Peyto Exploration & Development Corp (TSX: PEY) is a Canadian energy company involved in the development and production of natural gas and oil & natural gas liquids in Alberta’s deep basin. On December 31, 2020, the company’s total Proved plus Probable reserves were 5.0 trillion cubic feet equivalent (834 million barrels of oil equivalent) as evaluated by its independent petroleum engineers. Production is weighted approximately 86% to natural gas and 14% to oil & natural gas liquids.

Investment Rationale:

• Robust Production Profile in Q1FY21: Condensate and NGL production increased 5% from 11,585 bbl/d in the first quarter of 2020 to 12,138 in the first quarter of 2021. Natural gas production increased 13% from 401.6 mmcf/d in the first quarter of 2020 to 455.6 mmcf/d in the first quarter of 2021. Total first-quarter production increased 12% from 471.1 mmcfe/d to 528.4 mmcfe/d. Increasing production amid higher underlying commodity prices is likely to benefit the company and increases profitability.

Source: Company Presentation

• Significant Increase in the Underlying Commodity Prices Bolstered Financial Performance in Q1FY21: Peyto’s natural gas price, before hedging and diversification activities, averaged CAD 4.52/mcf during the first quarter of 2021, an increase of 75% from CAD 2.59/mcf for the equivalent period in 2020. Oil & natural gas liquids prices, before hedging, averaged CAD 52.84/bbl, an increase of 56% from CAD33.96/bbl a year earlier. Significantly higher commodity prices have bolstered the company’s financial performance and margin profile in the first quarter of 2021. The company’s fund flow from operation nudged by 78% on a sequential-quarter basis and also funded the company’s capex.

Source: Company Filing

• Reduction in Long-term Debt: The company’s long-term debt at the end of the first quarter of FY21 stood at CAD 1,156.3 million, down from CAD 1,176.6 million at the end of the Q4FY20. The significant surge in the cash flow over the last two quarters was the key reason behind debt reduction, and we also believe deleveraging of the balance sheet would continue in the upcoming quarters on the back of the higher free fund flows from operation led by the stable underlying commodity prices.

• Strong Financial Risk Profile: The company has a relatively lower debt proportion in the balance sheet as compared to the industry median, as Peyto’s total debt to equity ratio at the end of the Q1FY20 stood at 0.68x, whereas the industry median Debt/Equity ratio stood at 0.82x. The company has relatively better debt protection metrics as compared to the industry median, with the Net Debt/EBITDA ratio stood at 7.38x, whereas industry medina stood at 8.54x. Moreover, the company’s debt protection metrics have improved significantly over the past two quarters, where it was 12.8x at the end of Q4FY20 and 18.5x at the end of Q3FY20.

• Ample Liquidity: Peyto has a decent liquidity profile on account of healthy cash accruals and robust debt protection metrics. Cash accruals are expected to improve further in the next two fiscal quarters and are likely to be adequate for moderate capex and debt repayments on the back of firm underlying commodity prices. For the first quarter ended March 31, 2021, funds from operations totaled CAD 116.7 million or CAD 0.71 per share, compared to CAD 54.5 million or CAD 0.33 per share during the same quarter in 2020. The increase in funds from operation was due to an increase in commodity prices and higher production volumes.

• Competitive Advantage Against the Industry Peers: Peyto’s margin profile is significantly higher compared to the peers’ average, which reflects the solid competitive advantage Peyto’s shareholders can enjoy over the competition. Further, improving commodity prices on the back strong recovery in the global economy and elevated production profile is likely to keep the company’s margin profile broadly higher in the mid-term.

Source: Kalkine Group, Refinitiv (Thomson Reuters)

• Technical Indicators are Showing Upside Momentum: On the daily price, chart the stock prices are making higher high and higher lows, which is a bullish indicator. Moreover, prices are taking the support of the upward sloping trendline and continuously sustaining above it.

Source: Reuters (Thomson Reuters)

• Risk Associated to Investment:  The company’s business is largely depending on the length and direction of the underlying commodity prices. Any adverse move in the commodity prices could significantly dent the group’s performance and financial health.

Financial Highlights: Q1FY21

Source: Company Filing

• The production increased 12% during the quarter. First-quarter 2021 production of 88,070 boe/d comprised of 456 MMcf/d of natural gas, 7,018 bbl/d of Condensate and Pentanes, and 5,120 bbl/d of Butane and Propane. The total liquid yield was 27 bbl/MMcf or 13.8% of total production, which was down from 29 bbl/MMcf in Q1 2020 due to an increased focus on leaner gas Spirit River plays and the acquired Cecilia production (effective January 1, 2021).
• For the first quarter of 2021, royalties averaged CAD 0.29/mcfe or approximately 7% of Peyto's total petroleum and natural gas sales, excluding hedging losses. The increase was due to higher AECO and WTI prices. The royalty rate expressed as a percentage of natural gas and natural gas liquid sales would fluctuate from period to period as the Alberta Reference Price can differ significantly from the commodity prices realized by Peyto.

