Description
Seven Generations Energy (ticker: VII) is a Canadian Oil & Gas
producer; specifically, the largest player in condensation (mainly composed of
propane, butane, pentane and heavier hydrocarbon fractions) production in the North
Western Alberta region in Montney and is a rival to Paramount Resources. The
crown jewel for Seven Generations in Montney is their Kakwa River project, in
which 1.23B was invested over the past 2 years.
From its humble beginnings, Seven Generations was originally
financed by private equity investors and morphed into a listed company— CEO Marty
Proctor has exercised great fiscal discipline in comparison to other producers—
Paramount Resources, NuVista Energy, Kelt, etc.
Seven Generations has been listed for less than a decade (IPO:
November of 2014). Seven Generations lacks Paramount’s mature assets— Seven
Generation’s wells have a delineation rate of 45%, which is decreasing every
year at a rate of 2-3%. Paramount has mature wells with a 15-20% decline rate,
requiring less incremental expenditure. Management is moderating decline rates
to make production sustainable.
Liquefied natural gases, such as condensate, is a crucial component for
the dilution of bitumen to make dilbit, which enables pipeline transportation
of bitumen. Bitumen is the heaviest crude oil used today found in natural oil
sands deposits. The oil sands, also known as tar sands, contain a mixture of
sand, water and oily bitumen. In a liquid form, condensate takes up about 1/500th
of the volume of conventional natural gas for the same energy output, making pumping
and transportation more economical.
A crucial factor in investing in condensate companies in Alberta is supply
and demand— Condensate domestic demand (Canada) exceeds supply by more than 250,000
bbl per day, which is why Canada imports condensate from the U.S.
Seven Generations accounts for almost a quarter of all Canadian
condensate production. As the largest condensate producer in Canada with
strategic pipeline opportunities to sell natural gas at favorable prices to
North America, and a promise of greater amount buybacks in the future— should
decline rates go down, and Nest 3 prove an important catalyst— Seven Generations
has an intrinsic value of at least 14-16 per share or 4-7B in market cap, with
an enterprise value of approximately 11-15B (current enterprise value 3.56B),
which is 3-5x current worth.
Regions— Nest 1 to 3
With 7G leasing about 800 sections and a total of 500,000 net acres
of land (Paramount has 2 million acres); 7G has divided land parcels into 3
nest areas—
1. Nest 1 is an ultra-rich condensate region with 37% IRR and a capital
efficiency of $10,700/boe/day. In Q4 2019, there was a land swap that enables an
optimized development plant. IP365 is 750 boe/d.
2. Nest 2 is filled with condensate rich locations, especially the
north western portion of Nest 2— it was previously considered part of the
Wapiti region with 100 reserve locations converted. At 43% IRR and a capital
efficiency of $8,000/boe/day, there are favorable trends in condensate
recoveries. IP365 is 1000 boe/d.
3. Nest 3 is a high-Deliverability Natural Gas Weighted Region with 63%
IRR and a capital efficiency of $5700/boe/day. With the infrastructure and
crossing in 2019 completed with a single super pad/hub which employs a spoke
and hub build out, with potential to expand boundaries to the southern gas rich
region. IP365 is 1400 boe/d.
* All
assumptions for IRR depend on a US 40/bbl WTI, $2.5 Hub, at $3 Condensate
Differentials
Seven Generations has an excellent production mix consisting of approximately
60% NGLs & Condensate and 40% natural gas.
Here are 5 reasons why
Seven Generations will emerge as a successful producer—
1. Manageable debt and financing with a promise of future buybacks
Seven Generation’s management indicated conservatism in their recent
earning’s call with leverage— they have reduced debt levels to a range of 1.0x-1.5x
debt to cash flow, versus a previous 2.0x. This allows free cash flow to accrue
and we can expect future buybacks via NCIB (normal course issuer bid), which is
likely when WTI exceeds usd50/bbl.
