Advantage Oil & Gas: An Opportunity For The Long Term – Advantage Oil & Gas Ltd. (OTCMKTS:AAVVF)

Advantage Oil & Gas (OTC:AAVVF) released its Q1 results in line with its long-term plan. The natural gas producer increased its portion of NGL production while management confirmed the goal of NGL production reaching 22% of the total production by the end of 2021.

Over the last few weeks, several producers highlighted challenges with NGL prices. But we’ll see the impact on Advantage’s NGL production is limited.

In this context, the low market valuation is an opportunity to invest in the company while waiting for gas and NGL prices to improve over the long term.

Image source: Advantage Oil & Gas

Note: All the numbers in the article are in Canadian dollars unless otherwise noted.

Q1 Results

During Q1, production increased 13% year over year to reach 44,900 boe/d. In line with its plan, Advantage Oil & Gas increased its NGL production at a faster pace than the total production.

Over the last few quarters, the trend is even stronger as gas production decreased while NGL production increased.

Advantage Oil & Gas Q1 earnings: production

Source: Q1 2019 MD&A

Liquids represented almost 5% of the total Q1 production. And management confirmed the goal of increasing the NGL portion to 15% and 22% of the total production by the end of 2020 and 2021.

In the meantime, gas still represents the huge majority of the total production. Revenue from gas reached almost 88% of the total revenue during Q1.

Advantage Oil & Gas Q1 earnings: revenue

Source: Q1 2019 MD&A

Costs slightly increased compared to the previous quarter.

Advantage Oil & Gas Q1 earnings: costs and netbacks compared to Painted Pony and Peyto

Source: Author, based on company reports

The slightly lower quarter-over-quarter production and the higher liquids production contributed to the higher per-unit costs.

But the company generated a total positive netback of C$0.57/mcfe and C$0.75/mcfe before and after hedges, respectively. These results are similar to the results other gas producers reported.

Advantage Oil & Gas Q1 earnings: production compared to Painted Pony and Peyto

Source: Author, based on company reports

The higher capital program during Q1 at C$57 million exceeded the adjusted funds flow of C$50 million. Thus, the net debt increased to C$281.3 million compared to C$272.8 million at the end of last year. Yet, the net debt to annualized adjusted funds flow ratio is still reasonable at 1.4x.

But the company needs to spend its capital program within its adjusted funds flow to avoid higher leverage in the context of volatile prices. Management announced a C$10 million reduction of the capital program that will now be in the range of C$180 million to C$200 million.

For the full year, 28% of the gas production is exposed to AECO spot prices. As per the table below, the rest of the gas production is hedged or exposed to U.S. prices.

Advantage Oil & Gas Q1 earnings: hedges

Source: Presentation May 2019

Considering the modest AECO hedges and the usually lower – or even sometimes negative – AECO spot prices during summer, the company needs strong NGL prices to compensate for the expected low gas prices.

NGL components are not equal

These days, there’s a lot of noise around Canadian oil and gas prices. NGL prices don’t trigger the same amount of articles and breaking news.

Yet, NGL is also dependent on market conditions and oil and gas producers reported a wide range of NGL realized prices. For instance, Advantage Oil & Gas reported an NGL realized price of C$51.93/bbl during Q1. In contrast, Bonavista Energy (OTCPK:BNPUF) reported an NGL realized price of C$28.95/bbl.

The difference is due to the different pricing of components included in the NGL category: butane, pentane, propane, and condensate.

Many producers don’t disclose any extra detail about the NGL production and the reasons for such different prices. But we can get some useful information from a few producers.

This month, Peyto (OTCPK:PEYUF) discussed the pricing of NGL components:

Condensate, Pentane, Butane and Propane have typically been the NGLs of choice to help supplement our natural gas revenues when gas prices are down. Now with a glut of Butane that needs to clear the market, we are down to three in the short term (Butane will be back by fall). The Propane market anxiously awaits Altagas’ new Ridley Island export terminal to put a bite in Propane supply and help lift prices, so really for right now, we’re down to two products: Condensate and Pentane. – Source: Peyto President report May 2019

Tamarack Valley (OTC:TNEYF) also highlighted the challenging price environment for butane during Q1:

Currently, NGL supply outstrips demand and suffers from a lack of pipeline egress in Canada. In particular, Alberta spot butane markets continue to struggle after plummeting in the second half of 2018. As a result, the NGL rates achieved during the contract negotiations for the April 1, 2019 to March 31, 2020 contract period were materially lower than in prior years. In particular, butane as a percentage of WTI dropped from the range of 55% to 60% to the range of 10% to 15% while frac fees increased by approximately 30% to 35%. – Source: Q1 2019 MD&A Tamarack Valley

Peyto’s Q1 realized price by NGL component confirms the low propane and butane prices compared to pentane and condensate.

NGL prices per component

Source: Q1 2019 MD&A Peyto

Thus, the portion of pentane and condensate has an important impact on the realized prices. Bonavista’s lower NGL realized prices are due to the higher mix of butane and propane in its NGL production. On the other hand, Advantage Oil and Gas reported that pentane and condensate constituted 69% of its NGL production.

Thus, speaking about NGL prices without any extra information about the type of NGL isn’t meaningful. As long as pentane and condensate prices stay stronger than propane and butane, Advantage Oil & Gas isn’t as impacted as some other producers like Bonavista Energy.

Valuation

The market doesn’t seem to make any difference between Canadian gas producers. The stock price of the three companies I compared above dropped about 51% over the last twelve months.

ChartData by YCharts

From the flowing barrel perspective, the market values Advantage Oil & Gas at a discount, though.

Advantage Oil & Gas Q1 earnings: flowing barrel valuation compared to Painted Pony and Peyto

Source: Author, based on company reports

A part of the discount is due to the lower netback Advantage realized compared to Peyto for instance. Also, Peyto operates at lower costs while its portion of NGL is higher than Advantage’s. And Advantage Oil & Gas’ per-unit costs are expected to increase with the ramp-up of its NGL production.

Advantage Oil & Gas production forecast

Source: Presentation May 2019

To calculate my intrinsic fair value estimate, I consider the Q4 profits, after hedges, of C$0.78/mcfe. I apply a 12x multiple to these profits corresponding to a flat production.

Advantage Oil & Gas Q1 earnings: intrinsic valuation

Source: Author

The market values the company at an important 61.5% discount to my fair value estimate. Without taking into account hedges, the discount would still reach approximately 47%.

The exposure to volatile AECO gas prices impacts the market valuation. But, taking into account the growing part of NGL, the evolution of condensate and pentane prices will be more and more important for the company.

Advantage Oil & Gas long-term plan revenue

Source: Presentation May 2019

I won’t invest in Advantage Oil & Gas as I have a similar exposure to gas and NGL prices with my investment in Peyto. But Advantage Oil & Gas is worth considering in the perspective of a long-term value investment. The company can execute its strategy of growing NGL production while waiting for the NGL and gas prices to improve over the next several years.

Conclusion

During Q1, the NGL portion of the total production increased as expected. Thanks to its gas marketing diversification and hedges, Advantage Oil & Gas generated a total positive netback.

The company’s future revenue will depend more and more on NGL prices. Most of Advantage’s NGL production – condensate and pentane – isn’t impacted by the NGL price challenges some producers reported.

Yet, the market values the company at a discount. Considering the reasonable level of debt and the positive total netbacks over the last few quarters, the company doesn’t need higher gas and NGL prices to execute its long-term strategy. The low valuation provides a long-term investment opportunity while waiting for gas and NGL prices to improve over the next several years.

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Disclosure: I am/we are long PEYUF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.