CA - Gear Energy's Already Reduced Dividend Is Not Covered At $70 Oil

2023-12-08 10:30:00 ET

Summary

• Gear Energy's Q3 results were strong, with higher oil and gas prices contributing to an increase in the average realized price.
• The company reported a net income of C$8.15M, exceeding the net profit of the entire first semester.
• Gear Energy plans to invest C$57M in drilling and other capital projects in 2024, but a higher oil price is needed to cover the dividend.

Introduction

Although I currently have no position in Gear Energy ( GXE:CA ) ( GENGF ), I'm keeping an eye on the company as I consider it to be a pretty good trading vehicle and I wouldn’t mind re-establishing a long position to speculate on a higher oil price (or a lower WCS price differential).

The Q3 results were good, but oil and gas prices were higher

During the third quarter, Gear Energy produced approximately 5,500 barrels of oil-equivalent per day of which almost half was heavy oil which trades at a discount to light oil. During the summer, the price differential between heavy oil and light oil shrank and that was a very important element for Gear, which saw its average realized price increase to almost C$82 per barrel of oil-equivalent.

And that was the main driver for the strong netback result, as you can see above. The operating netback of C$45/boe was almost as high as in the third quarter of last year, and substantially higher than the results it was able to record in the first half of the year.

And that obviously had a positive impact on the company’s financial results. The total revenue came in at C$36.5M and after taking the net unrealized loss of C$0.8M on the hedge book into consideration, the net revenue was C$35.6M.

After deducting the C$27.5M in operating expenses, the company reported net income of C$8.15M for an EPS of C$0.03 per share. Which means the company’s net income in Q3 exceeded the net profit of the entire first semester.

As I generally like to have a look at the cash flow statement of an oil and gas producer, it was interesting to see Gear’s operating cash flow came in at C$17.5M. This does include C$1.2M in working capital investments, and it includes a relatively high amount of decommissioning liabilities compared to the previous few quarters.

Excluding the impact from the settlement of those decommissioning liabilities, the adjusted operating cash flow was C$18.8M and the free cash flow was approximately C$6.6M after deducting the capex and cash expenses related to the disposition of an asset.

At the end of the third quarter, Gear Energy had a total net debt position of approximately C$21M, as the company’s dividend policy has been too generous compared to its actual cash flow results. As you can see in the cash flow statement above, the adjusted operating cash flow in the first nine months of the year was C$47.5M, and after deducting the C$37.5M in capex, there was approximately C$10M available for dividends, but Gear paid about C$21M in cash dividends. The dividend has now been reduced to C$0.005 per share per month, resulting in a total annualized dividend of C$0.06 which means the full-year dividend requirement will be just C$16M and I believe this is a more prudent approach, not in the least because the oil price has been trending down in the current quarter.

An initial look at the 2024 guidance

Given there are very few uncertainties around the full-year 2023 results (other than the recent decrease in the oil and gas price, of course), I was looking forward to seeing the company’s guidance for 2024.

Gear Energy is proposing a C$57M capex budget which should be sufficient to realize a 3%-4% production growth, while the current monthly dividend of C$0.005 per share could and should be maintained.

Of the C$57M, C$40M will be used to drill 22 wells including 13 wells in the Lloydminster area. Three wells will be targeting medium oil, while an additional three wells will target light oil. The final three wells also will be focusing on heavy oil at Cold Lake. So of the 22 wells, 16 will be targeting heavy oil. The company also plans to spend C$5.3M on water flood expansions, while C$6.3M will be used to continue to reduce the liabilities associated with abandonment and reclamations. The final tranche of C$5M will be invested in land, seismic and other capital projects.

Unfortunately, the company will need a higher oil price to continue to cover the dividend. As the sensitivity analysis below shows, at US$70 WTI (and a WCS differential of US$17/barrel), the FFO will be just C$63M resulting in a free cash flow result of just C$6M or less than C$0.03 per share.

The table also shows the torque provided by Gear. If the differential comes in slightly lower or if the oil price comes in slightly higher, the FFO will increase by quite a bit. At US$75 WTI, for instance, the free cash flow will increase to approximately C$0.07 per share.

Investment thesis

I'm per definition not a fan of companies that voluntarily borrow cash to cover a dividend, but I think Gear Energy has made the right decision to slash its dividend. At the current rate of C$0.005 per share per month, the dividend yield still exceeds 9% - but investors are warned that at the current oil price, that dividend likely won’t be covered.

I currently have no position in Gear Energy. But as the company’s cash flows will be pretty volatile based on the oil price, I think Gear Energy is an excellent vehicle for investors believing in an oil price of at least US$75 and/or a lower price differential for heavy oil.

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