Spyglass Resources: Looking Under The Hood

Just a few months ago around Christmas time, a 3-way merger was announced between Pace, Charger and Avenex Energy. Spyglass was the resulting entity, a new dividend paying corporation with a balanced commodity mix.

It was a messy transaction on all fronts; the vote was postponed twice before the deal finally closed. Obviously, not everyone was happy especially with Pace and Avenex.

Nova Bancorp Ltd, a Pace shareholder, was very aggressive fighting the deal going so far as issuing press releases. One would think they held a substantial percentage of the company seeing their determination. But for a position representing less than 0.2% of the total amount of shares, their fight only cost Spyglass unnecessary expenses and delayed the merger.

On the Avenex front, selling Elbow River at 4.7x cash flow multiple was not well taken by shareholders. This was the company’s cash cow division funding most of the dividend. It seemed like the Avenex team just gave up…

Some investors dreamed of unlocking value through a corporate sale process. That’s particularly true for Pace given its net asset value was easily above $5.00 ($5.70/share for PDP and $6.80 on TP basis.)

The only problem is, we are in a buyer’s market with around 300k boepd for sale, this is simply pie in the sky thinking. Combining the 3 companies into a dividend paying entity , in my opinion, makes more sense in the long run given the O&G market we are currently going through.

spyglass resources

click to enlarge – consolidated asset based

The new Spyglass Resources SGL.TO 1.79 [-0.01] has its advantages and disadvantages.

On the positive side:

  • A decline rate of 20% perfectly fits the dividend model
  • The payout ratio is sustainable using the current price deck (<100%)
  • A huge land package with more than 1,000 locations to drill (multi-year drilling inventory)
  • Balanced commodity mix provides exposure to any upside in NG

On the negative side:

  • Debt is simply too high, almost 3.0x in 2013
  • The CEO comes from Charger Energy whose stock lost more than 80% of its value in 2012. This means market confidence in this management team will have to start from 0.

For those who bought Avenex Energy above $5 and are still holding, my condolences because you will neither be seeing this price in 2013 nor in 2014. The share price upside is capped at a maximum of $4.5/share for a yield of 6% from the current level of ~11% at $2.50 per share.

The 6% yield is based on Whitecap Resources WCP.TO 11.03 [-0.12], a well-run company with a respected management team. In order for Spyglass to get there, it will take several quarters of flawless execution and much lower debt levels. It can happen, just don’t hold your breath as time only will tell.

Mid-range, we may see $3.00 following a few quarters of successful execution if the yield compresses to 9%. You have to keep in mind, that the market will become more comfortable with the company as it builds history. The positive aspects enumerated above will certainly attract investors over time.

Management will be looking to reduce debt through non-core asset dispositions. These assets would not fit a dividend model due to high decline rates. The Slave Point play at Randell is one candidate for example. Spyglass might potentially be able to fetch a few million dollars from small asset sales, but the market will only price these in once they happen.

What matters the most in 2013 is the total payout ratio. The company has not initiated a  DRIP program yet. This year’s scenario calls for the following:

  • Average annual production of 16,000 boed (51% oil)
  • Edmonton light at ~$89 = realized price of $74.23
  • Natural Gas at $3.39/mcf AECO
  • 2013 capex of $75 million (mid-range)

It’s important to note the realized price based on Edmonton Light. The company’s oil production is a blend of heavy, medium, light sweet and light sour oil resulting in the cocktail price you see above.

The price for natural gas makes sense given storage is at or heading below the 5 year level. Spyglass has decent hedges in place with 34% of its estimated crude oil production hedged at an average floor price of C$94.84/bbl and approximately 41% of its estimated natural gas production hedged at an average floor price of $3.02/gj.

My total payout ratio estimate is below 100% right where the company guided (95%-100%)

SGL 2013 payout ratio

Even though oil price differentials have narrowed lately, I do not believe the problem is solved. This is an issue worth keeping an eye on as it would have an impact on the share price if we re-experience differentials volatility in the coming quarters. This is a risk you need to remember.

Finally, this is a show me stock. Capital gains upside in the near term is limited, it will likely materialize in 2014 if natural gas prices keep improving in tandem with a dropping Debt to CF multiple.  With time more investors will be getting comfortable with the company given the sustainability of the dividend. This is a stock with long term potential that could see it unfold in 2014.

What do you think of Spyglass?