Canacol Energy — Returning value to shareholders through dividend

As estimated in our previous note, Canacol announced an increase in natural gas production in Q319 following the completion of the Jobo to Cartagena pipeline in July 2019, which resulted in a rise of 100mscfd of export capacity for Canacol to 215mmscfd. The Jobo 3 natural gas processing facility also commenced operating in Q319, increasing Canacol’s natural gas treatment capacity from 200mmscfd to 330mmscfd.

Average natural gas production increased 22% from 121.5mmscfd in Q219 to 147.6mmscfd in Q319, resulting in natural gas revenues, net of royalties and transportation costs, of US$55.1m. We had previously estimated Q319 at c 161mmscfd; however, production in the quarter was slightly lower due to commissioning and integration downtime events. The company’s natural gas operating netbacks remained relatively in line (down 1%) with Q219 at US$3.86/mcf. Canacol achieved a 23% decrease in operating expenses through operational synergies and automation; however, these were offset by a decrease in realised natural gas prices. Q319 capex was US$30.8m (9M US$79m).

In July 2019, Canacol achieved an important milestone it had set for 2019 in completing the 100mmscfd capacity Jobo to Cartagena pipeline, and bringing Canacol’s natural gas production to a level of 215mmscfd in August 2019.

Concurrently, Canacol initiated negotiations for an additional export route, towards the south. A further 100mmscfd capacity pipeline towards Medellin is expected to be online by the end of 2023, according to management plans. Meanwhile, Canacol expects the imminent closing (November 2019) of a 12-year take-or-pay sales contract with a Colombian utility for half of the pipeline capacity. The next stage will be the formation of a consortium, expected by the end of 2019, which will be responsible for building and operating the Jobo to Medellin pipeline.

In our previous note, we tested Canacol’s financial capability relative to a possible dividend distribution to shareholders. We looked at FCF generation under our 2P development scenario, and also what shareholder returns could potentially look like if management were to move to returning FCF to shareholders, and assuming an estimated cash yield in line with dividend-paying peers. Our analysis showed that a yearly cash dividend at c US$30m is sustainable at least until 2025, even in our 2P scenario. In Q319 Canacol announced a US$7m dividend for the final quarter of 2019, which, annualised, would result in a US$28m cash dividend, in line with our estimate of a sustainable dividend for the company. This amount represents c C$0.052/share or a yield of approximately 4.4% annually at the current share price.

Canacol’s drilling success rate has continued in 2019, with discoveries in Ocarina-1 and Acordeon-1 and three development wells, Palmer-2, Nelson-7 and Clarinete-4. Since our September update note, the final well in the programme, exploration well Arandala-1, has been drilled, cased and completed, but test results have yet to be released. This is the only well in the programme targeting the shallower, lower pressured Porquero sandstone, with the majority of the company’s wells producing from the Cienago de Oro (CDO) sandstone.

Canacol has also provided test data for Clarinete-4, which flowed at a 40mmscfd and has now been tied into the new Clarinete to Jobo pipeline. The Pandereta-5 appraisal well was designed to target an increase in the Pandereta field 2P resources of 100bcf, by assessing an area outside the three-way closure tested by Pandereta-3. Pandereta-5 did not encounter commercial quantities of gas, but this will have limited impact on the field’s current gas reserves We expect a similar number of wells to be drilled in 2020, and details of this programme are expected to be released by January 2020.

The programme has confirmed Canacol’s strong successful exploration and appraisal track record, with 85% of these wells successfully drilled to date. The company utilises AVO methodology on seismic to distinguish between gas bearing and water bearing sandstones to support its high success rate in the Lower Magdalena Valley basin.

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 an 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 wells and tie-in costs) required to add reserves to sustain 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 2018 reserves of 559bcf, reflecting a relatively short production plateau of 215mmscfd 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 Q319 results and management’s new production guidance for FY19. We also reflect the production ramp-up in H219 and take into consideration the lower than estimated Q319 production of 147.6mmscfd versus our previous estimate of 160.6mmscfd. We also update our G&A estimates to reflect the reduction reported in January to September 2019. Our currency exchange assumption is updated from C$1.33/US$ to C$1.32/US$. Edison’s currency exchange figure is based on the average exchange rate for the last six months before the current quarter in order to avoid big fluctuations between notes.

Our base case valuation currently stands at C$6.35/share (-1%), broadly in line with our previous valuation, which was C$6.40/share.

The market appears to be fully valuing Canacol’s 2P reserve base but undervaluing prospective resource despite historically high E&A success rates, currently at 85%. We estimate a market-implied exploration success rate of just 80% based on 2.6tcf of net unrisked prospective resource (Gaffney Cline estimated Pmean). Below, in Exhibit 5, it is possible to see the impact of Edison’s 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$6.35/share. At a 10% discount rate this would be increased to C$6.98/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 post FY20 (based on 215mmscfd plateau production and after maintenance capex) is high at 20.3%. This supports shareholder cash returns. Canacol trades at a P/CF multiple of 6.8x in FY19 and 4.2x in FY20, compared to its Canadian E&P peers on 2.1x and 2.0x, and its North American E&P peers with South American operations on 3.8x and 2.5x, respectively.

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 6.

North American E&P peers with South American operations include Frontera Energy, Gran Tierra, Parex Resources, PetroTal and Geopark. The latter recently announced the acquisition of Amerisur, an oil player in Colombia, for US$315m reflecting a renewed merger and acquisition appetite in the region.

Canacol’s first nine months of 2019 netbacks per unit of production increased 3% from a reported full year FY18 US$3.80/mcf pre-tax, to US$3.92/mcf, resulting in a realised EBITDAX of US$122.9m for the period, compared to US$105.2m in the first nine months of 2018. The increases are mainly attributable to a reduction in operating expenses. With the production ramp-up to 215mmscfd, we forecast EBITDAX of US$178.2m in FY19 and US$273.0m in FY20, which will account for a full year at plateau production.

Canacol announced a US$7m dividend for Q419 in line with our previous estimates of this being a sustainable distribution. With the distribution of a cash dividend, our forecast reduction in net debt and gearing is now expected to be slightly slower. Nonetheless, we estimate that Canacol’s balance sheet will turn to positive net cash in 2021. Excess cash is, in our view, likely to be directed to expanding the company’s footprint through the drill bit considering the extensive acreage the company owns around its producing facilities. The excess cash will also offer significant capacity for returns to shareholders.

Exhibit 8 looks at FCF generation under our 2P development scenario, and shareholder returns taking into account the announced dividend and assuming it remains constant in the foreseeable future, and we can see that a yearly cash dividend at US$28m is sustainable at least until 2025, even in our 2P scenario.