I had a GREAT interview with the SPARTAN team…one of the most successful junior oil and gas teams in Canada in the last 20 years.  Rick McHardy and Fotis Kalantzis are now on their 4th iteration, having successfully monetized three previous companies for shareholders.

I thought the interview had enough insights into the Canadian energy patch it was worth sharing with everyone, not just subscribers. I think you’ll agree.  Here is a slightly cleaned up and shorter version of a long conversation we had just over a month ago:

TRANSCRIPT—SPARTAN DELTA CORP.
SDE-TSXV
FOTIS KALANTZIS, CEO / MARK HODGSON VP CORP DEV
JUNE 24 2020

 
Keith:        In this call what I’d like to do is have a free range discussion on where you see the market right now, where you guys see doing business in the WCXB. How things have changed since you guys left because man, the whole world’s been through the wringer since you left and came back.

So I would really rather hear about that stuff than any kind of explanation on assets. There are some questions I want to get a little granular on when it comes to strategy and assets and I appreciate you can only say so much.

I really want to hear what’s changed in the last two years and how you’re adapting your strategy to meet those changes. To me, that would be a great open way to start that conversation.

Fotis K:          We sold the last Spartan to Vermillion because we felt at the time that we needed to be in a bigger company, generating free cash flow and delivering a dividend to shareholders.

We had actually tried  to buy the Weyburn asset which has a low decline and would have created a bigger entity capable of delivering a meaningful dividend. Of course we lost that transaction to another bidder and then decided to sell the Company to Vermillion so our investors would have more liquidity yielding an opportunity to exit or  continue to hold the shares and collect the dividend.

Since 2018, we have spent lots of time talking to some of our long term investors that have been there with us over the years, both in the U.S. and in Canada. We even went to London and talked to some of our key relationships there. Everybody showed interest in us starting up again, but wanted size and liquidity.
                       
It very quickly became apparent to us we need to become a very large company with at least a billion dollar market cap, 100,000 barrels a day of production, capturing economies of scale, consolidating fairways and right sizing the businesses we were looking at.  Diversification  was also a key theme, both in terms of the commodity and the geography. So, contrary to the last few iterations, we are not planning to be a small cap  company or a single geography company. That’s the general strategy.

Keith:             Okay. That makes sense to me. That makes perfect sense. So it’s a bit grand a strategy really. The idea of  getting taken out by intermediates getting taken out by major, that’s kind of gone now. Is that a fair comment? And that would be a bit of a reason for that strategy?

Fotis K:          We think the junior model is difficult in this environment. We would also argue the pure play model has proven challenging. We think it’s all about size and we’re going to be opportunistic in this environment in growing scale.  We are fortunate to have the backing of several cornerstone investors and hope to steward that capital towards some of the best projects in the basin. We are hopeful to have the cost to capital advantage to consolidate, to be a part of the midcap space and to become a large company.

Keith:             Yes. That makes sense. Really, what I’ve heard you say is that with that grander idea, how much does organic growth fit into that? You’ve got this one group of assets now, you’re going to go out and do more.

Let’s just talk about that one set of assets here. With what’s changed in the industry, how do you guys want to grow? Before you would want to grow maybe just outside of internal capital, so you only had to raise a little bit of money each year to keep growing. Has that changed now? Do you keep growth completely under cash flow? What’s the strategy around organic growth given the situation today?

Fotis K:          While we don’t see growth necessarily being rewarded, we are focused on free cash flowing assets that have the ability to significantly grow organically–should commodity prices see a meaningful uptick. The assets that we bought have lots of upside, diverse but repeatable locations, and many of them are very economic today, some of them yielding greater than 100% rate of return on current strip pricing. We haven’t put official guidance out, but we are well positioned to provide investors with organic growth alongside leading free cash flow yield.
                       
In the very short term we’ll put free cash against the debt and on current pricing we should be debt free by the middle of next year. Of course, in the longer term, when we’re bigger, that free cash flow provides optionality to potentially pay a dividend back to our shareholders. But in the short term I would say we are going to focus on additional acquisitions.
                       
Keith:             Mm-hmm. Okay. Let’s just stick with… I’ve heard you say you’re going to have several footprints, and of course that’s why Mark was brought on with his international experience, but if we just stick in the WCSB for the moment, when you think about M&A there, one of my questions was how important was it to have a continuous asset base in the WCSB. Or would you bias your ideas and work to stay continuous or it really doesn’t matter, there’s just so much opportunity and such good infrastructure everywhere it really doesn’t matter?

