Description

BIRCHCLIFF ENERGY (BIREF):  THE FULL MONTNEY

(Denoted in Canadian $ Unless Otherwise Noted)

(As of 6-30-2016)

COMPANY OVERVIEW

Birchcliff Energy is a low cost natural gas producer in Canada.  The company’s two resource plays–the Montney/Doig and Charles Lake–are located in the Peace River Arch of the Western Canadian Sedimentary Basin. Formed in 2005, the company has primarily focused on the development of its extensive drilling inventory of natural gas wells in the lower and upper Montney/Doig and invested in a significant amount of infrastructure to lower its cost structure.  Production grew 15.5% YoY in 2015 to 38,950 boe/d, while production per share has grown at a ~20% CAGR over the past 5 years.  Billionaire investor Seymour Schulich also owns a 28% stake in the company.  Below is a financial summary of the company’s profit margin over the past six years.  Surprisingly, the company’s cost cutting helped it to report a profit last year despite the plunge in natural gas and oil prices.     

Source:  Birchcliff Energy 2015 Annual Report

The company has grown PDP reserves and 2P reserves at 16% and 27% CAGRs, respectively, since 2005.  2P reserves grew ~23% YoY in 2015 to ~573M boe, while proved reserves grew ~24% despite the substantial drop in oil and gas prices.  Managing to grow reserves at 20%+ in a year where oil and gas prices fell 50% or more is a testament to the strength of the company’s reserves.         

Thesis:

Birchcliff Energy holds one of the largest 2P natural gas reserves in Canada and has managed to cut operating and F&D costs over the past 5 years by focusing on its productive Montney resource play, continuing to implement operational efficiencies, and investing in strategic infrastructure to process its gas at low costs.  The company’s low cost position, large resource base, secured transportation capacity, flexible credit facility, and recent Gordondale acquisition allow investors to benefit from improving oil and gas Strip prices.  Birchcliff Energy trades at 5.8x 2018E EBITDA, which includes the recent Gordondale acquisition and assumes the current 2018 Strip.  Discounting the current 2016-2018 Strip and $3.00/GJ AECO and USD$55/bbl WTI thereafter, Birchcliff Energy should be worth $9.35/share, or 7.6x 2018E EBITDA (~$40,500 boe/d), by 2018.  This represents 36% upside from the current share price.  My sum of the parts valuation consists of:

1. $7.18/share based on 2018E NAV, excluding Gordondale assets  

2. $3.78/share for Gordondale assets based on 6.5x 2018E EBITDA     

3. $1.61/share of Net Debt for 2018                

Current Market Perception

Birchcliff Energy is considered a low cost Canadian natural gas producer with one of the largest 2P natural gas reserves.  Shares currently trade at 15.7x 2016E EBITDA (~$48,900 boe/d), which includes both EBITDA and production contributions from the Gordondale acquisition that is expected to close on July 28, 2016.  Assuming investors are valuing Birchcliff Energy at ~8.5x 2017 EBITDA, the current share price discounts ~$2.50/GJ for AECO gas and ~USD$50/bbl for WTI for 2017.  Since $2.50/GJ AECO gas is below the current futures curve, investors could be reluctant to discount any further upside in oil and gas prices at least until North America storage numbers begin to decline, or unless Birchcliff begins hedging more of its production at current Strip prices.  Investors may also still be skeptical about the 60% equity dilution to fund the $625M Gordondale acquisition.                            

GORDONDALE ACQUISITION

Birchcliff Energy paid Encana $625M for the Gordondale assets by raising $653M (104.5M shares) in gross proceeds via a bought-deal equity financing and an $18.75M private placement subscribed for by Seymour Schulich.  Based on the 26,000 boe/d of average production for 1H 2016 and annual 20% base decline rate, Birchcliff Energy paid ~$30,000 boe/d and $3.27/boe on a 2P reserves basis.  For reference, Enerplus Corporation divested ~$193M of non-core Alberta Deep Basin natural gas properties for ~$35,700 boe/d earlier this year.   The Gordondale acquisition will allow the company to de-lever its balance sheet, sustain its borrowing base with increased PDP reserves, and further consolidate acreage in its core Montney/Pouce Coupe play at a fairly attractive valuation.  Drilling buffers that border Birchcliff lands will also be eliminated, allowing for optimized well development planning.  The acquisition also comes with firm transportation capacity on Pembina’s pipeline system and an inventory of more liquids rich wells that provide the company with more flexibility to invest in liquids rich or gassier wells depending on oil and gas prices.  

