TNEYF - Tamarack Valley Energy: The Double-Edged Clearwater Play

2023-06-27 15:16:58 ET

Summary

• The Tamarack Valley Energy Ltd. heavy oil business adds volatility to profit swings.
• The light oil business is needed to assure decent cash flow for debt servicing during times of pricing weakness.
• Management is experienced enough to handle the rapid growth by acquisitions.
• A usually unforeseen risk by investors is what obligations come along with purchases.
• The heavy oil discount widened considerably in the first quarter.

(Note: This article was in the newsletter on May 28, 2023.)

Tamarack Valley Energy Ltd. ( TNEYF ) had a big cash flow drop when the discount for heavy oil widened in the first quarter. This Canadian company that reports using Canadian dollars (unless otherwise indicated), was a company that has grown by acquisitions. Investors need to remember that when any company purchases production, they often purchase things like transportation obligations that go with the production.

So, if for some reason, the transportation is to less than an ideal selling situation, the buyer is kind of stuck with the arrangement for a while. Most buyers figure out how to rectify the situation. But for a company like Tamarack where much of everything has come through purchases, this can take a while.

There is every possibility that any less-than-ideal things are part of the purchase price agreement. However, investors still have to wait out the optimization process. For anything midstream, it could be process that takes a few years because midstream contracts are long term. So, it may take a while for large volumes to go to the best markets.

Similarly, a purchase that is advertised could also have less-than-ideal hedging attached to it. However, hedging type issues often resolve themselves rather quickly (at least compared to midstream challenges).

Still, some of this points out the risks of growing through acquisitions when compared to organic growth. Investors never know when a current action results in news a quarter (or even a year or two) away from the present time. Sometimes, things thought to be a small chance occurrences "rear their ugly heads" to the disdain of Mr. Market. Given time, managements do fix a lot of these type things.

But the current weakness in oil prices did not give this management time to do anything about a widening discount (if there was even anything to be done about it). This management has some light oil production as well to assure some cash flow when that discount widens. Probably the obvious answer is to build the light oil production along with the Clearwater production so there is some cash flow protection should the heavy oil production need to be shut-in. However, that is not likely to be an optimal solution (for a year or two) as the heavy oil production is currently far greater than the light oil production. Clearly management has some work to do even though the location of much of the production is fantastic.

First Quarter

Investors can see the cash flow drying up from the weak oil prices in general and the widening of the heavy oil discount.

One of the things that is very difficult (or impossible) to hedge is that expansion of the heavy oil discount. Notice that for the price received, the difference between the heavy oil price and the light oil price is now roughly $33 per barrel. Whereas in the previous year that difference was closer to $16.

This is exactly the price action that makes heavy oil cash flow and profits far more volatile than light oil during the business cycle. The Clearwater Play supposedly has some of the best breakeven prices in the industry. But that advantage can easily be reversed when that discount decimates the heavy oil selling price much more so than is the case with light oil.

That effect was magnified by the tremendous increase in heavy oil production. Therefore, investors should expect that the percentage of light oil production will increase in the future to make sure the company has the cash flow it needs during the part of the business cycle with weak commodity prices.

The Clearwater heavy oil play is clearly very profitable. But the profits get made "all at one time." Hence the need for some cash flow planning throughout the business cycle.

What is likely to happen with the return of capital program for shareholders is a commitment to lower the debt load fast while management can combined with a very conservative definition of cash flow to return to shareholders.

The company needs a very conservative debt load in case the heavy oil provides little to no cash flow when the discount widens. In that situation the light oil production would need to properly service the debt load.

Management is also talking about improvements that make the heavy oil business more profitable through various advances in the business. However, even then, that widening discount is still a profitability and company viability threat. The more that management wants to expand heavy oil production, then the less debt the company can carry because of the heavy oil profitability volatility.

Summary

Here is the overall plan at the end of the first quarter:

Investors need to decide early if they can handle the risk of more than half of the production being heavy oil with the debt load shown above.

Rapid growth all by itself from a "shopping spree" carries its own risks. Here, those risks include a big chunk of heavy oil production (and all the corresponding arrangements and obligations that came with those purchases).

Now this management is very experienced at building and selling companies. In addition, some of the backing entities have considerable experience in this area. That alone can reduce some of the risks discussed. It also means that this is not going to be anything approaching an income vehicle. So, income investors can look elsewhere.

But it also means that common shareholders are likely in for a very "volatile" ride. Whenever I consider purchasing shares in a company where management has considerable experience building and selling companies, I often do not sell until management considers selling the company. Management often knows better than any outsiders what the company is worth. Therefore, I usually wait for management.

There are no guarantees, as management could make a mistake when it sells the company. But generally, they do a far better job than I ever could from this vantage point.

Liquids prices, and that includes heavy oil prices, are widely expected to firm-up as the fiscal year proceeds. That should mean a resumption of the cash flow.

Based upon the above discussion, these common shares are a speculative (maybe very speculative) strong buy consideration for those willing to endure the risks of a very volatile heavy oil business. This is going to be a stock with a lot of big swings. Therefore, those that cannot withstand 50% stock price changes "because it is Tuesday" need not apply. Of course, the market will be happy to provide a hindsight reason. But for those will a strong stomach, this stock could provide an exciting return.

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