Fotis K:          In the areas that we’re in now, around the West Central Alberta area, we are 25,000 boepd. We could easily, between some organic growth and some tuck in acquisitions grow to 40,000 in that fairway where we already have a strategic infrastructure footprint in place. Lots of room to expand and use it because there is still available capacity.
                       
Consolidation in the area has merits. Simple G&A savings, some operating and some debt servicing costs can be stripped out as well. Combined these could easily add tens of millions of synergies on cash flow.

Keith:             Wow, that’s a lot, just on M&A synergies.

Fotis K:          Well, if you look at a lot of companies that have large debt burdens, which cost them two, three, four dollars per boe in interest expense, there is value in restructuring. Then you also have some companies with between two and three dollars of G&A per boe. If we can restructure those businesses to say cut those two buckets in half, that is significant right?

Keith:             That sounds great on paper Fotis, but these teams have shown they’re not really that willing to do that. We’re not seeing that much MNA in the junior space at all. So how do you either wave the carrot or use the stick to make this happen? Do you bring in bankers? How do you… The industry itself just doesn’t seem very interested in this idea. I agree with you, it makes sense.

Fotis K:          I see the point that you’re making and there are signs of some entrenchment out there, but we think the banks and investors are really starting to want to see consolidation happen. M&A also doesn’t need to be about winners and losers, you can also see it as a merger between two good companies with the objective of creating a better company.

Keith:             You’re right. You do need to do that as an industry, but we’re seeing that it’s not happening. So what I’m hearing you say is, “Keith you just have to trust us. This is the art of the deal and we’ll let you know when we do something.”

Fotis K:          Yeah, that’s basically it. We think that between our balance sheet, which would provide a de-levering option, and our free cash flow, we make an attractive merger candidate for some companies.

Mark H.:        I think that’s one of the key differentiators right now Keith, compared to the talk of consolidation over the last five years, today we’re in an environment where companies are going to have to work hard to clean up the balance sheet issues this downturn is creating. It’s not a company specific issue, it’s the majority of the industry right now. Boards and lenders alike are calling for management to make moves to shore up the balance sheet, and it’s important to do that, especially if there’s potential overhang of further rounds of COVID that may continue to impact demand. Unfortunately, taking risk off the table often translates into dilution one way or the other for shareholders. It’s selling assets at a discount, it’s raising capital either through converts or equity at depressed valuations, or it’s potentially doing a merger with a company with a stronger balance sheet.
                       
So we like where we’re positioned not having that uphill battle to climb, but as Fotis mentioned, large shareholders, boards and banks are all looking at the underlying assets that are backstopping their various interests in the companies saying how can we maximize the value out of this and manage risk at the same time. I think transactions will start to happen here. It does come to that creative art of the deal of bringing the different stakeholders to the table to find a viable outcome to maximize value for everyone, while also managing the risks of an extended downturn.

Keith:             Mm-hmm. Okay. Again, I know you guys have time restricts so I don’t want to take too much time here, but certainly we’re seeing recaps here where it’s not being M&A, it’s getting done as a recap. Mark, talk to your part of the business here for a second.  Why don’t we talk about… Let’s switch gears for a second Mark and talk about your part of the business, the international strategy.

I’d be curious to know a couple things. A couple of my questions would be, what’s more important, asset based jurisdiction, how does that trade off work for you in your mind? Then I’d also be curious as to what the streets telling you about that, your big institutional shareholders, what are they telling you about that? As much as you’re allowed to, without spilling any beans, tell me a little bit about international strategy, what you’re thinking, gas, oil, Americas, outside the Americas, midstream, upstream, what are you guys thinking?

Mark H.:        Well, it’s still early days in our international strategy development, but I think the primary target internationally could be oil. The gas landscape is competitive with the majors all pursuing active gas strategies. The international oil landscape has been relatively abandoned over the last five to seven years, as the independents made their way back the US and invested heavily in shale. The large super majors have been under pressure to find cleaner more sustainable platforms and have focused their efforts on either offshore, low footprint, deep water exploration, or gas.
                       
