As we saw in the previous article, Original Investment Idea – Peyto Energy (Part 1), Peyto Energy has done an outstanding job earning large returns on invested capital. In the long run these returns on capital will drive investment returns and the amount of cash any company can return to shareholders.
Peyto Energy – A Bargain?
Now before we look at the numbers we must keep in mind that the single largest driver behind future return will be the gas prices. Have I said that before? Gas prices are at multi year lows and changes in the shale gas market may keep them low for a prolonged period. Investors must be aware of this risk. Anyone who makes an energy recommendation and doesn’t tell you this upfront, stop listening to anything else they say. They clearly don't understand the risk of their investments.
Now just for the sake of comparison let’s look at Peyto compared to Petrobakken. All numbers are based on year-end 2009 results (my previous article used the more recent Q2 numbers where PBN has less debt but a lot more shares outstanding). NAV is debt adjusted. This is a straight up, apples to apples comparison at year-end 2009.
To be fair, NG prices have fallen relative to the prices used in the 2009 reserve report, and that should reflect on the lower market price for Peyto. Now for Petrobakken, they have an asset that is worth less than invested capital when future cashflows are discounted at 10%. This doesn’t mean they have generated a negative return on invested capital. Now I don’t know exactly what Petrobakken’s cost of capital is, but it better be below 8-9% or they are destroying capital. And likewise with Peyto they have earned returns well in excess of 10%. As for Petrobakken going to $30 per share, Devin Shire (CanadianValue) better give us a better explanation of how he proposes they do it (Note: I am still waiting for that explanation, Here is Mine). They will basically have to spend (or should I say waste) a lot of capital at low returns to get the asset value there, or pray for oil to go up.
If we look specifically at Peyto their ROE has averaged 41% and return on invested capital (ROIC) comes in an average of 21%, for the past 10 years. Obviously, any company that can earn 41% ROE over the long-term will perform well.
Now history is fine, but definitely not the whole story. Going forward it appears that Peyto’s returns will be quite strong based on their new horizontal drilling techniques. Returns on these wells appear to be quite strong in spite of the low gas prices. If and when gas prices do recover Peyto will no doubt benefit from that tailwind as well. From the end of 2009 to end of 2011, they are forecast to nearly double production with just under $600 million in capital expenditures. Now this will rival Peyto’s investment returns from their early days.
Here is what they had to say in their latest news release relating to their horizontal drilling,
The success over the past twelve months is clear evidence that horizontal multi-stage fracturing technology has reduced Peyto’s cost to add new production by as much as 50% and enhanced the returns significantly. The current internal rate of return estimate for the 2010 capital program is 38% using first year gas and oil prices of C$3.87/GJ and C$80/bbl, respectively and the current future strip for subsequent years.
Now is Peyto a bargain, I guess that depends your outlook for NG prices. Each will have to make up their mind and vote with the own cash. Being able to earn 38% IRR on invested capital at $3.87/GJ prices is fantastic given that gas price is the lowest in years. What will happen when NG prices rebound?
Stock Options – Is The Hand in the Cookie Jar?
I personally believe how a company handles stock options/bonuses are very telling to whether they are shareholder friendly or not. Unlike my previous discussion PBG, which you can read here, Peyto only pays bonuses when management adds value. To do this Peyto pays both a reserves based bonus and a market based bonus.
The reserves bonus is a pool of 4% of the incremental increase in value, if any, adjusted to reflect changes in debt, equity, distributions, general and administrative costs and interest, of proved producing reserves calculated using a constant price at December 31 of the current year and a discount rate of 8%. In other words, they only pay a reserve bonus when management add value with all other variables held constant. A truly pay for performance agreement.
For the market based bonus, they offer share appreciation rights that vest over 3 years and are cancelled at the end of the three years and are paid out in cash. These rights are offered at the current market prices and will reward management for increasing the underlying price for the shares.
Now both of these are clearly aligned to shareholders and definitely get a passing grade.
Summary
Peyto proves to be an interesting case study as they are both the lowest cost producer of NG and also quite possibly the lowest cost finder and developer of NG in North America. The have done an excellent job historically with ROE and ROIC being 41% and 21% respectively over the past ten years. They have profitably generated very high returns on invested capital. Going forward, their recent advancements into horizontal drilling could possibly generate some of the best returns in their history, especially if NG prices rebound. Also, since converting to an income trust in 2003 Peyto has delivered $1.1 billion in cash to shareholders ($10.51/share). Now you can fake your accounting books but you can’t fake cash.
Finally, as for valuation, they trade at a discount to their 2009 YE NAV discounted at 10%. It should be noted that NG prices have fallen and may be a strong reason why they are trading below that price. However, being a value investor means being counter cyclical and NG is definitely at the low point in the commodity cycle. Now the price could stay low for an extended period of time, but likely doesn’t have much more room to go down.
Personally, I feel NG prices are below the marginal cost of production for mostly all companies. Recent announcements from Encana have confirmed this fact. Peyto has so far being counter cyclical and has increase its capex during this downturn to increase drilling. The cost of services (like drilling) are cheap right now and their low cost structure and focus on total returns allow them to profitably invest right now.
It definitely is ironic that Peyto just broke a new 52-week high and gas prices are near record lows. Remember, being the lowest cost producer in a commodity type business is the key.
Best Regards,
Kevin Graham
[url=http://canadianvalueinvesting.blogspot.com]canadianvalueinvesting.blogspot.com
[/url]
Disclosure – Long PEY.un, I have been a happy shareholder for many years.
I refer you to Peyto’s corporate presentation on their website (www.peyto.com) where you will find a wealth of information. Their corporate presentation and appendix provide ample comparison to the competition. Their most recent monthly newsletter provides industry comparisons of total cash costs of many competitors. Read Here.
