Arc Resources: A Gas or Oil Company?
by Edward Friedman
Analysis of the commodity space in Canada is fairly difficult as it is comprised of only a handful of high quality companies that consistently grow their production profitably, have strong balance sheets and generate positive free cash flows. Since most investors are chasing the same high quality names, these companies usually trade at lofty valuations. However, there are some rare cases when the market punishes a stock for seemingly producing the “wrong” commodity. Such is the case of Arc Resources.
Arc Resources is a large gas producer and its largest assets are located in the Montney basin in northeastern BC. In the past six months, gas prices in western Canada have been on a steep decline, down approximately 30% from C$3/mcf to C$1.9/mcf with very high volatility. The main reason for the decline is attributed to problems in the AECO market (Alberta gas), which has been severely strained due to pipeline capacity. So much so, that at times during October and November 2017, AECO spot gas traded at negative prices. Also, higher production in the Montney basin put strain on gas hubs in BC where gas trades at prices below C$1/mcf on a fairly consistent basis. The result of this large decline in the price of gas led to a sharp decline in all gas-related names.
In our previous publications we described the process we use in our commodity investing, implied pricing. Under this approach, we ask what price of commodity is implied in the current stock price and at what premium does the stock trade compared to the commodity price. At $2/mcf gas price, Arc’s current stock price (C$13.5) reflects WTI price of US$54, a 16% discount to current oil price (US$64.5).
In 2017 Arc’s share price declined by 34%, underperforming the S&P/TSX Exploration and Production index which declined by 14%. Also, its price-to-cash-flow multiple (P/CF) dropped from 13x at the end of 2016 to 6.5x today, one of the lowest levels over the last five years (Figure 1). A multiple of 6.5x means that an investor that buys the stock today will have earned the value of the stock through operating cash flows within 6.5 years. Historically, the stock traded at a multiple of 8x-9x.
Figure 1: Arc Resources Price-to-Operating-Cash-Flow (P/CF) and Stock Price Chart.
In addition to its low P/CF multiple, in this Market Intelligence we will provide a deeper look into the reasons on why we are strong buyers of Arc Resources. These reasons at a high level are as follows:
- Arc’s production is geared towards gas, however from a revenue perspective, operating cash flow and cash flow sensitivity perspective, Arc is impacted more by oil.
- We expect a resolution of the pipeline capacity issues in Alberta.
- We believe that Arc’s gas exposure serves as a cheap option to when gas prices will rise.
- The market is so concerned about Arc’s gas exposure that it values that part of the business at about half of its average valuation, even at $2/mcf gas.
We will start with Arc’s production and revenue profiles depicted in Figure 2. As can be seen, there is a large difference between Arc’s production composition and its revenue as while gas comprises 70% of the company’s production, it makes only 42% of its revenues. In addition, though Arc produces mostly in Northeast BC, it sells about 40% of its gas, through long term contracts with the pipeline companies, to hubs in Chicago, Ontario and the US Pacific coast where gas prices are higher and more stable. Therefore, its exposure to the AECO price volatility is lower than other companies that constrain themselves to selling mostly in local hubs.
Figure 2: Breakdown of Arc's Production and Revenue Profiles
Source: Company Reports
Next, cash flow. Investors focus on several metrics in oil and gas investing:
- Funds flow from operations (FFO) - Operating cash flow excluding working capital changes.
- Netbacks – cash profit per barrel. This metric is equal to revenue per barrel minus all cash expenses like transportation, operating expenses and royalties.
In its latest release, Arc provided its FFO sensitivity to changes in natural gas and oil prices. The sensitivity shows that for every 5% change in natural gas prices, FFO will be impacted, positively or negatively, by $15 million. Meanwhile, a similar change in oil prices will impact it by $25 million.
The company employs a sophisticated hedging program. For 2018, 38% of the company’s gas production is hedged around C$4/mcf and it also has additional hedges (30% of production) on the price differential between AECO and NYMEX gas price, both in percentages and in dollars. For 2019, Arc hedged 26% of its production and in 2020 it hedged 19% of it.
