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Peyto (OTCPK:PEYUF) management has the best “seat in the house” to judge an acquisition. But they cannot realistically put everything they know in the presentation to shareholders. This management, unlike many I follow, is now revealing some points that are probably as important if not more important than some of the reasons given at the time of the Repsol (OTCQX:REPYF) deal. These reasons “put a lock” on the upside while sharply lowering the downside risk. While some investors worry about the debt ratio for a normally conservative management, it is beginning to appear that management knew how to deal with that debt ratio quickly from the very beginning.
Activity Comparison
Management is now highlighting the difference in activity levels for this sizable (but still) bolt-on acquisition. Not many acquisitions this size can be called bolt-on. Even less contains the best acreage that management has long wanted.
Peyto Comparison Of Drilling Activity Levels (Peyto Corporate Presentation January 2024)
Repsol management confirmed that this was a noncore asset. Therefore, this management “wanted out”. Now we are going to find out just how badly they wanted out.
The first important detail is only 5 wells in the last five years. That backs up management’s assertion that this was noncore. But for Peyto it also means that the production was older and past the higher decline rates. Peyto could well have projected lower decline rates into the future as the “curve flattens” as well production ages. That means less capital is needed to maintain production.
But it also means that the cost per MCF climbs as production ages because the same assets are collecting less production from older production. Generally, the way to fix that is to do exactly what Peyto management plans to do. That is, you bring more nearby production online to fill up that idle capacity and the overall costs head right back down.
Peyto will likely bring online wells using the latest technology that will outperform anything Repsol did because of the lack of recent activity. Reworks to further reduce older production costs are likely as well.
Peyto Comparison To Acquired Acreage Profitability By Location (Peyto Corporate Presentation January 2024)
Management had mentioned earlier that the acquired acreage would lower costs. Investors can now see by location why that is the case. The Repsol acreage is on average better than the Peyto acreage. The acquisition therefore raises the quality of drilling prospects while likely lowering the corporate breakeven, as management has long implied.
This is another way of stating what management said the first time as a reason for this being a good acquisition.
But the key is with those better ROI’s shown above, the development of the superior returns will increase the margin at various commodity prices. That is going to be a boost to profits at a time when the industry only sees weak commodity prices in the future. The other big deal is that this acquisition produces roughly 25% liquids, which is much higher than the Peyto corporate average. Peyto was averaging very roughly 11% liquids in the current fiscal year (when everything was converted to BOE).
More liquids give some insulation to weak natural gas prices. It actually helps to assure that this acquisition is an early success. More importantly, “buy straw hats in January” applies. Peyto acquired these leases at a time of weak natural gas prices combined with a forecast for a warm winter. Better years likely lie ahead, with a lot of North American export capacity under construction. Therefore, no matter the first few years, this deal could prove to be a huge plus as North America joins the much stronger world natural gas market pricing.
This Leads To
The following statements were made by management.
Peyto Statements Of Acquisition Advantages (Peyto Repsol Acreage Acquisition Press Release)
Note that management is really emphasizing the original presentation from a different angle to highlight some more reasons why this is a great deal. From this particular statement, if management has paid for all proved developed producing reserves now as the purchase price, then future drilling locations for proved undeveloped reserves are free.
As I noted in a previous article, this is roughly $3 million per location cheaper than some paid for Permian drilling locations back during the boom years. This company has a huge cost advantage over many United States competitors, where paying for undeveloped locations is common.
Management also noted in the latest presentation that the combined entity has supporting infrastructure that is roughly 52% used. No matter how that is calculated, it is management’s way of stating that the infrastructure will support considerable production growth without a major capital project for some time to come. This is good news because management believes that the acquired acreage can support about 100,000 BOED eventually with superior profitability compared to the company average before the acquisition.
Potential Tailwinds
When shareholders wonder how management decides an acquisition can be accretive from the start, the above considerations weigh heavily in that decision. More importantly, even though management mentions that the debt ratio will go to a “stretched” 1.5. There appears to be adequate ways to bring that ratio down fast by simply growing production from superior return locations that basically came for free with the deal.
Management is now in the position of replacing (for example) 80% IRR current production that is naturally declining with 130% IRR production that costs less according to the presentation. If enough of these wells are drilled, then costs should begin to decline over time and margins at various selling prices will likewise expand over time.
Given that many investors see weak pricing for the foreseeable future, this is exactly the kind of acquisition that should be made at a time like this. Management would disagree with a lot of investors in that management probably sees stronger prices for the industry in the future as more export capacity becomes functional.
There is also a good chance that the green revolution aids natural gas demand growth through the demand for ethane and propane for the rapidly growing plastics market. Natural gas itself is the choice raw material for the rapidly growing hydrogen market.
Shareholders will benefit immediately from the lower cost of production of the acquired acreage. Long-term shareholders will likely benefit from stronger commodity prices. Another upside in the long term is the continuing technology advances that allow for more production at lower costs.
Risks
Management could be wrong about lower production costs once development begins.
Bolt-on acquisitions have a much higher success rate than other acquisitions. But they can fail to produce anticipated results.
Peyto has a relatively new president at the helm. A lack of experience can prove costly in a situation like this. There are others around the CEO that can minimize this “new person” risk. But it still exists.
The higher debt ratio increases the financial risk of failure. Should there be unforeseen issues with the acquisition that require more money than anticipated, there could be a stock offering that would dilute outstanding shares.
Oil and natural gas pricing is always volatile and hence a risk in this industry.
Conclusion
The stock remains a strong buy as this management has long proved themselves able to navigate the industry headwinds. This is a company that has gone through many downturns without write-offs at market bottoms. That is a very rare accomplishment for any management.
The stock price appears to value more pricing weakness and little to no positive effect of the acquisition. Management did what many management books state to do. That is, purchase or expand when prices are weak. Yet, the market is in no mood to reward a classic “book” move.
Management is highly likely to show significant results simply by developing the acreage. That should lead to considerable appreciation. Any cyclical pricing recovery would be icing on the cake. Over five years, stronger commodity prices and production growth could well result in a rare stock price triple from current levels.
Conservative investors may not like the debt ratio at current levels, while income investors may also be concerned about the level of risk. Other investors should find this an interesting proposition.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