Peyto Energy – A Bargain?
Now before we look at the numbers we must keep in mind that the single largest driver behind future return will be the gas prices. Have I said that before? Gas prices are at multi year lows and changes in the shale gas market may keep them low for a prolonged period. Investors must be aware of this risk. Anyone who makes an energy recommendation and doesn’t tell you this upfront, stop listening to anything else they say. They clearly don't understand the risk of their investments.
Now just for the sake of comparison let’s look at Peyto compared to Petrobakken. All numbers are based on year-end 2009 results (my previous article used the more recent Q2 numbers where PBN has less debt but a lot more shares outstanding). NAV is debt adjusted. This is a straight up, apples to apples comparison at year-end 2009.
Company | Peyto | Petrobakken |
Book Value | $ 5.69 | $ 17.18 |
NAV10 - BT 2P | $ 19.09 | $ 16.86 |
Stock Market Price | $ 15.45 | $ 22.52 |
To be fair, NG prices have fallen relative to the prices used in the 2009 reserve report, and that should reflect on the lower market price for Peyto. Now for Petrobakken, they have an asset that is worth less than invested capital when future cashflows are discounted at 10%. This doesn’t mean they have generated a negative return on invested capital. Now I don’t know exactly what Petrobakken’s cost of capital is, but it better be below 8-9% or they are destroying capital. And likewise with Peyto they have earned returns well in excess of 10%. As for Petrobakken going to $30 per share, Devin Shire (CanadianValue) better give us a better explanation of how he proposes they do it (Note: I am still waiting for that explanation, Here is Mine). They will basically have to spend (or should I say waste) a lot of capital at low returns to get the asset value there, or pray for oil to go up.
If we look specifically at Peyto their ROE has averaged 41% and return on invested capital (ROIC) comes in an average of 21%, for the past 10 years. Obviously, any company that can earn 41% ROE over the long-term will perform well.
Now history is fine, but definitely not the whole story. Going forward it appears that Peyto’s returns will be quite strong based on their new horizontal drilling techniques. Returns on these wells appear to be quite strong in spite of the low gas prices. If and when gas prices do recover Peyto will no doubt benefit from that tailwind as well. From the end of 2009 to end of 2011, they are forecast to nearly double production with just under $600 million in capital expenditures. Now this will rival Peyto’s investment returns from their early days.
Here is what they had to say in their latest news release relating to their horizontal drilling,
The success over the past twelve months is clear evidence that horizontal multi-stage fracturing technology has reduced Peyto’s cost to add new production by as much as 50% and enhanced the returns significantly. The current internal rate of return estimate for the 2010 capital program is 38% using first year gas and oil prices of C$3.87/GJ and C$80/bbl, respectively and the current future strip for subsequent years.
Now is Peyto a bargain, I guess that depends your outlook for NG prices. Each will have to make up their mind and vote with the own cash. Being able to earn 38% IRR on invested capital at $3.87/GJ prices is fantastic given that gas price is the lowest in years. What will happen when NG prices rebound?
Stock Options – Is The Hand in the Cookie Jar?
I personally believe how a company handles stock options/bonuses are very telling to whether they are shareholder friendly or not. Unlike my previous discussion PBG, which you can read here, Peyto only pays bonuses when management adds value. To do this Peyto pays both a reserves based bonus and a market based bonus.
The reserves bonus is a pool of 4% of the incremental increase in value, if any, adjusted to reflect changes in debt, equity, distributions, general and administrative costs and interest, of proved producing reserves calculated using a constant price at December 31 of the current year and a discount rate of 8%. In other words, they only pay a reserve bonus when management add value with all other variables held constant. A truly pay for performance agreement.
For the market based bonus, they offer share appreciation rights that vest over 3 years and are cancelled at the end of the three years and are paid out in cash. These rights are offered at the current market prices and will reward management for increasing the underlying price for the shares.
Now both of these are clearly aligned to shareholders and definitely get a passing grade.
Summary
Peyto proves to be an interesting case study as they are both the lowest cost producer of NG and also quite possibly the lowest cost finder and developer of NG in North America. The have done an excellent job historically with ROE and ROIC being 41% and 21% respectively over the past ten years. They have profitably generated very high returns on invested capital. Going forward, their recent advancements into horizontal drilling could possibly generate some of the best returns in their history, especially if NG prices rebound. Also, since converting to an income trust in 2003 Peyto has delivered $1.1 billion in cash to shareholders ($10.51/share). Now you can fake your accounting books but you can’t fake cash.
Finally, as for valuation, they trade at a discount to their 2009 YE NAV discounted at 10%. It should be noted that NG prices have fallen and may be a strong reason why they are trading below that price. However, being a value investor means being counter cyclical and NG is definitely at the low point in the commodity cycle. Now the price could stay low for an extended period of time, but likely doesn’t have much more room to go down.
Personally, I feel NG prices are below the marginal cost of production for mostly all companies. Recent announcements from Encana have confirmed this fact. Peyto has so far being counter cyclical and has increase its capex during this downturn to increase drilling. The cost of services (like drilling) are cheap right now and their low cost structure and focus on total returns allow them to profitably invest right now.
It definitely is ironic that Peyto just broke a new 52-week high and gas prices are near record lows. Remember, being the lowest cost producer in a commodity type business is the key.
Best Regards,
Kevin Graham
[url=http://canadianvalueinvesting.blogspot.com]canadianvalueinvesting.blogspot.com
[/url]
Disclosure – Long PEY.un, I have been a happy shareholder for many years.
I refer you to Peyto’s corporate presentation on their website (www.peyto.com) where you will find a wealth of information. Their corporate presentation and appendix provide ample comparison to the competition. Their most recent monthly newsletter provides industry comparisons of total cash costs of many competitors. Read Here.