I don’t think you’re going to see us go after anything offshore, but where there are projects that have material development potential, onshore, where we can apply horizontal drilling, frac technology, we think we can apply our skillset and create a lot of value to different jurisdictions and find good partners from a NOC (National Oil Company) basis.
                       
I spent the better part of six to months working up a few international concepts before Fotis and I connected on this reboot of the Spartan brand and in the end, the opportunities in Canada emerged at a faster paced in the M&A landscape so it was the natural first place to transact. We continue to develop ideas around different jurisdictions that we like and different assets that we like. We like jurisdictions where you can go in capitalize as the majors start to shed assets, which they did actively in the 80’s and 90’s.

There’s opportunities to go into places like Egypt or certain parts of the Middle East and acquire from some of the larger portfolios there and essentially take things that don’t hit the materiality thresholds of the majors and NOCs, but would enable us to  build a big enough position in that 50,000-75,000 barrel a day range to make it justifiable for a new country entry.

Keith:             Got it. Okay. That all makes sense to me. In terms of, if you look at other companies that have done that, like TransGlobe, which trades 1x cash flow or less, how does that play into your thinking, that the valuations on some of these assets, particularly in that part of the world, tend to get not really full value by North American investors?

Mark H.:        Yeah. I think companies with dual listings have had struggles building and maintaining their international shareholder base. In my experience the shareholders that are looking at North Africa are typically going to be domiciled in Europe. Canadian and North American investors like to look at Latin America. If you’re going to do a transaction in the Middle East you’re likely going to have to do a UK listing and you’re going to have to build up a material shareholder base through a material equity raise in London, otherwise you will fall into that same trap.

Keith:             Got it. Okay. That all makes sense to me. And as you said, you guys did go over to London and talk to your shareholder base there and try to get a sense into what they want to see from you guys so you’re obviously taking that into account. That’s pretty straight forward.

Mark H.:        It’s interesting, as a side note, you’re starting to see more London interest in North American upstream. They really stepped away from it for the last five to seven years. Canadian domestic companies have  struggled to get meetings in London. But with Diversified, which is a UK listed and domiciled entity getting funding to buy into U.S. dry gas, and then you’ve got I3 which is a North Sea player, now trying to raise money for a nearly 80 million dollar deal in the Canadian basin listed over there, capital is showing interest in Canada. It’s great that we are starting to see UK investors see value in the Canadian market. So, with the transactions that we’re looking at domestically we’re already starting to talk more to UK domicile investors because we see them as a meaningful capital pool.

Keith:             Mm-hmm. What about the idea of having a shareholder, like a Lundin group who’s so well known in the European markets as a frontier market kind of person. I don’t know how many groups or people that are like that around, they’re just an obvious one. Is that something you guys would consider or you guys don’t want to bother with something like that?
 
Mark H.:        Sure, it wouldn’t hurt to have a well-known international name as a shareholder, but I think with the right amount of marketing and with the right story, especially one that’s really geared around the skillset that the Spartan team exhibits I don’t see an issue in finding interest. In fact, Fotis and Rick have a great following in the UK marketplace.

Keith:             Yep, fair comment.We talk about upstream a lot, is there any midstream things that you guys would ever consider of is that just totally outside your wheelhouse? My experience is the mid streamers often have a lot of leverage and sometimes they’re a better play. Is that something that you guys would even think about or no?

Fotis K:          Midstream can be a value add or a value sink, depending on the cycle. What also we’ve learned through the business here is it’s nice when you buy an asset that comes with infrastructure instead of spending your own capital to build it. That’s one of the advantages that we got with this asset that we just bought. We own a significant amount of our infrastructure outright and we paid zero dollars for it. That gives us, in the short term of course, ability to organically grow or consolidate..

Keith:             Yep. That kind of answers that. When you’re looking at your current asset base, and you’re looking in North America, whether it’s Canada or the U.S. are you looking more at oil or more at gas? Do you think the market was a little surprised that you went with a gas weighted asset as your first asset as a new group was just so good that you couldn’t pass it up? Or was that intentionally you went after gas?

Fotis K:          Initially we started looking at oil, but what made me switch gears quickly is, if you remember in January when that plane was shot down in Iran and oil jumped, I think it was $54 and it jumped to $63, and then that only lasted three days and it deflated down again. To me that was a sign that something was going to happen with oil and of course, nobody expected COVID in that extent. But when that happened, before even COVID, I quickly switched gears and I said to Mark, “Let’s look at Bellatrix.” It was already six months into the CCAA process. We came at the 11th hour and we went after it hard among lots of competition and then of course March 9th came and the market collapsed and the competition seemed to wane around us.
                       
