2023-08-20 11:40:00 ET
Summary
- Surge Energy benefits from a narrowing WCS differential, boosting cash flow results in Q2.
- The company plans to exit 2023 with a production rate 6% higher than Q2.
- Surge Energy's convertible debentures offer attractive short-term investment with little doubt of repayment.
Introduction
Surge Energy ( SGY:CA ) ( ZPTAF ) is a small Canadian oil and gas producer with exposure to the narrowing WCS differential. This already boosted the company’s cash flow results in the second quarter of this year but the impact should be more pronounced in the current quarter thanks to the combination of higher WTI prices and a lower WCS differential. I currently only own the short-term convertible debentures but I am considering initiating a long position in the common shares as well.
A satisfying second quarter with strong cash flows
During the second quarter of the year, Surge Energy produced on average just under 23,500 barrels of oil-equivalent per da y. While that’s lower than in the first quarter, the results were impacted by unscheduled turnarounds. These should be non-recurring items and Surge confirmed it plans to exit 2023 with a production rate of 25,000 boe/day (which would be 6% higher than the Q2 production rate).
And although the WTI price remained relatively stable, Surge benefited from the decreasing WCS differentials which averaged just US$15/barrel in Q2 , down from an average of almost US$25/barrel in the first quarter. This definitely provided a nice boost to the realized price. As you can see below, the WTI price was about $2.5/barrel lower than in the first quarter of the year, but the company realized a C$2.5 higher price on a per-barrel basis thanks to the impact of the lower WCS differential compared to the first quarter. About half of Surge’s oil production is medium crude oil, and the price of that medium oil is closely correlated to the WCS price.
The total revenue in the second quarter (net of royalties and including the C$2.8M in realized and unrealized hedging losses ) was C$128.5M. The operating costs are still pretty low as you can see below. The company reported a pre-tax income of C$17.2M and a net income of C$14.1M. Keep in mind the taxes are deferred as Surge Energy has access to C$1.4B in tax pools. This means its earnings should be shielded from cash taxes for quite a while.
I’m more interested in Surge’s cash flow result. I don’t own the shares but I have a substantial long position in the company’s convertible debentures (see later), so I want to make sure the company can meet all its debt commitments.
In the second quarter, the reported operating cash flow was C$60.6M but this excludes the C$1.3M in lease payments and includes a C$2.5M working capital investment. Adjusted for these two elements, the underlying cash flow was C$61.8M and this includes a realized loss on hedges to the tune of C$2M. Applying market prices, the underlying operating cash flow would have been close to C$64M.
As you can see in the image above, the company spent about C$30.6M on capex which means the underlying free cash flow was approximately C$31M (including the C$2M realized hedging loss). That’s roughly C$0.32 per share.
The majority of the free cash flow was used to repay debt as Surge Energy spent in excess of C$20M in Q2 on paying back debt. And it needed about C$11.8M to cover the dividend.
Surge Energy plans to spend C$175M in capex this year which works out to C$44M per quarter. Using that number, the underlying free cash flow result was just C$18M during the second quarter which still isn’t great. While the dividend would still be fully covered, Surge would only have about C$6M available for debt reduction on a quarterly basis.
Fortunately the oil price has continued to increase and I am looking forward to seeing the company’s Q3 results as the cash flows should improve. At US$80 WTI and a US$20 WCS differential, the company’s guidance calls for a C$160M free cash flow result, which would be roughly C$1.62 per share. That would obviously mean the dividend is very well covered at the current oil price and WCS differential.
I still like the debentures for short-term high yield exposure
Surge Energy has one series of convertible debentures outstanding which mature in June 2024 (10.5 months from now. Those bonds are trading around 100% of the principal value which means the 6.75% coupon rate also is the yield to maturity).
While this represents a mark-up of just 175 bp over the implied 9 month Canada government bond yield (derived by comparing the 4.79% 1 year bond yield with the 5.23% 6 month yield), it appears to be an attractive short term investment.
While the convertible debentures rank junior to the bank debt and term debt, the total remaining size of the issue is just C$34.5M which should make it very easy for Surge to refinance and/or simply repay the debentures. So unless the oil prices collapses to a sub-$60 level, I don’t anticipate Surge Energy to have any issues to repay these debentures. Debenture holders can convert the debentures in shares at C$19.25 per share so I don’t expect the conversion feature to come into play.
Investment thesis
I own a substantial position in the 2024 debentures of Surge Energy, and I have very little doubt the company will be able to repay these debentures when they mature in June 2024. I don’t expect the company to call the debentures before the maturity date as the 6.75% fixed rate debt is the cheapest source of funding for Surge right now.
For further details see:
Surge Energy Offers A 6.75% YTM On A 10 Month Debenture