MEG Energy: Impacts Of The New Royalty Regime - Trans Mountain Expansion, Increased Payouts

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MEG Energy is expected to benefit from narrowing heavy oil differential caused by the coming TMX pipeline.By the end of the third quarter, the company should switch to a 100% payout via buybacks and ...

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(TSX:MEG:CA)(OTCPK:MEGEF) presents the purest play on the expected lower WTI/WCS differential caused by the Trans Mountain expansion (TMX). The company is about to start paying all FCF into shareholders' pockets. The only question: How much is already priced in the share price? Data by YCharts Despite the stock being over 20-bagger from 2020 lows and beating almost all its peers, I suggest investors to avoid anchoring and focus on the value. With detailed and conservative assumptions, the share price is worth ~C$39, which gives you around 22% upside to a fair price for 12.5% yearly returns going forward. There are risks as well, and recently, insiders were selling the stock, which makes me rate the stock as a decent HOLD. MEG's Business Model - Production, Blending, Transportation There are two common methods to produce oil from oil sands: surface mining and in situ production. In Situ vs. Surface Mining (oilsands magazine) MEG solely focuses on in situ production using the SAGD system. Its main asset is ~1.9B barrels of bitumen in the Christina Lake Project, with a production capacity of ~100,000 bbls/d, but regulatory approval for up to 210,000 bbls/d. Since heavy bitumen does not flow through pipelines, MEG needs to blend it with condensates to create a thermal oil known as Access Western Blend (AWB). MEG then transports the AWB through the Flanagan South and Seaway pipeline with a contracted capacity of 100,000 bbls/d, which is nearly all its production. Since the TMX pipeline is expected to start operations within a few weeks, MEG will be able to use another 20,000 bbls/d transportation capacity. Daily production levels fluctuate, and sometimes, MEG produces more oil than it can transport. As you can read in MEG's Annual Information Form, that's no issue, as MEG has a contracted storage capacity of 2.1 Mbbls. MEG's Competitive Strengths   Large reserves - In situ production gives the company the ability to reach deep underground reserves. With the current production pace, the company estimates 30+ years of proven reserves and 50+ years of 2P reserves (Proved+Probable). I do not expect to witness the company spending on acquisitions within my lifetime. Actually, we might see further expansion of MEG's reserves with future technological improvements.  Low production decline rate with low sustaining capital - The oil sand mining has zero production decline, which gives mining companies like Canadian Natural Resources Limited (CNQ) or Suncor Energy Inc. (SU) a great advantage. MEG focuses on in situ extraction, which has a decline rate. Yet, it is much smaller compared to conventional producers. Christina Lake Project has a ~10-15% decline rate. This gives the company a very low sustaining capital of only C$450M.  Low production costs - Production and transportation costs are sitting low at ~C$25 per barrel. The costs are further offset by cogeneration as MEG uses a gas turbine as a part of its production process, generating electrical power that MEG sells to Alberta's electrical grid.  Environmental costs - Compared to its oil sands peers, MEG does not mine from a surface. Thus, they do not need to deforest large areas. As all lands must be reclaimed by their peers.  MEG's Competitive Weaknesses   Not all barrels are created equal - Despite MEG having very large 50+ 2P reserves, these reserves are of 100% bitumen, which is not very valuable on its own.  No upgraders - While oil sands peers upgrade their bitumen into highly valuable SCO (synthetic crude oil), MEG does not own any upgraders, and it would be very expensive to build one. Instead, MEG blends its bitumen with condensates.  Dependent on undersupplied condensates - As I wrote in my ARC Resources analysis, Canada is a pure exporter of heavy oil but needs to import the condensates from the US. Buying condensates is the largest cost for MEG.  Christina Lake Project has reached the post-payout period - Royalty rates on pre-payout projects are in the range of 1-9% of gross revenue. As we can read in MEG's 2Q2023 results highlights, the Christina Lake Project reached a payout in the second quarter of 2023. The royalty regime had significantly increased to 25-40% of net revenue. We saw it in the last quarterly results when effective royalty rates jumped to 28.2% from 9.4% for the same period in 2022. Since only a part of the 2023 results were affected, we can expect the FY2024 numbers to be worse for investors. One important thing is that the royalty rate is calculated only from the bitumen sales, meaning MEG can deduct its costs of buying the condensates, which is significant. For more details about the calculation, you can read page 20 of the 2024 corporate presentation.  Recent Results, Financials, Capital Allocation & Shareholders Return In 2023, MEG achieved a record average yearly production of 101,425 bbls/d. Since the main constraint is the transport capacity from Canada, reaching a new record output was expected, as all oil sand operators increased outputs in anticipation of increased transport capacity from the TMX pipeline. This resulted in FCF of C$954M. The company is still in the phase of debt principal repayments. In 2023, they reduced the debt by C$437M to a net debt of C$964 at the year-end. The goal is clear: Achieve the debt level of C$600M, and MEG switches to a 100% payout to shareholders via share buybacks and potentially small base dividends. According to MEG, this should be reached by 3Q of this year. Trans Mountain Expansion And The Heavy Oil Differential The core of the investment thesis is now the TMX pipeline, which should be operational by 1st May 2024. This is a long-awaited improvement for the whole Canadian oil industry. This will help to shrink the heavy oil discount. Since MEG is 100% focused on heavy oil, it is the largest beneficiary of the lower heavy oil differential on a relative basis. As the company stated, each -US$1 in WTI/WCS differential gives the company C$47M of additional AFFO (FCF-Capex). With a current market cap of C$8.8B, that is ~0.5% of additional yearly FCF yield per US$1 change. Last year, the differential averaged ~US$18.5. Oil deliveries for May 2024 in Alberta trades at C$13.2. This already improves MEG FCF by an additional ~C$250M (nearly 3% additional FCF yield). Let's Put All We Know Into The Projection   Capital spending - The management is guiding for C$550M Capex spending. C$450M is to sustain the operations, and C$100M is to support the growth.  