My October 2021 purchase of ARC Resources (ARX:CA) and (OTCPK:AETUF) was the focus of this article. They are one of the largest Canadian producers of natural gas. The linked article also contains my perspective on investing in upstream oil and gas producers.
At the time the final question was whether to go into ARX or into Tourmaline (TSX:TOU:CA) and (OTCPK:TRMLF). On the basis of relative pricing, I went into ARX.
I have recently switched. The present article discusses why.
First, though, let me share why these two companies seem superior to me. That comes down first and foremost to geology.
This map shows the Western Canada Sedimentary Basin, or WCSB. It extends from the foothills of the Rocky Mountains to the west to the edge of the Canadian Shield, which runs from Winnipeg in the south to Lake Athabasca in the north.
The basin is a wedge of material that tapers from 6 km thick in the west to zero at the edge of the shield. It has been geologically stable for several hundred million years.
Over that period, the basin has been inundated with water many times. This produced episodes of sedimentation. Here is a geologic map of the past 200 million years:
As usual, those sediments turned into layers of hydrocarbons. Below any one point on the surface there are often many layers from which gas or oil can be extracted, as illustrated here on a graphic from Tourmaline.
Another significant aspect of the history is that the “part of the basin beneath the Interior Plains” is “largely undeformed”. The implication is that holding the right to drill large swaths of terrain in the western WCSB gives you “inventory” that has a very high probability of producing usable gas and oil at costs comparable to those in similar strata and soil types.
That region is usually described as having three plays. These are the Montney, the Duverney, and the Alberta Deep Basin, as shown here.
Both Tourmaline and ARC Resources have inventory that will support decades of drilling at current rates. Tourmaline has significant assets in the Montney and some in the Duvernay, but is most dominant in the Alberta Deep Basin. Here is their slide on that:
In contrast, ARC Resources is focused on the Montney:
Both firms report extremely low breakeven costs for natural gas, well below one US$/MMBtu. Henry Hub natural gas prices have not been that low since before 1994.
There are differentials between local markets and Henry Hub, often negative. But both these companies also have long-term agreements in place under which they deliver much of their gas to locations outside of the WCSB, obtaining prices available there.
Mix of Hydrocarbons
One difference that may impact valuation lies in the mix of hydrocarbons these two firms produce. The four categories these firms report are oil, condensates, NGLs, and natural gas. Also, while the prices of oil and condensates tend to move together, NGLs and natural gas each follow their own path.
You don’t very often find any one of these types entirely by itself. These two firms have different mixes.
On a barrel of energy, or boe, basis, about a quarter of the production of ARC Resources is crude oil and condensate. In contrast, the fraction of these two for Tourmaline, on the same basis, is a bit less than 10%.
In the first 3 quarters of 2022, crude oil and condensate returned significantly higher revenue per boe than did natural gas or NGLs. The result for ARC was that the revenue was split roughly 50/50 between those two liquids and the sum of natural gas and NGLs. And the vast majority of the revenue was from natural gas and condensate.
In contrast, crude oil and condensate only contributed about a fifth of the revenues for Tourmaline. The fraction contributed by NGLs was also small, being below 15%. Tourmaline is thus much more of a pure play on natural gas than ARC.
Balance Sheets
Both these firms have Debt to EBITDA far below 1 (0.3 for ARC and 0.1 for Tourmaline). ARC targets Debt to Funds From Operation of 1 to 1.5.
Their debt maturity ladders show no grounds for concern. Both carry a BBB rating from DBRS Morningstar.
My reaction still is that this is amazing and wonderful. Both these are a very far cry from the wildcatter always on the edge of going broke one sees in the movies.
Not Standing Still
With their inventory and scale established, neither firm has an essential need to keep acquiring large swaths of new terrain. Tactical fill-in acquisitions are more likely, unless something stupid cheap becomes available. This is a big contrast with many firms south of the border.
Both expect to grow production over time. Tourmaline is explicit that they will only grow production in proportion to overall demand for gas from the WCSB. ARC is not as explicit about that but they are not stupid either.
The remaining way to increase shareholder value is to reduce costs. Both are active in doing so. A couple relevant slides follow:
Risks
The main risks here, and almost the only risks, are political. These two firms have among the lowest emissions intensities of any North American producers, and the North Americans are the best in the world.
That does not guarantee that the idiots in Eastern Canada will not do something really stupid. But the strong federal structure of Canada will help resist that.
Capital Allocation
The bottom line here is that both companies are positioned to make a lot of money and to sustain this for decades. The question is what they will do with the money?
But there is a huge difference in capital allocation priorities. ARC is focused on buybacks while Tourmaline is focused on dividends. Two relevant slides follow:
In the colorful words of author Fluidsdoc, in our Energy Income Authority chat room, about Tourmaline
Those guys have been minding the store, own most of the real estate in the WCSB, have a pristine balance sheet, and plan to ramp production and stuff cash down investors throats next year. It’s a capitalist pig’s dream stock.
His most recent article on TOU is here.
Market Pricing
I originally bought ARX in part because of relative underperformance in the stock price relative to TOU. My estimate was that the market had undervalued the results of their recent, major merger. Mr. Market has not agreed with me, at least yet:
But if you look at other measures the valuation difference appears less significant. For example, the ratio of market cap to estimated 2023 Cash from Operations is 3.1 for ARX and 3.3 for TOU, a difference of less than 10%. Using measures such as EV/EBITDA or EV/DACF it looks like ARX may be undervalued by perhaps 20% relative to TOU.
Tourmaline also has advantages. To me the main one is length of track record. From this perspective, perhaps TOU deserves a modest premium.
In addition, though, the different mix of condensate vs natural gas matters. One’s views of the future pricing for these hydrocarbons will also impact one’s view of the value.
If one is more positive on the future of crude oil relative to natural gas, then this makes ARX relatively more valuable. And vice versa. But both are highly likely to be quite profitable no matter what.
An investor who does not want to closely follow pricing changes as the gas and oil markets go through their gyrations needs to make a decision on some other basis. For such an investor, it seems to me that choosing which to hold comes down mostly to what you think about capital allocation.
A young investor with decades to let earnings multiples normalize, such as for example a graduate student in Boston, may consider the choice between buybacks and dividends to be merely a matter of “capital allocation.” Investors worried about taxes also often prefer buybacks.
But buybacks some with the real risk that the market will not respond to the decline in share count, because earnings multiples are dropping. As I discussed here, this would be a major issue for anyone in my circumstances, needing to tap their portfolio for income.
Dividends come as cash now. They can be spent.
As a result, it makes more sense for me personally to be in TOU rather than in ARX. So I switched.
A Final Note
The end of oil and/or gas has often been prophesied. It seems a long way from coming to pass, especially in the WCSB sourcing hydrocarbons from the Jurassic forward as happens today.
But even after that, consider the next lower layers of the WCSB, shown here:
The Cambrian era began 540 million years ago. Life was abundant and left its sedimentary remains. Perhaps our grandchildren will be making money as these two firms or their successors extract the hydrocarbons that must be deeper in the WCSB.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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