2023-11-08 10:30:00 ET
Summary
- Surge Energy Inc.'s Q3 results were strong, with a 15% higher price for oil and a 13% higher price for NGLs.
- The company reported a net income of C$16.6M and a net free cash flow result of over C$38M.
- Surge Energy has issued a new series of convertible debentures and plans to use the proceeds to retire existing debentures and reduce debt.
Introduction
Surge Energy Inc. ( SGY:CA , ZPTAF ) is a small Canadian oil and gas producer with an anticipated exit rate of 25,000 boe/day by the end of this year. Thanks to the lower WCS differential in the third quarter, the company’s Q3 results were pretty strong and the available free cash flow was used to reduce the gross debt (and thus the net debt level as well). The lower debt levels should help the company to slow down the increasing interest expenses.
As expected, Surge’s third quarter was pretty strong
During the third quarter, Surge Energy produced a total of just over 24,100 barrels of oil-equivalent per day, and that’s almost 84% of the total oil-equivalent output. Just under 3% of the oil-equivalent output consisted of NGLs, while the remainder came from natural gas. As you can see below, Surge Energy was able to record a 15% higher price for its oil and a 13% higher price for its NGLs. And although the realized natural gas price increased by 9%, the C$2.15 per Mcf is clearly not helping much.
This resulted in a total revenue of just under C$185M while the net revenue of C$143M includes the C$33.4M in royalty payments as well as a hedging loss of C$10M (of which C$1.5M was a realized loss). The total operating expenses and transportation expenses remained under control, and Surge Energy reported a pre-tax income of C$21.8M.
After deducting the C$5.2M in taxes (these are non-cash taxes as Surge still has a substantial tax pool from historical losses and the company guided for a ‘four year tax horizon’), the bottom line shows a net income of C$16.6M for an EPS of C$0.17. This means the net income is still covering the current annual base dividend of C$0.48 per share (payable in monthly tranches of C$0.04 per share).
In my previous articles , I highlighted Surge’s cash flows, and I think it’s important to apply the same approach in this update article.
As you can see below, Surge reported an operating cash flow of C$71.3M, but this includes a C$12.6M investment in working capital elements. And just to be clear: the taxes and unrealized hedging losses were added back to the equation here. We should also deduct the C$1.3M in lease payments, and that’s how we end up with an adjusted operating cash flow of C$82.6M.
The total capex was just C$44M, which means the company reported a net free cash flow result of in excess of C$38M on an underlying basis. About C$12M was used to cover the dividend while the company also retired in excess of C$13M in debt. The remainder of the underlying free cash flow is tied up in working capital elements.
As of the end of September, Surge’s net debt stood at C$277M (excluding leases) which means we are getting close to the C$250M target level for additional shareholder rewards. As you can see below, the company is currently using 75% of its free cash flow to reduce the debt . The next threshold is reaching a net debt level of C$250M (which I anticipate to happen in Q1 2024, subject to changes in the working capital position) where after the total amount earmarked for shareholder rewards will double.
I recently invested in the newest debenture issued by Surge
I have owned all previously issued debentures of Surge Energy. I initially started to pick up convertible debentures during the COVID crisis as they were priced as if Surge was headed to bankruptcy. While the first half of 2020 was a difficult period for all oil and gas companies out there, Surge eventually survived and called that first series of debentures I invested in.
Meanwhile, I had already taken a position in the other series of debentures issued by Surge Energy, and I elaborated on that position and my risk/reward perception in my previous articles about Surge Energy. Although I had expected the company to only retire those convertible debentures upon maturity in June 2024 , the company was likely getting a little bit nervous about where the interest rates were heading, and it initiated a refinancing operation during the third quarter.
It engaged a syndicate of underwriters to issue a total of C$48.3M in new debentures with a coupon of 8.5% and a maturity in December 2028. As these are convertible debentures, the conversion rate has been established at C$13.25 per share . As that is approximately 50% higher than the current share price, I will consider these convertible debentures to be "cash debentures" as I am not taking the potential conversion into consideration.
The proceeds of this financing will be used to retire the existing series of 6.75% yielding convertible debentures which will be retired in the next few weeks. This is a mandatory call, and I don’t have the option to keep the 6.75% debentures until the maturity date in June 2024.
Interestingly, the company has raised more than it needs in this new issue: it raised a total of C$48.3M (so let’s say C$46M after expenses) while there are only C$34.5M of the 2019 debentures outstanding. This means there will be a "surplus" of C$11.5M which will likely be used to repay the bank debt.
Investment thesis
I participated in the IPO of the newest series of convertible debentures for a rather substantial amount (which is higher than my position size in the Series A debentures), as I like the risk/reward ratio of this new issue. Although a lot can happen in the next few years, I am confident Surge Energy will now allocate capital based on its needs and its commitment to first reduce the net debt before increasing the total amount of shareholder rewards is very encouraging. So, while I now have kicked the maturity date of my debentures down to 2028 and all other debt, including the term debt, will mature before my debentures, I think Surge Energy won’t have any issues refinancing its existing debt in the current oil price climate. Additionally, the net debt should continue to decrease pretty substantially in the next few quarters as the majority of the free cash flow will still be used for debt reduction.
I currently have no position in the common shares of Surge Energy Inc., but I have a substantial long position in the company’s debentures.
For further details see:
Surge Q3: Strong Cash Flows, Generous Dividend