2023-07-03 11:35:38 ET
Summary
- This heavy oil producer posted a decent profit at a time when the heavy oil discount expanded.
- Heavy oil profits are much more volatile than light oil profits.
- The company has no long-term debt and a relatively large working capital balance.
- Rapid growth in the future is more likely as long as heavy oil prices cooperate.
- The pace of discoveries indicates more avenues for growth in the future as well.
(This company is a Canadian company that reports using Canadian dollars unless otherwise noted.)
Headwater Exploration ( CDDRF ) faced the same headwinds as many in the industry. Yet the company managed to report a profit despite being a heavy oil producer where the discount widened enough to turn the heavy oil business into a marginal proposal at best for some.
Heavy oil is an enticing business when heavy oil prices are relatively strong. They honestly were not that bad in the latest quarter. But the industry had acquisitions based upon a fixed discount. But that discount is never fixed. The discount can be smaller than expected during the "good times" while widening to unacceptable levels during cyclical downturns.
Because the discount can widen during times of pricing weakness, the breakeven price (which is usually given as a WTI price) can be somewhat suspect as the discount assumption baked into that breakeven price may not hold. A wider discount means that the WTI price needed for heavy oil production to break even would then rise.
Headwater operates in one of the most profitable heavy oil basins in the business. But that discount necessitates a very conservative balance sheet. Some conservative balance sheets got a rude awaking in the latest quarter. Hopefully that gives managements time to arrange things so that the company will get through the next industry cyclical downturn in decent shape so that the companies can take advantage of the next cyclical recovery.
Production grew during this quarter of sagging sales prices by one of the faster percentages of all the companies I follow. This was likely made possible by the working capital shown above in excess of C$70 million.
Many companies I follow then follow up by reporting net debt. But this company has no long-term debt. Since there is no debt to service, the company has a competitive advantage in a very low margin industry. This management appears set to make sure that advantage remains given the sizable working capital balance.
Even though capital expenditures were lower than a year ago, the expenditures since the previous year were enough to decrease working capital. That may prove to be a seasonal comparison as not much work gets done during the Spring Breakup in Canada. That seasonal slowdown often gives Canadian managements a second chance to review the second half of the fiscal year schedule. As a result, there could be a revision to the plans if the oil pricing weakness continues.
Adjusted funds flows were down in the latest comparison. However, the rapid growth of production could eventually offset the effects of lower prices in later cycles. The key idea would be to maintain an acceptable margin under a wide variety of industry conditions so that drilling and completion activities can continue.
There have been times in the near past when prices were so low that the industry stopped drilling and even shut-in production to staunch negative cash flow situations. Those companies that hedged may have been able to just stop producing entirely while living off the hedges.
Even though the weak pricing conditions were not that bad, they can still serve as a warning for the inevitable cyclical downturns that this industry goes through.
The pricing volatility that this management discussed in the earnings press release shows itself in the form of very conservative forward growth projections.
In the past, management has revised each year as the company gets to the end of the fiscal year. At that point, management has a better view into at least the first six months. That is very helpful because the capital budget is heavily weighted towards the first and fourth quarters. Therefore, management can often plan at least the first half of the fiscal year capital expenditures reliably. Some managements may also hedge at that point if they feel the need to protect some cash flow.
But what is really the key is the growth of areas where discoveries have been made. As long as commodity prices are reasonable, this management can grow the company rapidly because the wells drilled are very profitable. The lack of dry holes so far (or relative lack as there has been an occasional one) points to continued expansion of production possibilities in the basin for the time being.
This area has stacked intervals as do many basins. So, there could also be growth by the production of intervals not now considered either a priority or particularly commercial. But management has clearly forecast a very conservative future growth scenario "just in case".
Now one of the potential activity expansion plans involves the testing of a new well design. Should this prove productive, it could lower breakeven costs even more to make more zones and leasing areas profitable.
Cash flow already grows at a decent pace because the well payback is in months rather than years for much of this basin. But as all the white space shows in the slide above, there are still a lot of potential areas that can be leased. Therefore, many of the companies shown on the slide will likely be reporting production growth for some time to come.
Canada generally has an additional cost advantage in that leasing costs are often far cheaper than in the United States. Therefore, profitable well results often show up as higher corporate profitability.
Summary
At a time when the heavy oil business became less profitable throughout the industry to the point where it became unprofitable for some, this company managed to report a decent heavy oil profit. Management also announced plans to follow through with the original capital budget.
The rapid growth of this company combined with the unusual profitability of the basin will likely allow for continued rapid growth despite management's guidance of far more conservative growth in the future.
Investors should expect the company to remain debt free as the heavy oil business is the most volatile of the upstream business. Therefore, a "fortress" balance sheet is probably the "way to go".
For me, this company is a strong buy consideration. Management has a fair amount of experience building and selling companies. The very strong balance sheet with no long-term debt reduces the risk of long-term loss of principal. It is actually a darn good way to operate in this very volatile industry with low visibility. There are far larger companies with much more financial and operational risk.
For further details see:
Headwater Exploration: Growth Continues