Description

Long Athabasca second lien debt was my application submission idea. I am reposting here with the numbers used in the original submission, so current from Jan 4th, 2016. The further selloff in oil and gas related assets in the past 12 days does not have much impact on the thesis.

Description:

The crash in oil prices this year has presented many interesting equity opportunities. However the vast majority of these are dependent on a bullish outlook for the commodity. In Athabasca Oil corp (ATH) we believe a fixed income opportunity has presented itself with equity like returns yet very low risk levels. 

ATH has senior secured second lien debt due in November 2017, trading at 76c on the dollar. This equates to a 24% ytm or just over a 50% total return to par in less than two years. Athabasca is in the unique position in the Canadian oil patch of having almost all of its gross debt offset by cash on its balance sheet due to well-timed asset sales to Petrochina. What little net debt ATH may have by year end 2016 is well covered by 3 distinct assets.

This opportunity exists due to Athabasca`s historical weak management teams who were poor stewards of capital, the selloff in the oil and gas sector overall as well as a largely undercovered Canadian distressed space.

Thesis:

The ATH senior secured second lien bonds currently trade at 76c on the dollar, creating the company at $740mm against $809M of cash and $1.25-4.1Bn of asset value. At 76-cents and a 7.5% coupon, this equates to a 24% annualized yield upon maturity on November 19th, 2017 or over 50% total returns with minimal downside risk. Athabasca currently has very low net debt levels. Here is a current snapshot of their capital structure. All numbers in this write up will be in Canadian dollars unless otherwise mentioned. 

Balance Sheet September 30th, 2015

           Assets
                        Cash               671
                        LOC                138
                        Net                809
       

          Liabilities
                       Senior secured      252
                       Senior second lien  550
                       Decommissioning      70
                       Net                 872

Current indebtedness                       -63

They also have a 125mm bank line that is currently undrawn. The Letter of credit in the table above is an irrevocable LOC that makes up the final payment from Petrochina to ATH for a 2014 asset sale. It is held at HSBC Canada and should be considered cash. It will convert to cash in 2016. Athabasca equity also trades for a market cap of 622mm.

Background:

The History of ATH is important to understand as to why the company has such a large cash position and also why it is so unloved. ATH IPO’d in Toronto in 2010 at $18 and immediately traded underwater. ATH was set up to exploit large resource plays such as the oil sands through SAGD extraction. These projects are extremely expensive to develop and so ATH entered into a sale agreement with Petrochina to sell 60% of their stake in two oil sands properties, Dover and Mackay for $1.9 billion in 2010. ATH then had the right to put the remaining 40% stakes of both properties to Petrochina upon regulator triggers being reached. Having reached these triggers in 2012 and 2014 ATH was able to sell these assets at a fixed price even though the market was souring on ATH as a whole. 

During this process ATH was busy spending money and seeing little in return. They kept one large SAGD project, Hangingstone, and brought phase 1 into production. They also began to test out their large Duvernay acreage. All of this resulted in large cash outflows with little current production to show for it. Investors became impatient, and this history coupled with the oil selloff saw the stock trade down to $1.50 where it is today. The original management team that IPO’d the stock has since been replaced and the new management team is trying to reshape ATH into a simpler, more narrowly focused company with real, growing production.

2016 Budget:

ATH recently put out their 2016 budget which enables us to have a clear view of what the company`s profile will look like at year end 2016, only 11 months away from when their debt is due. They split out their budget into two sections, their light oil division and their Thermal (SAGD) division. We will look at ATH on the basis of three different assets (two in the light oil division, the other being their SAGD producing assets), each saleable should ATH be unable to roll its small net debt burden in 2017. 

In the light oil division, Athabsaca will spend 71mm developing primarily their Duvernay and Montney lands. Per management this should enable them to generate 7k-8k barrels per day of production on average in 2016. This is one asset we will value later.

In their Thermal division, ATH will spend 11mm as their one SAGD project, Hangingstone phase 1, is already ramping up and requires little further capital other than maintenance going forward. Hangingstone is the second asset we will look at.

The last asset we will value is the 200,000 acres of Duvernay lands ATH holds the rights to. These lands fall into the light oil division but should be considered a separate asset from the flowing barrels.

