Cardinal Energy or MEG Energy

Capital efficiency is a key factor

In November 2023, Cardinal Energy (CJ.TO) announced a project to build an initial 6,000 barrel per day Steam Assist Gravity Drainage (SAGD) facility at an estimated capital cost of CDN$155 million. If achieved, the capital efficiency of that project in gross terms is ~$25,000 per flowing barrel. But, of course, the project advances in stages and starts to produce its own cash flow before the total project is complete. The project is called Reford and Cardinal projected its economics as follows:

As you can see from the chart, peak spending is CDN$68.5 million and declines quickly so that a more realistic “capital efficiency” calculation is just over CDN$11,000 per barrel.

Cardinal has only about 160 million shares outstanding, and I will compare it to MEG Energy with 270 million shares outstanding in a moment.

MEG Energy is recommended by most Bay Street analysts for its long dated reserves, efficient operations, and its plans to expand output at a capital efficiency of $10,000 per flowing barrel over the next few years. Expanded output by MEG will not add to reserves, just shorten the time period over which MEG exploits them. Scotia iTrade this morning recommended MEG with disclosure of its conclusions that MEG cash flow will approximate $1.3 billion this year and its sustaining capital will be about $650 million, leading to a free cash flow figure of $650 million more or less which will be used to repay debt, pay a small dividend, fund the expanded output plans and buy back stock. MEG has a few hundred million of tax losses carried forward but will soon be taxable, and faces a “post payback” royalty rate. The $650 million free cash flow figure assumes a flat US$70 WTI price according to Scotia, and a somewhat lower price for Western Canada Select (WCS) and the Access Western Blend (AWB) product which is what MEG actually sells. Obviously there is some risk commodity prices in future years can be both lower and higher than the assumed price.

MEG has about 35 years of reserves (some say 30 but I like to err on the side of conservatism, and for the point I wish to make, higher reserves are conservative to the conclusion. The Net Present Value (NPV) of a 35 year annuity of $650 million after tax is at a 12% discount rate is $5.3 billion. MEG has 270 million shares outstanding. All respect to Scotia but a NPV of $5.3 billion less current debt of about $600 million gives an intrinsic value of MEG shares of about CDN$23 a share. Investors betting on a better outcome are either assuming higher commodity prices, significantly lower costs or irrational markets.

MEG’s major cost input is energy. With a steam to oil ratio (SOR) of about 3 times, every barrel of oil consumes 3 barrels of steam and each barrel of steam consumes about 33 cubic feet of natural gas, so a good rule of thumb is 1 Mcf of gas for every barrel of oil. At today’s “strip” prices for natural gas for 2025 and beyond of CAD$3.50 per Mcf, MEG will have an energy input cost of somewhere around CDN$3.50 per barrel of oil. If natural gas prices embark on a secular rise as more gas is needed for LNG and data centres, a price of $6 to $10 per Mcf is possible, and in my opinion likely. MEG offsets its energy costs by selling surplus energy to the grid and mitigates this cost somewhat from time to time, mostly in summer months.

MEG investors appear to assume certainty. I don’t. A 12% discount rate is generous to MEG’s value and given the number and magnitude of risks, a higher discount rate may be warranted.

In any event, in my opinion MEG shares are worth somewhere between CDN$25 and $30 at best, and at today’s trading price of CDN$25 are fine as a long term hold but not as strong a choice as Cardinal.

Let me turn back to Cardinal, which produces about 20,000 Boe/day from conventional wells and pays a CDN$0.72 annual dividend at $0.06 per month. Current annual cash flow is about $20 million short of that needed to fund sustaining capital, the Reford project and the dividend, and debt now at $70 million will very likely grow to the $100 million range before Reford starts producing positive cash flow next year. By 2026, Reford cash flow should permit repayment of most if not all of the debt and Cardinal will become a debt free energy company with cash flow in the $300 million range about half of which should be free cash flow.

Cardinal has about 20 years of conventional reserves and its SAGD project should have a similar life, if not longer. The 12% NPV of a $300 million per year payment for 20 years is about $2.2 billion. With 160 million shares outstanding that comprises an intrinsic value (subject to all the implied assumptions) of about CDN$14 a share, more or less double the current share price.

In my opinion, for what it is worth (not much to most people) Cardinal is a better investment than MEG.