Baytex Energy: Management poised to increase profitability as expected (OTCMKTS:BTEGF)

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(Note: This article originally appeared in the Marketplace Newsletter on April 30, 2022 and has been updated as needed).

Baytex Energy (OTCPK:BTEGF) gets the same profit increases as much of the industry plus one more. Management announced a strong increase in production from the low starting point of the Clearwater area. These increases are expected to continue as heavy oil is exceptionally profitable, even in times of low prices.

In the past, this company had only Eagle Ford light oil as a source of cash flow, as margins on heavy oil tended to disappear to the point that management had to shut down production. Then the management acquired the viking light oil which was a huge financial help during the last recession.

Now the Clearwater game promises to help cash flow during the recession due to the exceptionally inexpensive structure. Therefore, management will likely develop this heavy oil area at the expense of legacy production (i.e. legacy heavy oil) to further reduce the cost of the company’s production mix. This means that profitability will increase along with Clearwater’s production, as lower cost production replaces higher cost production. For shareholders, this means the stock will outperform the industry as profitability increases.

(Canadian dollars unless otherwise specified)

Baytex Energy Debt Reduction and Free Cash Flow Uses

Baytex Energy Debt Reduction and Free Cash Flow Uses (Baytex Energy June 2022, Corporate Presentation)

Debt repayment will be a priority because even a very profitable heavy oil field still has the challenges of heavy oil. This means that during the next period of low commodity prices, the discount between heavy oil and light oil could expand to really pinch free cash flow from heavy oil production. The low-cost structure should allow Clearwater’s heavy oil production to continue to generate adequate cash. But there remains a greater risk that production will have to be halted until prices recover sufficiently.

Therefore, the debt structure must be very conservative to meet the possibilities of closing. Management clearly responds to the needs of a conservative financial structure with the strategy presented above. This company, like many others, is unlikely to increase overall production until balance sheet priorities are met. The current commodity price market assures that it will be quite quickly.

The other consideration is that management does not operate Eagle Ford properties. Therefore, any investment budget is first subject to the needs of Eagle Ford’s business, as Eagle Ford is the most profitable. The change is that the Clearwater game is clearly a second priority due to profitability. It is very rare for a heavy oil play to be consistently more profitable throughout the cycle than is the case for the Viking light oil play. But under current assumptions, Clearwater’s leases appear to achieve this goal.

Baytex Energy Clearwater Operating and Profitability Characteristics

Operating and Profitability Characteristics of Baytex Energy Clearwater (Baytex Energy June 2022, Corporate Presentation)

Management has come up with a new design of wells which they call Extended Reach Wells. These wells are even more cost effective than the previous design. This will likely lower the breakeven point of the game. This coin gets a large majority of heavy oil CAPEX due to profitability.

At present, production is rapidly increasing from a small production base. Thus, the capital expended is still relatively low for a company of this size. However, the profitability characteristics shown above likely mean that the capital budget (spent on Clearwater) will increase at the expense of other legacy heavy oil plays and at some point management will likely have to make a decision as to to the appropriate production mix because of the extreme profitability of this game.

If the management decides to increase the percentage of heavy oil produced (and it is likely), then it will probably be decided that no long term debt is acceptable (more than very low) to adapt to the characteristics of Reduced heavy oil prices during periods of low commodity prices.

The extremely short payout combined with the profitability shown above will have an unusually large profitability effect on the business. Profits here will grow beyond the favorable pricing environment that the entire industry is reporting.

In the latest first quarter report, management said Clearwater’s production had already reached 8,000 BOED, or around 10% of production. It happened in less than a year. Production is likely to continue to grow rapidly as profit features like the ones shown above for this coin are extremely rare.

Clearwater Wells Q4 2021 Upstream Exploration Cash Flow.`

Clearwater Wells Fourth Quarter 2021 Upstream Exploration Cash Flow (Fourth Quarter 2021 Upstream Exploration Earnings Press Release)

Upstream exploration production as reported for the fourth quarter of fiscal 2021.

Headwater Exploration Production As reported for the fourth quarter of fiscal 2021. (Headwater Exploration Fourth Quarter 2021, Earnings Press Release)

An indication of profitability can be given by the quarterly report of Headwater Exploration (OTCPK: CDDRF). This company represented on average just over 10% of Baytex Energy’s production. Still, the cash flow shown above is approaching about 20% of the cash flow reported by Baytex Energy in Q1 (even though falling commodity prices dominated the Q4 report). This outsized contribution is only getting better as commodity prices strengthen.

Baytex Energy has considerably more square footage and more cash to use to develop this highly profitable game. This play will be a significant “game changer” in that it will substantially increase the profitability of Baytex Energy at all times except for a few very extreme downturns.

Summary

Much of the industry focuses on repairing the balance sheet. This includes Baytex Energy.

(Canadian dollars unless otherwise specified)

Baytex Energy debt level projection and assumptions

Baytex Energy debt level projection and assumptions (Baytex Energy June 2022, corporate presentation)

The company has a great profit opportunity in the Clearwater Heavy Oil game. But any increased exposure to heavy oil requires a very conservative balance sheet structure because the heavy oil discount often extends to the point where gross profit disappears. This typically requires production to be halted until heavy oil prices recover sufficiently.

The Viking and Eagle Ford light oil plays would then likely provide cash flow until the industry recovery is underway. Therefore, management is correct to expect a very low debt balance going forward. Competitor Headwater Exploration has a debt-free balance sheet (for comparison purposes). Management need only wait for sufficient cash to redeem the 2027 notes shown above.

The earnings growth outlook is above the industry average outlook due to the Clearwater coin. This discovery is another demonstration that very profitable areas are still available in North America. Perhaps this area is not always obvious. But these discoveries keep being announced from time to time.

Even though oil and natural gas prices are at record highs, all we have to do at this point is let the free market work. North America has many times the unconventional games it had with the conventional. So there is plenty of room for production to expand at a lower cost. As the extended reach wells demonstrate, technology is advancing to further reduce costs in this relatively young industry.

Once industry balance sheets are repaired (and under current conditions this should happen quickly), there is every indication across the industry that production will grow faster to possibly cause the next cyclical downturn.

Heavy oil is in demand by the United States because our refining capacity is exceptionally sophisticated. As a country, therefore, we import heavy oil while exporting unconventionally produced light oil. We make money on the spread between premium light oil and discounted heavy oil. This should continue for the foreseeable future. The push for energy independence that is currently prevalent would drastically reduce the country’s profitability by wiping out that profit we are making (and worsening the balance of payments deficit). This must be part of the future discussion on our industrial strategy as a country.

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