XOM - Headwater Exploration: Succession Takes Center Stage

2023-12-19 14:41:45 ET

Summary

• At Headwater Exploration Inc., Neil Roszell transitions to Executive Chairman and Jason Jaskela becomes new CEO of Headwater Exploration.
• The company is acquiring acreage beyond the Clearwater Play.
• Headwater Exploration remains debt-free with a strong cash balance, allowing for organic growth, fast dividend growth, and fast cash flow growth.
• Management experience in building and selling companies reduces the usual small company risk.
• The fast well payback period is practically unheard of in this industry.

Headwater Exploration Inc. ( OTCPK:CDDRF ) has announced that Neil Roszell, the CEO and Chairman, will now move into the Chairman's position to become Executive Chairman. Jason Jaskela will become the new CEO. Another progression since the last article is the move to acquire acreage beyond the Clearwater Play. Management has done a lot more, as discussed below, since that article as well. The company is now well past the development stage, with enough production that cost and operational optimization is likely achieved.

One of the things minimizing both the succession process as well as moving beyond the Clearwater Play is the experience of management. This management sold Raging River to Baytex Energy Corp. ( BTE ) some years back. That is how Baytex Energy acquired the Viking light oil play.

Finances

This company remains debt free with a pretty good cash balance for the size of the company. The cash balance has been declining. However, it is still a lot of money for a company of this size. In fact, it could decline more and still be a lot of money for a company of this size.

Money goes a lot further in Canada because leases can be acquired for a lot less money than is the case in the United States. Therefore, the costs to incrementally grow organically are advantageous because they begin with a very low lease acquisition cost.

Well Payback

The company's production currently comes from Clearwater Play in Canada. That means this is a Canadian company that reports using Canadian dollars.

Oftentimes, it is not clear exactly how management calculates well profitability. Here, management gives far more information than is typical in most presentations.

(Note: This presentation is now gone from the company website and replaced with the December Presentation).

This company side-steps the conventional IRR discussion with a little graph above showing average payback results. Investors can then use their own assumptions about profitability. Most would agree these wells are extremely profitable using any reasonable calculation because a well that pays back twice in one year while beginning the third payback is one very profitable well. This company has a bunch of those types of wells. That means the company can drill two more wells with the same capital used on the first well in a twelve-month period. Such a fast payback allows for very fast cash flow growth.

Once the first payback is achieved, many managements would not hedge production because the well is that profitable. However, should protecting cash flow become a consideration, then hedging may become a viable strategy for this management even if the balance sheet is debt-free. The payback period is so short as shown above that hedging the cash flow for reasonable profitability is easy.

Other Areas

Management is expanding operations to other areas of the Clearwater Play. It needs to be noted that other areas can be as profitable or less profitable than Marten Hills which has enough history for the graph previously shown.

For the time being, management will, of course, allocate resources to the most profitable areas. But that would not stop them from drilling on acreage which is less profitable but still meets company criteria to develop as this area develops further.

Management reported on the latest exploration wells. This particular play is still reporting a lot of success and not too many dry holes. Some areas need a different well design. But the major consideration is that this play has yet to find the basin limits.

The slide above shows what happened when management tested new intervals in an area with known production. That effectively raises growth possibilities in future years as more cheap production is discovered.

Probably the big news with this discovery is a new well design for the basin that lowered costs and likely added more commercial acreage to develop. Investors can note this as another technology advancement that will likely spread to other basins where it can be used.

In addition to exploration wells extending the known basin limits, there is now a new well design to aid the process. The only thing that may slow the growth of this company is the price of oil.

Risks

The principal risk of the heavy oil business is that the discount to light oil expands during times of pricing weakness to the point that production has to be shut in to reduce negative cash flows. This company is 100% heavy oil (for all intents and purposes). Therefore, the whole business is exposed to that possibility, as there is not yet any light oil production or condensate production.

Other possibilities are reduced by the conservative balance sheet with no debt and a sizable cash balance. This kind of financial management allows the company as many chances as it needs to succeed if that ever becomes an issue.

Similarly, a company with no debt can simply stop drilling during times of commodity price weakness and either live off the hedging (and) or simply cash checks as production is sold until there is a pricing recovery that is sufficiently underway.

The management experience of building and selling companies minimizes the risk that rapid growth often poses because management is used to managing rapid growth and larger companies. The superior profitability of these wells also demonstrates some superior management ability.

Small companies always have the risk of loss of key personnel. Here, that risk is somewhat reduced because this group has been working together for a long time. There is therefore a good possibility that the loss of one person can easily be taken care of.

Good News And Bad News

Sometimes investors do not realize that there can still be bad news associated with finding oil. This next slide gives a glimpse into such a situation. This situation was reported last month and is a risk of finding oil that many investors may not consider or know about.

With this area, the good news is that the largely successful exploration wells continue. The bad news is that one well had heavier oil than expected and the flow rate was less than satisfactory. While this is minor, it points out that there are still risks to exploration even in this day and age. Management has to decide if this type of oil can be produced commercially or if a certain amount of leases needs to be abandoned for the time being.

In more extreme cases, Exxon Mobil Corporation ( XOM ), for example, has plugged and abandoned any heavy oil wells with sulfur content (in offshore Guyana) because the cost of producing that oil is too high for an effectively discounted product. Now, that could change in the future. But with plenty of light oil discoveries potentially available, Exxon Mobil is in no hurry to work with the heavy oil discoveries.

Key Ideas

This company is extremely profitable in the current environment with little of the small company risk that usually goes with small companies and startup companies.

The company has a cost advantage over United States competitors in that often new leases are available at very low costs (usually from the government but also from indigenous sources as well).

The profitability of the wells has allowed for fast growth. Many in the industry see decent commodity prices for the foreseeable future. The lack of industry-wide (in North America) production growth has allowed for that bullish forecast. However, should production supply far exceed demand to bring about a cyclical downturn, heavy oil is a discounted product with a very volatile profit variation because oftentimes the discount to light oil widens during cyclical downturns. That can make earnings by a company like this less valuable.

This company is moving the heavy oil production to secondary production very fast. In Canada, the relatively shallow oil deposits make secondary recovery fairly cheap.

This is a rare company that pays a generous dividend of C$.10 per share per quarter while growing fast. Management has in fact, guided to 10% growth in the coming fiscal year. It has to do with the payback of wells shown earlier in the article that allow the company to cater to market demands for the return of capital while reinvesting capital to grow production quickly. Very few areas of North America are as profitable as this heavy oil play.

The Future

Investors should continue to expect fast growth for the foreseeable future. Most budgets and guidance reflect flexibility to change with commodity selling price outlook. For the time being, expect this budget to hold unless there is a material change.

Investors should also expect dividend growth with the production growth. This is a rare company that can grow organically at a decent pace while paying a generous dividend as well.

Eventually, this company will likely be sold as was the case with previous companies this management developed. But this is clearly not the right time in the cycle for that to happen. Besides, management likely wants to build more value first.

When a company like this gets sold and there are decent numbers of other insiders selling their companies, then it is time to consider reducing the oil and gas positions to core amounts. Right now, that is clearly not the case. Instead, it would appear that insiders expect more good times ahead.

Headwater Exploration Inc. stock is a strong buy based on the above-average profitability and a seamless management succession plan. Upstream is very volatile, therefore conservative investors may want to look elsewhere. However, a basket of upstream companies like this one should perform well for some time to come.

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