Description

References to currency are in USD unless stated otherwise except that share prices are quoted in CAD and refer to the listing on the TSX. IPCO also trades on the Stockholm Exchange. 

Introduction

International Petroleum Corporation (IPCO or the Company) is an international oil and gas E&P company with a portfolio of cash-flowing energy assets in Canada, offshore Malaysia and France. IPCO was spun off from Lundin Petroleum in 2017 with the strategy to leverage its initial producing asset base (Malaysia, France, and a since-sold natural gas property in the Netherlands) as a platform for value accretive acquisitions of long-life, low-decline producing assets in stable jurisdictions with upside development potential. Since inception, IPCO has made three acquisitions that have fit those criteria which have resulted in a 7-fold increase in its proved + probable (2P) reserves and a 3-fold increase in production, each on a per-share basis, along with a huge contingent resource. All while the company’s G&A has increased by less than 30%.   

Like many of its energy peers, International Petroleum Corporation is currently swimming in cash flow. At an average WTI price of $97, IPCO projects annual free cash flow for 2022 of about $470M, equivalent to 28% of its current market cap and enterprise value (IPCO has no net debt) of $1.7B USD (@ $15.65 CAD per share). Putting projections aside and looking at actual results, IPCO brought in free cash flow of $263M in 2021, equivalent to 15% of its current market cap, on 3% lower production and a more pedestrian average WTI price of $68.

Where IPCO stands out from its peers is in its capital allocation. IPCO’s management runs the company like value-focused shareholders. Management has focused on free cash flow since inception, long before the recent energy shareholder revolution. It eschews stock options, focusing equity compensation instead on valuable but limited grants of restricted stock units that are paid out in cash (and the cost of which is included in EBITDA and free cash flow calculations). IPCO buys back stock rather than paying dividends or investing in growth cap ex when its share price is significantly undervalued. Historically, IPCO has made acquisitions of distressed targets at prices representing significant discounts to the cost of the target’s assets, and further increases value by cutting out the target’s G&A. 

Superior capital allocation tends to be thought of as an important component of returns, but one that plays out over the long term. But with IPCO likely to earn 15%-30% of its market cap annually in the near term, the value of its superior capital allocation decisions is magnified, supercharging already strong returns.

Valuation

Valuing a commodity producer is an amorphous process. The commodity price, the most important determinant of a company’s near-term financial figures, is an always moving target.

The Company’s preferred metric for valuation is the net present value (after-tax) of its proved plus probable reserves (“2P”) at an 8% discount rate. IPCO’s December 31, 2021 reserve values are based on forecast WTI crude oil price of $73, $70, and $68 for 2022, 2023, and 2024 respectively with prices increasing 2% annually thereafter and AECO natural gas prices (CAD/mmbtu) of $3.88, $3.36, and $3.02 for 2022, 2023, and 2024 respectively with prices increasing 2% annually thereafter.

IPCO’s 2P reserves of 270 MMboe (oil equivalent) are valued at $2.52 billion USD or about $23 CAD per share. Of this amount, $1.75B (69%) represents total proved reserves. Notably, the reserve estimate is based on only $346M (undiscounted) of future development costs over the five years 2022 – 2026, lower than the Company’s projection of $400M total spending over the five-year period to maintain production at 47,000 boe/d. Total future undiscounted development costs are only $803M, 19% of undiscounted future net revenues. I am comfortable underwriting the Company’s reserves at an 8% discount rate on account of its low estimated future development spend. Looking at a number of peer companies, future development costs as a percentage of future net revenues was materially higher (range of 26% - 45%), with the vast majority of that spending to occur over the immediate five year period. Using a 10% discount rate would value IPCO’s 2P reserves at $2.26 billion USD or about $21 CAD per share, still providing for a significant discount at today’s share price.

Given the Company’s long-term history of increasing EUR at France (Reserves of about 23 MMboe in 2002 have given rise to cumulative production plus current reserves of about 35 MMboe) and Malaysia (13 MMboe of 2012 reserves have given rise to cumulative production plus current reserves of about 21 MMboe) along with increasing production at Onion Lake and maintaining production at Suffield (which had been declining about 10% annually prior to IPCO’s purchase from Cenovus in January 2018), I believe it is reasonable to go beyond proved reserves and rely on the Company’s 2P reserve figures. With the reserve report based on forecast prices significantly below current and strip pricing for oil and natural gas and reflecting (in my mind) normal long-term pricing in relatively balanced scenarios, I feel comfortable relying on the net revenue calculations.

Note that the 2P reserve valuation provides no value for the contingent resources of the Company’s Blackrod project.

As a secondary check on valuation, I note that IPCO currently trades on an EV/FCF multiple of about 3.6, based on this year’s projected $470M FCF at $97 average WTI. The $2.52B valuation represents an EV/FCF multiple of 5.4. Looking at 2021 results ($68 average WTI), the valuation represents a multiple of 9.6 times 2021 free cash flow of $263M.

