VET - Vermilion: Fueling The Digital Era

2023-06-16 09:54:57 ET

Summary

• Vermilion Energy Inc. offers an investment opportunity at a valuation of approximately 3x forward free cash flow.
• Natural gas plays a vital role in the 3Ds: Deglobalization, Decarbonization, and Digitalization trends.
• Energy security and the need for electricity intensify in an unstable geopolitical environment and digitalized world.
• Vermilion, despite reserve challenges, could benefit from favorable natural gas prices, potentially generating significant free cash flow.

Investment Thesis

Vermilion Energy Inc. (VET) is priced at about 3x forward free cash flow ("FCF") - if we assume that in 2024, Europe's natural gas reaches around EUR55 MWH. This is a critical assumption.

What follows is an assessment of natural gas as key to a revolution that I call the 3Ds. And how Vermilion could participate in this trend.

Why Invest in Natural Gas?

There are 3 critical trends unfolding in the world. I call these the 3Ds.

• Deglobalization
• Decarbonization
• Digitalization.

I expound upon these at length to Deep Value Returns members. Here's the critical summary as it pertains to Vermilion.

In an unstable geopolitical backdrop, energy security is not an aspiration. It's the political responsibility of governments to ensure that their citizens get access to cheap and reliable energy.

Next, when it comes to ChatGPT there are a lot of assumptions around. Some assumptions point to as much as 175K homes worth of energy in one month, to run ChatGPT for a month. While another example states that each query of ChatGPT uses substantial amounts of power.

Why do I bring this up? To explain that we need a lot of electricity.

In the coming few years, we will see a massive ramp-up in digitalization. From charging our electric vehicles, or EVs, with electricity to smart devices in our house (for example, my fridge telling me that I haven't consumed enough green vegetables today), to running AI to enhance productivity.

All the while, we are actively attempting to reduce our dependency on coal. Natural gas has about 40% less carbon than coal. Hence, making natural gas is considered to be a bridge fuel as we strive towards net zero by 2050. But I'm not sure that's grounded in reality. While I'm not a climate activist, some things are just common sense, I want a better world.

But sadly, natural gas is much more than a bridge fuel. It's one of the critical components of our energy transition. Natural gas and nuclear power are the two base load energy that can allow us to embrace intermittent renewable energy sources.

The Critical Use of Natural Gas

A lot of people believe that natural gas is only used in winter. But this is false. Natural gas is used to make electricity. Yes, heating, but cooling, too.

Here's a quote from EIA ,

The world faces a looming 'cold crunch.'' Using air conditioners and electric fans to stay cool accounts for nearly 20% of the total electricity used in buildings around the world today

Natural gas is widely used for electricity generation. And the more the world digitizes, the more natural gas (plus nuclear and all other energy sources) we need. The energy transition that's underway is slow.

The biggest use of petroleum can't be replaced with renewable energy. That's a fact. You can't fly/ freight around the world people/ merchandise while carrying a windmill on the plane/ship.

Meanwhile, for all the noise and capital investment that renewable energy gets, we are talking about 12%. For that to get to double, we are going to require a massive amount of investment.

Consider this, more than 50% of the renewable energy the U.S. gets, is from hydropower and biomass (burning wood).

Why Vermilion?

I've followed Vermilion for a long time. And I believe that this management team may not be some of the best operators in the world, and the assets Vermilion holds may not be the best either, see below.

The 1P assets have around 8 years of reserve left. Anything less than 10 poses a problem.

That being said, as I write these words, the price of EU's natural gas is around EUR35 MHW. With that in mind, consider this:

If we assume that next year prices for TTF average around EUR55 MHW, this would see about CAD$1.4 billion of funds from operations.

Subtract away CAD$600 million for capex, and Vermilion could see around $800 million of free cash flow in 2024.

This would put Vermilion around 3x next year's free cash flow.

Now, this is the critical assumption. The price of natural gas in 2024 is unknown. I previously believed that natural gas prices in 2023 would be higher than they are right now. And although the price of TTF is jumping higher in the past few days, we are still far from around the EUR50 MWH that we saw in 2021 (pre-Russian invasion).

The Bottom Line

Vermilion is priced at 3x free cash flow, assuming Europe's natural gas reaches around EUR55 MWh in 2024.

This assessment explores the significance of natural gas in the context of the three unfolding trends known as the 3Ds: Deglobalization, Decarbonization, and Digitalization.

Energy security becomes a political responsibility in an unstable geopolitical backdrop, and the need for electricity intensifies as digitalization expands.

Natural gas plays a crucial role in our energy transition, serving as a bridge fuel with lower carbon emissions and complementing intermittent renewable sources.

Vermilion, although facing challenges such as depleting reserves, can benefit from favorable natural gas prices.

However, it's essential to acknowledge the uncertain nature of natural gas prices in the future, necessitating careful consideration of Vermilion Energy Inc. prospects.

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