As energy prices hit 6 year lows in January 2015, energy producers across North America cut their budgets, and reduced growth expectations—often to zero.
But not one Montney producer.
So far, newly-listed and highly-regarded Seven Generations Energy (VII-TSX) is standing by their 2015 spend of $1.6 billion in the very liquids rich gas area called Kakwa, in Alberta but near the B.C. border in the Montney gas play. The Montney has some of the best economics of any play in North America.
“7Gen” does have the proven management, they have the hedges and they have the premium valuation to skate through the current commodity price slump for 2015.
But it will come at a cost—drilling their best plays for a 31% IRR at $45 WTI and US$2.80/mcf natural gas—and that takes into account their (great) hedging. It takes a pristine, net-cash balance sheet to just under 2x debt-to-cash-flow.
7Gen’s main issue could be they’re growing because they have to, not because they want to in these low prices. They have take-or-pay provisions with two different pipelines that commit them to increasing volumes of condensate—worth as much as oil in Canada—and natural gas.
For our American readers–after Encana’s Prairie Sky (PSK-TSX) spinout, 7Gen was the most anticipated IPO in the Canadian oilpatch in 2014, raising $880 million net at $18/share the last week of October. As a private company, it had some of the biggest backers in Canada, including the Canada Pension Board.
The company has almost everything The Market wants:
- Management has a Big Success already—CEO Pat Carlson sold privately-owned North American Oil Sands to Norway’s Statoil in 2007 for $2 billion.
- A very large land package with prolific wells—that paid out in months to a year before the energy price collapse.
- Great support from The Street that gives it a premium valuation
- $1.02 billion cash and an untapped $480 million credit line against two term debt facilities totaling $785 million
The only thing they don’t have is good timing—since their October IPO, oil and gas prices have plummeted, sending payouts on wells from 8 to 25 months plus.
But 7Gen is hedged 50% on 2015 volumes and about one-third on 2016 volumes at over $4/mcf natural gas and $101/boe on their liquids. Q4 production was 43,500 boe/d and 2015 guidance remains at 55,000 – 60,000 boe/d.
Those great hedges allow the company to keep drilling economically to meet their take-or-pay provisions with two pipelines—Alliance Aux Sable and Pembina.
It’s these take-or-pay contracts—which is forcing the company to spend 3x cash flow and go to 1.8x debt-to-cash-flow at these commodity prices while doubling production—that make 7Gen the talk of The Street right now.
What is a take-or-pay agreement? It’s where a producer agrees to provide a minimum volume of gas/oil/liquids and the producer MUST pay a tariff or toll to the pipeline operator regardless of the actual volume it delivers. If a producer falls short of that minimum volume threshold, the more expensive it makes the rest of your actual production.
For example, if production comes in on average at 75% of the total take-or-pay volume commitment, the effective toll would be 33% higher than the per unit toll you signed up for. If you are 50% short the effective toll is double!
This can quickly make your transportation costs or all-in costs look very uncompetitive relative to your peers.
On the gas side, 7Gen has signed a deal with Alliance/Aux Sable that lasts until 2022 with minimum volumes of 250 mmcf/d by Q4/15 (about 80,000 boe/d), ramping up to 500 mmcf/d by Q4/18.
The agreement with Pembina has condensate, oil and liquids components but the primary focus is the condensate portion of the deal. 7Gen’s production is already almost double the initial take or pay threshold for the Pembina agreement but by Q1/17 the minimum commitment jumps to 30,000 bbl/d versus estimated Q4/14 production of roughly 15,000 bbl/d.
The Street is concerned that these minimum volume thresholds are driving 7Gen to grow more than any other single factor. From their own presentation they indicate that wells drilled in their “Nest” core area range from an IRR of 0% to 31% at current price levels (WTI $45, NYMEX Gas $2.80) with a minimum payback of 25 months, and this is the sweet spot of their land holdings.
Nobody on The Street wanted to talk on the record about this—and with good reason. Everybody wants to be part of the next financing. The Canadian oilpatch is a very small town. (There’s only 10-15 intermediates and juniors worth following closely.)
I had a brief chat with the Company. They say they do have flexibility with their take of pay contract, in that they could buy gas in the open market and put it in the pipe, as opposed to drill-to-fill, and add they do get calls from other producers looking for part of their pipeline capacity. With the Alliance pipeline fully contracted, they (and their sell-side supporters) see this is as a Big Positive, as opposed to the fear that’s driving them to drill into low prices.
Management did admit this take-or-pay issue is the single most mis-understood part of their story by The Street.
If they can buy other production, that begs the question that was the impetus for the story—why drill into those low prices and low IRRs and impair your balance sheet any more than you have to? Hedges in 2016 are only one third to one quarter of production vs. 50% in 2015 (and those are H1 weighted). If they have flexibility, is drilling low IRR wells really the best use of capital?
If they do decide to drill their commitments, they definitely have enough wells they can drill (the “drill inventory”) in their core play, called Nest 2, to meet the provisions. There is eight years of drilling at 12 wells a section (1 section=1 square mile) over two geological layers.
That takes a lot of the geological risk out of the take-or-pay provisions. That’s actually very important—no other play in their company has those great economics.
They also point out almost all their natural gas goes to Chicago on the Alliance pipeline, getting 60 cents more/mcf than it does in Canada at Edmonton’s AECO pricing benchmark. Propane pricing is also much stronger in the US at Conway than it is in Canada.
The company also says it does have $230 million in its 2015 budget geared towards acquisitions and exploration, which it could defer.
But investors also need to realize they plan to greatly outspend cash flow in 2016. And even more concerning could be the 193.9 million shares that come free trading on May 5. Right now the only free trading shares are from the $18 IPO. The effective financing prices for 7Gen when they were private were $6.25 and $3/share—prices that are now heavily in the money.
However, it’s not all doom and gloom. 7Gen appears to be in the sweet spot of the Montney play in the Kakwa region. They have prolific wells and are still improving completion and recovery techniques.
They have an identified inventory of over 500 wells. For now they have a very strong balance sheet. They have great hedges for the first half of 2015. Completion technology (fracking) is still improving; lowering costs.
There is no doubt 7Gen has the ability to outperform its industry counterparts, the question is at what cost.
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