On the Money

Ver­mil­ion En­ergy benefits from hav­ing a va­ri­ety of assets in a va­ri­ety of places

Alberta Venture - - Contents - By Jody Chud­ley

Ver­mil­ion En­ergy finds strength in di­ver­sity

The Play

Usu­ally in this part of my monthly write-up I tell you about “the play” that the com­pany I’m pro­fil­ing is op­er­at­ing in. This month I can’t re­ally nar­row it down like that since I’m talk­ing about a com­pany with an ex­tremely di­ver­si­fied as­set base.

In in­vest­ing, di­ver­si­fi­ca­tion is good. When it comes to run­ning an oil and gas pro­ducer, I’m not sure that it is. This is an in­dus­try in which be­ing a low-cost pro­ducer is crit­i­cal for any sig­nif­i­cant level of long-term suc­cess. If you have spent any time in­vest­ing in this sec­tor, you will know this is the case.

Find­ing one good play to base your com­pany around is hard enough, given what you are com­pet­ing against. Try­ing to find sev­eral so you can of­fer a di­ver­si­fied as­set base to in­vestors is that much harder.

That makes the mid-sized com­pany in fo­cus this week a bit un­usual. It has an as­set base that is di­ver­si­fied in al­most ev­ery way imag­in­able. In terms of plays, there is di­ver­si­fi­ca­tion since the com­pany op­er­ates shale and con­ven­tional assets, and both on­shore and off­shore. By com­mod­ity there is di­ver­si­fi­ca­tion since the com­pany sells both oil and nat­u­ral gas, as well as hy­dro­car­bons with dif­fer­ent price points (WTI, Brent, Aeco, Euro­pean nat­u­ral gas). There is ge­o­graphic di­ver­si­fi­ca­tion as the com­pany’s assets are spread across not only coun­tries but con­ti­nents hit­ting North Amer­ica, Europe and Aus­tralia.

Most im­por­tantly, all of this is di­ver­si­fi­ca­tion an in­vestor should like.

The Pick

Ver­mil­ion En­ergy (TSE:VET) This oil and gas pro­ducer is Ver­mil­ion En­ergy and it is a very well-run com­pany. Ver­mil­ion has the kind of di­ver­si­fied assets that you might ex­pect to find in an oil and gas ma­jor rather than a mid-sized pro­ducer. Ver­mil­ion re­ceives sig­nif­i­cant por­tions of its pro­duc­tion from Canada, France, Ire­land, Aus­tralia and the Nether­lands.

While di­ver­si­fied, Ver­mil­ion’s pro­duc­tion com­bines for high af­ter-tax cash flow net­backs. That is how much money each bar­rel of pro­duc­tion gen­er­ates af­ter op­er­at­ing ex­penses. Hav­ing high net­backs means that you are gen­er­at­ing a lot of cash flow from your pro­duc­tion. On this measure, Ver­mil­ion ranks as one of the most prof­itable Cana­dian-listed pro­duc­ers.

That isn’t all there is to like about Ver­mil­ion’s pro­duc­tion. It also has one of the low­est de­cline rates in the in­dus­try. Hav­ing a low de­cline rate means that you don’t have to spend as much cash drilling new wells to off­set pro­duc­tion de­clines. Put high net­backs with low de­cline rates and you can gen­er­ate some se­ri­ous free cash flow, some­thing rather un­com­mon in this capital in­ten­sive in­dus­try.

Ver­mil­ion refers to its “ef­fec­tive” cor­po­rate de­cline rate as be­ing at 13 per cent. Com­pare that to a pure-play pro­ducer like Rag­ing River ( a good com­pany) which has a de­cline rate of over 40 per cent and you can ap­pre­ci­ate Ver­mil­ion’s ad­van­tage.

Ver­mil­ion’s ef­fec­tive rate of de­cline is lower than its nat­u­ral rate be­cause Ver­mil­ion cre­ates the ef­fec­tive rate by re­strict­ing pro­duc­tion in the Nether­lands and Aus­tralia. By re­strict­ing pro­duc­tion on those two prop­er­ties (done to max­i­mize long-term re­cov­er­ies) the de­cline rate is zero.

Since good things come in threes, I’ll point out one more thing to like about Ver­mil­ion’s pro­duc­tion: It doesn’t cost much to bring it on­line. In 2015, Ver­mil­ion’s find­ing and de­vel­op­ment cost was just $9 per bar­rel. That has come down from $35 per bar­rel in 2011 and is a level that Ver­mil­ion be­lieves it can main­tain due to re­duced drilling times.

The Postscript

Add these three at­tributes to­gether (high net­back, low de­clines, strong capital ef­fi­cien­cies) and good things are bound to hap­pen. That is ex­actly the case at Ver­mil­ion, where free cash flow has surged in 2016 and will con­tinue higher in 2017 and 2018.

By free cash flow I’m talk­ing about cash left over af­ter de­duct­ing all capital ex­pen­di­tures (in­clud­ing growth spend­ing). Ver­mil­ion’s free cash flow will nearly quadru­ple this year from where it was in 2014, quite an achieve­ment con­sid­er­ing oil prices are about half what they were back then.

Ver­mil­ion shares pro­vide a div­i­dend yield of 4.7 per cent and the com­pany ex­pects to grow pro­duc­tion by four to eight per cent in the years ahead. It will do this with a healthy bal­ance sheet and its debt to cash flow should be un­der 1.5 by the end of this year.

Af­ter us­ing free cash flow to im­prove the cor­po­rate bal­ance sheet over the next six months I would ex­pect that we could see Ver­mil­ion hike its div­i­dend by up to 25 per cent near the end of 2017. That could be a wel­come cat­a­lyst for Ver­mil­ion’s share price.

“When we started, we were drilling and cas­ing those wells in 21 days. Now, we drill and case them in about nine days.” – An­thony Marino, CEO, talk­ing to Dig­i­tal News Group about a play in Al­berta’s West Pem­bina re­gion


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