Gear Energy Ltd (TSX: GXE) is engaged in the business of acquiring, developing, and holding interests in petroleum and natural gas properties and assets. Its oil-focused operations are located in three core areas; Lloydminster Heavy Oil, Central Alberta Light/Medium Oil, and Southeast Saskatchewan Light Oil.

• 2021 Usher a Considerable Optimism for Recovery in Demand for Commodities: 2021 ushered in considerable optimism for both the global economy and a recovered demand for commodities because of COVID-19 vaccination rollouts. All of this has translated into an increase in West Texas Intermediate (“WTI”) oil prices in the first quarter. WTI started the year at US$48 per barrel and averaged US$58 per barrel for the first quarter. This scenario is rosy compared to twelve months back to April 2020 when WTI dropped to a historical low of negative US$37 per barrel. Whereas 2020 was a year dedicated to harvesting cash flow to repay debt and minimizing capital spending, 2021 will be a year where Gear recommences capital investment through the drilling of new wells and the expansion of waterfloods while still continuously repaying debt.

Source: U.S Energy Information Administration (EIA), Short-term Energy Outlook, April 2021

• Increases Annual Production Guidance for 2021 on the Back of Strengthening WTI Prices: With the strengthening commodity prices, Gear has modestly increased its Capital and abandonment expenditures plan for 2021 from CAD 20 million to CAD 27 million. As a result, Gear has increased 2021 annual production guidance to 5,500 to 5,600 boe per day. Higher underlying commodity prices and a higher production is likely to bolster the group’s financial health in the near future.

Source: Company Filing

• Fund Flow from Operations Nudged 32% in Q1FY21: Funds from operations increased from CAD 6.3 million or CAD 10.20 per boe in the first quarter of 2020 to CAD 8.3 million or CAD 17.19 per boe in the first quarter of 2021. This implies a surge of 32% on a YoY basis. The increase in funds from operations was the result of increased revenues due to higher realized commodity prices, and decreased operating, transportation, and general and administrative costs, offset by decreased sales volumes, increased royalties, interest, risk management losses and realized foreign exchange losses.

Source: Company Filing

• Significantly Narrowed Net Losses in Q1FY21: Higher commodity realization prices led by a strong rally in the underlying commodities has significantly narrowed its net losses in the first quarter of 2021. Gear generated a net loss of CAD 3.5 million for the three months ended March 31, 2021, compared to a net loss of CAD 110.2 million for the same period in 2020. For the first quarter of 2021, US-denominated WTI prices increased by 25% over the same period in 2020, the WCS differential tightened from US$20.53 per barrel to US$12.47 per barrel, the Canadian Light Sweet differential narrowed from US$7.58 per barrel to US$5.24 per barrel, and the LSB differential narrowed from US$7.76 per barrel to US$5.02 per barrel. As a result of favorable differentials and stronger WTI prices, Gear’s realized price increased from CAD 31.24 per boe to CAD 50.46 per boe.            

Source: Company Filing

• Operating Net Back Jumps 173% on a YoY basis: Energy commodities don’t fall out of trees. A lot of time, effort, and money go into identifying oil reserves, drilling them out of the earth, and then turning them into the finished product ready for consumption. Operating netback provides a summary of the costs associated with bringing oil to the marketplace. It tells us the amount of money the company actually generates and keeps for itself per barrel. In case of Gear’s, Operating netback prior to risk management contracts was CAD 26.17 per boe in the first quarter of 2021, an increase of 173% from the same period in 2020. The increase in operating netbacks was primarily the result of increased commodity prices, partially offset by higher royalties and operating costs.

Source: Company Filing

• Robust Risk Management Profile: Gear’s risk profile strengthened in Q1FY21, with healthy cash flow expected in fiscal 2021 on the back of higher underlying commodity prices. Also, the debt protection metrics have significantly improved in Q1FY21, with Net Debt/FFO stood at 1.2x from 1.6x at the end of December 31, 2021, well below the standard 4x, which is considered as a thumb rule for stronger financial strength to manage debt. Further, the total debt/equity ratio declined to 0.45x at the end of Q1FY21 vs 0.61x at the end of Q4FY20.  Moreover, Gear’s leverage position is quite better than the industry median as well. The above debt protection metrics shows lower balance sheet risks for the company.

Source: Refinitiv (Thomson Reuters)

• Registered a Technical Breakout on a Weekly Price Chart: Recently, on the weekly price chart, the stock price broke out of the horizontal trendline resistance level of CAD 0.64. Since the breakout, prices are sustaining above the breakout level. This breakout suggests that the stock is likely to go up in the near term.

Technical Price Chart. Source: Refinitiv (Thomson Reuters)

• Hovering in a Long-term Bullish Zone: Despite recent correction in the stock after a rally since February 2021, GXE shares are hovering in bullish territory, with stocks hovering well above the crucial short-term and long-term support levels of 50-day and 200-day SMAs. This implies that the bullish trend is still largely intact in the stock. Moreover, the Price/200-day SMA ratio stood at 2.25x, which implies that the stock is trading approximately 125% above the 200-day SMA. The larger the positive spread between closing and 200-day SMA, the stronger the bullish trend is.

