Earlier this year, I wrote analyses about Peyto being well-positioned in the gas market as the lowest-cost Canadian producer. While the gas prices in the US picked up and are currently trading close to US$3/MMBtu, the Canadian AECO prices created a large differential, trading close to US$0.5/MMBtu. If selling for AECO prices, even Peyto wouldn't be profitable at these levels. Fortunately for us, Peyto has a strong hedging and diversification strategy and has hedged its gas prices till 2026. This makes its high dividend yield of 9% well-secured while waiting for gas price recovery.
In this article, I will reflect on the Q1 results, will review the continuation of the Repsol assets implementation, and update the five years outlook to assess valuation.
Strong start to 2024
The CEO opened the Q1 conference call, highlighting the C$205M in funds from operations, a result that the company last saw in late 2022 when the gas prices were significantly higher. This demonstrates resilience even in less-than-ideal market conditions.
The standout for the quarter was the C$94M hedging gain from Peyto's systematic hedging approach. This gain has significantly helped to pay C$64M in dividends, reduce the debt by C$23M, and even contribute to the capital spending program for developing the acquired Repsol lands. Considering the ~30 years of 2P reserves, investing in Peyto is all about developing the land. That's why I don't think about the hedging strategy only as a safety net, but as an essential step to make sure the lands will be developed. The stability of those fat dividends is the cherry on the cake for me.
Drilling deeper and smarter
During the last quarter, Peyto brought 15 new wells on the stream, leveraging the acquired Repsol lands. These new wells are showing a ~30% increase in productivity compared to the legacy assets, affirming the quality of these acquired assets and the quality of management's decision to make this acquisition.
A highlight for the quarter was a venture into longer lateral wells reaching up to 2,400 meters. This is a part of Peyto's strategy to increase the recovery rates, which should cause the growth of total production. For example, the Dunvegan wells demonstrate higher production levels and higher liquid content.
Peyto is not only drilling more, but also drilling smarter. The integration of the Repsol assets has been seamless so far, resulting in improved productivity and operational efficiency. Peyto is focused on enhancing liquids recovery and further cost reduction. For example, I could mention pipeline and compressor installations, which are progressing well.
The management has decided to stop recovering low-value ethane via a third-party deep-cut plant and redirect the gas to its own facilities. This, in my view, shows the strategic thinking of Peyto's management, as it should further lower the operating costs by ~C$0.02/Mcf (C$0.12/BOE), solidifying Peyto's reputation as the lowest-cost producer.
Overall, Peyto reached production of 125,017 BOE/D during the first quarter. This growth trend is expected to continue with a 2028 target production of ~160k BOE/D.
How stable is the 9% dividend yield?
As I mentioned above, hedging is an important part of the company's strategy. Investing in Peyto is not about speculation on quick spikes in natural gas prices. Instead, Peyto is locking such prices, which will allow the company to pay its dividends and capital program.
While the average realized sales price for Peyto's gas and NGLs was only C$3.5/Mcf, including the hedges, it accounts for C$4.87/Mcf in 1Q2024.
Peyto's realized prices have consistently outperformed its benchmarks, with a 1Q2024 gas sales price of 29% over the average monthly AECO index. We contribute this success to Peyto's pricing diversification across North America.
Peyto's realized prices have consistently outperformed its benchmarks, with a 1Q2024 gas sales price of 29% over the average monthly AECO index. I contribute this success to Peyto's pricing diversification across North America.
This is especially important in times when the differential between Canadian AECO and US Henry Hub prices gets very wide, which is currently happening.
Unhedged producers that are selling for spot AECO prices are currently significantly unprofitable, while Peyto hedged most of its gas above $3.5/MMcf.
I believe that this 29% earned premium (excluding hedging gains) has the potential to be even higher in the future, considering that Peyto's pricing will be much more exposed to Henry Hub pricing in the future and Cascade Power plant is already in progress, which we should see in the Q2 results.