ATH has also indicated they intent to use their cash to lower their gross debt levels in 2016 to the tune of 300mm. 255mm of this is the senior secured debt in the table above. This is callable on May 7th 2016 for 101 of face value, or 255mm. It is US denominated debt but ATH locked in the exchange rate in 2015 so 255mm is a firm Canadian dollar figure. Redeeming this 8.25% paper will help lower interest costs. The other 45mm of debt reduction may come in the form of buying the second lien debt that we are investing in on the open market or perhaps calling part of it at par on November 19th, 2016 as is ATHs right. Since this hasn’t yet been communicated we will hold back from building it into our numbers.

Putting this all together, and using broker cash flow estimates off strip pricing we get the below snapshot:

2015 Q4 estimates
                    Cash flow including interest       -39
                    Capex                              -82

                    Year end net debt                  -184

2016 Estimates
                    Cash flow at strip pre interest    -21
                    Capex                              -91
                    Interest on second lien            -41
                    Interest on senior secured         -13

                    Beginning cash                      688
                    buyback Senior Secured @ 101       -255
                    Operations, capex and interest     -166
                    Ending cash                         267




Cap table Year End 2016

                   Cash                                 267
                   Senior secured second lien           550
                   Decommissioning                       70
                   Line of credit                         0
                   Ending net debt                      353

Management has guided to a 2016 year end net debt position of $250mm. We come in slightly higher mostly likely because we are using strip pricing vs. management’s $50 WTI assumption as well as including decommissioning. We will now examine the 3 assets to see what sort of coverage we get vs our assumption for a 353mm net debt position.

Light oil:

The light oil division is only now beginning to grow. In 2016 ATH will be finishing off some wells drilled in 2015 in both their Duvernay and Montney plays. In their corporate presentation ATH claims $27 netbacks at $50 WTI so these flowing barrels should still be profitable in today’s environment and indeed generate free cash today before corporate G&A. At the midpoint of guidance ATH will average 7,500 boe/d with a slightly increasing production profile throughout the year. To assign a valuation, we look at 2 comps who have similar light oil and gas profiles, Lightstream and Crescent point.

Lightstream (LTS), formerly Petrobakken, is a stressed Canadian E&P company that focuses on light oil in the Bakken and Cardium regions. It has a similar oil/gas production profile. The company has been mismanaged for years and is extremely likely to declare bankruptcy if oil prices do not recover. Its production is in decline and the different tranches of debt trade at cents on the dollar. Using mark to market of the capital structure and 2016 production, Lightstream trades for $38.5k per flowing barrel. 

Crescent Point (CPG) is a highly regarded E&P company in Canada with a strong balance sheet and well respected management team. It is also a light oil focused company with a slightly higher liquids production profile than ATH. Using 2016 estimates, it trades for $74.4k per flowing barrel. Top light oil US producers such as Pioneer and Continental trade for $80k-$100k barrel per flowing. Given the weak reputation and less proven nature of ATHs light oil division, it is more reasonable to use the lower Lightstream valuation per flowing. This yields a $289mm valuation for 2016 production.

In an asset sale scenario possible buyers are many as these are developed flowing barrels and thus are easy to value and operate by many industry players. Transactions are getting done even in this stressed environment (Legacy oil, Long Run, Pengrowth all sold themselves or flowing assets in the last few months).

ATH also owns infrastructure in this region that it previously partially monetized for $150mm. They feel they can get a similar number for their remaining infrastructure in a stressed environment should they need the capital when the bonds come due.

Hangingstone:

Hangingstone phase 1 is a SAGD project located near Fort McMurray. It was completed in early 2015 for a cost of $750mm and is ramping up to nameplate capacity of 12,000 boe/d. It should end 2015 with production of approximately 7,000 boe/d before reaching target in the second half of 2016. For those less familiar with SAGD projects, they generally entail high upfront costs to bring them on production and then feature low or no declines for a production profile of 35 years with little maintenance costs other than drilling new wells as older ones deplete. However they produce heavy oil which sells for a discount to WTI. ATH has already invested the upfront capital for phase 1. Management estimates cash flow breakeven at between $40-$45 WTI, thus on current strip pricing it is cash flow negative for 2016 (especially as cash flow break-even would be even higher in the ramp up phase).