Note that there are numerous gives and takes to the proper FCF figure to use going forward. IPCO is currently paying taxes only in France, and will begin paying taxes in Canada and Malaysia (barring future acquisitions that bring additional tax losses) in about two years time. On the other hand, the FCF figures include material discretionary interest expense ($22M in 2022) and are based on natural gas prices of $3 CAD per mcf, leaving potentially substantial upside in future years. Lastly, this year’s projected capital expenditures are $127M versus an average of $70M over 2023-2026 under the flat production rubric.  

Capital Allocation

Despite spending nearly the entire period since the Company’s inception in 2017 in a weak energy market, IPCO’s management has significantly increased the Company’s per share value. Now, the Company has the wind at its back. With huge cash flows pouring in, the Company has a tremendous opportunity to increase per share value and it is strongly taking advantage of it. Notably, IPCO is backed by the Lundin family which owns 40.7M shares through Nemesia S.a.r.l., which currently represents 29% of the Company. The Lundin family did not sell any shares in either SIB instituted by the Company (2017 and 2022) and their percentage ownership has been increasing as a result of the Company’s substantial buybacks.  

Debt Repayment and Buybacks

Despite having relatively low debt to start with, the Company’s first use of the significant cash flows that began in 2021 was to completely pay down its net debt. From $321M of net debt (bank loans/bonds minus cash) at 12/31/2020, IPCO was net cash positive as of April of 2022.

After purchasing 4.4M shares through its normal course bid (which is subject to restrictions regarding daily trading and total purchases) by May 3, management announced a substantial issuer bid of $100M, enabling the company to purchase 8.25M shares in late June.

On the Q1 conference call, CEO Mike Nicholson responded to a question asking whether the $100M would be better used on Phase 1 of its Blackrod project (which is being studied).

“I think the first question about would it be better to redirect the $100 million of buyback to Blackrod, I think the simple answer is absolutely not. I mean if you looked at the value slide that I showed on the chart, the 2P value of our portfolio is above SEK150 a share. And if you add just the Phase 1 value of Blackrod, you are getting up to close to SEK200 a share, and that’s on a $70 per barrel valuation. So, if we can use $100M cash flow to buyback at a 50% discount to 2P plus Phase 1 Blackrod on a $70 valuation, I think that creates a huge amount of value for our long-term shareholders.”    

Following completion of the SIB (which was extended as the Company raised the initial Dutch tender price of CAD $12 - $14 to CAD $13.50 - $15.50 after not receiving enough take-up), the Company went right back to its normal course issuer bid and purchased just under 1% (.8%) of outstanding shares over each of the next three weeks, followed by a mere 553,000 shares (.4% of shares outstanding) in the final week of July.

Comparing the value increase of a buyback at significantly discounted prices to retaining cash or paying a dividend shows the large value accretion of the Company’s buybacks. Based on the Company’s $7.07 CAD start of year share price, I estimate a 43% percentage increase in per share value through August 1 (increase in per share company value divided by $7.07 share price) as a result of debt repaid and shares bought back versus an estimated 30% increase in per share value under a debt buyback and cash retention policy. Paying out the excess cash in dividends would be equal to or less than the retention scenario (on account of taxes).  

Share-Based Compensation

The flip-side of buybacks too often is stock option issuance. What one hand giveth, the other taketh away.

For many energy companies, this became an even bigger problem during the pandemic-induced decline in share prices as more options were given out (as a lower share price led to a lower expense per option) and are now being exercised in full at very low strike prices. To be fair, given the multi-year decline in energy company share prices prior to the pandemic, many previously granted options expired worthless; that being said, it is frustrating to look through the SEDI database at the companies in one’s portfolio and see the masses of energy executives exercising all their options and immediately selling every last share for huge gains. At the end of the day, the huge decline in share prices ended up a boon for remaining executives who received a larger number of options at extremely low prices and seem to be considerably better off on account of the bust-boom pattern while long-term shareholders break even.   

Since 2018, IPCO discontinued the issue of stock options, instead utilizing share units which are paid out in cash based on the Company’s share price at the time of vesting. Senior executives receive performance share units with 75% of the grants tied to post-grant relative share price performance against peers over a 3-year period. Non-executives receive restricted share units which vest over time.

IPCO’s approach has three major advantages. Because they are paid out in cash, there is no share dilution (and no unseemly rush to immediately sell every vested option). Second, as they are paid out in cash, the Company does not remove the related expense from its calculations of free cash flow like so many peers do. Third, the Company is cognizant of the value of what it is providing and maintains reasonable amounts which its lists as its “burn rate” in its annual management information circular. The burn rate (defined as total share units issued divided by the year’s average share count for 2018 – 2020 ranged from .78% to 1.15% and was 1.82% in 2021 following extremely strong performance against the Company’s targets.

Acquisitions

IPCO has grown through three major acquisitions and continues to seek additional acquisitions going forward.

