Peyto: Giving Lessons In How To Hedge

seekingalpha11-23

Peyto's hedging program enabled it to achieve C$2.95 per MCF, nearly four times the market price.The company's strategy of hedging well in advance helps it avoid AECO pricing volatility while allowing...

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This Canadian natural gas producer (that reports in Canadian dollars unless otherwise noted) raked in revenue to the tune of C$2.95 per MCF. That is nearly four times the going price. The hedging program has long netted on the profitability side before this happened. This time the hedging program prevented a major financial disaster. This company hedges well in advance and therefore misses the run-up in natural gas prices by a year or so. But in exchange for that it also misses some very destructive pricing that persists in areas with a lot of natural gas production. By avoiding the AECO pricing volatility, the company manages to report a net gain for its hedging program even though there are years when the hedging has lost money. That net gain since the company went public is a major distinction from many consistent hedging programs. Third Quarter Results Of course, that hedging program led to outstanding results compared to many in the industry.   Peyto Summary Of Third Quarter 2024, Financial Results (Peyto Earnings Press Release Third Quarter 2024) As a result of the hedging operation, the company reported satisfactory profits that declined minimally from the previous year. Some of this was also due to the acquisition which added considerable liquids production to what was a dry gas producer. This performance may be the top performance for a primarily natural gas producer in all of North America. It also demonstrates that there are a number of ways for producers to avoid the losses that many are reporting. Additionally, as this producer demonstrates, the hedging program does not have to be a zero-sum operation (which means whatever the hedging gains during a period of falling prices is then lost when prices rise). This company has long reported a gain from its hedging operations in the long term. Drilling Program The acquisition was expected to lead to lower costs along with producing a more valuable production stream. So far, that seems to be the case. What is happening as a result of this success is more of the capital budget directed towards the acquisition of acreage.   Peyto Drilling And Completion Cost Trends (Peyto Corporate Presentation November 2024) This part of the corporate presentation demonstrates a straightforward volume increase. Since it was obviously hedged, that counts as a profitability increase. But there is also a liquids component to this production increase that really was not all that significant before the acquisition. It is still on the small side. But I suspect that will be yet another way for management to create more \"breathing room\" during times like these when natural gas prices are low. Advantage Of Acquiring Repsol Acreage The Repsol (OTCQX:REPYY) acreage that was acquired is exceeding the original guidance given in a significant way. The ability to increase Peyto profitability puts it into the \"first call\" position for capital expenditures. To a certain extent, that was unexpected.   Peyto Strategy For Acreage Acquired From Repsol (Peyto Corporate Presentation November 2024) One of the unspoken advantages of this outperformance is that it will help to reduce the leverage ratio because capital dollars spent on the acquired acreage are \"going a lot further\" than is the case with the legacy acreage. As a result, this acreage is being emphasized in the latest drilling program. Now it does take time to optimize the combined operations as is shown on another slide. But as this newer drilling become significant to the company revenue, it will influence corporate profitability for some years ahead. Dunvegan Interval Is A Bonus Upside The Dunvegan interval is a known interval that recent technology advances have made productive at current commodity price levels. This interval extends onto legacy acreage. The early returns may make this a focus of the capital budget in the near future.   Peyto Dunvegan Profitability Characteristics (Peyto Corporate Presentation November 2024) So far, this appears to be the most profitable interval when tested against the legacy business. Obviously, more testing needs to be done. But with early results like what is shown above, management can be counted upon to take advantage of the profitability here quickly. This interval turns out to extend out to legacy acreage as well. Therefore, the testing will be to see where the hi-grade results will most likely be. Most likely the preliminary results here will be adding to company reserves well into the future. Peyto acreage is in a \"stacked interval\" area. What is on the reserve report is only what is commercial at the current time. As technology advances, the company can take advantage of more intervals, as is being demonstrated with this \"discovery\". Exploration has changed greatly from 50 years ago in that many times these companies know where the oil and gas is. It is more a question of low enough production costs to make the interval competitive in the marketplace. In this case, not only is the interval competitive, but it is also now the lowest cost interval. Summary The company is likely to report some lower operating costs at least for the next fiscal year with the acquired lower cost acreage. The trend towards a greater liquids production percentage in the production mix is likely to slowly continue as well.   Peyto Goals For Fiscal Year 2024 (Peyto Corporate Presentation November 2024) Peyto generally shows a robust full cycle netback as shown above. Management has succeeded in keeping costs very low while slowly increasing the amount of liquids produced. Some of this is due to finding new liquids rich intervals on the legacy acreage that can now be produced. But every now and then the company makes a bolt-on acquisition that \"jump starts\" the process or accelerates it. The combined capital and dividend resulted in negative free cash flow. But the year-to-date result is not so far off that it cannot be corrected in the fourth quarter. While the natural gas market will continue to be challenging, the liquids production that the company is finding could well be profitable to produce regardless of natural gas pricing. This company has made a very conservative switch to some liquids production work in a way that few have, thanks to a robust hedging program. Peyto remains a strong buy because the acquisition of Repsol acreage has turned out to be a better bargain than anticipated and the company has the relatively new Dunvegan interval to produce. The financial leverage is a bit high for Peyto. But the company has several ways to grow EBITDA (the numerator of the leverage) while waiting for natural gas prices to recover to pay down debt. Either way will decrease the debt ratio, which is what Mr. Market is looking for. Risks Any acquisition can at any time fail to meet expectations going forward. The Repsol acreage acquisition was bolt-on. Therefore, management knew this acreage very well before they ever thought about buying it. However, there is always the risk of a surprise that causes a downside evaluation even if it is reduced in this case. Any upstream company has some exposure to the volatility and low visibility of future commodity prices. This company uses the hedging program to reduce the volatility part and manages to overall earn a profit doing so. But something could change that would cause a needed strategy change to the hedging program to maintain that long-term profitability record. In the meantime, a severe and long-term sustained drop of commodity prices could materially change the company outlook even with a robust hedging program. A loss of key personnel could materially change the company outlook.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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