The project has the potential for future phases to bring overall production to 80k boe/d at an incremental cost of $30k-$35k per barrel vs phase one which came in at $62.5k per barrel. This is expected as there are many initial costs for the first phase of a SAGD project. ATH already built out pipeline capacity both in and out (in for dilbit, out for bitumen) for the full 80k potential project size during phase one. Based on initial results as well as the pilot wells, the project is expected to have a steam oil ratio of around 3.0 which would rank it as an average SAGD project.

Valuing a SAGD project is difficult in this environment as none can be justified off of cash flow at current prices. Using market comps is also difficult as the majority of these projects are owned by large integrates such as Suncor, Cenovus, Husky, Shell ect. The only pure play public comp would be MEG energy as MEG does not own any refining assets nor light oil assets. MEG has top quartile assets and decent growth potential (albeit not at today’s prices) and should trade at a premium to Hangingstone. Using mark to market on MEG debt and equity, MEG trades at approximately $60k per flowing barrel in 2016. Applying this to Hangingstone gets us a valuation of $720mm which is close to the cost ATH spent developing the project. More conservatively, we value Hangingstone at $30k per flowing which is about 50% of cost. This equates to a $360mm valuation. Hangingstone would require a $62 WTI price at NPV10 to justify this valuation. This seems high but at $70 the NPV10 jumps to $520mm. Someone would pay for this optionality, especially considering the extra optionality of increasing production from 12k barrels to 80k barrels in a recovery environment. Specific buyers could be industry players looking to increase their approved SAGD portfolio especially after the Alberta government has capped total emissions bringing into question if any currently unapproved resources will be allowed to be developed. Other prospective buyers in a stressed scenario could be pension funds and private equity looking for long life, inflation protected, low capital requirement assets (see Cenovus recent sale of royalty lands to Ontario Teachers fund)

Duvernay Lands:

The Duvernay formation is a developing resource play in Alberta that has the potential to be quite large. We will skip the details but in broad strokes, the Duvernay is an early stage resource play that is found deep underground. Well costs are still quite high as the play is being delineated and has not been developed for efficiency but rather proving out reserves up to this point. Major players such as Chevron, Encana, Shell and ATH are the largest rights owners. ATH has acquired a 200,000 acre position. Based on recent transactions we can ascribe a valuation to the land position. The below table shows recent transactions. 

Duvernay Transactions Price per acre

Dec-15 Yoho sells to undisclosed (Exxon)             $ 4,852
Nov-15 Trilogy sells to undisclosed (Shell)          $14,000
Oct-14 Chevron sells to Kuwait                       $15,152
2013 Alta sells to Chevron                           $14,700
2012 Encana sells to PetroChina                      $9,800

The most recent transactions are obviously the most relevant as they were completed this quarter under depressed industry conditions. Since the Yoho transaction was in a stressed scenario we view it as a conservative comp should ATH also find itself needing to complete a stressed sale in one year’s time. The Yoho transaction also included some flowing barrels which would mean the undeveloped land value would be slightly lower. We have assumed ATH could monetize its lands for $3k per acre. This gives is a value of $600mm. The above transactions highlight potential purchasers in a sale scenario, with Shell and Chevron being potential buyers considering their lands are offsetting to ATH’s lands.

Sum of the parts:

Putting these 3 assets together, we see based on where ATH should stand at year end 2016, their net debt position of $353 million should be easily covered. We summarize in the table below. The low valuation is most likely appropriate in this environment with the high valuation reflecting a higher oil price era. 


Hangingstone value at 30k flowing                $360
Hangingstone at MEG valuation                              $720
Light oil at 38.5k (LTS) flowing                 $289
Light oil at 74.4k (CPG) flowing                           $558
Duvernay at 3k acre                              $600
Duvernay at 14k acre                                       $2,800

Total Low Valuations                            $1,249

High Valuations                                            $4,078

Here is the cap table from earlier of what ATH will look like given guidance at year end 2016. It is worth pointing out that we will be the only debt outstanding at this point; there is nothing ahead of us.