With 1.1B available on 1.37B (5 year term) of senior secured credit
facility (unsecured notes). Seven Generations doesn’t have any near-term
maturities— as of March, Q2, 2020, 298M was drawn on that revolver to repay
some of the unsecured 2023 notes with accordion feature from the earlier conversion—
which reduced interest rates from 6.8 % to about 2%. Maturity has now been
pushed the end of 2024 from mid-2023. 700M at 5.375% is due in 2025.
By avoiding any exposure to maturity issues, and maintaining
liquidity on the bank line, Seven Generations will be able to ride through
commodity cycles. Seven Generation’s revolving credit facility is covenant
based, not reserves based.
2. Maintenance Capex Reduction for Sustainable Production
The desire to reduce debt levels towards the 1.0-1.5x Debt to Cash
flow range will naturally diminish maintenance capital expenditures—with an 11%
drop in production, this results in Capex down from 1.3-1.7B to 650-800M in
2020; management promises the capex to remain intact even if commodity prices
improve. To give you historical reference— capital expenditures were 2012—280M,
2014—920M, 2015— 1.35B. This allows Seven Generations to maintain production in
the 180,000 boe/day range.
To protect Seven Generation’s balance sheet and preserve drilling
inventory, management reduced capital budget by 41% and deferred the start-up
of 11 new wells with 65-70 development wells in 2020. In Q1, 2020 drill and
complete costs were about CAD 7.3 million per well, which is 1 million per well
lower than originally budgeted for the year, and 33% below the costs for 2017. Operating
costs in Q1 2020 were CAD 4.54/boe, about 20% below 2017 levels. Seven
Generations completed the wind-down of its 8 drilling rig and 2 completion
spread program in early Q2, and commenced an operational pause. Salary and
benefits were also reduced.
CEO Marty Proctor said during a recent podcast interview the
company's decline rate would diminish by about 3% every year, which will lower
maintenance expenditures by CAD 60 to 80 million per year, or CAD 0.98/boe at
the midpoint, assuming production remains near the 200,000 boe/day range.
Seven Generations has also maximized efficiency and output through
multi-level stacked pads to improve infrastructure utilization— with a boost of
50% more inventory per section, and 30% increase in NPV per section and a
reduction of 85,000 truck-loads of reduced water transportation.
These operating cost efficiencies have given Seven Generations
Energy much higher netbacks than competitors in the Canadian oil and gas
landscape.
3. Decline rate moderation (40% to 30% by 2022) and diverting capital from
Nest 1 to Nest 3 with higher IRR leads to sustainability as a low cost producer
Seven Generations has greater than 80Mbbl/day capacity with more
than 60 Mbbl/day that is wholly owned and operated with optional access to an
additional 20 Mbbl/day from 3rd parties is and is able to average
half-cycle IRRs greater than 50%.
Seven Generation’s business model has pivoted towards a more
sustainable decline rate— in an earning’s call, Seven Generation’s management
indicated it entered 2020 with approximately a 40% corporate decline rate, with
management expecting declines to enter the 30% range by mid-2022 under its
current program. Seven Generations will break-even on a drilling and completion
basis at USD 33 per barrel, but declines in to the 30% range could bring it
down to USD 29-31 per barrel.
In a low 40s WTI and at a $2.50 per MMBtu price environment— with
weaker condensate differentials, Nest 3 is the best returning region in Seven
Generation’s portfolio. As prices move into the mid-40s and condensate differentials
improve to where we are today (September 2020), all regions start to exhibit
favorable well economics.
Seven Generations is currently directing capital away from Nest 1 to
Nest 3, which is more gas prone. All development activity for the second half
of 2020 will be shifted towards the Nest 3 region to lower initial decline rate.
While Nest 1 drilling economics have improved considerably, management should
be flexible towards production allocations across wells.
In 2019, Seven Generations completed a 120 million pipeline network
that connects the southern part, the Nest 3 area, to the core. The lower
Montney well on the 10-16-62-4 pad in Nest 3 continues to exceed expectations,
with the well continuing to be the best condensate producer on the pad. Overall
IP270 volumes of 1,934 boe/d are 12% above the average upper/middle Montney
locations on the pad, and condensate rates over the same time frame averaged
506 bbl/d, 39% above the average upper/middle Montney location on the pad.
