September 12, 2009

Value idea: Peyto Energy Trust

Natural gas is at extreme lows as it should; there is tremendous supply in the system. Storage is almost full. There will be no where to put extra production. The reason is the vast discoveries of shale gas. North America is abundant with natural gas contrary to what was believed of North America peak gas. Even with a harsh winter I do not think the supply picture will improve.

However I believe that goods or assets can't sustain prices below its average production cost over the long term. Sure there will be some divergence in some periods but it should return to equilibrium eventually. The question is when. I am not going to speculate on that as it is going to be a crap chute at best.

However a good position if I can find a way to participate in the price recovery of natural gas, while I get some downside protection and a margin of safety. I think Peyto Energy Trust (Pey.un) gives me this proposition. Peyto is :
Canada-based energy trust. The Trust’s principal business activity is the exploration for, development and production of petroleum and natural gas in Western Canada. As of December 31, 2008, the total proved plus probable reserves were 998.3 billion cubic feet equivalent (166.4 million barrels of oil equivalent) with a reserve life of 23 years. Production is weighted approximately 85% natural gas and 15% natural gas liquids and oil.
I like Peyto for the following:
  • hedge book for half of their production of the next 12 months at an average price of $7.5 per mcf
  • low debt to capitalization and good coverage of debt service and dividends
  • low cost producer of natural gas. currently their operating costs per BOE is $2.56 as of their latest quarter
  • long life reserves
  • the cost structure for the most part is variable and gets reduced with lower revenues.
  • cheap valuation where its Entp. Value to NPV is .57, a measure to value the company to its discounted cash flow from reserves in the ground.
  • The current dividend yield is Distribution is 15.5%. The coverage of the distribution is good but if gas prices continue its decline it will be halved.
  • I get good odds betting on natural gas plays. The upside is potentially large while the downside is limited. We are already at a decade low of natural gas price. Most Natural gas producer did not participate fully in the recent rally and lag the indices by a wide margin.
  • And a very good management, extremely good management.
  • My catalyst will be the revision to mean in natural gas prices as most likely it can't keep going down. We are in a period of supply and demand imbalance and there should be an equilibrium found in the next 12 months.

What can go wrong:
  • Payout ratio is trending higher, which is understandable given the weak revenue figure. Peyto has already cut its distribution and it could a further cut is probable.
  • Natural gas is the "widow maker" and can be very volatile. There is no reason it can't go to low $2s per mcf.
  • Their operating lines can be shut or reduced if credit environment deteriorates further. Producers rely on operating lines to fund operations and exploration.
  • Royalties are influx in the government of Alberta and can be very fickle to factor in analysing operations. Couple years ago royalties has been hiked on gas producers but once the bust has set in it was reconsidered.
  • The conversion to corporate entity issue. Trusts will be subject to regular corporate taxes in 2011 so this is issue is hanging on Peyto and all trusts alike.

A note: This is a Canadian trust equivalent to master limited partnership in the US so it will have personal tax consequences that will have to be taken into consideration when purchasing


Anonymous said...

What is your intrinsic value range on the company? As well, how do you value a commodity company when its value is dictated by the price of that particular commodity?

Sami said...

by evaluating its reserves in the ground. All resource companies publish NPV (Net present Value) figure. It is a calculation of the discounted future generation if they sell their reserves. They forecast prices using the forward price curve and I agree that this can fluctuate based on the price of the commodity. but if you use large discount rate you may be can get a good margin of safety.

But your point is very valid about resource companies. You will have to take a view on the underlying commodity if you buy their stock.

I figure it trading at half of what is fair value based on their reserves. so a range in 18-20 is fair value for Peyto. Last year it was trading above $20 but nat gas prices were around $6-7.

How low can gas price go I figure not much more. but it could stay in this range for a while as supply work it self out.

Anonymous said...

Thank you very much for that explanation Sami. What resources or literature do you recommend for someone who wants to learn more about analyzing a resource based company?

Are you planning to take a position in this company?

Sami said...

I did buy @ 9.2.

you can read Handbook of Canadian Security Analysis there is a chapter about resources it is a very good start.

also another good valuation to these companies is Price per cash flow or funds from operations

Anonymous said...


Another Natural Gas Play you might be interested in:

Sami said...

Peyto is not unique there are many gas med caps that offer good value.

I think those gas plays will become cheaper still in spring, if gas says at this level. The annual reserves figures will reflect lower gas prices so the NPV of recoverable reserves will be lower. Banks set their credit lines based on that figure so some will face credit lines cutbacks leading to liquidity issues.

so I am willing to buy more at that time. It is interesting area and a lot of good plays can be found.