(Advantage Oil & Gas)
There are two ways to practise wealth preservation when investing in the inherently volatile oil and gas sector. You can opt for integrated producers like Suncor Energy, Imperial Oil or Husky Energy, whose refining and retail divisions can compensate when crude oil prices dive—haven’t noticed much of a drop in gasoline prices, have you?—or you can find upstream-only producers whose savvy leadership teams, low-cost resource bases and smart financial management allow them to make money anyway.
The majors will always be the safe bets. But what if you’re playing a longer game? What if you think oil prices are going to come back within a three- to five-year time frame? Then it’s the pure-play exploration and production (E&P) companies that are going to bring you the greater return. Among mid- and large-cap oil and gas producers, only one has generated a positive return over the past 12 months: Advantage Oil and Gas Ltd. (TSX: AAV). Focused on producing natural gas from the Montney formation in northwestern Alberta, it has the lowest cost of production in the business; CEO Andy Mah insists it can break even at natural gas prices of US$1 per thousand cubic feet. (Prices at Alberta’s benchmark AECO hub have hovered around US$2.50 this year.) On top of that, Advantage has the potential for significant upside should North American gas prices recover to even half the US$8 mark they were at in 2008 or should a major proponent commit to building a liquefied natural gas (LNG) export facility on the B.C. coast.
The company Mah joined as president and chief operating officer as a result of a merger in 2006 with Ketch Resources Trust (formerly Ketch Resources Inc.) was a very different one indeed. Then known as Advantage Energy Income Fund, it was one of several mid-tier producers with roughly the same formula: acquire producing wells across the Western Canadian Sedimentary Basin from junior exploration companies and others looking to divest, pump them dry and spin off the profits to unitholders in the form of monthly distributions, such that it paid little or no corporate income tax. Advantage had production of 40,000 barrels of oil equivalent a day and revenues of $350 million a year from a far-flung portfolio of both oil- and gas-weighted properties, meant for one purpose: to generate a steady income for investors.
Almost as soon as Mah arrived, though, that model was rendered untenable. The federal government announced on Halloween, 2006, that it would begin taxing income trust distributions in 2011. Like its peers, Advantage would convert back to a corporation in 2009. In practical terms, that meant it had to abandon its income focus and adopt more of a growth model. At the same time, the run-up in commodity prices of the previous decade was crumbling. With shale gas production taking off in the United States just as the recession hit, natural gas prices cratered to less than $4 per thousand cubic feet. Oil, meanwhile, plunged to US$35 a barrel before rebounding.
Changes were in order. Like a lot of former income trusts, Advantage was more a wonder of financial engineering than petroleum. It was founded by a chartered accountant, Kelly Drader. Now it needed more of an operations person in charge to find efficiencies and chart a way forward. Mah, an engineer by training, was promoted to CEO while Drader moved to the chief financial officer’s desk and continued to run affiliate Longview Oil Corp. Two years later, Drader left Advantage in yet another shakeup.
The company’s operational footprint also needed to be rationalized. “We had assets from northeast B.C. to southeast Saskatchewan,” Mah recalls. Advantage also had a relatively high debt load from acquiring them. As a result of one of its later acquisitions (Sound Energy Trust), it ended up with an exploration property in the Montney formation, near Glacier, Alta., on the British Columbia border.
“At that time, the Montney was in its infancy,” Mah says. The formation is a 300-metre-thick layer of soapstone lying kilometres beneath the foothills of the northern Rocky Mountains. Industry giants like Encana Corp. and Royal Dutch Shell were getting phenomenal results employing new horizontal drilling and hydraulic fracturing techniques on the deposit nearby. And the more Advantage’s engineers and technologists probed the Glacier property, the more they became convinced it harboured a huge resource, one that by itself might allow Advantage to grow for years to come.
