Finding long-term value above the oil price noise

Since the 2014 price crash, it’s been a difficult couple of years for Canadian oil and gas producers tussling with high costs and stubbornly low prices.

Canadian producers must be disciplined stewards of their financials, and in this installment of “How to Read,” we take a look one such player. ARC Resources (TSX:ARX), a mid-cap Canadian oil and gas company based in Calgary, has been singled out by analysts as a smartly managed producer that takes a long-term view.

The experts

• Amir Arif

  analyst, oil and gas, Cormark Securities, Calgary

• 

  Nima Billou

  analyst, energy and special situations, Veritas Investment Research, Toronto

• 

  Jennifer Stevenson

  vice-president and portfolio manager, Dynamic Funds, Calgary

With production of about 40% oil and liquids and 60% natural gas, the company is benefiting from an early move into the Montney natural gas formation in Northern Alberta and B.C., where it has been producing natural gas from some of North America’s highest quality wells and fields—and at a low relative cost.

Analysts like ARC for its long-term approach, exemplary financial disclosure, and conservative cash and liability management.

“It’s one of the top long-term holdings, especially for conservative investors, given the low balance sheet leverage and the visible growth laid out for the next five years,” says Amir Arif, analyst for Cormark Securities. “When you look at how clean the balance sheet is today, we think they are in a good position to start increasing their dividend in a few years.”

Below, we take a detailed look at four ARC resources tables: its guidance, netbacks (per-barrel profitability), balance sheet and cash flows. We’ve gone back to see how the company’s financials fared in Q1 2016 (the three-month period ending March 31, 2016), when oil and natural gas prices plummeted to a 10-year low.

Annual guidance

The guidance table (above) is a report card on how the company fared in its production and expense forecasts. While many energy companies combine their product guidance, effectively hiding some disclosure, ARC breaks out its forecasts at the product level.

Natural gas liquids, or NGLs, receive about half to a third of the price of a barrel of crude. Some companies combine all liquids at a blended price, concealing the volume of NGLs they’re producing. For instance, a company may not want to disclose that it produces a large volume of NGLs, Billou says. Here, ARC reveals it.

Total guidance: The estimated 116,000 to 120,000 barrels per day reflects ARC’s expected processing capacity. Note that the production guidance is provided in barrels of oil equivalent per day.

Cost per barrel: Expenses are measured in dollars per barrel of oil equivalent.

G&A expenses: For general and administrative expenses, use this line—not the line below that includes share-based compensation and fancy accounting. Expenses, reflecting general corporate overhead costs, came in higher than expected, at $1.93 per barrel of oil equivalent. “The operating expenses are a lot lower, the transportation expenses are lower, but the G&A expenses are higher than their guidance. That would be something to go further into the financials—to look at why,” Stevenson says.

Natural gas condensate is a valuable product in Western Canada, selling for more than light oil. Producers blend the liquid product with heavier crude oil to increase viscosity and allow it to be shipped by pipeline. Condensate is not often disclosed separately in energy company guidance. “It’s rare to see condensate broken out,” Billou says. “If it’s not just lumped in, with NGLs and crude together, it’s always crude oil and condensate that are put together.”

Total production: A solid guidance table would show actual production that is in line with the guidance or higher. ARC’s total production for Q1 2016 was 124,224 barrels per day, 3.5% higher than the top end of its guidance (120,000 barrels per day). Stevenson points out that ARC outperforms that top end of the guidance on every production metric.

Operating expenses: At $6.10 per barrel, costs are lean. “The operating cost structure is very good for ARC relative to a lot of its peers,” says Arif. “They’re top quartile in terms of their low operating cost structure.”

Netbacks

Essentially a measurement of profit per unit of production, netbacks (above) represent “the super important number” for the oil and gas sector, explains Stevenson. Totals are measured in dollars per barrel of oil equivalent. ARC’s product-level disclosure is above the industry norm, Billou adds. It shows profitability according to types of crude, condensate, natural gas and NGLs.

Netback prior to hedging: This reflects the company’s field level cash flow before hedging and the performance of ARC’s wells and assets, particularly the Montney play. NGLs, for instance, lost $5.71 per barrel, while light and medium crude earned $19.43 per barrel. Overall, ARC earned $10.53 per barrel equivalent before hedging. Says Arif: “In one of the worst commodity markets we’ve ever experienced—at the low point of that commodity cycle—this is a company that was still generating positive operating earnings. It reflects the quality of the asset base they’ve transitioned into.”

Average sales price: Compare Q1 2016 and Q1 2015 sales prices (highlighted above) to reveal the impact of the oil price drop. ARC’s average price per barrel dropped to $20.39 from $28.20 a year earlier. “We already had crummy prices in Q1 2015, but Q1 2016 was crummier,” Stevenson says. “That’s a [28%] decrease in the average sales price.”

Netback after hedging: ARC has a reputation for an active, regimented hedging program meant to guarantee profitability and cash flow stability through oil price ups and downs. The company’s complex hedging strategies involve trading in futures and other instruments like swaps and collars. This line (second from bottom) shows the benefits of the program, with the netback after hedging at $16.57 in Q1 2016 versus $20.03 a year earlier. While ARC’s average sales price dropped 28%, its profit after hedging only fell 17%. “So, they sheltered almost half of that decrease,” Stevenson says. “That’s actually cash in their jeans—another six bucks per boe [barrel of oil equivalent]. […] That’s one thing this company is known for.”

