Description

Summary

Making good returns in oil and gas stocks has been relatively easy this year because of the rise in the underlying commodity prices from near lows at the start of the year. However, we think that a safer way to invest in the sector is to identify “best in class” management teams who own good assets and understand that the way to creating shareholder value in a commoditized industry is to be the lowest cost operator.

We wrote up a CAD$1.5bn market cap oil producer, Raging River Exploration, two years ago and believe Tourmaline represents a similar case except on the natural gas front. All numbers below are in Canadian dollars unless otherwise noted. 

Description & Economics

Tourmaline is a natural gas focused E&P company with three core areas in the Alberta Deep Basin, NEBC Montney and the Peace River High Charlie Lake. The company seeks to own large land positions in the areas that it operates as well as retain operatorship and infrastructure in the core areas as this helps control costs and is strategically helpful. Although TOU is primarily gas weighted, the associated liquids production can swing the profitability significantly as changes in the oil price influence how the liquids are priced. The management team is known to be technically savvy operators and the company employs only 180 full time staff in both the office and field which is orders of magnitude less than peers.

Tourmaline is the second largest natural gas producer (by production and reserves) in Western Canada. Out of the top 25 wells drilled in Western Canada in 2015, TOU occupied 17 positions, including 9 of the top 10 wells. Given TOU’s large presence in a few areas, the company does a very good job making sure that it has significant infrastructure to meet current and future growth needs, which over time helps lower operating costs further.

Three very useful metrics we track for E&P companies are production and reserves per share vs operating cost per boe. To state the obvious we look for those who, year after year (regardless of cycle timing), deliver growth in the per share metrics and constantly bring down costs. Recently, many E&P’s are happy to showcase decreasing costs/boe in their corporate presentations as industry costs have come off 20-30%. Aside from a slight increase in 2014, TOU has decreased operating costs every year from about $6.50/boe in 2009 to less than $4.35/boe in 2013; these are currently running at $3.56/boe.

In that time G&A costs decreased every year from ~2.46/boe to $0.45/boe today. From 2009 until end of 2015, production/share and reserves per share have grown at an annual rate of 50% and 40%, respectively. For those who are curious about why PWT or ERF have such poor share price performance, even before the oil price drop started in mid-2014, I would suggest plotting the production/share and operating costs/boe on the same chart and see what happens to tired oil and gas assets when most of the cash flow is used to pay a distribution instead of capex.

Management & History

In the October 2016 publication of Alberta Oil, the magazine profiled “The Best Little Oil Companies in Canada”. We would agree with the majority of the profiled management teams on the list. The TOU profile opened with “If you had $100 million and had to give it to one oil and gas man to try and turn it into something bigger, Mike Rose may be your best bet.” We agree. By our estimates investors in Mr. Rose’s last two companies achieved impressive returns: Berkley Petroleum founded in 1993 ultimately sold to Anadarko in 2001 for $1.6bn, a ~40% IRR to original public shareholders. Duverney Oil founded in 2001 and sold to Shell in 2008 for $5.9bn, delivered IRR of ~55% to original (non-management) shareholders.

Given this track record it is no surprise that in November 2008, in the midst of the financial crisis, TOU was able to raise $300mm of the starting capital for TOU. Those who backed Mr. Rose initially in TOU are sitting on an IRR of 23%; those who invested when TOU went public in late 2010 are looking at an IRR of 10% to date. Both of these returns are at current prices after a decrease of ~40% from peak. It is not surprising that management still owns 25% of TOU on a fully diluted basis. 

Valuation

Based on year end 2015 reserve numbers TOU had a 2P NAV of just over $37/share.  Since then the company has made significant progress developing new reserves and production, along with the added benefit of increased commodity prices. The company has a significant runway to continue adding reserves economically (just under 10% of its ~12,500 drilling locations is booked in the reserves). Given this, we believe the current share price is not pricing in any progress since then for a management team that is one of the best in terms of achieving progress and beating guidance and expectations.

For those who like relative valuations, TOU typically traded at a premium to peers. Currently it is trading at a discount at ~$48,000 EV/boe/d and 8.2x EV/Debt Adj’d Cash Flow. In our view this is far too low for the lowest cost operator, growing quickly, with incentivized management. Assuming they trade at the average of their peer group that would put the share price ~25-35% higher than here. This relative analysis assumes no increase in commodity prices but more a catch up to peers. Net debt to cash flow is modest, although high for TOU, at 1.6x on exit 2016 numbers. The company plans to delever to just under 1x by year end 2017 which we believe is reasonable given the already completed pre-spend on infrastructure for 2017 production growth. 

Risk

Evidently the oil and gas sector is cyclical. We mention this because it seems that value investors seem to forget the tried and true axiom of ‘be greedy when others are fearful’. Although we believe we are past the bottom of the cycle and closer to a trough than a peak, we cannot forget that oil and gas prices are extremely volatile. Any decrease in price will decrease the value of TOU over the short term. As TOU has demonstrated over the last two years, even in a low price environment management can grow the business because of the low cost nature of operations.

Catalyst

Continued execution of the business plan. Sale of the company; likely to a large buyer looking to acquire supply for a West Coast LNG project.