The Company purchased Suffield in January 2018 in an all-cash transaction. Against a purchase price of $419M, IPCO has extracted free cash flow of $200M between 2018 – 2021 with 2021 oil production 8% higher and production of natural gas (which did not see new drilling due to low prices over the ownership period) 2% lower compared to 2017 pre-acquisition production. Suffield has a huge land base with a very large opportunity set for inexpensive shallow gas drilling booked as a contingent resource along with continued opportunities to increase oil production through drilling and enhanced recovery techniques. With energy prices significantly higher, Suffield should provide huge returns this year and going forward.    

IPCO purchased BlackPearl in an all-stock transaction in December 2018. This acquisition represents the only time during IPCO’s history where its share count increased with the share count nearly doubling as a result. Despite issuing equity, 2P reserves per share increased from 1.47 boe/share at 12/31/2017 (inclusive of the Suffield acquisition) to 1.76 boe/share at 12/31/2018 while increasing the Company’s oil weighting from 42% to 74%. Through this transaction, IPCO also acquired the Blackrod SAGD contingent resource which has received regulatory approval for an 80,000 boepd SAGD oil sands project. IPCO issued shares valued at CAD $393M for Blackpearl whose most recent financial statements showed tangible book value of CAD $631M including PP&E and exploration assets with a book value of $881M. BlackPearl also maintained $361M CAD of net operating loss carry-forwards that passed over to IPCO.

Granite was another acquisition purchased at a major discount to the cost of its assets. IPCO purchased Granite’s severely beaten-down shares (I remember because I unfortunately owned them) in early 2020 for $37M CAD compared to net tangible book value on Granite’s latest financial statements of $195M CAD including $254M CAD of PP&E. IPCO also took on $40M CAD of Granite bank debt for total consideration of $77M CAD. Granite’s year-end 2019 reserve report showed proved reserves of 15.4 mmboe (88% oil) with a before-tax PV (10%) of $246M (at WCS forecast prices of $60 - $68 CAD during the 2020 -2025 period). Before-tax PV of 2P reserves was $305M CAD. Granite also had $80M CAD of net operating loss carry-forwards that passed to IPCO. IPCO sees a clear path forward to doubling high netback oil production from the acquired Ferguson field 1,500 boepd upon acquisition to 3,000 boepd over the next three years using the operation’s own cash flow.

Each of these acquisitions brought excellent value in the form of current production along with significant opportunities for well-defined organic growth.

IPCO continues to be on the lookout for major acquisitions. The Company issued $300M in bonds in order to have cash on hand so that it could move decisively to make a significant acquisition as oil majors are shopping numerous packages. Despite a strong desire for an acquisition, management remains price-focused. CEO Mike Nicholson responded to a question regarding the M&A environment on the Q1 call:

“Smaller mid-cap companies like us, obviously, can see where we trade … in terms of our discount to net asset value or where our free cash flow yield is. So, when we look at new M&A opportunities, they have to compete with share buybacks [and] our projects like Blackrod with a $50 per barrel breakeven. And my sense is right now, the majors have perhaps too lofty value expectations.” 

G&A

Following each of these acquisitions, G&A barely budged, providing additional value. G&A expense (including share-based compensation and a small amount of depreciation) only increased from $10.4M in 2017 to $11.1M in 2018 following the transformational Suffield acquisition and remained in the $12M-$13M range throughout 2019-2021 ($12.4M in 2021) despite the combined impact of these three large acquisitions.

BlackPearl’s 2017 G&A plus stock-based compensation was $10.7M CAD in 2017 (and running 10% higher through Q3 2018). Granite had $3.1M of G&A in 2019 (ignoring SBC negative cost) with prior years G&A running in the $5M - $6M CAD range. As Suffield was an asset acquisition, we don’t have access to associated G&A. Incorporating these major acquisitions without the associated $15M+ CAD of G&A provides material additional value.

Hedging

IPCO management also made a major call regarding hedging. In the face of significant backwardation in the futures market and with debt largely paid down such that lenders could not dictate hedging policy, the Company decided not to hedge oil prices. (It maintained a hedge of the WTI-WCS differential at about $13.) This has paid off in a very large way compared to most other Canadian non-majors who have faced substantial losses on their hedges. IPCO did hedge 1/3 of natural gas production during the shoulder season of Q2 and Q3 which will result in small losses but pricing during this period had historically fallen and it will result in a small impact. Natural gas for Q4 winter pricing and 2023 pricing remaining unhedged with the potential for significant incremental free cash flow if natural gas prices remain elevated. Note that the company’s free cash flow projections assume a $3.00 CAD/mcf price for natural gas.

Conclusion

IPCO is cheap based on a valuation of its reserves using reasonable long-term energy prices. Meanwhile, it is bringing in huge cash flows during the current high-price period. With a management that has proven itself extremely capable of increasing company per-share value during the lean times, I believe IPCO is strongly positioned to deliver continued share-price gains over the near-term and long-term.   

Catalyst

Continued inflow of free cash flow

Continued buybacks

Acquisition

Major Risks:

Major decline in energy prices