2023-09-19 15:17:55 ET
Summary
- Headwater Exploration is a Canadian heavy oil producer that has grown production significantly in recent years.
- The costs are very competitive for the company.
- The free cash flow will increase going forward due to a higher production and a lower reinvestment rate.
Investment Thesis
Headwater Exploration ( HWX:CA ) is a Canadian heavy oil producer, which has grown its production very aggressively over the last few years, in absolute terms, but more importantly, on a per share basis.
Figure 1 - Source: Headwater Quarterly Reports
Figure 2 - Source: Data from Headwater Q2-23 MDA
As the second chart above illustrates, Headwater is a liquids rich producer, with the vast majority of production and revenues coming from heavy oil and there is only a very small amount of exposure to natural gas.
This exposure was very beneficial during the first half of 2023, when the discount between Western Canadian Select ("WCS") and WTI was decreasing, and natural gas prices were particularly weak. So, Headwater outperformed most peers by a decent margin then. More recently, with natural gas prices rebounding somewhat and the WCS discount increasing again, Headwater has underperformed slightly. In 2023, the stock price performance has still been relatively good.
Figure 3 - Source: Koyfin
For anyone interested in a quality growth company, with most of its revenues coming from heavy oil, Headwater is an interesting company.
Financials & Costs
Headwater is a debt free oil producer with positive working capital, which makes it relatively unique among its Canadian peers. While many Canadian oil producers have deleveraged over the last couple of years, most still rely on credit lines and have negative working capital. Being debt free has its advantages and disadvantages, how those are valued depends on your preferences.
With the lack of debt and low cost of operation, Headwater might not have the highest leverage in a rising oil price environment, even if the impressive growth rate does partly offset the lower leverage otherwise.
However, being debt free will make Headwater much more robust in a downturn, which is a feature I value greatly. Also, rather than paying interest expenses, the company receives interest income on its cash position, which benefits margins. Another positive aspect of not having debt is that a larger portion of free cash flow can eventually be distributed to shareholders, rather than having to focus on debt repayments, even if much of Headwater's 2023 funds flow is being reinvested for growth as illustrated in the table below. The reinvestment rate is however expected to drop substantially in the coming years.
Figure 4 - Source: Headwater September 2023 Corporate Presentation
In the charts below, I have compared Headwater's Q2-23 costs and revenues to a couple of Canadian low-cost producers. Where we can see that the company had an excellent sales price in Q2-23, which is due to having a higher percentage of production coming from liquids. However, we can also see that costs have been very competitive, especially when we consider Headwater's smaller size. The excellent sales price and competitive costs, are why the company had a superior netback in the most recent quarter.
Figure 5 - Source: Quarterly Reports
Figure 6 - Source: Quarterly Reports
We can see in the following chart that Q2-23 was not an anomaly, as Headwater has over the last few years had very healthy netback and fund flows in Canadian Dollars per barrels of oil equivalent.
Figure 7 - Source: Headwater Quarterly Reports
Valuation & Conclusion
Headwater is a company which has had an impressive growth rate over the last few years. The company has also guided for a more modest growth rate in 2024 and 2025, along with a lower reinvestment rate.
Figure 8 - Source: Headwater Quarterly Reports
The free cash flow projections are relatively low in 2023, but the company did recently start to pay a quarterly dividend, which comes to a yield of 5.5% using the latest share price. With the benefit of higher production going forward, a lower reinvestment rate, and the higher energy prices we are currently seeing. The future looks rather bright for Headwater, where the free cash flow yield is estimated to be around 15-20% for 2024-2025.
The price of WTI will naturally have an impact, but also the discount on WCS. Most expect the discount to decrease once the Trans Mountain Pipeline is operational, which is expected to come online in early 2024. However, there is at least the risk of a delay due to a slight route change, which is facing opposition . I am not overly concerned about the pipeline being halted at this stage, it is more a question of a possible delay, with the potential to impact Headwater’s margins going forward.
Figure 9 - Source: Picture from IEEFA
Headwater might not be the cheapest company in the industry, nor have the highest shareholder distributions in the near-term, due to its focus on growth. However, it is an impressive oil producer which ticks most quality boxes I look for, and it is trading at a good price. So, I am long the stock. I would also not rule out the 2024-2025 production estimates being somewhat conservative, as we have seen the company under-promise and overdeliver in the past.
For further details see:
Headwater Exploration: A Low-Cost Heavy Oil Producer With A Track Record Of Growth