The timing worked perfectly for us.

Keith:             It sure did.

Fotis K:          So at the end, we started with a gas asset  which is 100% AECO linked and now is the right time to be exposed to AECO so I think it worked perfectly on our end. That’s why I said in the beginning we are not looking to be a pure play anymore. As long as it’s an opportunistic position, it provides a high level of return, we’re going to go after it. Especially in areas that we know. In Cardium area, don’t forget, we built two previous Spartan Cardium companies just a little bit north of here.
                       
So, we know this area quite well and we’re very excited that we got this asset. Last week we went out to the field with the team here and were excited with the large size and high quality of the facilities, everything all automated. Because of all this automation, it’s already built for low cost growth, it will allow us to keep adding to that system now and optimize it and expand it. That’s big going forward in terms of becoming more efficient, both in terms of the numbers, but also in terms of keeping track of your carbon footprint and emissions and everything else. At the end of the day we want to be a modern company that addresses all these issues when it comes to ESG.
                       
For example, we are fostering a great partnership with the O’Chiese First Nation in this area…

Keith:             Fotis, I do want to talk about that, but I’ve only got a few minutes left. I want to talk a little bit more about economics… What I heard you say is the infrastructure in the Bellatrix assets were top notch, Cadillac, stainless steel, gold plated, automated, and that’s going to be great for you. I’ve heard you say that that’s going to be a fantastic base to build on because they did things almost more than top drawer. Is that a fair comment?

Fotis K:          Yes.

Keith:             So we won’t say that they over capitalized, but we’ll say they definitely went top drawer. That’s good to know. If we were to go back to these, and these are tier one assets in your mind, when you move forward in these assets you say that you can get some free cash flow going, pay down a little debt and still have some free cash flow left over.

So, right now, are you more bullish on oil here or gas here? And when you think about growing your production 5-10% organically, is that mostly on the gas side, mostly on the oil side. What are you thinking that way?

Fotis K:          Based on where the markets are right now, yes, we are going to focus on developing liquids rich gas. We came out of the gate with an aggressive hedge program to lock in the near-term economics of the deal.  For this year we hedged 60% of our production, but all gas. For next year we hedged about 45%. My view on that now, since we have all the available infrastructure which has probably close to 100 mmcf/d available capacity is that if we have an additional run on gas, we can simply drill an extra well or two, because we already have existing pads with all the pipelines built, so very quickly we can go and drill an extra two, three, four wells and increase our  gas production and capitalize on a better AECO tape, or improved NGL pricing.

On the other hand, if we see oil running to 50 bucks we can go and drill some of our Cardium or Charlie lake wells and then increase our  oil mix. Then again, also using the same infrastructure footprint and pipelines we already have in the ground.
                       
We have the flexibility for organic growth exposure to both commodities, if we have a recovery on either of them. If not and we’re seeing more weakness, we’ve hedged 60% of it, and you can see our hedges in the deck, we put them in there. I think it was $2.25/gj that we locked it. So we protected the downside and also we have protected the metrics of the deal. That’s it. Then we take the rest of the cash flow and we go and do acquisitions.

Keith:             Got it.

Fotis K:          So we have the flexibility.

Keith:             Yep. Okay. Just in the few minutes that we have left, one question that I wanted to ask you is right now all the investors love to hate Canadian oil and gas, they love to hate upstream sector. What do you think is the most underappreciated part of Canadian oil and gas by the investing public right now?

Fotis K:          I think right now, everybody has been pretty much painted with the same brush. Even when you look at the comps, everybody’s trading at a lower multiple than we have seen in a long time. It doesn’t matter if you’re the company with the best balance sheet or the worst, everybody’s being treated about the same.
                       
In the old days, there was a big delta and there were a lot of good companies with the cost to capital to go after the undervalued companies. Right now, everybody’s so very very close, there’s no differentiation. So I hope investors start appreciating and valuing companies that have the ability to generate free cash flow growth, be it through the drill bit or through acquisitions. Look at us for example. We’re now brand new, we don’t have any skeletons in the closet, no bad contracts, no expensive take or pay commitments, we generate free cash flow and have a clean balance sheet, yet, we are trading at similar multiples to companies facing bankruptcy.
                       
