CA - Cardinal Energy: Stuck In A Holding Pattern (Rating Downgrade)

2023-12-07 07:42:14 ET

Summary

• Cardinal Energy has had a rough 2023 due to underperformance post-Q3 earnings report.
• The company announced a new venture called the Thermal Operating Group. Long term, the project is a slam dunk, but getting there will be a challenge.
• Cardinal's payout ratio is already over 100% with WTI at $70, which will go to 190%-200% with the Thermal Group spending.
• Still very undervalued, but few catalysts near term and a possibility of a dividend cut.

Hi everyone,

It's been quite a while since my last article and I'm just getting back into the rhythm of things. I thought I'd start with an update on Cardinal Energy ( CJ:CA ).

The last time I wrote about the company was in January 2022 which you can find here .

Overall, Cardinal has had a rough 2023, but that's mostly due to the recent underperformance post-Q3 earnings report.

Overall, I thought the Q3 earnings report from an operational perspective was very good. I think what has spooked the markets is the new "Thermal Operating Group" division (more on that in a bit).

Oil is back with a six handle and the mood in energy is bleak. And it's December so we're in the middle of quite a bit of tax loss selling to add to the misery.

As for oil prices, while I've been a long-time bull, it's been a tough (and disappointing year). We're at the seasonally weakest time of the year for oil which is only making things worse.

I think (or perhaps hope) we'll bounce back to $75 (for WTI) in the New Year but it's hard to predict the next 12 to 18 months. Europe is likely already in a recession. Australia and Canada probably aren't that far behind either. I still think the US will likely have a soft landing / muddle-through but China is a big question mark.

By this time next year, I think we could see oil rebound back to $80 - $85 a barrel but it's hard to get much more excited because of the amount of OPEC space capacity that's sitting on the sidelines (by some estimates it's over 3mm bbl/d).

One bright spot is the possible completion of the Trans Mountain expansion (at the point I'll believe it when I see it). Currently, the WCS spread is sitting around $21/bbl and any tightening to the spread will be very beneficial to Cardinal.

This leads me to discuss Cardinal's newest venture.

The Thermal Operating Group

As part of its Q3 results (which can be found here ), Cardinal announced that it would be undertaking a new venture which they dubbed the Thermal Operating Group.

The Thermal Operating Group is a steam-assisted gravity drainage ((SAGD)) system to extract oil that has become very common in the Canadian oil patch. Cenovus' Christina Lake is probably the best-known example.

The rationale for the development isn't very surprising either. The Canadian Federal government has decided that EOR (enhanced oil recovery) which both Cardinal Energy and Whitecap Resources ( WCP:CA ) pursue would be ineligible for CCUS (carbon capture, utilization, and storage) tax credits (among other things).

So both energy companies have negative Scope 1 & 2 emissions but aren't getting any benefits. So why not pursue other oil & gas developments that would increase their emissions to zero?

SAGD also has a very nice alignment with Cardinal's strategy of low-cost and low-decline profile which matches well with the rest of their portfolio (management forecasts a flat production profile of 20 years with minimal sustaining capital requirements).

There is a catch though, and it's a big catch. SAGD requires an enormous up-front capital. The project will take approximately two years to complete and require $155 million (with almost of it being spent before any production comes online).

The current predicament reminds me of the legendary Softbank slide.

Once the SAGD sites are up and running, Cardinal will be rolling in excess profits cash flow. But getting there in the current environment will be tricky.

To add to the problem, with WTI at $70 they can't cover their current dividend and capex.

In Q1 of this year, they realized an equivalent oil price of $69/bbl and had to take on ~$15mm of bank debt to cover the dividend. Fortunately, in Q3 their operations were excellent and the equivalent oil price was $80/bbl so they were able to reduce debts by $14.3mm. But it shows just how close they are.

Most of the banks estimate that with the SAGD project spending, Cardinal's total payout ratio will be between 190% and 200% next year and early 2025.

In fairness to management, they've done a great job paying down the debt so they have plenty of room on their credit facilities.

Management has indicated a willingness to take on debt for the project and they've identified up to $50mm in other capital spending that could deferred. But based on the share price reaction, it's evident that investors are in a "sell first, ask questions later" mood.

I think long-term the project is a slam dunk for Cardinal. However, I'm not as confident as management that they will be able to fund the project without cutting the dividend (which is costing them almost $30mm/quarter). Especially if interest rates aren't cut because they're currently paying 8.1% on their credit facility.

So if you're investing in Cardinal just for the dividend, I think that you will be disappointed. I think that cutting the dividend by half would take any funding concerns off the table and if we don't see any material improvement in oil prices in Q1 2024 it seems highly likely.

Valuation

Hopefully, the article hasn't come across as too negative though. Because I think the company is very undervalued (although the entire energy sector looks cheap after the last two months).

Using the following main assumptions:

• 20% discount rate.
• Oil prices bottoming here and slowly climbing back to $85/bbl by the end of 2024 (which might turn out to be wildly optimistic and wrong) and staying there for the next couple of years.
• The SAGD project is completed on time and within budget (lots of ifs).

I can get a target price of around C$11.50-$11.75/share which would represent roughly 100% upside from here.

But it won't be an easy ride as it will be bumpy and volatile. Even in my more optimistic forecast (at least versus current strip pricing), without a dividend cut the company will add just over $30mm in debt in H1 2024.

And if oil hangs around $70/bbl, I estimate that they'll be adding $20mm to $30mm of debt every quarter until the project is operational (depending on the WCS discount).

So for me, I'll continue to hold Cardinal as a core part of my holdings and energy investments. But I put a hold rating on the stock and won't be adding to the company until either oil prices move back to $80/bbl or the dividend is cut.

Hope you enjoyed the article and have a good holiday.

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