MRO - Baytex Energy: Risk Mitigation

2023-05-08 16:12:08 ET

Summary

• The new Baytex Energy Corp. CEO has worked with several key Ranger Oil personnel. This will reduce the merger risk of failure.
• Baytex is likely to do more mergers in the future under the new CEO.
• Heavy oil is more profitable during times of robust pricing and less profitable (if its cash flows at all) during cyclical industry downturns.
• The merger continues the Baytex Energy Corp. tendency to increase the percentage of light oil production.
• A conservative balance sheet is necessary because heavy oil is less profitable during an industry downturn.

(Note: This is a Canadian company that reports in Canadian Dollars unless otherwise noted.)

The new CEO at Baytex Energy Corp. ( BTE ) mentioned that he has worked with several staff members of Ranger Oil Corporation ( ROCC ). That statement helps to reduce the risk of combining staff after the merger of the two companies. He also mentioned that in the past he has built companies through acquisitions. That is also valuable experience that will reduce the risk of such a strategy in the future.

Companies can grow and later merge or can be sold for a profit in a number of ways. Tamarack Valley Energy Ltd. ( TNEYF ) would be a good example of a company growing by acquisition. Headwater Exploration Inc. ( CDDRF ), on the other hand, is growing organically. Each way of doing things has its own risks and rewards.

Baytex Energy began as a heavy oil producer and was largely a heavy oil producer when I first began to cover the company here at Seeking Alpha. That has changed over the years as light oil has become a greater part of the production mix. The merger with Ranger Oil continues that trend.

Heavy oil is a discounted product from the more desirable light oil production. It is often more profitable in the current commodity price environment, where prices are at robust levels. But during a time of weak commodity prices, the discount to heavy oil prices often expands to the point where heavy oil has no cash flow if produced. Therefore, the company will often shut-in this production to prevent negative cash flow when heavy oil is produced.

That means that the company would then rely on light oil production during a time of weak commodity prices for the cash flow that it needs. This kind of makes heavy oil production a sort of lottery ticket that wins during times of robust commodity prices, but has no value during cyclical downturns.

This means that companies like Baytex Energy need to prepare for the inevitable cyclical downturn ahead of time. That appears to be what the company is doing at the current time. Management has during the latest "road show" put a limit on the Clearwater heavy oil production. But that could change with the addition of more light oil production from the merger.

In the current business environment , Baytex really does not have a more profitable play than the Clearwater leases. It is extremely hard to match the returns shown above anywhere in North America. This play has a further advantage in that the leasing cost is dirt cheap compared to more famous plays like the Permian.

This particular part of the heavy oil play is temporarily limited to the long-term production goal shown above. But that can change as management explores other intervals for possible development and also determines the possibilities of nearby leases that the company also holds.

The advances made that enable Clearwater to be so profitable could well extend to other intervals and other lease-holdings in the area shown above eventually. Right now, Clearwater is clearly the most profitable play in the company portfolio. But as technology advances, that advantage could easily shift to one of the other areas shown above or even a completely different area.

How management balances the long-term debt with the earnings volatility that typically accompanies heavy oil production is an unfolding story. But it is one that bears close monitoring.

Clearwater has an unusually low breakeven for heavy oil. So that opens the possibility that Clearwater wells could cash flow in an industry downturn. That would be welcome news to all the heavy oil producers that suffered terribly when cash flow dried up numerous times between 2015 and 2020. Whether management should "bet the company" on such an outcome is another matter.

Ranger Oil Merger

The Ranger Oil merger has profitability enhancement possibilities as well. Baytex Energy does not operate the current Eagle Ford properties. Instead, Marathon Oil Corporation ( MRO ) is the operator. Marathon is probably the best or one of the best operators in the business. As a partner to Marathon, Baytex Energy has access to a log of good information that will likely improve the Ranger Oil operation once the merger completes.

As shown above , the Eagle Ford breaks even low enough to lower the corporate breakeven using current operations. This is pretty good. But Marathon does better.

As shown above, the Eagle Ford leases that Baytex already have are slightly more profitable. That extra profitability points to a lower breakeven, probably somewhere in the WTI $30's area (which has been mentioned by management on and off in the past).

It is always a "gamble," but there is a good possibility that some of the techniques used by Marathon to achieve those good results can also be used by Baytex after the merger to increase the profitability of the acquired properties more. No guarantees, of course.

Key Takeaways

The Baytex Energy Corp. Eagle Ford acquisition promises to add more light oil production that will lower the corporate breakeven point. That light oil production would also enable more heavy oil production that is more profitable now, but generally is not as profitable during a cyclical downturn because the discount to light oil often widens.

Baytex Energy Corp. has a couple of ways to win from this acquisition that would benefit shareholders besides the obvious upfront accretive aspects of the merger.

More importantly, the merger appears to signal that management will return the company to a growth path after several years of debt reduction. Chances are excellent that the debt load will never again be as burdensome as it was when I first began covering the company.

The risk with the new CEO is the obvious risk that he may overpay for an acquisition or that an acquisition would otherwise fail. But the less obvious risk is that a CEO who is oriented towards acquisitions may ignore the savings that are achievable with continuing operational improvements. Therefore, this investment needs to be monitored until a track record is achieved under the new CEO.

Overall, Baytex Energy Corp. appears to be a strong buy for investors interested in capital appreciation with a dividend as a secondary (or lower) consideration. At some point, a company like this one may be sold. Operations have come a very long way from the time when I first began following the company. The current version of Baytex Energy Corp. is much improved from those days.

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