Keith:             Got it. That makes sense. Moving on…what do you guys do differently when you drill a well that allows you to do it cheaper?

Fotis K:          First of all, we’re very hands on with operations. We are using a lot of the same team and strategy over the years and we try, of course, when we go into an area to scale it in such a way to keep drilling all year round and use the economy of scale, use continuous drilling, to reduce costs.
                       
We’re very frugal in the way we run our business. We’re not just working here, we’re investors here too, so we want to make sure that we shave off every single available dollar of every piece of every part of the business. We’ve been able to do that over the years and we feel confident that we’re going to do it with these assets too.

Keith:             Okay, that sounds good. Fotis, I remember when I was your office years ago talking about the Renegade acquisition you said the one reason why you guys were able to do double or triple what the Renegade team had been able to do was just because you had the money to do it, you had the capital, and those other guys were capital constrained. Is that the same here with these assets? I get the sense that it’s not.

The assets are relatively well developed but you’re going to introduce some cost savings. Most of your technical tweaking isn’t’ going to be in the area that it’s going to allow you to do what you did at Renegade, but rather just keep incrementally improving economics. Is that fair or do you think that there’s something that you’re going to be able to do to these assets that will be able to give you the same kind of huge jump in production that you enjoyed when you took over the Renegade assets?

Fotis K:          Well, every asset is different. For this one here, keep in mind that nothing has been done on it for a year now after they got in serious balance sheet trouble last year. We now have the ability to go back in and put more capital and attention to these assets. We kept the best people within the organization, but we also brought outside people and now we’re telling all these new people “We want you to be as creative as possible, you’re are owners in this company.” Some of them invested early in our company. “We want you to be frugal, drive costs down and be creative in the way you’re doing business.”
                       
I wouldn’t say there are huge incremental savings beyond the $70 million per year we have stripped out already, but we think scale is going to help and we’re going to see how this unfolds. There are lots of optimization opportunities within the production base.

Keith:             Okay. So production optimization, what does that mean?

Fotis K:          It means lots of well reviews, bringing in some workovers, rerouting some of the production to increase efficiencies, we have two big  phases in our plant. They were running both of the them at less than full capacity, we’re only running now one, which is yielding good cost savings. That’s going to potentially add some volumes given it is also a deep cut phase, and at the same time save a bunch of money on the operating cost side of running that facility. That’s one example.

Keith:             Okay. I’m cognizant that there’s only five minutes left. You’ve got a very hard stop. Is there anything here, when you were out on the street marketing here in the last eight weeks Fotis, what were the smart questions? What have we not talked about here that some of the institutions and analysts who are more concerned about than what we’ve talked about here? What have we not spoken about here that you think is important that the Street has brought up with you before?

Fotis K:          Well, to me, what came up when I was marketing is that there where some investors that they like the story , they like the team because they know us from before, but they couldn’t play because the deal was too small. They didn’t want to go down cap, and for them we’re still a small cap company, and they wanted liquidity to come and go. They basically told us, we want you to do the consolidation, but we cannot come in yet until you show us that you are actually intending to be a 100,000 boepd corporation.
                       
Keith:             Size matters.

Fotis K:          Yep.

Keith:             You got it. Mark, is there any other thing that you would say the street was kind of wanting to hone on or wanting to make sure? Is there something here that I’ve missed that you think is important?

Mark H.:        I don’t think they have focused on anything that you haven’t touched on Keith. I really think one of the key themes here is – what will the companies that have historically been the go to names in the space have to do as they emerged from this crisis to shore up the holes left by this extended downturn?

To my earlier point, what dilutive measure may be necessary to get themself back into an investment position in the sector. I don’t think that people have really wrapped their heads around what that is going to have to look like and what that means as an opportunity set for those to have strength in their balance sheet and access to capital.

I correlate that to how you build value, you’ve been around this business for a long time and you’ve seen CNRL grow, that’s how long-term value is built; waiting until times like this when you can opportunistically take advantage of the weakness in the sector. That’s how we’re viewing the opportunity in front of us here, starting from a smaller base, but with the potential to build core positions that create a generational investment opportunity for our shareholders.

Keith:             I’m so grateful here. Thank you, thank you, thank you so much. I think there was a lot of great information here.

Fotis K.        Thank you for the interview and your earlier report on us Keith.