Assuming current Strip prices, the Gordondale assets should generate ~$151M in EBITDA and ~$63M in free cash flow for 2017.  This also assumes capex spend of $37M for the remainder of 2016 and $87.9M in 2017 to increase production to ~28,200 boe/d.  Applying a 6.5x EBITDA multiple yields a ~$1B enterprise value, or $3.78/share, for 2018.  This implies a valuation of ~$36,000 boe/d, which is in-line with recent asset divestitures.  If AECO gas and WTI oil prices rose to $3.25/GJ and USD$60/bbl, respectively, for 2017-2018, then the value attributed to the Gordondale assets would climb to ~$4.50/share.           

Gordondale Pro-Forma Projections

COMPETITIVE POSITION

PCS (Pouce Coupe South) Gas Plant Supports Low-Cost Production Growth

Birchcliff Energy’s PCS gas plant can currently process 180,000 mcf/d of natural gas.  Owning a processing plant provides Birchcliff with a lower cost structure since the company can adjust its development plans depending on commodity prices and generates ~$1.00/mcf in operating cost savings compared to using third party gas processing facilities.  It cost $0.31/mcf ($1.90/boe) to process natural gas through the PCS gas plant in 2015.  Low operating costs allow Birchcliff to remain profitable even when many other competitors are generating losses at current natural gas prices.  The company has ramped up natural gas production only when it brought on additional processing capacity at its PCS gas plant.  Preparation for construction of Phase V expansion is already underway and will increase the PCS processing capacity to 260,000 mcf/d by late 2017 for a total cost of $90M ($57M capital spend remaining for 2016-2017).  Following the Phase V completion, management expects to spend an additional ~$46M over 2018-2019 on the Phase VI expansion, which will increase the PCS gas plant processing capacity by another 80,000 mcf/d to 340,000 mcf/d by the end of 2019.                            

Montney/Doig Offers Attractive Well Economics

Birchcliff Energy has an extensive, repeatable drilling inventory of wells within its stacked Montney/Doig resource play.  The company has drilled 187.9 net wells as of December 31, 2015 and has focused its drilling to mainly two intervals:  the Upper Montney (D5) and Lower Montney (D1) intervals.  The Montney D4 interval provides additional upside optionality if the company succeeds in adding substantial reserves from its development program.  

Source:  Birchcliff Energy Investor Presentation (May 2016)

Management estimates there are 3,611 net potential well locations based on the company’s resource development to date.  This works out to ~3.1 net wells per section.  For modeling purposes, I assume there are 2.4 net wells per section since the company is likely drilling longer laterals to increase EURs per well.                         

Birchcliff Energy is also achieving better well performance from its current drilling program.  The company increased proved plus probable natural gas reserves from its Montney/Doig resource play by over 600 Bcf in 2015.  Positive technical revisions accounted for ~200 Bcf of the increase due to Deloitte’s (independent qualified reserves evaluator) assignment of a new Montney/Doig type curve to future well locations by Deloitte.  All wells are choked initially and have an average IP365 rate of ~2,850 mcfe/d based on Deloitte’s Tier 0 and Tier 1 type curves.    Choked wells lead to higher ultimate recovery and better reservoir management, which leads to lower decline rates and subsequently lower maintenance capital expenditures.  Birchcliff estimates an overall base production decline rate of ~20% for 2016.  Birchcliff typically recovers 8.5-11.5 bbls per MMcf of liquids from its Montney/Doig wells, and nearly all of these liquids are high value oil and condensate.                 

Source:  Birchcliff Energy Investor Presentation (May 2016)

Below is the decline curve for the Montney/Doig based on a 50/50 mix of the Deloitte Tier 0 and Tier 1 type curves.  The May 2016 investor presentation did not specify the annual decline rates below, but I was able to derive the implied decline rates based on the number of wells required to hold production at 80,000 mcf/d each year.  However, I modeled slightly more conservative well economics by assuming an IP365 of ~2,700 mcfe/d, EUR of 5.7 Bcfe per well and liquids recovery of 9.2 bbls per MMcf as well as an 11% annual decline rate in Year 5 and thereafter.    

Source:  Birchcliff Energy Investor Presentation (May 2016), Internal Estimates

Below is an illustrative table provided by management that show full cycle IRR scenarios for different AECO gas prices based on an initial investment of ~$80M for 80 mmcf/d of gas processing capacity and 28 wells at ~$4.4M per well.  Based on the current 2017 AECO strip price of $2.70/GJ and USD$45/bbl for WTI, Birchcliff Energy would generate between a 19%-26% full cycle IRR on these wells.                      

