Arcan Resources Ltd.
(ARN-V) C$1.60
Bulking up on Carbs in the Swan Hills -- Initiating Coverage
Event
We are initiating coverage on Arcan Resources Ltd. (ARN-V) with a BUY
recommendation and $3.75 target price.
Having established its position as early as 2005, ARN is one of the first
juniors to drill horizontal wells in the Beaverhill Lake (BHL) formation at
Swan Hills, which is now one of the hottest light oil plays in Alberta. The
company has struggled with debt over the years, as the capital required to
develop the play is beyond the capacity for any junior to handle, in our view.
That said, ARN is potentially an ideal target if the play ultimately
consolidates, as we expect – given its contiguous land base, production
history, and current valuation metrics.
Exhibit 1. Summary of our Investment Thesis
• 98% Light Oil and 100% Operated • Significant Exposure to High Decline
Rates
• Large Contiguous Land Base on the
Swan Hills BHL • Capitalization Risk - Is the Play too big
for the Juniors?
• Exposure to the Oilier Part of the Play • Highly Levered Balance Sheet
• Reserves Growth and High Reserves
Life Index • Challenges Implementing Current
Waterflood at Deer Mountain
• Strategic investment in StimSol
Secures Acid Supply • Play May Not Be Ripe for
Consolidation Just Yet
• Positive Momentum From the Virginia
Hills
• Legacy Vertical Production
What We Like Cautionary Considerations
Source: TD Securities.
Details
ARN is exposed to what are arguably some of the most prospective lands on
the Swan Hills BHL light oil play. The company’s Swan Hills assets include a
high working interest in two producing units (Deer Mountain # 2 and Morse
River # 1), and a large contiguous block of land on the eastern flank of the play (Ethel and Swan Hills South).
ARN is virtually a pure-play on this asset, one that has attracted significant attention from the Intermediate
Canadian E&Ps in recent years. ARN’s Swan Hills assets are 100% operated and have a very high working
interest, ranging from 81% to 100%, but closer to 100% on average. Given the excitement surrounding this
sweet light oil play, most of the land is already locked up and, in our view, ARN is a natural candidate for
either a consolidator or a completely new entrant to the area.
Unfortunately, the play has not been without its challenges for ARN. Headline IP rates are high, but so are
declines and well costs. Operating costs have also been higher than expected, as infrastructure spending has
lagged drilling budgets and unplanned downtime has affected operations. As a result, ARN’s balance sheet has
been – and remains – stretched, as it struggles to capitalize the play fast enough “outrun the treadmill” so to
speak.
In our view, the Swan Hills BHL is not only better suited to a larger, well-capitalized player, but also one that
has a diverse enough asset base capable of diffusing the significant impact of wells that decline by 40% in the
first three months alone. On that note, ARN has done a commendable job of assembling the land base over the
past seven years, delineating the asset, and increasing reserves. Reserves growth has outpaced production
growth significantly, resulting in one of the highest reserve life index (RLI) among its peers. ARN’s 2011 2P
RLI was 28.3 years, nearly double the oil-weighted peer group average of 14.4 years.
Outlook
The outlook for ARN has weakened considerably year to date. In addition to the macro environment (i.e.,
continued risk aversion in the equities and commodities markets), ARN has faced several challenges in recent
quarters:
? Well downtime has been an issue (juniors with concentrated production are naturally more vulnerable)
and, as a result, production has come in below expectations lately.
? Second Wave Petroleum Inc. (SCS-T), another junior Swan Hills pure-play, initiated and unsuccessfully
concluded, a strategic review process. More recently, Second Wave announced a significant 2012 budget
cut, which may be cause for the market to question the robustness of the BHL play at US$80-85/bbl WTI
prices.
? Recent management shuffle and a $4.5-million consent judgment against a former employee of the firm
have resulted in the market questioning the integrity of the firm’s internal controls/governance.
Although ARN has successfully increased reserves through an aggressive delineation program, it has faced
challenges in growing production, which, to us, indicates an asset better suited to a larger and better-capitalized
player. Until recently, ARN outspent cash flow by a significant margin, which has resulted in increased levels
of debt. Going forward, ARN’s stated goal is that of managing debt and reducing overhead. As a result, in Q3
and Q4 of 2012, management does not plan to spend above cash flow – even if that means fewer wells drilled.
Valuation
ARN currently trades at a P/NAVMG of 38% and an EV/2013E DACF multiple of 3.5x; this compares with an
average of 74% and 3.5x, respectively, for its closest peer group under our coverage.
Justification of Target Price
Our target price reflects a base valuation of $4.32 that combines our NAVMG of $4.18 at a 65% weighting and
$4.58 using an EV/DACF multiple of 5.5x 2013E DACF at a 35% weighting. This is then adjusted by a
subjective factor of -15% (within a range of +/-25% for the sector) to arrive at our calculated target price of
$3.67 (rounded to $3.75).
Key Risks to Target Price
Key risks associated with our target price include business risks of the company and industry, including but not
limited to: loss of key employees, drilling success, volatile commodity prices, operating costs, capital cost
overruns, product supply and demand, financing/access to capital, government regulations, legislation,
royalties, taxes, exchange rates, interest rates, and environmental and weather concerns.
In addition to industry risks, key near-term risks specific to ARN include: 1) asset and production base
almost exclusively levered to Canadian light oil pricing, 2) asset base concentrated to one region (Swan
Hills), which leaves the company disproportionately susceptible to regional risks, including inclement
weather, cost inflation, and frac fluid supply, 3) companies of this size face growth challenges from a
cost structure perspective until they achieve a level of production that allows them to benefit from
economies of scale, 4) decline rates from new wells could be substantially higher than expected, which,
for a company of ARN’s size, could materially alter production and ultimately reduce cash flow
projections used to finance future growth, 5) operational challenges managing a waterflood program,
including low voidage replacement, 6) elevated debt levels could significantly impair the company’s
ability to grow, 7) G&A costs have been exceptionally high to date, particularly for the company’s size,
and 8) Crescent Point owns 19% of outstanding equity, which could serve as an effective hurdle for an
outside bidder.
Investment Conclusion
ARN’s stock price has sold off dramatically in recent months – production levels and operating costs
continued to fall below expectations, while capital spending and debt levels continued to increase. The stock
currently trades at a significant discount to NAV, at 44% of our 2P NAVBD or 38% of our NAVMG. That said,
on a cash flow basis, it generally trades in line with its peers, at 3.5x EV/2013E DACF, which further supports
our thesis that the capital intensity of the play may just be too much to handle. Access to capital, whether
equity, debt, or selling down its interests, should help alleviate debt in the short term, but may not be a longterm
solution. In our view, a strategic business combination is most likely, particularly at current valuation
levels.
We are initiating coverage with $3.75 target price and BUY recommendation.