Description

Summary:

Alvopetro is a Canadian oil and gas producer operating in Brazil.  The company has a stellar management team with an incredible 4 decade track record of value creation through numerous cycles.  The company trades at a modest (~30%) discount to its 2P PV10 (though cash-flows should be inflation protected) with net cash.  If either of ALV’'s 2 growth projects pan out the company would be trading at 33-50% of fair value and if both pan out potentially as little as 20% of fair value.  Given the current valuation, management’s track record, and results to date on the growth initiatives, the risk/reward looks attractive.

Note: Values in USD unless otherwise noted.  Stock trades under ALVOF US and ALV CN tickers - for the sake of keeping the currency simple (they report in USD) I focus on ALVOF US.

Overview:

Alvopetro is a Canadian listed (with a US OTC listing under ALVOF) gas producer with operations in the Bahia state of Brazil.

ALV produces ~2.5kboepd (15mmcf/d) of predominantly gas (~95%) from the Cabure field in the Reconcavo Basin.  This gas runs on an independently owned pipeline to an independently owned gas processing facility where it is sold under an independent gas sales agreement to the local distributor (I use the word independent so many times as owning midstream assets and selling directly to utilities is fairly rare in Brazil).

Pricing for ALV’s production is formulaic and based on a number of benchmarks (HH, WTI, Brent, etc.) with both a ceiling and a floor.  At present, the company is selling at the ceiling price of $11.28/Mcf (after a recalculation in February of 2022) but was selling near the floor as recently as early 2021.  Notably, ALV’s contracted price adjusts with US CPI so for those seeking an inflation hedge this might provide one.  In terms of demand, the utility has indicated they would (more or less) take all the production ALV could get them and the price the utility is paying is still a material discount to the price Petrobras commands.

Beyond that, ALV is an extremely efficient operator.  At current prices the company spends ~$.75/mcf on royalty payments and ~$.60-.65/mcf on production expenses (along with ~$1.50/mcf of corporate overheads which should be headed toward ~$1.00 as debt is paid down).  This puts the operating netback at nearly $10/mcf or in the high 80’s % (the EBITDA margin is ~75%).

Operations:

Cabure:

Cabure is ALV’s only producing asset at present.  As mentioned, it produces ~15mmcf/d, net, to ALV’s interest.  The project, a conventional natural gas field, is 49.1% owned by ALV (with the remainder held by Imetame Energia Ltda. who is using their production to run a power plant and thus taking their share of reserves very slowly).  Cabure was primarily developed during 2018, 2019, and 2020.  While there was about 2-3 quarters of slippage in the ~2 year timeline (in large part due to delays getting right of way access for the pipeline), management successfully executed on every aspect of their plan.

As mentioned, Cabure is producing at 15mmcf/d and, at current prices, generating ~$15.5m of revenue quarterly which translates into $11.5-12m of quarterly pre-tax cashflow. With ~30bcf of reserves at Cabure, R/P is approximately 5.5.  Production rates shouldn’t decline much given that ALV’s partner is delaying their take (so they’ll have to handle the declines but that’s fine with them as their needs are low and stable) so 5-6 years of ~$45-50m of pre-tax cash-flow is probably about right given current prices (or $200-300m of cash-flow of which ~$50m should go to taxes).  On an after-tax basis the NPV10 of the project is ~$180m; that excludes corporate overheads which probably lower that value by ~$30m but also uses lower assumed gas prices than ALV is currently earnings (or than would be called for on the strip) net I think $170m for an NPV10 of Cabure is probably appropriate; remember, however, that the contract sales price is tied to US CPI so a 10% discount rate might be pretty conservative as it is probably close to a real rate.

Infrastructure/Mid-stream:

Alvopetro fully owns an 11-km pipeline and a gas plant with 18+ mmcfpd of capacity.  While the value of these assets is largely captured by the Cabure field valuation, they provide important optionality and lower the costs and risks of ALV’s growth plans.

The gas plant can be expanded more easily than a new one can be built and the pipeline (which can be twinned) already runs to their Murucututu project.  Management has plans to bring the gas processing and pipeline capacity to 35mmcfpd if the growth prospects pan out.

Murucututu - Development:

Murucututu is a 5,460 acre vertically drilled but stimulation required deep basin gas resource 100% owned by ALV.

Management has long had its eye on Murucututu and, in fact, this field was the focus of Alvopetro’s original designs for the area.  The reason it was developed after Cabure is that ALV needed to have a gas sales agreement in place before it could justify spending the CapEx to develop the necessary infrastructure and wells; as Murucututu is unconventional and the range of outcomes here is much wider than at the conventional Cabure, management used Cabure’s higher degree of certainty to get the pieces in place to develop Murucututu (principally a gas sales agreement which would then permit them to spend on a pipeline and processing facility).

