First quarter 2022: Promotion to next league
Saturn Oil + Gas Inc. is again reporting new records in production volumes and is clearly moving up into a new league with the completed transformation. With production of 7,600 boe/d in the final month of the January-March 2022 quarter, Saturn is on track to meet or exceed its recently upgraded 2022 guidance of average production of 7,950 to 8,350 boe per day. In particular, earnings from the new oil fields at the Oxbow acreage drove adjusted funds flow (cash flow) to CAD 13.5 million, or CAD 0.50 per share, for the first three months of 2022. Average Q1 operating earnings of CAD 56.94 per boe sold were a good CAD 21.28 above the previous period, Q4 2021 earnings.
To fuel further growth, as previously reported, an equity raise of CAD 20.6 million was completed in Q1 2022 in the form of a public bought deal matched with a private placement. As a result, the company was able to make progress on three strategic fronts: 1) Saturn completed a strategic acquisition of oil and gas properties in the Plato area of West-Central Saskatchewan with 240 boe/d of production, for consideration of CAD 7.6 million; 2) the equity raise allowed for the consolidation of outstanding debt as Saturn moved from two primary lenders to one, offering much needed financial flexibility; and 3) Saturn was able to reduce net debt.
Looking at Saturn's balance sheet net debt decreased, as planned, to CAD 65.2 million from year end 2021 of CAD 71.1. Q1 2022 EBITDA reached CAD 16.3 million, implying a net debt ratio of 1.0 to annualized EBITDA, which is a modest leverage level. However, Saturn is following a policy of rapid debt repayment and based on current calculations, net debt will reach zero by the end of 2023. From which point the Company will generate quarterly net surpluses of at least CAD 25 million, which can be put into further expansion or distributed to shareholders. It would be advisable to dock additional properties in order to leverage maximum synergy potential in production. In the oil business, size is an absolute advantage.
Valuation remains a mystery
It is the Company's fourth consecutive quarterly record since completing the transformative Oxbow asset acquisition in June 2021. Current high energy prices are playing into Saturn's favor, as they are providing a significant boost to earnings from oil volumes sold. The average price per boe sold was CAD 101.41, a price that is quite respectable in the course of the quarter, since the price of oil only really started to rise after the start of the war on February 24. One's joy, the other's sorrow - in such a way it must be expressed probably. Because while the rest of the world suffers from high energy prices, Saturn profits.
The important hedging briefly explained
Some investor groups seem to have problems with the net income statement losses that have to be reported quarter after quarter, from unrealized hedging losses. That is because international accounting rules require that expected losses from hedges on oil production in future periods must be included as losses in the current period. In view of the enormous rise in oil prices since the beginning of the year, the value of the oil volumes expected to be sold in the future has already increased significantly. They appear in the accounts as negative revenue and far outweigh the current operating surpluses. Nevertheless, they are only an accounting exercise on paper, because they do not have to be paid for with cash. By requirement of the accountants pen it would appear Saturn had minus CAD 64.3 million in revenue in Q1 2022. This would be an odd achievement in a quarter of record production and soaring oil prices. In the reality of cash flow, Saturn actually earned net cash flow of CAD 13.5 million in the quarter which they used to pay down debt and drill new oil wells to grow the business.
The hedge book is quickly explained for Saturn: the sum of negative income from the hedging in of all the future periods into the year 2026 adds up to CAD 103.8 million and are booked as an "unrealized loss" in the current quarter. This is done on expectations oil prices will stay at this high level well into the future. In the next quarter, Q2 2022, the calculation starts all over again. If the oil price should move down in future periods, this will relieve the pressure on Saturn's hedge book and they would have to do a book value write-up. Then hedging gains would be added to revenue and flow into operating profits. Therefore, under the scenario of rising oil prices, reported profits of hedged companies crash. Conversely, when oil price slump, reported profits soar. It is on the face a counterintuitive accounting policy because actual cash flow earning rise and fall in the exact opposite manner. The intention of hedging production is to smooth the future cash flow profile of companies in the volatile oil and gas business, and to this purpose hedges work well. The unfortunate downside is that on a non-cash basis, these policies can create wild fluctuations in reported profits, and can be misleading to investors.