The encouraging results from the first Nest 3 lower Montney well
prompted Seven Generations to add two additional lower Montney wells in the
area in 2020— improving the capital efficiency mix due to the high
deliverability. Over the next 24 months, further benefits from decline rate
moderation will result in another 6% to 12% decrease in total maintenance capex.
When condensate prices are stronger, Seven Generations can always consider
Nest 1. Although not as lucrative as Nest 3, Nest 1’s well economics still
compare favorably to wells operated by the majority of Montney producers. These
wells have an IRR of about 15% and a payback of 3 years at current prices.
As oil prices firm up, the ability to blend more production from the
Nest 1 region into Seven Generation’s total production profile is likely to put
condensate yields back on track— similar to 2018. Revenue from condensate
reached 70% of Seven Generation’s total revenue in Q1 2020 with 69,000 barrels
of condensate per day. Given the same
equivalent volume, due to higher prices, condensate production brings in higher
revenues than natural gas.
In terms of Seven Generation’s internal rate of return for its
projects, Nest 2 Wells have an IRR of roughly 40-60% at USD 40-50 WTI and USD
1.8-2.80 NYMEX gas, representing a payback period of 12-15 months. At a discount
rate of 10%, the net present value of these wells is approximately 20-35
million.
4. Differentiated pipelines for Natural Gas brings pricing options
Seven Generations has more than enough processing capacity with 3
owned plants, with additional access to third-party processing. When it comes
to pipeline capacity, they have more than enough egress for gas.
Seven Generations has egress of about 700 million cubic feet per
day— mostly to the Midwest, some of it to Henry Hub, some to Eastern Canada,
some to Malin. As of 2020, with dire conditions, Seven Generations has reduced
to 500 million cubic feet per day. There is a lot of additional room to grow
gas production over other liquids
Seven Generations sells oil & gas via domestic (Alberta) and
exports (80% of natural gas is outside Alberta) to the U.S— with 90% of Seven
Generation’s natural gas sales in the U.S Midwest, the US Gulf Coast, and Eastern
Canada with a realized price of $3.41/Mcf for 2019, with the local AECO
benchmark price averaged at $1.67/GJ. Seven Generations is far from reaching
its total capacity of 1 Bcf/d. With Cutbank/Lator/Gold Creek alone— the
capacity is 760MMcf/d.
These main pipelines which transfers Seven Generation’s produce—
- GTN at 90-92 MMcf/d
- Alliance at 500 MMcf/d to
Chicago and the mid-west market
- NGPL at 100MMcf/d for Henry Hub
(Henry Hub has been selling to Cheniere— the gas is then placed on the water
for LNG)
- TCPL at 77 MMcf/d to eastern Canada
This means that for natural gas, 700MMcf/d of pricing optionality is
available due to diversified market access.
Alliance provides Seven Generations with over 500Mcf per day, nearly
2/3 of pipeline capacity, but is currently slightly out of the money. Alliance provides
access to the Midwest market and enables transportation of gas through Kinder
Morgan's NGPL line directly to the Gulf Coast. The Alliance partnership also
provides tremendous amount of flexibility, particularly with regards to renewal
options.
The primary term of Seven Generation’s current Alliance contract
expires in the Q4 of 2022 with option for renewal or termination of
transportation capacity completely—if terminated, Seven Generations will market
their gas in Alberta or on TC Energy connected systems.
In the long term, through projects in British Columbia, Kitimat,
Jordan Cove LNG Terminal, natural gas take-away capacity will improve.
5. Reserves
With approximately 1.6B boe of gross proved plus probable reserves,
this is enough to last 20 years of domestic Canadian energy supplies and
exports.
Seven Generations possesses one of the best liquefied natural gas
land in the entire Montney. Covering approximately 500,000 acres— Seven
Generations owns a vast amount of land and over 1100 undeveloped locations with
2P reserves of 1.6B Boe and 1P reserves of 842 Boe.
