Crude oil prices have fallen from their June highs of USD 120 but remain around the USD 100 level leaving investments in oil producers still a compelling alternative. While global supply remains tight, investors fear that a higher-than-expected inflation reading could spark a bigger-than-anticipated rate hike, increasing the odds of a recession. As a result, investors should be a little more discerning when picking energy stocks.

Saturn Oil & Gas Inc. (TSX-V: SOIL) (FSE: SMKA) is a unique and undervalued Canadian energy company with high-quality, light oil-weighted assets. After closing the accretive Viking acquisition in July 2022 for $248 million, the company’s savvy management team is already generating significant cash flow that will only accelerate over the coming months with its active drilling program.

Production Growth

Saturn Oil’s transformational acquisition in July 2022 has just now put the company on the radar of many value investors as its oil production recently surpassed 10,000 barrels a day. The company has been growing rapidly with a three prong strategy: 1) accretive acquisitions; 2) development drilling; and 3) reactivating existing oil wells that were previously uneconomic during previous lower oil prices.  The latest Viking acquisition has catapulted Saturn to the next level putting the company into the top 10 largest oil producers in Saskatchewan overnight.

While the company took on $275 million in transaction financing, the key move in this transaction was hedging the downside risk of the new production.  The acquisition dramatically expanded output at precisely the right time.  Saturn was able to lock in 85% of the new production’s economics in early June 2022 when oil prices were higher than today. The stable production base acquired is now matched with stabilized oil pricing to create a predictable cash flow stream, regardless of oil price volatility.  What is most notable about the Viking acquisition was the low purchase price of only 1.8x the expected cash flow of the next 12 months.

With the contribution of the new acquisition, management is forecasting robust 2023 corporate cash flow in the range of $216.3 million to $230.9 million, which equates to between $3.63 and $3.87 per basic share. Saturn’s operational forecasts appear lofty considering the shares are currently trading below $2.50 and the company recently raised $75 million in equity with units priced at $2.75 in May 2022.  

Saturn’s strategy is to grow production with approximately half of future cash flows with the other half budgeted for rapid debt reduction.  At its current pace, management expects to achieve net debt-free operations by the third quarter of 2024 and exiting 2025 with $235 million in cash on its balance sheet. At the same time, its capital expenditure program looks to drive production to about 15,000 boe/d by 2025, generating $860 million in cumulative cash flow over three years.  Currently Saturn’s market capitalization is under $150 million.

At the core, future growth comes from the compelling drilling economics based on today’s high oil price environment. For instance, the company’s Oxbow wells cost about $1 million to drill and are expected to payout in four to six-months, which translates to a 400% annual return on investment, assuming WTI oil price of USD 95.  With such quick paybacks, the company targets investing the same funds two to three times in the same 12 month period compounding growth.

Oxbow has compelling unit economics. Source: Investor Presentation

With oil prices at this lofty level, drilling for new production is very lucrative for companies in the oil patch.  As long oil prices stay above USD 75, Saturn will maintain an active drill program with plans for 26 new horizontal Obow wells, and 49 wells in total, for H2 2022 to drive production growth.  For perspective, Saturn drilled a total of 42 wells in the 5 years between 2017-2021 when oil prices were much lower.

Attractive Valuation

Saturn Oil & Gas has a high level of oil-weighted production, exceptional netbacks, and a compelling valuation by almost any measure. While valuation is important during bull markets, it’s even more vital in bear markets when investors are hesitant to own growth stocks with high valuation multiples. Low valuations are generally attractive to investors and also provide a protective margin of safety if there is an economic downturn.

In June 2022, Beacon Securities’ research analyst Kirk Wilson re-issued his Buy rating with an increased target price of $9.00 per share, reflecting a more than 400% premium to the current market price. With its 2023 projected cash flow multiple of approximately 1x, the stock has the most compelling valuation in its Canadian oil peer group, where most others trade between 2x and 4x.

SOIL has an attractive valuation relative to its peers. Source: Investor Presentation, Beacon Securities Ltd.  2. EV/DACF: Enterprise Value divided by Debt Adjusted Cash Flow

As management delivers on its promises, the market may not be able to ignore the stock’s valuation gap for much longer. The company has a total inventory of over 500 (gross) booked drilling locations in addition to an extensive list of optimization candidates in its existing portfolio, paving the way for robust organic production and free cash flow for about 15 years.

Downside protection

With war in Ukraine and fears of a potential global recession, oil prices have been volatile.  To protect against the threat of a sudden oil price drop, Saturn has locked in 85% of its current production at set oil prices through its hedging program.  Hedging ensures the cash flow for capital expenditure programs and debt repayment will be available.  On the other hand, hedging does cap some of the upside of potential higher oil prices.  Investors with expectations of near term oil prices of USD 150 and higher might be best to look past Saturn and evaluate unhedged oil companies.  However, if oil continues to trade at current levels, Saturn expects to deliver solid cash flow growth, rapid debt reduction and downside protection in case oil prices fall.

Looking Ahead

While recession fears increase, many analysts note that they don’t have a great track record for killing energy demand. The absence of increased supply and the reluctance of the major oil companies to increase spending are combining to keep petroleum product inventories at critically low levels, suggesting that oil prices may remain elevated for some time.  If high oil prices remain, players in Canada’s oil patch will continue to have windfall profits we haven’t seen since 2014.

Still, investors may want to be a little more discerning when it comes to selecting the right opportunities for their portfolios. Saturn Oil & Gas Inc. (TSX-V: SOIL) (FSE: SMKA) represents a compelling value in today’s market with a sustainable growth path and downside protection from potential sliding oil prices.  Given much of its growth has come in the past 14 months, relatively few investors have ever heard of Saturn.  Value investors may want to take a closer look before the wider market catches on.

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