Last week, Arcan Resources released its year-end 2011 results leaving investors with mixed feelings. If you always thought the stock was a great buy below $4, you might want to start getting used to sub $4 prices as the norm for the balance of the year. While ARN is extremely attractive based on its 172 net sections at Swan Hills combined with Crescent Point Energy’s footprint in the stock, the debt will most likely undermine the stock’s performance for the rest of the year.
Arcan Resources ARN.V 0.38 [0.00] holds 172 net sections at Swan Hills, one of the hottest light oil plays in Alberta. In 2011, Crescent Point moved aggressively to put a leash on all the junior players in the area resulting in the acquisition of 19.9% of ARN. What this means is that we know CPG will buy them out in the end, we just don’t know when. So before holding your breath for the buyout, it’s good to speak to some of Reliable Energy’s long time investors to get a feel of how frustrating the wait could turn out to be. Of course CPG may move in for the kill this year which is probable but not likely in my opinion.
Moving on to debt, let’s take a closer look at what I believe is the main reason the stock will underperform in 2012. ARN spent $250 million last year including $30 million for the StimSol acquisition (a small stimulation services company). The company is guiding for annual average production in the range of 6,000-6,500 boed on the back of $175-$200 million in spending for 2012. The company will be exiting the year at around $290M in debt including the $171M in debentures (which is debt no matter what you label it). In our scenario, ARN will produce 6,300 boed in annual average production weighted 95% to oil which is the mid-range of its guidance. Using the following price deck:
- $90 Realized price per oil barrel
- $2/mcf realized price for natural gas
The oil price used is slightly below the company realized price of $93.58 per barrel sold in Q4-2011. Natural gas prices are almost immaterial to cash flow in the case of Arcan so $2 is fair enough. Operating costs for 2012 will be trending lower from last year from about ~$23 per barrel in the first half down to ~$13 per barrel in the second half of the year which results in $18/boe average. Obviously, the massive investment in infrastructure is starting to pay off.
Our scenario results in cash netbacks of $39/boe; that’s not very sexy for 40° api light sweet oil. But most importantly, with annual cash flow of about $89 million, the debt to cash flow ratio is above 3.25! Do you remember what happened to PetroBakken last summer when markets were melting? The scenario could very well get repeated this year if Europe triggers another selling frenzy. ARN’s debt has simply marked it for abuse anytime investors become nervous holding a company with high debt. Debt has also resulted in neutralizing its premium valuation on a flowing barrel basis at least for this year.
The situation improves slightly in 2013 as the debt to cash flow ratio falls to around 2.25 on the back of 7,500 boed in average annual production and a hypothetical $125M in capex i.e. drilling from cash flow only. Nonetheless, I have to render unto Caesar the things which are Caesar’s and for Arcan there are 3 catalysts that might surprise. First, the company reserved $40M in Stimsol products for 3rd party consumption, how much will that contribute to cash flow? Second, will the company be able to repeat its success at Virginia Hills where its first well had an IP21 rate of 1,226 boed on its remaining acreage? Third, will its EOR waterflood operations add more production volumes that what is being accounted for?
Arcan is by no means in any financial danger, the company expects its bank lines to be renewed at a minimum of $175 million but the fact of the matter remains that debt will undermine the stock performance of this company for the rest of the year and potentially into 2013. Some of the upcoming catalysts might support the share price but overall the DCF ratio will have the last word in attracting investor’s money.