Cap table Year End 2016

                   Cash                              267
                   Senior secured second lien        550
                   Decommissioning                    70
                   Line of credit                      0
                   Ending net debt                   353


The $1.25 billion low valuation allows for a 72% haircut on these asset valuations before our senior secured second lien debt becomes impaired. 

With the current market cap of $622mm the equity could also be considered undervalued using this sum of the parts but doesn’t offer nearly the same attractiveness as the bonds due to the real risk of permanent impairment of capital. 

Risks to the thesis:

Oil prices: 

Even at $37 WTI we feel ATH would manage to easily pay off this debt position at maturity. However if oil falls well below this number and the future curve indicates no recovery in sight these assets may be difficult to monetize in the short-term. The hardest hit would be the Hangingstone asset as it has the highest breakeven price upon flowing. The least affected would be the Duvernay lands as those could always be sold to a major looking to increase their land base for future development. Based on the Duvernay land valuation we feel comfortable that this asset alone could be used to pay off debtholders.

Management squandering capital: 

In the past this has been a problem as management spent hundreds of millions of dollars in the light oil division with little to show for it. However the past 2-years has seen a complete turnover of upper management and a change in directors. The new management team has communicated that cleaning up the capital structure and a focus on reducing costs is a priority. A further risk here related to oil prices could be in WTI firming up towards the end of 2016 to encourage ATH management to invest new capital only to see prices plummet again with the bonds coming due at the end of 2017. We view this as low risk considering at year end 2016 the bonds will be due in less than a year and this prudent talking management team is unlikely to take any big risks so close to the due date.

Hangingstone underperforming and the Duvernay being a dud:

 
We view these risks as becoming less likely every day but they are still worth highlighting. Once a SAGD project begins producing it is very hard to alter the performance over the life of the project. In fact it is often the case that after the first 6 months of production you can get a sense of the quality of the development. We are approaching that point on Hangingstone and so far it is performing to plan but there is always the potential for it to experience difficulty in the next 6 months and become an unattractive asset. 

There is also the risk, as with any new play, that the Duvernay fails to live up to expectations and loses its luster. We also view this risk as small given the Duvernay has been being drilled for a few years now and others such as Encana are seeing good results. The Duvernay had more wells licensed in 2015 than the Canadian Bakken, which shows it is maturing as a play.

Catalysts:

Tender. ATH has indicated they intent to call their 252mm First lien debt when it becomes callable for 101 in May 2016. This still leaves 45mm of room to buyback the Second lien debt in the open market or begin a tender based on management’s goal of reducing gross debt by $300mm in 2016. The second lien is callable at par in November 2016 and if possible we believe ATH would like to call the entire issue and term out a new smaller issue. Should this happen the IRR jumps to 45% and would be the best case scenario. This is possible under an oil price recovery scenario. 

Asset sales. ATH can begin to monetize one of their 3 assets to reduce net indebtedness. The most likely scenario would be a partial monetization of their Duvernay lands similar what Trilogy completed in November 2015 for $85mm. That transaction multiple was $14,000 per acre, well above the $3,000/acre we are modeling for the entirety of the lands. ATH also owns partial stakes in duvernay infrastructure that they believe they could easily monetize for a further $150mm. Any of these steps would bring attention to the strong balance sheet.

Maturity. The bonds mature in 23 months and should none of the above happen they will begin to converge towards par as ATH communicates a plan to roll or redeem the bonds. Maturity is a natural catalyst.

Conclusion:

ATH bonds offer an approximately 50% return opportunity in under 2 years. The bonds are trading below intrinsic value as the market sells off anything related to oil and due to the poor reputation of the prior management team for squandering capital. While most distressed oil bonds are dependent on an oil price recovery, ATH has a very low net debt position thanks to prior asset sales to Petrochina. Management has outlined a conservative 2016 capital budget that also includes a plan to reduce gross debt. Their largest producing asset, Hangingstone, requires little further capital to operate. Their expected net debt is easily covered by their 3 main assets. 

Catalyst

Tender: Bonds callable at Par in November 2016

Asset Sales: Athabasca may monetize some of their future development lands 

Maturity: Bonds will naturally trade back to par as the November 2017 maturity date nears and the company demonstrates an ability to redeem the issue.