ALV has already drilled 2 wells at Murucututu (197-1 and 183-1) and they have confirmed the existence of the resource.

The company anticipates the field being developed via 18 wells (2 already drilled) with 4 (2 already drilled) falling in the reserves category, 4 falling in the contingent resource category, and the remaining 10 falling in the prospective resource category.  While these categories indicate increasing uncertainty this is due to their increasing distance/uncertainty as it relates to the 2 drilled wells not from extremely wide dispersions in assumed EUR’s of the wells.

On a 2P basis, the NPV10 of the Murucututu project is some $60m.

If we include 3P, contingent, and prospective resource, the NPV10 rises to some $300m+.  The same caveats apply here as above (some additional overhead should probably be assumed but the impact should be less, prices are probably too low and don’t appear to include the CPI component).

In terms of quantities of gas, the 2P is ~20bcf going up to 72bcf under the prospective resource level.  Assuming an $8.50/mcf (~75% of $11.25) pre-tax margin points to $170-600m of future pre-tax cash-flow.

Exploration Program

Finally, ALV is undertaking an exploration program in an area West of Murucututu.

The company is drilling 2 wells (182-C1 and 183-B1).  

182-C1 has already been completed and discovered 25 meters of potential net natural gas pay (8.2% average porosity); a follow-up well is planned.  Well testing on 182-C1 is expected to occur in Q2 ‘22.

183-B1 is currently being drilled.

The range of potential outcomes here is quite large but GLJ has estimated that these wells might result in the company discovering some ~10mmBoE (60bcf) of resource (which will require many more wells to develop).  There’s no reason the economics here should be much different than Murucututu and if this is successful it might well rival Murutucututu pointing to value of potentially $250m+.

Management:

Management here has an exceptional track record.  Not only have they succeeded in bootstrapping ALV into a successful gas producer but this isn’t their first rodeo.  Key management team members were involved with: 

• Petrominerales which IPOed at a ~CAD$400m market cap in 2006, raised ~CAD$120m as a public company, bought back ~CAD$400m of stock and paid ~$175m in dividends and then was sold to Pacific Rubiales in 2013 for CAD$1.3bln.  Bloomberg tells me the TRA from IPO to sale was ~19.5% annually.

• Pacalta Resources which IPOed in 1988 with a ~CAD$40m market cap and was sold to Alberta Energy Co for CAD$900m in 1999.  Bloomberg tells me the TRA from IPO to sale was an astounding 46% annually.

The Chairman was the CEO of Pacalta Resources until it was sold and was the CEO of Petrominerals before abdicating to ALV’s current CEO.

The CEO was in senior finance positions at Pacalta and was the CEO for the last 3.5 years of Petrominerales run as a public company.

Beyond that, the CFO, Exploration Manager, Operations Director, and VP of Corporate and Legal worked at Petrominerales.

For ALV’s part, while the XOP is down ~50% from 2014 (when ALV IPOed), ALV’s stock is up nearly 100% due to prudent financial management and successful execution.

Insiders own 11% of ALV with Bloomberg listing the Chairman at 4.5% and the CEO at 3.85%.

While management is clearly interested in growing the business, not only does their track record make me comfortable with them taking risks with company resources, the company rewards shareholders with a sizable dividend of $.08/share/qtr or a ~5.8% yield at current prices.

Valuation:

With a US$182m enterprise value, ALV is trading right around the value of its interest in Cabure (assuming a 10% discount rate on a CPI-linked stream of cash-flows).  Murucututu’s 2P assets alone put the company at a ~30% discount to its NPV10.  Real success at either Murucututu or the exploration property (which, given the track record and data points to date seems more likely than not) would put this thing at ~US$10-15 of fair value; success at both could see fair value approaching US$25/share.  Beyond that, you have a fantastic management team with a toe hold in a country that is increasingly privatizing its energy industry - there are a number of small operations in the Reconcavo basin that might be interesting acquisition targets for an entity that already has midstream infrastructure and a sales agreement with a local utility in place.  Management also has a track record of selling and doing so at opportune times and on attractive terms.

Risks:

• The company is producing against the ceiling of its contract price.  The floor is about 50% lower.  If energy prices collapse, the valuations above could be cut nearly in half (for Cabure) or somewhat more (for development projects which don’t have the capital sunk).

• Failures at Murucututu or the exploration projects

Disclaimer: In an effort to maintain an appropriate position size, the author has, in the past, sold shares at prices both lower and higher than where the stock is currently trading and may face similar position sizing restraints in the future.  As well, the usual caveats apply which include but are not limited to the fact that the author may transact in the securities of the company for any reason without notice.

Catalyst

• Exploration success
• Dividend increase