XOM - Baytex Energy: Margin Mix Change Continues

2023-03-22 11:14:53 ET

Summary

• Clearwater appears to lower the heavy oil breakeven cost a good C$10 per barrel of oil over legacy acreage.
• Clearwater acreage also increases the company's exposure to a discounted heavy oil product that often suffers from weaker pricing during downturns.
• The 2015-2020 period was particularly brutal for heavy oil producers.
• The reaction to that brutal period has been a call for lower debt levels and a pessimistic outlook for heavy oil production.
• The lower debt level and low breakeven of Clearwater should offset the pessimistic outlook of the market.

Baytex Energy (BTE) (A Canadian company that reports in Canadian dollars unless otherwise noted) has actively developed the low-cost Clearwater play. That development will gradually lower the average cost of the corporate breakeven. It also increases the company exposure to a discounted product that often suffers from weak pricing during commodity price downturns. Therefore, shareholder returns may have to wait as management continues to lower the debt in preparation for the next inevitable commodity price downturn when the discount for heavy oil could widen from benchmark prices.

The 2015-2020 period was particularly brutal for heavy oil. This was the sector that made no money and at times no cash flow. This sector of the oil industry was likely shut-in the most during the weak prices that prevailed much of that time. The short 2018 rally was hardly much of a relief to that part of the industry.

Therefore, the debt market and the stock market have far more conservative outlooks going forward to compensate for some very bad experiences that lasted for years. That is good news for investors because the forward expectations are definitely muted as shown by the low valuations compared to cash flow and current earnings. An asymmetric return is still a darn good possibility.

The rather negative industry outlook is keeping speculative money away from the industry. So, all the projects that were "sure to lose money" are not contributing to an ultra-fast production increase that was the case in the past. Instead, well-heeled companies like Exxon Mobil ( XOM ) and EOG ( EOG ) are the ones growing production while many others like Baytex are getting the balance sheet ready for the next inevitable downturn.

Such conditions are a prescription for long-term growth. That means a recovery along the lines of many historical recoveries rather than the aborted 2018 recovery followed by a very punishing 2020. It is going to take a long-time for Mr. Market to realize that things have returned to normal. Since stocks normally climb a wall of worry, this appears to be a good time to invest in oil and gas.

Technology Effect

Clearwater is a probably a major play that is coming online due to the continuous forward momentum of technology. There are people that are watching well results and are alarmed that well results in established plays are declining. But that has been the case for the industry since before I was born, and it will likely happen long after I am gone.

A simple example would be that Tier one acreage was a vertical well about 3,000 feet deep that flowed 200 BOD and did not unexpectedly dry up prematurely. No one ever thought that a 10,000-foot vertical well would be profitable. Yet as the vertical well results declined and tier one acreage dried up, along came horizontal drilling which opened up more tier one acreage. Then along came the unconventional explosion that resulted in really a whole new industry.

I do not know what the future holds. But I have a lot of faith that technology will continue forward to open up more tier one acreage as the Clearwater play demonstrates. Before this it was the Scoop and Stack plays in Oklahoma. Many investors are ready to predict the end of oil and gas because a belief in what will happen that is not tangible is something that is not practical for big chunks of the market.

It is possible that technology will not move forward starting tomorrow. I just prefer to go with history and have faith in the future.

Clearwater Profit Effect

Clearwater will be breakeven at a good $10 below many other heavy oil projects. This is a fascinating development because if WTI is for example $35 then heavy oil is often around say $25. So, to breakeven with heavy oil when WTI is at $35 is quite an accomplishment.

The company is experimenting with extended reach (meaning longer horizontal wells) wells that appear to be lowering the breakeven point even more. It will of course take some history to establish that enough to formally present and "stand by" something like that. But preliminarily the wells drilled appear to have darn good results.

For shareholders, this means that the company will likely pocket C$10 for every barrel of Clearwater production that replaces legacy heavy oil production. Notice that these returns far exceed the usual heavy oil on the company's legacy acreage.

But what is not clear is the proper debt levels to enlarge heavy oil production overall in the company production product mix. Just replacing heavy oil from legacy acreage with Clearwater production is going to grow cash flow far in excess of any production growth.

This is where the Ranger Oil ( ROCC ) acquisition comes in handy. If management decides to grow that Clearwater production to grow overall production. Then there is a question of how to ready the company for the next downturn when heavy oil pricing tends to be weaker than average historical relationships. The major question is will the lower breakeven point offset the weaker pricing to provide the company with sufficient cash flow to service the chosen debt levels.

The Ranger Oil acquisition assures a far stronger cash flow of light oil which is a premium product. Then during times of weak pricing, there is more than likely going to be sufficient cash flow if the heavy oil discount widens enough for management to consider a shut-in of production.

Right now, clearly the money will roll in and it's going to be coming in in large numbers. Management reported t hat Clearwater production exceeded 10,000 BOD. All indications are that Clearwater will be the major beneficiary of heavy oil capital dollars as long as risking the company during the next downturn is not an issue. In the meantime, the lower heavy oil cost is now at the point to materially change the company profitability going forward. How fast that happens depends upon the risk aversion of management combined with the current robust pricing environment (forward outlook).

Moving Forward

This management has found a major profit improvement play. There seems to be one of these every few years these days. Now that management has this, the market has yet to anticipate the improved profitability that results from this.

Mr. Market is still concentrating on debt and past downturn performances that were downright scary for all but the most "risk-on" investors. The lower debt level and the management goal of still lower debt levels have changed that consideration. However, Mr. Market likely wants proof. That proof is very much at hand. All that is needed is higher production levels to demonstrate to the market that the increased profitability is real.

This is just the kind of situation that makes it safer than usual for investors. There is every reason to believe that the future is going to be far more profitable than the past. All investors need to do is wait for the market to realize that.

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