What is in Arc’s future development pipeline? Arc cut its capex for 2018 from $830 million to $690 million, mostly in order to maintain its debt ratio. Arc’s debt ratio is 0.17x net debt to equity and 1x net debt to EBITDA, both among the lowest in the industry. 50% of the company’s capex will go to the Dawson and Sunrise projects which are mostly gas projects. However, these projects have substantially lower cost of production compared to the company’s current production. Therefore, these will generate higher netbacks than existing projects. In addition, past 2018 the company plans to expand its oil production as the company’s reserves in the Montney are of higher quality, therefore, it is expected to generate better netbacks compared to heavier or lower quality crudes.
In light of the current gas price, why is Arc developing gas projects instead of potentially more profitable oil projects? Sunrise and Dawson projects, both of which are located in the Montney are very low cost production projects (~C$0.3/mcf as opposed to current average of C$0.7/mcf). In addition, the Sunrise project has already been sanctioned and the Dawson project is in the third stage of development. Therefore, stopping these projects mid stage would be detrimental to the company and a commodity company that develops projects with a 20-30 year view should not stop a project just because the commodity dropped, potentially temporarily, and especially if the projects are still profitable and earn their cost of capital at prevailing commodity prices.
Why is AECO so volatile? There are two main reasons for that.
- Gas production in Northeast BC and Alberta has grown much more than was initially expected.
- As a result of the larger increase in production, the Nova Gas Transmission Line (NGTL) capacity became insufficient.
Historically, AECO traded at a small discount (~10%) to US gas (NYMEX), reflecting transportation costs. However, in September TransCanada announced changes to its supply contract, changes that created difficulties for shippers to get their product to the main hubs in Alberta and out of the province or to storage. This change resulted in a steep expansion in that discount between AECO and NYMEX and to negative AECO levels on some days.
TransCanada, which owns the NGTL system allocated C$7.1 billion to expand this system. However, the expansion will take two years to construct, assuming that hearings on the project go well and there are no delays. Figure 3 shows that AECO traded at a steep discount to NYMEX in the late 90’s. Additional pipeline capacity helped alleviate this pressure. Though circumstances are somewhat different, as today we have gas production from shale and LNG exports, we believe that it will work this time as well.
The saying about oil prices goes “the best cure for low oil prices is low oil prices”. It works in oil and it works in any other commodity. Gas producers are not uniform. Some are high cost producers and some have much lower cost of production like Arc. In addition to more pipeline capacity, additional support to gas prices will come from high cost producers cutting production or outright exiting the market due to inability to finance themselves in the current price environment.
This brings us to the equity market. While the energy market is absorbing AECO price volatility, gas stocks are also volatile. However, as presented earlier, Arc is more impacted by oil price fluctuations than by gas and in 2019 onwards, Arc is expected to develop its oil projects. As mentioned, in 2017 Arc’s shares underperformed the S&P/TSX Exploration and Production index, mostly due to gas price concerns and herein lies the opportunity in the current share price.
At current levels the market values Arc’s gas business at roughly half its worth even at C$2/mcf gas. We fully appreciate the market’s concerns about higher overall gas production and pipeline capacity, but since the market is the best discounting mechanism, waiting for capacity issues to be resolved to buy the stock may be too late as the market will most likely take it higher long before the problem is ameliorated and this will show the gas option in full force. How?
- Execution of the company’s strategy. As the company reports and results continue remaining robust, we believe that investors will regain their confidence in the company, thus potentially rerating the stock to a higher multiple.
- If the market takes Arc’s stock back to its average P/CF multiple of 8x, the stock will rise 24%.
- If gas price goes to C$3/mcf, the stock is expected to rise 53% with oil staying at current levels.
In conclusion, Arc is a gas company by production, but an oil company by revenues and cash flow. The market took it down due to concerns about gas pricing emanating from pipeline capacity and growing gas production in Northeast BC. We believe these fears are irrational, and at the current price we own Arc with a cheap option on gas pricing, that even before pipeline capacity is alleviated, this option will bear fruit and lead the stock to outperform.