cash flow, and production take a hit.
o D/CF = 1.8 to 2.62
o Total Payout (Post DRIP) = 100% to 103%
o Year-End Cash Flow - $225M to $135.6 M
o Production - 21,500 to 18,123 boepd
· If prices recover in 2016 as forecasted, Twin Butte still recovers, but less optimally relative to Scenario 1.
o D/CF = 1.76
o Total Payout (Post DRIP) = 100%
o Year-End Cash Flow - $201M
o CAPEX - $140M
o Production - 18,954 boepd
Conclusion
Twin Butte will survive the storm relative to some other names. While there may be some more downside to the share price given what's about to happen with other producers (and the expected herd mentality that comes with it), Twin Butte's fundamentals should trump fear when it comes to investment decisions. The dividend is sustainable and the stock remains a bargain with a sizeable yield if your time horizon is long-term.
If I could send a message to the board at Twin Butte, it would simply be, "stay the course". Continue to shift production to medium oil relative to heavy oil. Continue to reduce operating costs. Ignore what WTI is doing in the market. Prices (both WTI and share prices) will eventually correct itself. Historically, Twin Butte has strived to maintain total payout under 100% and has always guided to revise CAPEX to stay within the target. I applaud management for this position but 2015 may call for a special circumstance to relax the rule given the unprecedented price correction. The analysis suggests Scenario 2 is sub-optimal for a longer-term recovery. A cut in CAPEX significantly reduces production, cash flow, and strains debt/cash flow for current and future periods. CAPEX is the lifeblood for simply maintaining production to offset declines. If management can live with a temporary hike in the total payout ratio for 2015, they would emerge well poised to dominate in a space with fewer players and stronger balance sheet.