Source:  Birchcliff Energy Investor Presentation (May 2016)

For reference, below is a cost curve generated by Credit Suisse for the major North American gas plays assuming a breakeven IRR of 15% and USD$40 WTI.  The Montney Pouce Coupe South (Birchcliff Energy) play has a Henry Hub breakeven of USD$2.51/mmBTU, which is already on the lower half of the cost curve.  It is also important to note that liquids make up only about 5% of the EUR per Birchcliff’s Montney/Doig well, while other liquids rich gas plays generally yield at least 20% liquids or more.  The company can attribute much of its ability to generate such competitive returns–despite its lower liquids yield–to owning its PCS gas plant.  However, Credit Suisse’s assumption of USD$40 WTI to generate the breakeven 15% IRR could be a bit generous for the Canadian gas producers since the chart below also assumes an AECO basis differential of USD$0.50/mmBTU, which is below the historical average of ~USD$0.60/mmBTU and the current AECO basis spread of ~ $1.29/mcf.  The chart does directionally show the competitiveness of Birchcliff’s Montney resource play relative to other natural gas plays.        

Source:  Credit Suisse Equity Research (February 1, 2016), Seven Generations 2015 Annual Report

Transportation Capacity Secured to Support Future Production Growth

Birchcliff Energy will have sufficient transportation capacity to increase natural gas production to 260,000 mcf/d by April 2018, which will align with the Phase V start-up at the PCS Gas Plant.  The company will also have 340,000 mcf/d of transportation capacity secured by May 2019, which aligns with the completion of the Phase VI expansion of the PCS Gas Plant.  Refer to “Summary Financials” chart at end of report for annual production projections for 2016-2020.  The Gordondale acquisition also comes with firm transportation capacity on Pembina’s pipeline system.  

Source:  Birchcliff Energy Investor Presentation (May 2016)

Existing Credit Facilities Provide Sufficient Liquidity Despite Slight Borrowing Base Reduction

Birchcliff Energy currently has extendible revolving credit facilities that mature on May 11, 2018.  The company’s strength in PDP reserves has allowed it to grow and maintain its borrowing base as evident from the company’s historical borrowing base and NPV-10 of its PDP reserves (chart below).  The Credit facility has no financial covenants as well.  However, the banks did reduce the company’s borrowing base by $50M, or 6%, to $750M during its semi-annual review on May 11, 2016 due to the depressed commodity price environment at the time.  Based on the drawn portion of the company’s credit facilities as of March, 31, 2016, the company has ~$94M remaining to draw down on.  Birchcliff should be able to spend within cash flow in 2016 based on current strip prices and end the year with a Net Debt/EBITDA of 4.0x.  Net Debt/EBITDA then actually declines to 1.1x by end of 2018 based on current Strip prices.  Given the higher commodity prices since the last redetermination and  increased PDP reserves and balance sheet de-levering from the Gordondale acquisition, there is likely little risk of a further borrowing base reduction.           

Source:  Birchcliff Energy Investor Presentation (May 2016)

COMMODITY PRICING OUTLOOK

Natural Gas

Natural gas prices in Canada plunged over the past year due to a combination of Canadian producers growing production, competing low-cost supplies from the Marcellus, and the warmer winter in 2015 that led to less heating demand and a build-up of high level of storage inventory.  To add to a string of bad luck, the recent fires in Alberta that shut-in ~1M bbl/d of oil sands production–which uses natural gas in the extraction process–led to a ~1 Bcf/d decline in natural gas consumption.  As a result, AECO prices dropped to below $0.50/mcf–their lowest on record.   AECO prices have rebounded dramatically since then to $2.42/mcf ($2.29/GJ) as of June 29, 2016, and the futures curve shows a much healthier outlook for gas prices with $2.84/GJ and $2.76/GJ expected for 2017 and 2018, respectively.  My base case scenario discounts the current 2016-2018 futures curve for AECO and $3.00/GJ thereafter.  This seems to be a fairly conservative scenario given historical AECO gas prices and the continued decline in production and rig counts.           

Source:  http://www.gasalberta.com/pricing-market.htm

Natural gas prices are also likely to continue to rise over the next 2-3 years since a good portion of specific resource plays have break-even costs above USD$3.00/mmBTU as referenced in the “Breakeven Price by Play chart shown earlier”.  Another study presented by RS Energy Group that Encana Corporation included in its recent investor presentation also illustrates that the break-even price for many of the key North American natural gas plays are USD$3.50/mmBTU and above.  

Source: Encana Corporate Presentation (May 2016), RS Energy Group

The table below shows many of the largest natural gas producers in North America have also slashed their capex budgets by 50% or more compared to 2015.  This should not be surprising given the break-even prices shown earlier.