Source: Company Filing

• For the first quarter, operating expenses were CAD 16.9 million compared to CAD 16.7 million for the same quarter in 2020. On a unit-of-production basis, operating costs decreased 8% from CAD 0.39/mcfe to CAD 0.36/mcfe.

Source: Company Filing

• Funds from operations per share were up 115%. The group generated CAD 117 million of Funds from Operations in Q1 2021 (CAD 0.71/share) compared to CAD 55 million in Q1 2020 (CAD 0.33/share) due to higher commodity price realizations combined with higher production. FFO in the quarter exceeded the combination of capital expenditures (CAD 73 million), acquisitions (CAD 36 million), and dividends (CAD 1.6 million) by CAD 6 million resulting in a total payout ratio of 95%.
• The total cash cost was CAD 1.24/Mcfe. The company’s industry-leading low total cash costs included CAD 0.29/Mcfe royalties, CAD 0.36/Mcfe operating costs, CAD 0.17/Mcfe transportation, CAD 0.04/Mcfe G&A and CAD 0.38/Mcfe interest, which combined with a realized price of CAD 3.70/Mcfe resulted in a CAD 2.46/Mcfe (CAD 14.81/boe) cash netback, up 94% from CAD 1.27/Mcfe (CAD 7.63/boe) in Q1 2020.
• Operating costs per unit for Q1 2021 were down 8% from Q1 2020, largely due to increased volumes and higher facility utilization, while royalties were up due to higher commodity prices. Interest charges were also up 31% because of higher stamping fees negotiated as part of the temporary covenant provisions.
• Capital investment stood at CAD 73 million in organic activity. A total of 27 gross (22.5 networking interest) wells were drilled in the first quarter, 21 gross (17 net) wells were completed, and 20 gross (16.7 net) wells were brought on production. In addition, two acquisitions totaling CAD 35.6 million (effective January 1, 2021) were closed in the quarter.
• Over the last 12 months, new production additions, inclusive of acquisitions, accounted for approximately 34,000 boe/d at the end of the quarter, which, when combined with a trailing twelve-month capital investment of CAD 276 million, equates to an annualized capital efficiency of CAD 8,100/boe/d.
• Earnings of CAD 38.5 million were generated in the quarter, while dividends of CAD 1.6 million were paid to shareholders. During the quarter, Peyto earned CAD 0.35 for every dollar of capital invested.
• Moreover, Peyto enjoyed an active first quarter despite the continued impacts and constraints of the global COVID-19 pandemic. The company maintained its vigilant focus on safety and successfully conducted a full winter drilling and completions program while also fully integrating two property acquisitions, including taking over operations of its 10th owned and operated natural gas processing plant. Total Company-owned and operated plant processing capacity now stands at approximately 875 MMcf/d making Peyto the 11th largest Canadian gas processing company. 

Shareholding Pattern

Top-10 shareholders in the company held around 36.7% stake. Letko, Brosseau & Associates Inc.  and SailingStone Capital Partners LLC are among the largest shareholder in the company and carrying an outstanding position 12.31% and 9.98%, respectively. The institutional ownership in “PEY” stood at 36.17%, and ownership of the strategic entities stood at 2.53%.

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: The outlook for natural gas prices continues to improve. The combination of falling market diversification costs and rising North American natural gas prices, driven by reduced supply from tempered industry investment combined with strong global demand, is likely to result in higher realized natural gas prices. This would result in improving Peyto's cash flow and balance sheet as well as increasing the value of its developed reserves. The company's long producing reserve life in the improving price environment should enable Peyto to increase its return of capital to investors in the form of further debt reduction and, when appropriate, increased dividends.

At the same time, Peyto continues to obtain additional Deep Basin opportunities to invest capital and deliver profits for shareholders. Consolidation in the Canadian natural gas industry and in the Alberta Deep Basin has resulted in less competition for opportunities in Peyto's traditional core areas. With its large infrastructure network of pipelines and gas plants, Peyto can generate superior returns on its remaining undeveloped resources.

Further, with the surge in the fund flow from operations, the company is consistently deleveraging its balance sheet, which is reducing balance sheet risks for the investors with strong debt protection metrics.

Therefore, based on the above rationale and valuation, we recommend a "Buy" rating on the stock at the closing price of CAD 5.73 on May 20, 2021.

Technical Price Chart (as on May 20, 2021). Source: Refinitiv (Thomson Reuters)

*Recommendation is valid at May 21, 2021 price as well.

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Disclaimer

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