Decline rates - The historical decline rate was 10-15%. It should slightly speed up going forward. This, together with the higher production output, should lead to higher sustaining capital in the future, which I expect at around C$550M in 2028.  Production growth - Management is guiding for ~115,000 bbls/d of production in 2026. This gives them a growth CAGR of ~4.3% for the next five years.  Tax - I am projecting no tax payments till 2027, as the company has a tax pool of ~C$5B.  Royalty - As the production has reached a post-payout status, I expect the royalty to be ~C$19-C$20 per barrel in the pricing environment of US$80-WTI. That's an additional cost of ~C$300M compared to last year.  Heavy oil differential - I am accounting for US$13.5 WTI/WCS differential for this year and US$11 going forward. I believe this is quite conservative as many analysts predict the differential to trade in single digits.  WTI prices - I will first make a base case scenario with US$80-WTI, which is close to the current strip pricing, and later, I will make a sensitivity analysis.  Feel free to review all my assumptions in the projection table or skip to the graph right below. Author's Estimation (Five Years Projection) Let's review what the numbers have to tell us. Author's Estimation (Five Years Projection) As you can see, I only expect an 8% buyback yield in 2024 as the company is expected to spend C$364M on debt repayments to achieve the C$600M debt target. FY2025 should be \"The Year\" for investors as 100% of FCF should flow into shareholders' pockets via buybacks and potential small dividends. The yield should be around 14% with assumed oil prices. The yield should continue growing with the growth in output. 2028 should already be slightly down as the company is expected to run out of the tax pools. Valuation In my opinion, careful investors should not derive value from the PE ratio, current dividend yield, or whatever valuation metric one chooses. It should be derived from future cash flows. Put it simply: EBITDA won't put bread on your table. When applying a simple DCF model on the projected FCF and discounting by 12.5%, we get a target share price of C$39, which is 22% higher compared to the current price of $C31.8. Author's Calculation (DCF Valuation) If you assume a possibility of selling the stock for 8xFCFE multiple in 2028 and flat oil prices, your IRR should result in around 18%p.a. Risks The WTI/WCS differential is very important for the company's FCF generation. If the total Canadian heavy oil supply grows, the market could become oversupplied again, which would raise the differential. As I said before, the company either has to use diluents to create a dilbit or use an upgrader to make SCO. MEG doesn't have any of it and is dependent on others. It is questionable if they can secure either option to utilize their whole ~50 years of reserves. The valuation is built on stable oil prices. We know oil prices will be everything but stable. Since oil is driving the value of future cash flows and presents the largest risk to the share price, I am going to assess the sensitivity analysis. Sensitivity The company presents the sensitivities in the table below. Sensitivities (MEG presentation) I applied them as closely as possible to my model. With the same assumption of a 12.5% discount rate, this is how the target price would change. Below the price target is also the expected five-year IRR if commodity prices were to change. Author's Calculation (Sensitivities) My Investment Decision Pros: large bitumen reserves, low declines, low sustaining capital, low costs, large tax pool, benefits from narrowing WTI/WCS differential, output growth, clean balance sheet, and coming 100% payout ratio. Cons: no upgraders, dependency on undersupplied condensates, higher royalty payments. When comparing MEG's valuation to that of its larger peers, I expect more upside from the integrated Cenovus Energy Inc. (CVE:CA) and Suncor Energy Inc. (SU:CA). But these are turnaround stories that might not develop as one hopes for. Canadian Natural Resources Limited (CNQ:CA) seems to be fully priced, but considering its superior quality, I think the fairness of its current price is close to MEG's. Projection & Valuation (Author's Projection & Valuation) (Links to my Cenovus analysis, Suncor analysis, and Canadian Natural analysis) Most of the positives seem to be already priced in since my conservative assumptions result in a target price of C$39 per share or an upside of 22% from the current price. Insiders selling (simplywall.st) I believe there is a further upside, but I would be hesitant to initiate a position since the insiders started to sell the stock. MEG is still a decent hold for me, and if I had already owned the stock and had to pay capital gain tax, I would not sell. Let me know if you disagree or if you know any details that I might have missed in my analysis, as I believe we are much smarter together. Feel free to review my comparative Google Sheet table with price targets, sensitivities, and links to my analysis. I am regularly updating the table with any new developments in the market.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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