Source:  Jefferies, Company Filings

Natural gas storage figures in the U.S. are also fairly bullish given the below average weekly injections over the past couple of months due to lower production, increasing exports, and seasonal summer demand.  The EIA weekly natural gas storage report showed an injection of +42 Bcf for the week ending June 24, 2016, the lowest injection over the past 5 years.  Seeking Alpha contributor, HFI, published a good article for reference this week: http://seekingalpha.com/article/3985550-weekly-natural-gas-storage-report-lowest-injection-last-5-years.  Natural gas prices surged nearly 50% since the last week of May 2016 to USD$2.99/mmBTU as of July 1, 2016 due to the recent bullish weekly storage figures.  

Crude Oil

Crude prices have also rebounded sharply from its lows earlier this year.  WTI traded at USD$49.88/bbl as of 6-29-2016 and the 2017 Strip is at USD$53.60/bbl.  The Edmonton Mixed Sweet benchmark is at $60.51/bbl and Edmonton Condensate trades at $61.10/bbl.  The market is beginning to rebalance as well following supply disruptions this year particularly in Canada, Nigeria, Iraq, Libya, and Venezuela.  According to the EIA, unplanned global oil supply disruptions averaged over 3.6M bbl/d in May 2016–the highest monthly level recorded by the EIA since 2011.  From April to May 2016, disruptions grew by ~0.8M bbl/d largely driven by shut-in production in Canada’s oil sands due to wildfires in Fort McMurray, Alberta.  The EIA’s weekly U.S. field production of crude oil also reported a 10% decline to 8.6M bbl/d for the week ending June 24, 2016 from 9.6M bbl/d in the prior year period.        

Source:  U.S. Energy Information Administration, Short-Term Energy Outlook (June 2016)        

VALUATION

Birchcliff Energy trades at 15.7x 2016E EBITDA, or an EV/boe/d of ~$48,900 assuming average daily production of ~50,550 boe/d.   However, I value the company using a sum of the parts methodology.  First, I derive forward target EV/EBITDA and P/CF multiples for the legacy Birchcliff Energy assets (excludes Gordondale) based on a NAV methodology.    Assuming a 10% discount rate, the 2018E NAV of these assets is $7.18/share based on my base case price deck (see below).  The Gordondale assets are then valued separately based on 6.5x 2018E EBITDA, which implies a NAV of $3.78/share.  Birchcliff Energy should end 2018 with $1.61/share in Net Debt.  My 2018E price target comes out to $9.35/share (7.6x 2018E EBITDA), or 36% above the current share price.  If AECO gas and WTI oil prices normalize at $3.25/GJ and USD$60/bbl, respectively, from 2017 and thereafter, then Birchcliff Energy would be worth $12.15/share (7.5x 2018E EBITDA), a 77% premium to the current share price.            

Source for AECO and WTI Strip (2016-2018):  http://www.gasalberta.com/pricing-market.htm , FirstEnergy Capital

Margin of Safety

There is no denying that an investment in Birchcliff Energy would be sensitive to changes in oil and gas prices and that risk should be measured based on the chance of a permanent loss of capital.  If AECO gas remained at $2.00/GJ and WTI stayed at USD$45.00/bbl for the next 2-3 years, Birchcliff Energy could put itself up for sale.  Under this scenario, management could maintain production of ~64,000 boe/d by reducing capex for new wells and delaying the expansion of the PCS gas plant to be free cash flow neutral.  Assuming buyout metrics of $30,000-$35,000 boe/d, Birchcliff Energy could then sell itself for $5.00-$6.00/share.  However, it is also important to understand the probability of oil and gas prices remaining this low for another 2-3 years.  If these low prices persisted for several more years, many producers would either go bankrupt or be unable to continue drilling new wells since they would need to spend within cash flow to pay down their credit lines.  Oil and gas supply would then likely fall below demand and prices would have to increase.  Either way, the company should easily be able to sell itself at the aforementioned price range given its large, contiguous Montney acreage and built out infrastructure.  It could also just wait for higher prices given its low cost position relative to many of its peers.      

SUMMARY FINANCIALS (INCLUDES GORDONDALE ASSETS)

Risks:

1. Strip and long-term natural gas and oil prices fall below current assumptions

2. AECO basis differential to Henry Hub pricing remains above $1.00/mcf

3. Phases V and VI expansions of PCS gas plant delayed beyond 2018-2019 due to lower commodity price environment

4. Management does not hedge any production assuming gas prices rebound to much more favorable levels, thus exposing Birchcliff Energy to any potential downside price volatility

5. Future horizontal wells yield results below Montney Tier 0 and Tier 1 type curves

6. Share price overhang if Seymour Schulich, a private investor who owns a nearly 28% stake, decides to divest a portion or his entire stake

Catalyst

• Higher natural gas prices.
• Potential sale of the company.