Of these 1100 locations, approximately 55% lie within the company's
primary development block, termed Nest 2. The liquid-rich natural gas produced
in Nest 2 is “sweeter” than other natural gases found in the region (less than
100 ppm H2S), allowing for minimal investment requirements in sour gas
processing facilities. As such, the cost of producing one MMbtu of gas is only
US$0.94, ranking the company as one of the most competitive suppliers of gas in
North America.
Assuming WTI of $40, gas at $2.50 and a minus $8 condensate
differential. Approximately 1,300 Nest-quality locations in the Upper Montney have
attractive well economics on a half cycle and a full cycle basis. Nest
locations imply -- with 1,316 Nest locations in the Upper Montney alone;
implying about 19 years of top-tier drilling inventory, assuming about 70
locations are drilled per year.
Risks—
Specific risks include unplanned facility downtime, not delivering
on production targets, deploying capital ahead of time for additional
production, and higher than expected decline rates.
Sector risks include a decline in commodity prices and rising
industry costs.
Here are 3 risks to
consider—
1. Depth of Inventory/ Adequate Reserves & inability to improve
decline/depletion rate
Seven Generation claims to have 15-20 years of inventory—2P reserves
are 1.6 billion barrels equivalent. Divide 1.6B by 200k boe/d, and you get 22
years (8000/365days) of inventory.
Shale plays or “resource plays” have an average well profile
different from conventional wells. Horizontal and multistage fracking are used
to create more contact between the well bore and the oil & gas formation.
This gives wells very high IP 30 rates, but eventually diminishes the yield.
Seven Generations is now trying to moderate their growth rate after
years of hyper growth. Their decline rate is about 45% a year after being at 50%,
and is being reduced by 2-3% a year. High decline rates with new horizontal
shale wells as reserves require more active drilling and a higher replacement
requirement.
On average, Nest 2 wells loses 30-40% of production yields after 250
days, and 80% of yields after 2 years, due to over pumping and the spread of
contamination and land subsidence. Although Seven Generation's unconventional
plays are not as stable long term as peers, at current low oil prices— it is
still the preferred method of production, since it leads to a faster payout.
2. Out of the Money Prices
While oil and gas are at an all-time low, prices are still
unpredictable with many variables affecting commodity prices. There is a
misconception that Seven Generation gets Chicago pricing instead of low AECO
prices— Seven Generation has a premium on their NGLs, but the gas is still in
Alberta. For the bulk of the rest of the year, AECO prices may US$1.00/MMBtu
below Henry Hub. When the Alberta price exceeds Henry Hub, exports have lagged.
To adapt to the new commodity price uncertainties brought about by
supply and demand impacts resulting from OPEC decision-making and the COVID-19
pandemic— for 2021, Nest regions will have a more balanced mix. With resumed
activity and recovery to higher liquids prices, Nest 1 will resume. Ultimately,
all decisions are based on well economics and maintaining flexibility to
changes in commodity prices.
3. Increasing Transportation Costs and other costs
One major increasing expense is transportation costs—Seven
Generation’s costs are higher at 7.5-8.25/boe while Paramount is at 3-3.5/boe. Transportation
costs (per BOE) are expected to grow 3% a year, as a result of the increasing
cost of fuel less any cost savings attributed to bundling of large lots of production.
Valuation (reserves and
cash flow)
1. Cash flow and Production
If production is maintained at 180-200k boe/day and improves to
200-250k boe/day due to lower capital expenditures, at WTI $45-50 for oil and
$3-6 condensate differentials, I expect the bear case for EBITDA to be at least
150-180M with 65-70 wells on production, and the bull case to be near 220-290M
with 80-95 wells.
In 2019, with operating cash flow of approximately 1.4B and capital
investments of about 1.23B, Seven Generations had free cash flow of about 160M.
Even in Q1 of 2020, Seven Generations generated a modest amount of free cash
flow.
