The tight supply in global crude oil markets have lifted almost the entire energy sector, especially junior oil companies leveraged to light oil. Many of these companies have endured the hardship of low oil prices for eight years and are just now having their day in the sun, with robust cash flows and highly economic drilling programs. In many cases, this has translated to the shares of junior oil companies doubling or even tripling in price in the past 12 months.
In this article, we’ll take a look at how investors can find the remaining bargains in the oil patch and why investors should focus on sustainable oil producers for their energy allocations.
Higher Prices & Uncertainty
Crude oil prices remain well above $100 per barrel thanks to OPEC+’s limited supply and robust post-COVID-19 demand. While demand could slow due to China’s COVID-19 lockdowns, the European Union’s threat to block Russian oil imports and OPEC+’s reluctance to increase supply have kept oil prices near multi-year highs and the market very tight.
Of course, there’s no guarantee that oil prices will remain elevated over the intermediate or long-term. OPEC+ could agree to a significant supply increase during their June meeting, if they even have spare capacity, and quickly change the direction of the market. Or, if we are at the start of a dreaded recession, a larger than expected drop in crude oil demand could send prices sharply lower and inventories higher. And the bigger question, how long will we rely on oil as a major energy source for our economy?
As a result, investors should be selective when it comes to their energy exposure. Many of the high-flying companies who’s share price went up with soaring oil prices might follow oil lower if the commodity price retreats. Undervalued stocks could provide a margin of safety from a valuation standpoint. And, if oil prices do hold in for a while, investors should consider investing in companies that have the land base and drilling inventory to sustain, or even grow, their current oil production levels.
Saturn Oil’s Unique Story
Saturn Oil & Gas Inc. (TSX-V: SOIL) provides great exposure to rising oil prices with a built-in margin of safety. Saturn was off virtually every investor’s radar screen entering 2021, with first quarter production averaging only 233 barrels of oil per day. But during the depths of the COVID-19 pandemic Saturn had been looking for bargains themselves and negotiated the purchase of 450 net sections of land that came with 6,400 boe/d of production. Truly a transformational acquisition, the “Oxbow Asset”, set the foundations for a new oil focused growth company.
To facilitate the Oxbow acquisition, the then tiny Saturn raised over 100% of their market cap in equity and closed the leveraged buyout with a new capital partner from New York, in June 2021. Saturn won’t disclose who the billionaire capital partner is but commented that they had a common vision to the huge economic potential of the oil industry, given the geopolitical environment.
As part of the massive land base in the heart of the prolific Williston Oil Basin that runs from Montana, the Dakotas and Saskatchewan, Saturn acquired hundreds of future oil drilling locations. This built-in portfolio of new well location will allow the company to organically grow the new production acquired for decades.
While Saturn is a relatively new company, it is made up of industry professionals that have spent their careers focused on developing oil properties in Saskatchewan. Post acquisition, the team embarked on an ambitious 15 well drilling program, increasing oil production to 7,600 boe/d in March 2022. Along the way, Saturn drilled the largest producing oil well in Saskatchewan, of the over 550 wells drilled in the province in Q4 2022.
Lightning Strikes Twice
In May 2022 Saturn, announced another game changing acquisition, this time for 4,000 boe/d of predominantly light oil production in their core Viking operational area in Saskatchewan. Upon the closing of acquisition #2, the “Viking Asset”, scheduled for July 6, 2022, Saturn is expected to produce approximately 11,400 boe/d, of which 96% is made up of crude oil and Natural Gas Liquids. Breaking through the 10,000 boe/d mark is a critical milestone for junior oil companies to establishing critical mass for operations and within the capital markets.
The Viking acquisition doubled Saturn’s land position in West-central Saskatchewan and increased its drilling inventory by 250%, once again ensuring that the production acquired is sustainable. This Viking acquisition is intended as a cash cow, supporting debt repayment, capital to maintain production and free cash flow to accelerate development of the Oxbow Asset.
Financing Saturn again is the same deep pocketed capital partner from New York, who has now more than tripled up on their debt support for Saturn. Along side the debt was a bought equity deal for $75 million which brought in some of the most respected pension funds and money managers in Canada, the US and Australia.
It is understandable if you hadn’t heard of Saturn Oil & Gas before. With recent drilling success and two notable acquisitions, the company has increased production 4,750% in less than 18 months and is just now becoming a significant energy producer in Canada. After the July 2022 closing of the most recent acquisition, Saturn will be vaulted into the top 10 largest oil producers in Saskatchewan.
Having only started to become recognized on most investors’ radar screens, Saturn has been a relative laggard to its oil producing peers in terms of share price appreciation. While the company was busy adding oil production in chunks over the past 18 months, the accretion of each acquisition and their early drilling success has yet to be reflected in the share price.
