2023-05-13 11:45:00 ET
Summary
- Surge Energy recently closed a C$202M acquisition which boosted its production rate by about 20%.
- The company was free cash flow positive in Q1 but has been 'overspending' on its dividend based on its own capital allocation framework.
- I own the 6.75% debentures maturing in June 2024.
Introduction
I have always had a weak spot for Surge Energy (ZPTAF) (SGY:CA) after I was able to pick up its convertible debentures at a very attractive discount to the principal value in 2020 when the oil markets were exceptionally weak. The company has done a good job in increasing its production rate and cash flow but the oil price is obviously no longer cooperating so I wanted to have a closer look at the company's performance in the first quarter of the year.
Strong cash flows on the back of the Enerplus acquisition
The Q1 results published by Surge were important as it was the first full quarter with contribution from an acquisition which closed in the fourth quarter of last year. As a brief reminder, Surge Energy acquired 3,850 boe/day production from Enerplus ( ERF ) in a C$202M deal .
Needless to say this had a positive impact on the production numbers and the cash flow results. The total average production rate exceeded 25,000 barrels of oil-equivalent per day and in excess of 80% consisted of oil. About 3% of the oil-equivalent production was generated through the sales of Natural Gas Liquids while the remainder of the oil-equivalent production rate came from the natural gas output.
The realized prices were somewhat disappointing given the weakness on the oil markets in general. The average oil price for light oil was just under C$103/barrel but the WCS (heavy oil) price was less than C$70/barrel during the first quarter . The combination of lighter oil and WCS prices resulted in a weighted average realized oil price of just over C$80 per barrel while the Natural Gas Liquids were sold a just over C$55/barrel.
The company reported a total revenue of just under C$162M from the sale of its oil and gas and generated an additional C$2.5M in processing income. Unfortunately the average royalty rate remains high at almost 20% which means the reported revenue was C$137M (including a net gain on hedges of about C$1.6M).
Fortunately, Surge Energy remains a low-cost producer, and perhaps even more important, its transportation expenses are pretty low. This helped the bottom line as despite the relatively weak oil and gas price, the company remained profitable with a pre-tax income of C$17.1M and a net income of C$14.8M which resulted in an EPS of C$0.15.
That's okay given the circumstances, especially as we know the gross debt and net debt will continue to decrease, which should reduce the pressure on the income (and cash flow) statement as interest expenses should decrease. That being said, the interest rates on the financial markets are still somewhat increasing, so we will likely see the interest expenses creep up a little bit before they go down.
The cash flows are still decent. The reported operating cash flow was C$54.5M, but this includes a C$5.5M investment in the working capital position but excludes C$1.3M paid on leases. This means the underlying operating cash flow was approximately C$58.7M. This includes a C$2M loss on hedges, it excludes a C$3.6M unrealized gain on hedges and it includes C$3.25M in decommissioning expenditures.
The total capex incurred during the first quarter was C$45.7M but as the full-year capex budget is C$175M, the normalized quarterly capex is slightly lower. It wouldn't make that much of a difference (about C$2M) which means the underlying free cash flow result during the first quarter of the year was approximately C$15M (including the hedging losses). As there are 98.4M shares outstanding, the free cash flow result came in pretty close to the reported net income of C$0.15 per share. The company pays a monthly dividend of C$0.04 per share, which means about 80% of the free cash flow is flowing back to the shareholders.
That's very nice, but it also means the company is retaining just a few million dollars per quarter to reduce its net debt and I think a more aggressive stance towards debt reduction will add more value in the long run. Additionally, Surge's own return of capital framework mentions that as long as the net debt exceeds C$250M, 75% of the free cash flow should go towards debt reduction and this ratio is to be reduced to 50% if the net debt level comes in between C$175-250M.
This means Surge Energy is currently 'overspending' on its dividend and while I obviously understand the company wants its dividend to be somewhat predictable and it isn't going to change the monthly dividend every other quarter, the net debt currently does exceed C$250M (C$275M excluding lease liabilities as of the end of Q1) and a more cautious approach appears to be warranted if the oil price doesn't pick up soon. Surge Energy does have some hedges in place but I don't think this will be a major source of additional revenue based on the current oil and gas prices.
Investment thesis
I currently have no position in the common shares of Surge Energy. Although the stock is not expensive, I'd prefer to see the company make debt reduction a stronger priority as the current interest expenses of in excess of C$34M per year are relatively high compared to the actual free cash flow. Cutting the interest expenses by 50% would increase the quarterly free cash flow result by 5 cents to C$0.20 per share and that would allow Surge to reduce its net debt by in excess of C$30M per year. Based on a WTI oil price of US$80 and a WCS price of C$83.45 per barrel, Surge anticipates to generate C$160M in free cash flow this year (before making dividend payments).
While I don't own any shares, I still feel very comfortable owning the convertible debentures maturing in June 2024. This is a relatively small issue size (the outstanding principal amount is C$34.5M) and I have very little doubt Surge will be able to refinance this debt by the summer of next year.
For further details see:
Surge Energy Offers A Generous 6% Dividend Yield, But I Prefer The Debentures