Canacol Energy — 2020 set to be Canacol’s largest drilling campaign

Canacol Energy’s main objectives for 2020 include drilling 12 wells, including nine exploration wells, representing the largest ever exploration programme executed by the company, one appraisal well and two development wells. The company estimates investing c US$114m in capex for 2020, which will be fully funded from existing cash and 2020 cash flow. The budget also allows for a minimum of US$7m in quarterly dividends, as well as c US$15m in debt reduction in 2020. Management has also been working on delivering a definitive agreement for the construction of a new gas pipeline from Jobo to Medellin, which will increase its sale capacity by 100mmscfd to a total of 315mmscfd by the end of 2023.

Canacol also announced its updated 2P gas reserves totalling c 624bcf at 31 December 2019, c 12% higher than its 31 December 2018 values. This increase in reserves was a result of the drilling and completion of Nelson-13 and Palmer-2 on the Esperanza natural gas block, Acordeon-1, Ocarina-1 and Clarinete-4 on the VIM-5 natural gas block, and Arandala-1 on the VIM-21 natural gas block, all in the Lower Magdalena Valley basin (by c 69bcf). Technical revisions in the Palmer, Nelson, Cañahuate and Clarinete gas fields also contributed to this increase (by c 48bcf). The new 2P reserve book results in an RLI of 8.3 years based on natural gas production guidance of 205mmscfd.

The company is also strengthening its corporate social responsibility with a series of initiatives in Colombia, through Fundación Entretejiendo, to provide natural gas to local communities that used to burn wood as a source of primary energy.

The company’s drilling campaign commenced in January 2020 with the spudding of the Nelson-14 development well, which will be followed around early-March with the second development well, Clarinete-5. Exploration drilling is scheduled from Q220, with the Fresa-1 well to be followed by Porro Norte-1. The locations and expected timings of the scheduled wells can be seen in Exhibits 1 and 2. The company plans to drill eight of 12 wells with the Pioneer 53 drilling rig and is currently negotiating a second drilling rig, which will commence drilling four exploration wells from May 2020. This will allow for additional wells to be drilled before the end of the year, if required.

Nelson-14 and Clarinete-5 are both targeting the main Cienaga De Oro (CDO) reservoir with the objective of improving reservoir drainage of gas-charged sandstones located updip of each well. Nelson-14 reached a total depth of 10,150ft and encountered 309ft of net gas pay with 24% average porosity. The well has been tied into the Nelson production manifold and is already in production. Fresa-1 is located in VIM 21 and will drill a three-way fault dependent closure to assess the presence of CDO gas-charged reservoir sandstones. Porro Norte-1, in VIM 5, will drill a four-way anticline with fault dependent upside to assess the presence of gas in multiple stacked targets, including the CDO, but also the Porquero and Tubara sandstones. Both exploration wells will benefit from Canacol’s continued application of its AVO methodology (using 3D and 2D seismic in Fresa-1 and Porro Norte-1, respectively), which has delivered an ongoing success rate of 83% in the company’s exploration and appraisal well results.

In December 2019, Canacol announced that it has secured a 100% working interest in three new conventional gas exploration contracts in the latest bid round in Colombia. The award of these contracts increases the company’s existing position in the Lower Magdalena Valley basin where it is the leading independent producer of conventional natural gas, with the award of VIM-33, and also establishes a new core area in the Middle Magdalena Valley basin, with the award of VMM-45 and VMM-49. The new contracts increase Canacol’s acreage by 29% to 1.4m net acres. The company expects exploration activity on these new blocks to begin in 2020, with a view to carrying out drilling in 2021 and 2022.

Our 2P valuation incorporates discounted cash flows, reflecting the monetisation of the company’s existing reserve base, adjusting for overheads, net debt and decommissioning provisions to arrive at a NAV. We also look at two additional valuation scenarios that include incremental reserves over and above 2P. Here we include ‘maintenance’ capex (largely 3D seismic, exploration and development wells and tie-in costs) required to add reserves to sustain a production plateau. Our DCFs utilise a standardised discount rate of 12.5%, but we provide sensitivities to this key assumption later in this note. Key model inputs for our valuation scenarios can be found in our initiation note.

In our 2P valuation case, we use reported year-end 2019 reserves of 624bcf, reflecting a relatively short production plateau of 205mmscfd sales prior to terminal decline, assuming minimal incremental drilling beyond planned development wells and zero value for acreage and prospective resource. We now update our estimates based on 2019–20 company guidance on production and capex. We roll forward our discount date to 2020 and estimate a net debt position for FY19 of US$271m. Our base case valuation currently stands at C$7.16/share reflecting a 13% increase on our previous valuation, which was C$6.35/share.

The market appears to be fully valuing Canacol’s 2P reserve base but undervaluing prospective resource, despite historically high exploration and appraisal (E&A) success rates, currently at 83%. We estimate a market-implied exploration success rate of just 80% based on 2.6tcf of net unrisked prospective resource (Gaffney Cline estimated Pmean). In Exhibit 4 below, it is possible to see the impact of our different valuation scenarios versus the current share price.

We have used a generic discount rate of 12.5% in our valuation. This is in line with that used for funded, cash-generative E&Ps with operations in emerging markets, resulting in a valuation of C$7.16/share. At a 10% discount rate, it would increase to C$7.92/share. We provide a sensitivity to this key input below.

Canacol currently trades at a premium to our NPV12.5 valuation of the company’s 2P reserve base, reflecting its ability to continue to replace production and grow its reserve base. Relative to Canacol’s peer group, the free cash flow yield in FY20 (based on 205mmscfd plateau production and after maintenance capex) is high at 9.3%, supporting shareholder cash returns. However, it is lower than our previous published estimates of 20.3% due to an increase in our capex assumption for 2020, which now stands at $114m as per company guidance. Canacol trades at a P/CF multiple of 3.2x in FY20e, compared to its Canadian E&P peers on 2.1x and its North American E&P peers with South American operations on 2.3x. North American E&P peers with South American operations include Frontera Energy, Gran Tierra, Parex Resources, PetroTal and Geopark.

We feel this is justified given the company’s historical exploration and appraisal success rates, as well as installed infrastructure capable of supporting plateau production well beyond that implied by current reserves. Other supporting factors include limited exposure to commodity price volatility, low levels of debt and high netbacks, which could help justify a lower cost of capital than our assumed 12.5%. We provide a sensitivity to this driver in Exhibit 5.

Canacol announced that it will invest an estimated c US$114m in capex in 2020, which will be fully funded from existing cash and 2020 cash flow. It expects EBITDA of c US$265m for the year (vs our estimate of US$258m). The budget also allows for a minimum of US$7m in quarterly dividends, as well as c US$15m in debt reduction in 2020. The company also expects a decrease in net debt/EBTIDA in the coming years, guiding to 1.1x net debt/EBITDA for year-end 2020, compared to 2.3x in September 2019. We believe excess cash is likely to be directed at expanding Canacol’s footprint through the drill bit, considering the extensive acreage the company owns around its producing facilities. The excess cash could also offer significant capacity for returns to shareholders, either via dividend payments or a share buyback programme.

Exhibit 7 shows free cash flow (FCF) generation under our 2P development scenario, together with shareholder returns taking into account the announced dividend and assuming it remains constant in the foreseeable future. We can see that with a yearly cash dividend of US$28m, Canacol’s base case scenario is sustainable until at least 2025, even in our 2P scenario.