Focusing on the cash side of accounting, the most recently reported CAD 16.3 million of EBITDA cash flow was due to an offset by a realized hedging book loss of CAD 20.6 million. Without this measure, EBITDA of CAD +36.9 million would have been incurred and after deducting the CAD 2.8 million in net interest for the last quarter, cash flow would have been CAD 34.1 million. It is an interesting exercise to see what is the true cash flow generating ability of the assets are, especially as the hedged volumes are scheduled to drop yearly. But realized hedge losses are cash based, so we remain focus on the still impressive CAD 13.5 million of cash flow earned. Accurately analyzing the cash flows coming into the company demonstrate the resources for interest payment, debt redemption and operational purposes. And these are budgeted to deliver nearly CAD 80 million to the Company's coffers in 2022.
New guidance for 2022: Bar set a bit higher still
The fully funded 40.2 net well drilling program for 2022 is about 32% complete, with the bulk of the remaining drilling activity planned for resumption in June and running through December. The Company plans to operate two drill rigs during this period, with one rig each for the key growth areas: the Oxbow asset and the Viking asset. The Company drilled twelve horizontal wells in the Frobisher and Tilston formations at the Oxbow asset in Southeast Saskatchewan in the fourth quarter of 2021 and the first quarter of 2022, where it achieved a 100% success rate and high first total flow rates. Eight of these wells now have 30-day production data, which has increased the Company's estimate of average expected ultimate crude oil production for these wells. Based on the strong economics of the recent drilling programs, Saturn's board has increased the 2022 capital expenditure budget by CAD 6 million, with three additional wells to be drilled at the Oxbow asset and three additional wells at the Viking asset.
Given the recent increase in global oil prices, Saturn is also increasing the oil price assumption for its 2022 WTI crude oil reference price forecast from USD 75 to USD 95. No changes were made to natural gas prices or exchange rates. The revised forecast for 2022 includes average annual production in the range of 7,950 to 8,350 boe/d (95% crude oil and natural gas liquids), representing a YOY production increase of 17% to 22%. This is the sustainable rate Saturn is targeting going forward while spending only 50% of the cash flow operations generate. EBITDA is expected to be in the range of CAD 90.0 to CAD 94.5 million, with cash flow expected to be in the range of CAD 78.0 to CAD 82.5 million. Free cash flow is also expected to increase to between CAD 29.4 million and CAD 33.9 million, and the corresponding cash flow yield would increase to between 33% and 39%. All things considered, this brings the projected net debt at year-end 2022 down to CAD 36.4 million to CAD 42.0 million, a 41% to 59% decrease from year-end 2021 debt.
Interim conclusion: Dramatically undervalued
With the new guidance, Saturn is once again noticeably boosting its output for 2022, as increased capital expenditures continue to change projected and expected cash flows upward. The currently available research studies by Beacon, Echelon GBC Research and Velocity, used cash flow multiple analysis and discounted cash flows to today's value and already arrived at fair value target prices between CAD 7.00 and CAD 13.12.
Most recently, Saturn shares peaked at CAD 2.82. If the market wants to jump on the moving train due to the upcoming updates of the research houses, there will likely be no more sellers and Saturn Oil + Gas will experience a revaluation.
An important comparison is the 2022 expected cash flow per basic share of CAD 2.48 which also happens to be very close to the expected hedging loss of CAD 2.47 per basic share. The implication is that in the absence of hedging losses, total cash flow per share would be forecasted at CAD 4.95. So, post hedging Saturn shares are trading at a 1.1x cash flow multiple with 19 year reserve life index and decades of drilling inventory to sustain production. An argument could be made that a well hedged cash flow per share would warrant a higher multiple and not one well below the peer average of 3x to 4x. Investors should quickly realize that there is no cheaper oil stock in North America right now.
On Thursday, May 19, 2022, Saturn CEO John Jeffrey will certainly go into more detail about the company's development at the 3rd International Investment Forum (IIF).
The update is based on our initial Report 11/21