Technical Price chart. Source: Refinitiv (Thomson Reuters)

• Risk Associated to Investment: The company is exposed to a variety of risks ranging from Commodity price risk, Currency Transition risk, and Interest rate risk. Further, the company is exposed to the next wave of covid-19 as it can hamper production. Also, production is exposed to weather condition.  

Financial Highlights: Q1FY21

Source: Company Filing

• Funds from operations increased from CAD 6.3 million or CAD 10.20 per boe in the first quarter of 2020 to CAD 8.3 million or CAD 17.19 per boe in the first quarter of 2021.
• Cash flows from operating activities increased from CAD 9.8 million or CAD 15.95 per boe in the first quarter of 2020 to CAD 9.9 million or CAD 20.60 per boe in the first quarter of 2021.
• Gear generated a net loss of CAD 3.5 million for the three months ended March 31, 2021, compared to a net loss of CAD 110.2 million for the same period in 2020.
• In the first quarter of 2021, sales production volumes averaged 5,335 boe per day compared to 6,744 boe per day in the same period in 2020.
• In the first quarter of 2021, Gear drilled 10.3 net wells, of which ten were brought on production in the period. The new wells contributed approximately 165 barrels per day of oil to the quarter as a result of only being online for a portion of the period. These additional volumes from the new wells were offset by natural declines in base production.
• For the first quarter of 2021, Gear’s realized pricing increased from CAD 31.24 per boe to CAD 50.46 per boe.
• In the first quarter of 2021, royalties as a percentage of commodity sales were 9.4% compared to 11.7% for the same period in 2020. Over the last couple of years, Gear’s royalty rates have gradually declined as Gear continually replaces production from new wells, which have an initial lower royalty rate encumbrance than legacy production.
• Operating costs plus transportation for the first quarter of 2021 was CAD 19.52 per boe, compared to CAD 18.01 per boe for the same period in 2020. This increase was mainly a result of increased well servicing and maintenance activity and start-up costs associated with the newly drilled Paradise Hill wells.
• In the first quarter of 2021, G&A expenses totaled CAD 1.1 million, compared to CAD 1.7 million for the same period in 2020. The majority of the decrease relates to a 2019 performance bonus declared and paid in the first quarter of 2020.
• In the first quarter of 2021, interest and financing charges totaled CAD 0.9 million compared to CAD 0.8 million in the same period of 2020, representing an increase of 15%. 

Relative Performance against the Benchmark Index

The GXE shares registered strong relative outperformance against the benchmark S&P/TSX Small-Cap index and significantly outperformed the benchmark over 1-Year, 3-Months and 1-Month by 153%, 75% and 38%, respectively. This implies strong relative strength in the stocks against the broader market.

Top-10 Shareholders

Top-10 shareholders in the company held around 15.8% stake. Burgundy Asset Management Ltd. and Gray (Donald T) are among the largest shareholder in the company and carrying an outstanding position 7.95%, and 3.68% respectively. The institutional ownership in “GXE” stood at 8.18%, and ownership of the strategic entities stood at 7.7%.

Source: Refinitiv (Thomson Reuters)

Valuation Methodology (Illustrative): EV to Sales based Valuation Metrics

Note: Premium (discount) is based on our assessment of the company’s growth drivers, economic moat, competitive advantage, stock’s current and historical multiple against peer group average/median and investment risks

Stock Recommendation: We expect that Gear Energy would generate higher fund from operation in the second quarter of fiscal 2021, driven by increased commodity prices and increasing production. Further, a higher commodity price along with robust cost management efficiency would boost the financial strength of the business by deleveraging the company's balance sheet. Also, the margin profile is expected to improve, which would generate a higher operating netback for the company to fund its future growth potentials. Moreover, the company has a robust financial risk profile with strong debt protection metrics.

Also, from the technical standpoint, share price broke out of the horizontal line resistance recently and sustaining above it since the breakout. Moreover, shares are hovering in a long-term bullish trend with price traded above the crucial long-term as well as short-term support level of 200-day and 50-day SMA. Based on technical analysis, the stock has support at CAD 0.54 level.

Further, from the NTM Price to Cash Flow Standpoint, its shares are trading at a multiple of 3.55x, which is considered as a good opportunity to bag shares. A Price/Cash Flow of less than 5x, with decent fundamentals considered to be a safe bet as a rule of thumb.

However, the company's stock performance could be significantly adverse if underlying commodity prices fell.

Therefore, based on the above rationale and valuation, we recommend a "Speculative Buy" rating on the stock at the closing price of CAD 0.69 on May 18, 2021.   

*Depending upon the risk tolerance, investors may consider unwinding their positions in a respective stock once the estimated target price is reached or if the price closes below the support level.

1-Year Price Chart (as on May 18, 2021). Source: Refinitiv (Thomson Reuters)

*Recommendation is valid at May 19, 2021 price as well.

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