Seven Generation’s enormous infrastructure provides economies of
scale which generates a high cash flow netback at $18-20/boe. Rising production
of oil sands creates a strong demand for condensate. Condensate enjoys a price
on par with WTI, which lends Seven Generations a stable and high operating
netback. While Paramount and Seven Generation have different profiles in
Natural Gas and Condensate, Seven Generations has more pricing flexibility due
to additional pipeline options.
Average realized prices range from $10-70/boe depending on the
condensate in the production mix. C5+ LNGS (condensates) go for as high as
$70/boe while C3 and C4 gases (propane and butane have dropped to as low as
$10-20/boe since the energy crash). Seven Generations Energy's 150bbl/MMcf
liquids to gas ratio is significantly higher than the 40bbl/MMcf average in
western Canada, giving Seven Generations as high as $6/MMcf in savings.
With 2.2B net debt, and a 1.4B market cap, with 333M shares
outstanding, assuming 500M EBITDA, Seven Generations has a EV of 3.6B, and is
trading 3x LTM EBITDA. Book value is 4-5B, or $12/ share. Shares are currently
(August 27, 2020) 4.2/share.
Paramount Resources is uncertain to produce FCF in 2021, but Seven
Generations surely will. A bird in hand is worth two in the bush— despite Seven
Generations having almost double the enterprise value of Paramount Resources— CEO
Marty has not over leveraged Seven Generation’s balance sheet nor over produced
at inopportune moments. Paramount previously had to sell off assets due to
overly aggressive production to cover basic liquidity assets needs during bad
times.
Seven Generations (43% natural gas, 35% condensate, 22% other NGLs):
Enterprise Value: 3.56B
1P Reserves: 842 MMBoe
2P Reserves: 1600 MMBoe
Q2 2020 Production: 183,200 boe/d
EV/2P= 3.56B/1.6B Barrels = 2.23x
EV/1P = 3.56B/ 842M Barrels = 4.22x
Seven Generations is valued at 2.23 times its enterprise value to 2P
reserves
EV/ LTM EBITDA =3.56B/ 1.3B = 2.72x
Paramount Resources (47% liquids):
Enterprise Value: 1.15B
1P Reserves: 335 MMBoe
2P Reserves: 632 MMBoe (47% liquids)
Q2 2020 Production: 68,839 Boe/d (39% liquids)
EV/2P= 1.15B/632M Barrels = 1.8x
EV/1P = 1.15B/ 335M Barrels = 3.43x
Paramount is valued at 1.8 times its enterprise value to 2P reserves
EV/ LTM EBITDA =1.15B/ 421M = 2.73x
2. Reserves
The 2P reserves for Seven Generations don’t paint a complete picture,
since it only includes about 975 locations or 3/4 of the Upper Montney in the
Nest. Seven Generations has more areas for development, including the lower
Montney, Wapiti, etc.
Pre-Covid-19, Seven Generations was selling 200kboe/d, whereas
Paramount was selling 90-100kboe/day, with nearly 500MMcf/d of natural gas
sales. In addition to this, Seven Generations has 842 MMBoe in 1P reserves,
whereas Paramount has 335 MMBoe. Paramount has 2 million net acres of land, yet
despite a lower decline rate and longer operating history, their production
isn’t as prolific as Seven Generation (500k acres), and reserves are less. 2P
reserves for Seven Generations is 1600 MMBoe, while Paramount is 632 MMBoe.
Despite Seven Generations having an enterprise value double of Paramount, the
probable reserves still make Seven Generations a justified purchase.
Oil and gas is a sector where you think you know enough to be right,
but there will always be macro-economic factors such as Covid-19 and the banter
between the middle-east and Russia. You can never know enough to predict where
you're wrong— there are always external factors out of an investor’s control.
This makes me conservative and I would sell immediately when the stock price exceeds
intrinsic value.
Catalyst
Focus on Nest 3 and wells with
higher IRR with Nest 1 as optional upside
Natural Gas pipeline capacity
at Henry Hub, Alliance, and the Mid-West is currently out of the money and will
revert
45% decline rates being reduced
2-3% a year to a 30% rate by 2022
Maintenance capex reduced
Prices improving with
condensate production going up