Reducing Debt and Sustaining Dividends
Despite the company reducing its debt by C$23M in Q1, the debt is still elevated after the Repsol acquisition. The long-term debt interest rate grew to 6.5%, forcing the management to prioritize debt repayments over opportunistic buybacks. The current combination of growth capex, dividends, and debt repayments is a mix of capital allocation I expect for the next few years, and due to the forward hedges, I don't expect any surprises caused by gas price volatility.
As you can see on the chart below, as in 3Q2023, even if the FCF for the quarter does not cover the dividend payment, it's not a reason to cut the dividend. With the hedges in place, I have no worries about potential dividend cuts.
Increased demand for natural gas
The LNG export capacity from North America is expected to more than double through 2027. For Canadian producers, the LNG Canada project is the most significant. While Peyto has no direct exposure to LNG export, the whole NA gas market is expected to benefit. Peyto is ready to capitalize on higher prices with higher production output.
The other factor that excites me is the potential energy demand surge from advancements in AI. The infrastructure for AI development and training will need a lot of energy. For example, the search from Chat-GPT is estimated to consume ~25x more energy compared to a search from Google.
Valuation
I am now going to build up the projection model, which I will use to value the company.
- Gas prices - I am assuming AECO, rising to C$3 in 2026 following the strip.
- Production growth - Management is guiding for growth close to ~160k BOE/D in 2028. I believe that if the gas prices rise more than expected, Peyto will be ready to boost production further.
- Realized prices - I am modeling Peyto's realized gas prices 25% above the benchmark while keeping in mind that there is potential for even better pricing, as I explained above.
- Costs - Peyto already has very low costs, but I still expect them to slightly decrease as explained above. With rising gas prices, we can expect higher royalty payments, which is the main reason for my overall higher expected future costs. Another savings should come from interest cost reduction over time as Peyto reduces its debt.
- Hedges - Since my model calculates with very low AECO prices, we can expect very high hedging gains over the coming quarters and years.
- Capex - The total Capex is expected to come at around C$475M, of which C$350M is used to offset the declines and the rest to support the growth.
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I do not expect the numbers for the next three years to change much, as most of the gas prices are hedged. As you can see, the dividend yield of 9% is not only covered but can grow significantly in the coming years. While I do not expect the management to increase the base dividends, we should see some special dividends or faster debt reduction.
Ultimately, if this goes as expected and Peyto stops spending for growth in 2028, we could reach a sustainable FCF yield of 24%.
Applying a discount factor to these cash flows, we can see that Peyto is currently trading close to a 20% discount rate. I believe that midcap gas producers should trade around or below a 15% discount rate, which would imply a share price of C$20 and a 35% upside compared to the current price.
Risks and Sensitivity
Despite the strong performance and, in my opinion, very low valuation, there are risks to consider. The natural gas market is highly volatile by nature. Despite Peyto's hedging strategy, sustained low gas prices could pressure margins, which, in combination with high debt levels, could pose a challenge if the market conditions worsen. Operational risks such as wildfires should also be kept in mind.
The main risk for any commodity-producing company comes from commodity prices. I am running the same PV15 valuation under different oil and gas prices to see where the company's breakeven is and how much leverage the company has toward the gas price.
(This Sensitivity analysis ignores the hedges for 2026.)
As you can see, a small movement in future AECO of C$0.25/mcf swings the FCF by ~15%. This high sensitivity represents a risk but also an opportunity.
Investment decision
I initiated a position after publishing my first Peyto analysis, and I am holding the shares for the long term and would consider selling if the prices move close to C$25 a share. The strong insider buying activity gives me a good signal that insiders also believe the Risk/Reward is highly in my favor.
Pros:
- Peyto successfully continues to implement Repsol's lands with a growing production, expecting 160k BOE/D in 2028.
- The 9% yield is well covered with the hedging in place to withstand the low gas prices environment.
- The company is ready to boost output if gas prices rise more than expected.
- Strong insider buying.
Cons:
- The interest rate on Peyto's debt grows, and management is forced to focus on debt repayments. While I believe it does not present a risk of debt failure, it means there will be less capital available for special dividends and buybacks.