In early 2013 the junior energy market turned on a dime—it went from rewarding growth, to rewarding sustainability—companies that grow within cash flow.
Few companies can do this—and the smaller you are, the more difficult it is. But one of the smallest doing this successfully is Brian Schmidt’s Tamarack Valley Energy (TSX Venture: TVE).
What’s the secret? Wells that payout fast—within a year; 16 months at the outside.
I’ve said before—this is the #1 factor I look at in junior producers. How fast do the wells pay out?
Juniors need that fast payout to recycle that cash back into the next well. Few Canadian teams can grow production and not grow their debt.
“Year long payouts aren’t really common,” Schmidt told me in an interview recently. “You can’t do that coming in late to a play; well, you can get 1 year payout on half cycle economics, which doesn’t include land costs, but we look at everything on full cycle basis.”
“We have got our debt to cash flow from 3:1 down to 1.6:1, all through the drill bit. Before our merger with Sure Energy, we would have taken production up from 2160 boe/d (barrels of oil equivalent) in 2012 to 3000 in 2013, and cash flow from $17 million a year to $30 million a year with no new equity.
“We had to get our payout down to about a year. You can’t do 18-month payouts and grow. The guys worked hard to cut our Cardium costs by $1 million a well and our Viking Redwater play costs were reduced by $300,000 per well.”
Pre-merger, Tamarack is producing 2,890 boe/d (barrels of oil equivalent) and 41% of that is natural gas, and 59% oil and Natural Gas Liquids (NGLs). They have been steadily increasing their oil production, which is making them more profitable.
Schmidt says a lot of factors go into getting 12-month paybacks:
1. Getting in early on a play, and not overpaying for land—they paid $5.3 million for their 13 Cardium sections, and soon after other producers were paying $4 million for just one section.
2. Doing a lot of the little technical things right, like picking the right drilling mud and bits, using water vs. oil for their frack fluid, and monobore drilling (you don’t have to stop drilling to put in casing; a 2-day savings). Constant tweaking of drilling and fracking, and cost discipline are key—which is becoming more rare, Schmidt says.
“I think this industry in the junior sector lost some of its value discipline. The old strategy was to raise a bit of money, drill some wells and get some PUDs (Proven Undeveloped drill locations) and sell.
“The rate of return wasn’t the economics of the wells themselves, it was the disposition value. But now the royalty trusts are gone and intermediates aren’t paying premiums for juniors. The only way to create value is through the full cycle rate of return.
“And without equity coming in, full cycle rate of return becomes transparent to the market. How many companies have crashed and burned? In the last 6 months, there are 4 or 5 and the whole junior sector is being painted with that.”
And that paint brush is all about punishing companies who spend more capital and/or paying dividends than they produce in cash flow.
Schmidt suggests it will cost him $28-$30 million to keep production flat (the industry calls that sustaining capex) at 3000 bopd, increase TVE’s liquids weighting (oil and NGLs) to 60-65%, keep debt flat and get free cash flow be $4-$6 million using an $80per barrel Edmonton Par pricing. (It’s now $10 over that)
Despite that, TVE trades a big discount to its peer group—3.5x cash flow vs. peer average of 4.9x cash flow.
“I get two negatives from The Street,” says Schmidt, “size and liquidity. Liquidity (if a stock trades a lot of daily volume it’s called liquid; if it doesn’t it’s called thin–KS) is getting better.”
So Schmidt went out and did two deals that looked after those concerns. Announced on the same day, he took over Sure Energy for 6.3 million shares and assuming $32 million debt, AND he did a deal to earn 70% Working Interest into a 113 net section Cardium play. Sure did a $25 million financing at the same time, which means Tamarack issued another 10.1 million shares at $2.47. That makes for roughly 47 million shares out in total.
Post merger, Schmidt will be producing 3,828 boe/d, of which 56% are oil/liquids (and therefore 44% natural gas) with an operating netback of just under $36/barrel with 365 low risk drill locations in inventory. Schmidt says his payout performance will improve after these deals, as Sure Energy’s Redwater play is on Crown land, with lower royalties than demanded by Tamarack’s freehold lands.
Tamarack has two core plays that are allowing the company to self-fund growth.
Play #1 – Lochend/Garrington Cardium
Each Cardium well is costing Tamarack Valley roughly $2.8 to $3.4 million. These are expensive wells for a small company, but through strong production and cost-effective execution, Tamarack Valley is making this play work very profitably.
The payout period for Tamarack’s Cardium wells is 8-14 months. This is the kind of short payback that a junior producer needs so that cash can be quickly reinvested in the next well to keep growing production.
Tamarack has drilled some of the best wells in the basin compared to their Cardium peer group.
Tamarack is also getting those wells on production quickly—50 days on average. Junior producers often don’t control all of the infrastructure they need. For example after a well is drilled a junior producer may need to tie into a third party gas processing plant. This can lead to delays in connecting wells since the third party is going to look after its own interests first.
Play #2 – Redwater Viking
Tamarack’s second core play is the Viking in Redwater. This play is ideal for a junior producer.
Each Viking well costs only $1 million and has a payout period of 9-12 months—they’re shallow, so less time and money to drill.
These aren’t sexy wells that have booming initial production rates of 1,000 barrels per day like other resource plays in North America. But these low cost wells have great economics for a junior.
In both the Cardium and Viking, Tamarack has reduced the cost of bringing a well onto production. Cardium well costs are down 25% in three years to under $3 million. Viking well costs are down 30% to just over $1 million.
Bringing those well costs down greatly shortens the payout period of a well and improves the well profitability.
Valuation
It isn’t hard to find junior oil and gas companies that appear inexpensive in the current market environment. Many of these companies are cheap for a reason, though because they simply can’t grow without issuing equity and many are overlevered—too much debt.
Pre-merger, Schmidt was proving to the market he was one of the few who could grow production inside cash flow AND improve the balance sheet. Now his challenge is to bring his cost down further by expanding the playing field—both on his farm-in, where he’s paying 100% to earn 70% and the much larger Viking inventory.
His goal is to keep debt to cash flow steady at 1.7x or less as he increases production to 4,250 boepd at YearEnd (YE) 2013 to 5,350 boepd at YE 2014. So debt will grow, but at a lower rate than cash flow. He’s basing all that math on oil at $83/barrel.
Tamarack’s post-merger valuation—with net debt of an estimated $71 million and 3828 boepd production, is 4.8x EV/EBITDA, but only 3.5x 2014 cash flow based on $81 oil. Both these numbers are below peer averages, as is their $51,725 per flowing barrel.
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