Canacol Energy — Fixed-contract gas prices protect cash flows

2019 was a transformational year for Canacol. With the expansion of the 85km of 20-inch gas pipeline between its operated Jobo gas processing facility and Cartagena, the company increased its export capacity by 100mmscfd. Around one month after completing the pipeline, Canacol announced that it had achieved a record 217mmscfd of natural gas sales in August 2019. This led to the company achieving a record average annual production of 143mmscfd, an increase of 28% compared to 2018. Canacol also announced its updated 2P gas reserves totalling c 624bcf at 31 December 2019, c 12% higher than its 31 December 2018 values. In 2019, Canacol also paid its maiden dividend of C$0.052/share.

For 2020, Canacol’s main objectives 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 plans to invest 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 sales capacity by 100mmscfd to a total of 315mmscfd by the end of 2023.

Canacol’s production mix consists of 100% natural gas with no oil production, with c 80% of gas production sold under long-term (typically of five to 10 years’ duration and including inflation clauses) take or pay contracts denominated in US dollars and priced at the wellhead. The remaining c 20% is sold under interruptible contracts also denominated in US dollars and priced at the wellhead. The spot portion of the portfolio is usually sold at a higher price. We note that Colombia’s spot prices are not linked to global oil or gas price benchmarks, and usually these higher prices compensate for any transportation costs associated, resulting in realized prices, net of transportation, being consistent with Canacol’s fixed-priced contracts.

Consequently, Canacol is shielded from the current effects of low oil prices, which have seen its oil-weighted peers recently cutting their capital programmes, production forecasts and return of capital to shareholders. In the long term, if natural gas demand decreases in Colombia due to persistent low economic activity, only the 20% of spot pricing contracts might be affected. Nonetheless, this has not been observed yet.

As such, Canacol maintains its previously announced 2020 capex, production and distribution of capital guidance. The 2020 capital budget remains at US$114m, which is expected to be fully funded from existing cash held and 2020 cash flow. Canacol expects realized contractual gas sales for 2020 to average c 205mmscfd, 43% higher than the 2019 average. The average natural gas sales price, net of transportation costs, is expected to be US$4.80/mcf, which is in line with our expectations. Actual contractual gas sales during the period 1 January to 13 March 2020 averaged 207mmscfd.

Canacol’s forecast production, EBITDAX and cash flow from operations for 2020 are expected to be substantially higher than previous years, with management guided EBITDAX at c US$265m, US$5m higher than our slightly updated estimate. Our resulting FY20e free cash flow (FCF) of c US$75m is sufficient to cover quarterly dividends of US$7m (US$28m per year), reduce debt (Canacol estimates allocating c US$15m for debt reduction) and continue to repurchase common shares under its normal course issuer bid.

Our 2P valuation incorporates discounted cash flows, reflecting 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. Changes to our valuation include an updated end-FY19 net debt position of US$300m versus our previous estimate of US$271m, and lower operating costs following company guidance of US$0.25/mcf versus our previous estimates of US$0.27/mcf. Our base case valuation currently stands at C$7.02/share reflecting, a 2% decrease on our previous valuation of C$7.16/share.

The market appears to be undervaluing Canacol’s 2P reserve base and its 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). Exhibit 2 below shows 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$7.02/share. At a 10% discount rate, it would increase to C$7.79/share. We provide a sensitivity to this key input below.

Canacol currently trades at a c 50% discount to our NPV12.5 base case scenario valuation of the company’s 2P reserve base plus prospective resources. 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 11.8%, supporting shareholder cash returns. Canacol trades at a P/CF multiple of 2.6x in FY20e, compared to its Canadian E&P peers on 1.2x and its North American E&P peers with South American operations on 1.4x. North American E&P peers with South American operations include Frontera Energy, Gran Tierra, Parex Resources, PetroTal and GeoPark. Since our last note, which was published before the markets crash and the oil price collapse, Canacol’s share price has decreased by c 20%, while its peer group of North American E&Ps with South American operations has declined by 61%.

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 current 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 3.

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 EBITDAX of c US$265m for the year (vs our slightly revised estimate of US$260m). Canacol’s budget also allows for a minimum of US$7m in quarterly dividends, as well as c US$15m in debt reduction in 2020. It 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 2.1x in December 2019, in line with our updated estimates. We believe excess cash (see Exhibits 5 and 6) 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 6 shows 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, under our base case scenario this is sustainable until at least 2025, even in our 2P scenario.