“We sold everything else off,” Mah says simply. Between 2009 and 2013, the company got rid of assets producing 35,000 barrels of oil equivalent per day. The last piece divested was its 45% stake in Longview Oil. With the proceeds, Advantage stabilized its balance sheet and reinvested in Glacier, including building its own gas processing plant and feeder pipes, enabling it to sell its product directly into the TransCanada pipeline system eight kilometres away. The idea, Mah says, was to create a completely self-contained, low-cost operation that could grow its output organically out of cash flow, with no need for outside financing or entanglements with industry partners. It hedged half its production to ensure cash flow would be there two and three years hence. And it got lean, going from 180 employees in 2011 to 26 today. That includes just three executives—Mah, chief financial officer Craig Blackwood and senior vice-president Neil Bokenfohr—and four supervisors at the plant and well sites. Even the board was trimmed to three members, before a couple of independent directors were added in the past year.
Seen from the outside, the strategy was not an obvious winner at first. “It was viewed as a turnaround story a couple of years ago. They had some balance-sheet problems,” says CIBC World Markets analyst Dave Popowich, who began formally covering Advantage in September. From 2010 to 2014, much of the industry was pivoting from natural gas to oil, for which prices were still lucrative, and to the next best thing, natural gas liquids such as butane and naphtha. And here was Advantage doubling down on dry gas. (In 2012, the company would come across a liquids-rich layer about midway through its chunk of the Montney.)
“We stuck to our guns and said, ‘We can make money,’” Mah says—even at today’s terrible gas prices. The company has posted small net losses in recent quarters, but those are largely due to how accountants deal with the repricing of hedges, he says. The cash flow is still strongly positive, and “cash is really what you live on. Net income has all these other crazy reporting elements.”
He gets no argument from the analysts covering the stock. “It was severely mispriced a year ago,” says Robert Fitzmartyn with FirstEnergy Capital. While Advantage has had some luck and timing on its side—“The results [from Glacier’s wells] have gotten so much better, even in the last year”—Fitzmartyn credits Mah and his tiny team for sticking to its plan and not getting distracted by the opportunity to enter other plays that were attracting investment. “A disciplined, methodical approach can really preserve returns for future years,” he says.
“Management deserves credit for identifying the asset [to focus on] early,” adds Popowich. “It was smart of them to invest in their own gas plant early on. Advantage had the foresight to get the capital spend out of the way a few years ago, and now they’re reaping the benefits.”
That fortunate circumstance is no accident. “Our management group sat down and said, ‘If we’ve got something as good as we think it is, let’s not screw it up in the first three or four years,’” Mah says. “We’ve all learned things that E&P companies do that put you in the wrong spot.”
“The company has almost as much production behind pipe as what it is producing today,” wrote Brian Milne, analyst with National Bank, in a research note in September. That is, it can increase production with almost no capital expenditure.
One potential threat on the horizon is the prospect of higher royalty payments to the province resulting from the new NDP government’s royalty review. Advantage’s drilling program to date has benefited from a credit that effectively lowered its royalty to 5% of gas sales, Fitzmartyn notes, “so they’d be one of the lower royalty payers out there.” However, if the government opts to target extraction with a higher carbon footprint, as some observers expect, Advantage should get off lightly. Whatever the results of the review, changes likely won’t be implemented until 2018.
On the upside, located where it is in the Montney, Advantage is well-placed to benefit from the development of LNG export terminals on the B.C. coast, if and when they come to pass. Though natural gas prices declined significantly in Asia this year, weakening the case for LNG exports, an AltaCorp Capital report still foresaw four projects going ahead over the next 10 years.
Advantage has had conversations with LNG proponents around supply deals and even outright acquisition, but Mah isn’t holding his breath. He’s just focused on making money in the here and now, while continuing to grow production in the 15% to 25% per year range.
“At this point, we’re sitting pretty. We don’t need to drill one well to achieve next year’s growth target,” Mah says. “Any drilling we do now is for 2017 or 2018.”
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