2023-07-10 13:09:42 ET
Summary
- PrairieSky Royalty owns the land and mineral rights to leases for various Canadian E&P companies and has the largest royalty play in Canada with 5.2 million acres.
- The stock price appears extremely overvalued relative to other royalty and E&P plays.
- The set-up may be ripe for a pare-trade between PrairieSky Royalty and Freehold Royalties.
Please note all figures are in CAD unless otherwise noted.
Introduction
PrairieSky Royalty ( PSK:CA ) owns the land and mineral rights to the leases of many different Canadian E&P companies. PSK is the largest royalty play in Canada with 5.2 Million acres and daily production of over 24 Million beo/d with almost half of that in crude oil. Their asset base is in the low decline plays in Viking, Clearwater, and Duvernay.
PSK has been expanding their production into the Clearwater play in Alberta and now has the largest Clearwater royalty acreage position with over 1,300,000 acres in the region. The Clearwater is now the largest non-oil sands play in Canada, having grown from effectively nil in 2017. Spur accounts for about a third of total production and more land and de?risked drilling inventory than all other operators combined. 47% of the investment has been returned to PSK and the lands are ~20% developed. The region shows a very lucrative return profile, with an ROIC of ~25%.
Investment Thesis
Like E&P companies, PSK was not spared from falling commodity prices in Q1 2023. The results did show royalty production averaged 24,809 boe/d, 4% higher than Q1 2022 royalty production volumes of 23,892 boe/d. This was not enough to offset the 16% decline in pricing as revenues totalled $126.1 Million in Q1 2023, a 10% decrease from Q1 2022 revenues of $139.9 Million. This resulted in a 77% decline in the operating netback from $56.97/boe to $43.80/boe.
While most E&P companies and royalty plays are either down or sideways since January 2023 PSK is actually up ~13%.
Now PSK is not actually suffering by any means as they took advantage of high commodity prices and reduced net debt by almost $400 Million in 2022 and even at current commodity prices net debt to FFO is 0.85X. The quarterly $0.24/share dividend is also well covered by FFO and by my estimate could cover this dividend at even $55/bbl USD crude oil pricing.
The bull case for the stock is that its valuation is not quite as expensive relative to its historical levels, although it traded as almost a penny stock in 2020 and the valuation has rapidly expanded since, which brings its average down. Furthermore, OPEC+ plans to extend cuts to crude oil production through 2024 and the outlook for natural gas is overly bearish, therefore, pricing assumptions being used by the analyst community may be too conservative anyway. There are three major counterarguments to the bull thesis.
The first being that prior to 2022, Canadian interest rates were near zero now even the 10-year Canada Bond Yield trades at almost the same dividend yield as PSK at 3.45%. Previous troughs won't be as likely to hold when the same yield is being offered risk-free.
Second and most important is, when we compare this stock to other royalty plays, the stock begins to look much more overvalued (aside from Texas Pacific Land Corporation ( TPL )).
Those who follow my work may recall that I have written on Freehold Royalties ( FRU:CA ) several times. Most times I have had a bullish thesis but recently downgraded to a hold as even its valuation isn't too compelling. FRU has about the same acreage as PSK in Canada, with an additional 0.9 Million gross acres in the USA, mostly in the Eagle Ford and Permian Basins. FRU's production is about 60% of PSK's as FRU has 440,000 gross acres in the desirable Clearwater locations while PSK has three times that. One could argue this warrants the premium in their valuation relative to FRU. Other than that, the two companies have tremendous overlap in the Viking and Duvernay regions and their assets are nearly identical.
35% of FRU's production is now U.S. based. The Eagle Ford and Permian basins tend to be more prolific as they can come on production at ten times that of a typical Canadian well. FRU realized pricing in Q1 2023 that was 38% higher than Canadian realized pricing. Moreover, FRU's realized $/BOE has actually been higher than PSK and in Q1 2023 was 10% higher. FRU's operating netbacks have been 15-20% higher than that of PSK's as a result of the higher pricing that has been realized. So the fact that PSK has greater exposure to the desirable Clearwater basin does not hold much weight.
Finally, PSK faces increasing competition from E&P plays which trade at less than half the valuation. The royalty model has been looked at as a lower-risk means to gain access to oil and gas assets due to its absence of operating costs, which should arguably necessitate a higher multiple than the traditional E&P play. The problem is that all of the E&P companies shown in the below graph have reduced debt levels to extremely low levels as well (less than 1.5X EBITDA). PSK may be able to maintain their dividend at $50/bbl USD crude oil prices, but so can many E&P companies as a result of paying reduced interest expenses.
PSK boasts about returning $1.5 Billion to shareholders since 2014. Imperial Oil ( IMO:CA ) and Canadian Natural Resources ( CNQ:CA ) returned more than three times that in the past 12 months. These numbers can make a huge difference in the free cash flow yields you generate. This makes it very difficult to justify paying more than twice the price for a royalty play versus "best in class" E&P companies.
Conclusion
Even if the energy bulls are correct and the current commodity price levels are a short-term blip, and we will see oil and gas prices return to their levels seen in 2022 before the end of 2023, the set-up is not ripe for big returns given E&P companies have much greater leverage to rising commodity prices. On the other hand, the stock has as much as 40%-50% downside even if commodity prices stay flat, which would put the multiple in line with FRU or Viper Energy ( VNOM ).
I am taking a hard pass on PSK, given there are much better opportunities in the oil and gas space. If one was ambitious enough, the set-up may be ripe for a pair trade, with FRU or VNOM as the long and PSK as the short.
For further details see:
PrairieSky Royalty: Entering Bubble Territory