Summary

• There is a market perception that the diversification into more liquids has been timid and inadequate.
• Returns on the newer high liquids producing wells have been less than standout.
• Still, management could point to the fact that liquids production covered all the cash costs in the latest period.
• Drilling and completion costs are declining while well production is continuing to increase over previous well attempts.
• Fiscal year 2020 will probably be pivotal as the company returns to growth mode.

Peyto (OTCPK:PEYUF) is one of the more conservatively-run gas producers around. For a very long time, management produced dry gas and just hoped that the gas pricing cycle would allow for sufficient profits most of the time. Belatedly, the company switched to liquids-rich leases to drill. When they did, management touted the latest accomplishment for the liquids production:

“Approximately 41%, or C$0.87/Mcfe, of Peyto’s unhedged revenue came from its associated natural gas liquids sales while 59%, or C$1.26/Mcfe, came from natural gas. Natural gas and oil hedging activity contributed C$0.37/Mcfe for total revenue of C$2.50/Mcfe. Liquids production represented 14% of total production but 37% of unhedged revenue. Revenue from the liquids production covered all cash costs.”

This management is measuring success a little differently than many. While management admitted to falling short on well profitability, they nevertheless touted all the cash costs of production being covered by liquids revenues.

Even though about 14% of the production covers all the costs, company profitability is still not what it should be. The liquids program is still decreasing costs that are heading towards C$2 million per well while increasing production in an attempt to gain the profitability the company needs.

Management admitted that third quarter gas pricing hit some of the lowest realized pricing ever in the company history. Therefore, either this company needs to better insulate itself from the mercurial Canadian gas pricing market or the company needs to just drill for liquids period (instead of liquids-rich gas).

“The average Cardium well in Wildhay is recovering approximately 25,000 bbls of condensate in its first 6 months of production while costs for the total Cardium drilling program to date are 10% lower than last year, at C$2.25 million per well. Natural gas prices in Alberta plunged in the quarter to some of the lowest prices in the past 30 years as restricted access to storage prevented supplies from finding a market. Despite the Company’s market diversification efforts this still resulted in some of the lowest realized natural gas prices in Peyto’s 20-year history.”

Even though the diversification into some liquids production is successful to some extent. The prices received for those liquids have dropped as more gas producers enter liquids-rich drilling and production. In the United States, unconventional production growth has also led to the growth in the production of these associated products as oil production expanded.

Even though management has made some careful (cautious) steps towards more profitable drilling, a more drastic strategy may be called for. Peyto may have to consider drilling for light oil in order to survive long term in the industry.

Management did state that they consider next year’s natural gas pricing to appear to be stronger than the current year. Therefore, they are increasing the budget. But production did drop the last two years because of the emphasis of debt repayment. Even though debt was repaid, the financial ratios became stretched as gas prices continued lower. This lowered cash flow (and EBITDA) at a pace faster than management anticipated. It may make drilling for liquids a greater necessity than management is willing to admit.

The 25K barrels of condensate recovered from one well in the quote above may look good to a formerly dry gas producer, but the fact is overall profits and cash flow still lag market expectations. That has put Peyto stock in the doghouse.

The cause for optimism is the continuing improvement shown above. If that year one average liquids comment is correct, then these wells will produce 100,000 barrels of various liquids in the first year. More than that may be necessary as several liquids prices decline due to supply increases. Condensate in Canada is sorely needed to mix with thermal and heavy oil so the oil flows through pipelines. Now, whether management can “upgrade” to more profitable liquids mixes with the acreage already possessed is definitely up for debate.

Summary

Management decisions to pay down debt and allow production to drop due to low prices have stretched some balance sheet ratios even though debt was paid. The deteriorating balance sheet ratios may have led to a decision to begin production growth even though management stated that natural gas pricing appears to be firmer in the future.

The move to liquids has been less than a standout success so far. Nonetheless, management counts as a success that the liquids revenue basically paid all the cash costs in the latest period. Of course, the intent is for liquids to become a larger part of the business. Clearly, management has to work on profitability as well. That means costs have to decrease and well production needs to increase for profitability to return to historical levels.

Infrastructure requirements do not appear to be a big deal. If Peyto needs manufacturing capacity, it appears a number of neighboring operators have that capacity at this time until management makes a decision to do liquids processing itself.

An argument can be made that a bolder move into more liquids production and sales is needed. The latest diversification strategy appears to be too cautious. The future results will decide the accuracy of that statement. This company has been through industry cycles before and is currently navigating this one just fine. Mr. Market clearly has not liked management’s strategy. But that does not mean that management has picked an incorrect strategy.

The balance sheet ratios may be stretched, but they are still satisfactory and therefore allow management considerable flexibility. Plus much of the lease interests involve stacked plays that could hold a larger percentage of oil. Peyto may be known as a dry gas producer. But only some of the potential intervals have been explored. Remaining intervals have the speculative potential to surprise Mr. Market on the upside as technology changes continue to sweep the industry.

Weak market conditions ensure lower (and maybe lowest) service costs continuing. Meanwhile well production continues to improve throughout the industry. Therefore, there is a very good chance for production to surprise on the upside next year when management returns to growth mode.

Overall, this company is a reasonably safe bet at current prices that the diversification attempt will prove successful. Management has now had about two years to acquire the necessary skills that involve drilling and producing more liquids. There is every chance that this will be the best year yet in the “enhanced liquids drilling” diversification attempt. Improvements will continue into the future.

Those hallmark low costs should continue to give this company an edge for years to come. Even though gas prices are low, they still provide a lot of necessary cash to drill for more profitable liquids. The stock therefore has a decent recovery potential as part of a basket of natural gas producers.