Surge Energy Stock: Lower Debt To Boost Shareholder Rewards (TSX:SGY)

Oil Pump in Winter

HABesen

Introduction

Surge Energy (OTCPK:ZPTAF) isn’t one of the most popular oil stocks in Canada as some of the management decisions have raised eyebrows in the pre-COVID era and I wasn’t sure the company would survive the pandemic. But in the past two years, Surge’s management team has done the right things. While I currently have no position in the stock (despite having Surge on my watch list for quite a while now), I have a substantial long position in the 2022 and 2024 debentures which I think provide good value for money in the current climate.

Surge Energy Price Chart
SGY data by YCharts

The company’s main listing is on the Toronto Stock Exchange where it’s trading with SGY as its ticker symbol. The average daily volume in Canada is superior to the secondary listings with an average of in excess of 900,000 shares. The debentures also are trading on the TSX with SGY.DB and SGY.DB.A as ticker symbols. All amounts in this article are in Canadian Dollars.

As expected, a very strong performance in the second quarter

In the second quarter of 2022, Surge Energy reported a total oil-equivalent production rate of just over 21,000 barrels per day, and about 80% consisted of oil. Another 799 barrels per day were NGLs while the remainder, just under 15% of the oil-equivalent production, was natural gas (which was sold at an average realized price of C$6.86 per mcf).

Oil Production

Surge Energy Investor Relations

This resulted in a very strong revenue, which more than doubled on the back of a 40% production increase and an average realized oil-equivalent price increase of in excess of 20%. While the headline revenue shows C$213M for the quarter, Surge also had to pay about C$37.7M in royalties and recorded a net loss of just over C$14M on hedging contracts. The net revenue in the second quarter was C$163M.

Income Statement

Surge Energy Investor Relations

The total operating expenses came in at just over C$90M. About 40% of these expenses were related to depreciation and depletion charges, while the finance expenses represented almost 10% of all operating expenses. Which means that as Surge continues to reduce its net debt, its interest expenses will continue to decrease and the profitability will improve. The bottom line showed a net income of C$72M for an EPS of C$0.86. And again, this includes a C$14M loss on the hedging positions.

According to the cash flow statement, Surge Energy generated an operating cash flow of C$76M, which includes a C$46M loss on the hedging positions. After deducting the C$1.5M in lease payments, the operating cash flow was just over C$74M, which was predominantly used to fund the C$37M in capex. The company also repaid about $46M in net debt during the quarter.

Cash Flow Statement

Surge Energy Investor Relations

Excluding the hedging losses, the adjusted operating cash flow in the Q2 pricing environment would have come in at in excess of C$120M for a free cash flow north of C$80M (or almost C$1/share in the second quarter). The realized loss indeed came in at almost C$24/barrel and if we would attribute the entire hedging loss to the oil sales, Surge Energy essentially recorded an oil revenue of C$102/barrel, which works out to a WTI price in the mid-80s.

Netback breakdown

Surge Energy Investor Relations

There still are some hedges in place, but as you can see below, those will start to roll off soon and the impact going forward should be relatively limited.

Hedge Book

Surge Energy Investor Relations

The balance sheet is getting safer fast

A strong cash flow is important to strengthen the balance sheet. That’s important because the company’s entire capital allocation framework depends on the net debt. We are currently in the first of three pre-defined phases, as Surge has recently reinstated its dividend. The company now pays C$0.035/month for C$0.42/year for a dividend yield of approximately 4.3%.

Debt Guidance

Surge Energy Investor Relations

As soon as the net debt drops below C$200M, Surge will reduce the pace it is reducing the net debt at an about 25% of the free cash flow will then be used to fund acquisitions, share buybacks and/or additional dividends.

Excluding lease obligations, the net debt came in at C$260M as of the end of June, so we are still a few quarters away from reaching that C$200M threshold. It is however important to note, Surge is rapidly paying down its bank debt. This will have a noticeable impact on the interest expenses going forward, which will further boost the free cash flow result and accelerate the net debt repayment.

With a little bit of luck (and barren unforeseen circumstances), Surge Energy could potentially reach the C$200M net debt level by the end of 2022, although this will also depend on the working capital changes. Perhaps Q1 2023 is a better (and more reliable) target date for the net debt to fall below C$200M.

In 2023, we should also see an even sharper reduction of the interest expenses as Surge Energy’s C$44M 5.75% convertible debenture will mature at the end of this year. In May, Surge announced it was planning to retire the debenture ahead of its maturity date, but I haven’t seen an update since. By simply repaying this debenture, Surge Energy will reduce its interest expenses by about C$2.5M per year.

Investment thesis

I still don’t have a long position in Surge Energy, but I am happy to own both the 5.75% 2022 debenture as well as the 2024 6.75% debenture. I don’t foresee any difficulties to get the full repayment of the 2022 bond on the maturity date in December (or before, as indicated by the company) as the company has access to in excess of C$120M on its line of credit while the total size of the debenture is less than C$45M.

I’m keeping close tabs on the common stock, as I could initiate a long position as well. But for now, my focus is on the debentures which I think offer good value for money as even the 6.75% 2024 debenture is trading at just over par for a YTM of just under 6.5%.

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