Realized hedging gain: The total realized hedging gain—the difference before and after hedging—was $6.04 per barrel of oil equivalent. It shows how much ARC’s hedging program saved the company. While prices plummeted, the company didn’t suffer as much as it could have.

Balance sheet

For oil and gas companies, the balance sheet (above) and cash flow statements are vital. Strategists find they offer more accurate assessments than the income statement, which uses fancy accounting and tends to be more backward-looking. For the balance sheet, assets are less important since they’re long term and do not tend to change radically. More importantly, the balance sheet indicates how liabilities are moving up or down—and why.

Leverage is net debt to EBITDA: how much debt the company has in relation to cash flowing in. Net debt is total debt minus working capital, adjusted for derivatives. ARC’s net debt is $886 million. Then, find EBITDA: revenues minus cash expenses before taxes and interest expense. Finally, divide net debt by EBITDA to find leverage. In Q1 2016, ARC’s debt to EBITDA was a healthy 1.3×. “That was at a time when the rest of the industry was well north of 2× debt to EBITDA. Despite low commodity prices, they were able to sustain themselves. […] Other companies had to issue equity or […] sell assets,” says Arif. “It’s part of the reason we like this name for longer-term investors.”

Debt: Add long-term debt and current portion of long-term debt for total debt; then do the same for the previous year to see the change. ARC kept its borrowing in check: it reduced activity during the quarter and paid down debt. “Both current and long-term debt went down. Not a whole heck of a lot, but given that March 2016 was the trough of pricing, they could have easily added debt,” Billou says. “One way to manage a difficult quarter when cash flows are lower is to spend less money,” adds Stevenson. “You’re preserving shareholder capital for a time when return on investment is better.”

Cash and cash equivalents: Cash fell only slightly year over year, to $165.5 million. “You can see their cash balances didn’t go down, and they didn’t borrow, which means that they were able to generate positive free cash flow and pay down debt. Or, they were able to sell assets,” Billou says. “Either way, during a difficult time they found a way to lower leverage.”

Accounts payable and accrued liabilities: In Canada, calendar Q1 is the most active quarter for oil and gas companies because the ground is frozen, and the harder ground facilitates the movement of big machines. With more activity in this period, many Canadian oil and gas companies grow their liabilities in Q1, aiming to repay them with future cash flow. Analysts check whether the balance sheet rebalances by the end of the year. Here, coming in at $119.2 million, ARC’s accounts payable and accrued liabilities actually fell from the previous quarter, when they were $137.5 million. In a very difficult quarter, the change in liabilities indicates prudent financial management and that activities were paid for with cash flow.

Cash flows

Interpreting the oil and gas producer business requires a focus on cash flow (above) and EBITDA. Income statements can hide what’s actually happening in the fields while cash flows provide a more truthful picture. “Personally, I like cash flow because it just shows you how much cash is coming out of the ground and into the business,” Stevenson says. “Cash is cash is cash. You can touch it, smell it. I like cash.”

Cash flow from operating activities: The quarter’s cash flow comes in at $152.7 million, up from $145.7 million a year earlier. “Given that it was a weak period for the sector, that it went up a little bit (or at least is stable) just speaks to the solid operations of the company,” Stevenson says. Cash flow from operations covered ARC’s total spend for dividends ($43.3 million), property plant and equipment ($43.5 million) and exploration ($15.5 million); they total $102.3 million.

Acquisition of properties: Acquisition costs were low, at just $15.1 million. Again, the company reports prudent spending in a difficult price environment. “Look at how responsible they were. They’re not going out to buy a big, massive company; they’re going to a buy bit of land here and there, or very specific assets,” Billou says. “When you don’t have the money, you don’t run up the credit card.”

Income taxes: One advantage of low energy prices is less income tax owed. ARC’s taxes for the quarter? Zero. It illustrates a negative operating environment, as well as some effective accounting from a company that doesn’t spend unnecessarily.

Operating cash flow per barrel: Take total energy production from the guidance (124,224 barrels per day) and multiply it by 91 days in the quarter to find total barrels of oil equivalent during the quarter: 11.3 million. Then, divide total operating cash flow ($152.7 million) by total barrels for the quarter (11.3 million) to find cash flow per barrel during the quarter: you’ll arrive at $13.51. “It’s pretty good considering pricing was $20.39 a barrel,” Billou says, comparing it to the average sales price from the guidance. “That’s incredible that they still managed to generate $13.51 of cash flow.” Compare cash flow per barrel against previous quarters to see the change up or down.

Property, plant and equipment: ARC pulled back its capital investment in plant and equipment to $43.5 million, from $131.1 million—a big drop from the previous year and a prudent action during a rough quarter. “These guys are spending a lot less, being good stewards of capital in a tough commodity price environment,” Stevenson says. Adds Billou: “They’re pursuing growth that makes sense, that’s economic.”