2023-04-03 15:39:11 ET
Summary
- Ovintiv got the shareholder return strategy right in 2022.
- Ovintiv, however, messed up in a big way on hedging for both 2022 and 2023.
- This has got the company back doing deals to reduce its gas exposure, and long suffering investors must be pulling out their hair.
- We look at the transactions announced and see if our $50 target can be achieved once more.
When we last covered Ovintiv Inc. ( OVV ) ( OVV:CA ), we made a clear bullish call. It was one of those rare stocks where we endorsed the potential of a substantial upside. Specifically we said,
One additional factor here is that 2022 capex budgets will possibly be hit for oil and gas companies as they grapple with this new tail risk. In the shorter term there may be more pressure on commodity prices as some companies rush to hedge. This is not a bad idea here as even selling calls on some amount of production can buffer downswings and currently implied volatility of oil is through the roof. OVV is well hedged for 2022, but will possibly also add some more buffers. We reiterate our $50 price target for this company and remain bullish on its prospects.
Source: 50% Upside Over Next 18 Months
The stock took an interesting trajectory and handily exceeded our target in half the timeframe.
Seeking Alpha
It has pulled back significantly and announced a big deal just this morning. We examine the fundamentals in light of these events.
The Deal
OVV's interest in buying Permian assets from P-E firm EnCap Investments for approximately $4 billion in cash and stock, including debt was reported late Sunday night . As it happens with these deals, the parties tend to occasionally end talks on the leak or more often, finalize the details. The latter happened in this case and OVV confirmed that they had signed on the dotted line .
The deal was funded in two ways. 32.6 million shares of OVV shares are to be issued and the rest of the portion will come from cash ($3.125 billion). While the cash seems excessively high relative to the market capitalization of OVV, it will be partly funded through the pending sale of the company's Bakken assets ($825 million). OVV has received fully committed bridge financing from Goldman Sachs ( GS ) Bank USA and Morgan Stanley ( MS ) for the rest of the funds.
The acquisition includes 75,000 barrels of oil equivalent, or BOE, per day of production, with about 80% coming from liquids. The undeveloped land portion is pretty large and makes up about 50,000 acres in Martin and Andrews Counties. At first glance the price paid appears reasonable at about $57,000 per BOE/Day. OVV did however issue a decent amount of stock for this and investors are likely unhappy about that. Why issue expensive stock for more assets? Why issue stock that you spent money buying back at a higher price?
We agree that part hurts investors, but the alternative here is going full debt loaded and we know how that has worked out for investors in the energy sector. So while we are not too thrilled with that equity issuance, it is still better than the alternative.
OVV expects this to close at the end of Q2-2023, so its updated guidance includes half year of production from these assets. It also assumes closing of the its own asset sale at the same timepoint.
OVV Presentation
The key takeaways here are that OVV has unloaded some natural gas heavy assets for a more oil and liquids focused production.
You can see above that natural gas production stays flat while total and oil numbers move up. From a pricing point, investors likely feel that this makes sense. After all, oil is at $80/barrel and natural gas is struggling to hold the $2.00/MCF mark. While this looks appealing on paper, OVV has a long history of chasing the wrong assets at the wrong time.
Its initial separation from the company now known as Cenovus Energy ( CVE ) to focus on natural gas was a bad move. Its jump into oil again by buying Athlon Energy was right at the peak of oil prices in 2014. It hated natural gas again and hedged its 2022 natural gas production at awful prices. If that was not bad enough, OVV reminded investors that it would not add to its hedges to lock in $7.00/MCF for 2023. They reiterated that hedging was no longer a great idea and gave away tons of cash flow by going in the opposite direction.
If we were unhedged this year, our free cash flow yield would more than double to almost 40%. This is an amazing setup for our shareholders going into 2023, and it reinforces our desire to repurchase shares with free cash flow.
Our substantial free cash flow profile is allowing us to return meaningful cash to our shareholders. Based on our third quarter free cash flow, we expect to return $250 million to our shareholders in the fourth quarter. This translates to an annualized cash return yield of 7%. If we remove the $821 million impact of our hedges for the calculation, our cash return yield would more than double to about 19%.
Even without the hedges removed, our 7% cash return yield is significantly higher than the broader market. When looking at what our cash return yield would be on an unhedged basis, it is more than 4x the broader market. The roll-off of our 2022 hedging program is imminent. And when we look ahead to 2023, the uplift to our cash flow generation is substantial and will result in incredible upside for our cash return profile.
Source: OVV Q3-2022 Transcript
What was actually imminent was the top in natural gas prices. So here we are with one more move away from natural gas after proudly refusing to hedge. This market chasing behavior and selling (hedging) at bottoms and buying (letting hedges roll off) at tops is an awful policy. Unloading natural gas assets is a continuation of that. Maybe this works out, if the recently announced OPEC move gives a big boost to the projected cash flow. But from a strategy stand point, you have to deduct marks from management for this.
Valuation and Verdict
OVV is still going to get about 35% of its production from natural gas and is completely exposed on it.
OVV Presentation
That's because it used three way collar options and sold a second put below $2.25-$3.00/mcf.
OVV Presentation
On the oil side it has done the same thing and overall volumes hedged are very small. OVV investment comes down to whether you're bullish on energy and can at least stand some natural gas exposure despite the very low prices. It also comes down to whether you believe that management's bad judgement on hedging can be overcome with a superlative valuation.
We believe that theory still holds but this is not a stock we want to chase. That part becomes more important in a recession where margins can collapse if oil prices follow natural gas down. For our income play we chose the $40 strikes on our last trade.
Author's App
Despite being so deep in the money, the options had an amazing return profile. As it turned out we needed that margin of safety (breakeven at $30.90) as OVV tanked shortly after that. Also, as it turns out, if OVV ends over $40.00 at expiration, we will make more than originally projected, thanks to this little nugget.
On April 2, 2023, Ovintiv's Board of Directors declared a quarterly dividend of $0.30 per share of common stock payable on June 30, 2023, to shareholders of record as of June 15, 2023. This represents a 20% increase in the Company's base dividend payment on an annualized basis. This is the second increase announced by Ovintiv in the last 12 months.
Source: Ovintiv
We still rate the shares as a "buy" and think $50 can be reached again over time. We would put management in the penalty box here though and see if they can deliver the production numbers while holding the line on capex. Their debt to EBITDA targets must also be watched. There's a reason that OVV has underperformed Energy Select Sector SPDR ( XLE ) by 182.6% since 2010.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
For further details see:
Ovintiv: Bad Decisions Put Management In The Penalty Box