Cash Flow is King
With the Viking acquisition set to close in about two weeks, the company has given shareholders increased expectations for cash flow. In May 2022 the company had just increased its midpoint guidance to $2.48 of adjusted funds flow (AFF) per basic share. On the back of the recent Viking acquisition, Saturn is now signalling to approximately $2.92 in AFF per share in 2022, an increase of 18% from previous guidance. With a full year’s impact of the new acquisition and an expanded future drilling program, the company is indicating 2023 AFF of approximately $3.98 per basic share.
With the share price currently less than $3.00, the company trades at less than 1x its cash flow per basic share and is relatively inexpensive compared to its oil weighted peers.
Beacon Securities Limited was the first independent investment dealer to launch research coverage on Saturn, less than a year ago. On the back of the recent Viking acquisition, Beacon raised its 12 month target share price on Saturn to $9.00 (was $8.50) with a buy recommendation. The target price tracks to a 2.8x EV/DACF multiple for 2023e which is slightly below 3.1x average the peer group currently trades at. Trading at only 1.0x EV/2023e DACF, Saturn clearly has the least expensive valuation of the group.
Canadian Junior Oil and Gas Peer Group
Enterprise Value (EV) vs. 2023e Debt Adjusted Cash Flow (DACF)
Source: Beacon Securities Inc. Limited. June 21, 2022
The junior oil companies as a group trades at a relative lower valuation levels (only 3.1x 2023 cash flow) compared to prior economic cycles. The deep value of Saturn’s shares could give comfort to new investors that they are less likely to be buying at the top.
Debt, a Double-Edged Sword?
Saturn’s series of accretive oil acquisitions could not happen without the support of its NY based lending partner. Typically leverage implies risk to shareholder’s equity. However, Saturn has structured the debt with a rapid repayment schedule such that the cash flow from the assets pay down the acquisition debt in under three years. 50% of the loan is planned to be retired in the first year, 30% is repaid in year two with the remaining 20% is set for pay back in year three.
Saturn has also taken advantage of the current high energy prices and locked in some future oil sales such that even if there is a sharp pull back in global oil prices, the interest and debt repayments are assured. The volumes of the oil hedges recently entered into are higher in the near term and decrease in time as debt repayments are reduced. Saturn’s cash flow guidance is reflective of the expected hedging expenses, but the risk management also builds in downside protection for equity holders.
In general, Saturn directs 50% of cash flows to debt retirement and 50% towards drilling new wells to fuel sustainable growth. Given the strong current oil prices, Saturn forecasts they have the ability to be debt free in Q4 2024. At which time the acquired assets will be 100% owned by shareholders. When the time comes that there is no more loan to be serviced, or the debt has been reduced to a manageable level going forward, Saturn will have to make some big decisions on what to do with all the cash flow. The company has discussed in previous news releases that it is reviewing the potential for future dividends or share repurchases.
The key to having a new asset pay off its own acquisition debt, is you must purchase assets inexpensively. To that point, Saturn has been a bargain hunter, acquiring the Oxbow acquisition and the Viking acquisition at 1.2x and 1.8x cash flow, respectively. The low cost of oil acquisitions and the relatively low valuation of traded oil companies is a reflection that there is not a lot of capital available in the oil patch. Major oil companies and international investors alike are pulling back on investment in oil production. Fossil fuels are widely seen as a legacy industry, and not in line with the new green energy transition. Investors have to make their own projections of if and when there will be an oil free economy. However, there are plenty of indications that the economy will rely on oil for several more decades. If oil demand persists for some time to come, it is likely to be far in excess of where global supply is headed.
It would be a challenge to find an oil company with a lower valuation than Saturn Oil & Gas Inc. (TSX-V: SOIL). Prior to Saturn reaching its recent critical mass, most investors in the last year would have had a challenge finding Saturn at all. By piecing together synergistic acquisitions, drilling success and maintaining its 100% Saskatchewan strategy, Saturn has quickly emerged as one of the newest and most inexpensive oil producers in Canada.
Given the company’s strong cash flows and internal inventory of growth projects, Saturn is now focused on transforming itself from within. By rapidly paying down acquisition debt and sustainably growing production organically, Saturn’s next step is to consolidate its current asset base and build shareholder value. The company has indicated that with its post acquisition asset base and proposed internal drilling program, corporate production should grow through 14,000 boe/d by late 2023, at which time debt levels will be slashed by over 50%. Achieving these targets should help to clearly establish Saturn on the map of Canadian oil producers.
For more information, visit the company’s website or download their investor presentation.