(Note: This article originally appeared in the July 16, 2022 newsletter and has been updated as needed.)
(Note: This is a Canadian company and reports in Canadian dollars unless otherwise specified.)
Peyto’s Presidential Report (OTCPK:PEYUF) for July is over and the first thing that mattered was all the mud that kept activity at a creeping level. The spring breakup was exceptionally muddy and long. Thank you June rains. The equipment obviously has problems when the roads are muddy because that mud flies everywhere while the equipment sinks. Thus, the second half of the fiscal year will start slowly. Any possible low volume comparison will be due to weather conditions that hampered completion activities.
Sure enough, by the time the August presidential report came out, management was facing bottlenecks as it tried to get things back on track for the all-important winter heating season.
Management is concerned as they try to bring as many wells online as possible in time for the important heating season. Good prices achieved when wells initially have such high (and rapidly declining) production can add a significant percentage or two (sometimes more) to the ROI of the well. In an industry where every extra penny typically hits the bottom line with minimal deductions, such considerations are very important.
After all, industry profits are a relatively small percentage of revenue (usually). So that extra penny or so often makes a decent difference between a good quarter and a great quarter.
The net effect of the weather will be to transfer some starting volumes from the third quarter to the fourth quarter. Now, it remains to be seen whether the company can completely overcome the mud problem. Mother Nature obviously does not have the same timetable as management. So the mud problem could (and did) last longer than desired. Then came even more challenges. This is not new to the Canadian industry. But it helps to understand the unpredictability of challenges on the way to profits.
Peyto Cost History
The advantage of the Canadian dollar gives this company one of the lowest costs in North America of any basin.
The company had its best margin year in 2021 since 2015. This was accomplished with a lower average selling price. Any commodity business must continually cut costs to stay competitive. Peyto has maintained some of the highest costs in the industry despite a cautious business in producing high liquids.
This dry gas producer was squeezed in fiscal 2019 and 2020 when gas prices were extremely low in Canada. The venture into liquids production has not been very quick as costs are so low that the coming industry recovery has brought cash flow back to robust levels that have lasted until the present time. .
Moreover, this management is playing the same “game” or strategy as many dry gas producers who have ventured into more liquids. This objective is to keep the costs at the level of dry gas to take advantage of the advantages of liquids in the margins. As noted above, management is largely successful in cutting costs.
A quick review of the areas of operations is certainly encouraging.
Many companies like this are experiencing unusual profitability. As export capacity increases in the United States, the natural gas price cycle will likely join the global price cycle in the future. This global price cycle is much higher than it is in North America.
In the meantime, the current environment has paying wells in record time. Many of these companies can report satisfactory minimum well profitability with all costs recovered in less than a year.
Today, the industry is emphasizing shareholder returns and reducing debt levels. But the growing emphasis on cost reduction means that more wells can be drilled with the same capital. Peyto management has signaled in the past, from time to time, the possibility of adding wells to the capital budget because the cost savings were significant enough.
As debt levels decline, less cash will be needed to service the remaining debt. This reduction in debt service costs will also free up more money to potentially spend on increasing production. The industry could never resist high prices for long. On the other hand, fiscal year 2020 caused quite a bit of damage to many balance sheets and also made the debt market more conservative. Therefore, a first financial adjustment should be expected by investors (and consumers). But if the past is any guide, robust growth will resume at some point to cause the next cyclical downturn.
Probably one of the biggest discussions brought to the presidential bulletin is that the industry discussion should be about maximizing return”ON“the capital does not return”OfThis is because a lot of professional investors don’t want their capital back. Instead, they want it to continue creating wealth. That’s why they invested in the first place.
Many investors have lost money in past business cycles because they failed to do their due diligence or properly monitor their investments in this very low profile industry (which is also rapidly moving). The result is that they want their money back before they fear losing it. However, building wealth in the industry is a very different ball game where you accept abortive cycles like the latest as part of the risks of this industry. Planning for it to happen again like Mr. Market tends to do is counterproductive even if it’s predictable. Simply put, you can’t move forward in this industry constantly fearing the ghosts of the past. All you can do is do your best as the future unfolds.
Bottom line is that this company is an earnings leader that generally (but not always) avoids impairment charges. There are plenty of companies in the industry reporting decent profits during the good times because they wrote off as much as possible during the recession (while largely blaming lower cost or market reckoning) .
Here in Canada, accounting rules allow these write-downs to reverse as the industry recovers. This is not the case in the United States. Therefore, in the United States, the “accounting game” is to write off as much as possible so that the coming recovery will make the business as profitable as possible. Canada has largely eliminated this game through reversals of impairment charges.
The first thing I look for in any cyclical industry is average profitability. This company has a hard-to-beat average profitability by any measure.
Profitability comes from a consistent focus on cost as well as considerable midstream integration. This company owns most of its gasworks and the corresponding pipelines up to the connection to the long-distance pipelines that bring the product to market.
Ownership of midstream assets helps shield the business from some of the upstream volatility. The focus on costs “every step of the way” also protects the company’s combined profitability. Often diversification fails because management does not keep all parts of the diversification sufficiently profitable. This is usually when fallout occurs.
Management will continue to focus on reducing costs while increasing average revenue through a slow and continuous transition to more liquids. Management purchased some liquid-rich land some time ago. But many areas in Canada already had liquid-rich intervals that just weren’t profitable to produce until recently.
There is talk of tier one acreage depletion. But investors should remember that tier one acreage when I grew up was a 3,000 foot vertical well that flowed at least 200 BOD (and never not dried up unexpectedly). We have come a long way since then. It is very reasonable to assume that improving technology will continue to unlock previously non-commercial intervals and leases while moving locations to Tier 1.
Most oil and gas companies report an increase in reserves and drilling locations each year. It can be lumpy because innovations are not predictable. But the long-term outlook still looks favorable for reserve growth.
Similarly, the long-term outlook for petroleum products remains very positive. Many are used to produce products used in the Green Revolution. Natural gas itself is the preferred source of hydrogen (currently).
This makes a business like this a very good long-term consideration. Note that Canadian companies tend to be much less committed to a level of dividend. Thus, the dividend should definitely be considered variable.
But as a profitable natural gas producer, it is one of the best companies to consider for investment.
Editor’s Note: This article discusses one or more securities that do not trade on a major US exchange. Please be aware of the risks associated with these actions.