Chapter Fifteen: Efficient Investing in Inefficient Markets - Hidden Gems - Birchcliff energy

Most investors ignore the value of its long-life reserves

Anyone who has listened to Eric Nuttall try to describe why he sees value in energy names knows his schtick is to calculate how many years it would take a given company to go private by using its free cash flow to repurchase shares and how many subsequent years an investor would get “for free” based on the current price of the stock. Eric doesn’t believe a company could actually go private at the current stock price, but thinks his description will “dumb down” the complexity of business valuation for ordinary investors. Eric is a constant advocate of share buybacks as a way to improve investment returns despite the jaded record of that approach in real life.

Implicit in Eric’s approach is a recognition that reserve life is important and that companies that have long reserve lives are more valuable than those with shorter reserve lives. Seems simple enough - more reserves are more valuable than less reserves.

Securities regulations require oil & gas companies to publish annual reserve estimates in accordance with detailed requirements set out in National Instrument 53-101 (NI 53-101). The National Instrument requires a calculation of the present value of the reserves at various discount rates based on forecast commodity prices and expected costs to develop the reserves. Typically, companies will calculate a net present value at a 10% discount rate based on a set of future commodity prices, often comprises of the average projected prices derived by independent reserve valuation firms like McDaniel and Sproule. NI 53-101 requires and independent valuation of reserves to avoid “puffery” by management who have an obvious conflict.

Birchcliff used Deloitte for its 2022 Reserve Report. Deloitee calculated the present value of Birchcliff’s reserves at a 10% discount rate was CAD$8.2 billion.

With 266.8 million shares outstanding, that valuation comes to ~CAD$28 a Birchcliff share. The market doesn’t buy the approach (and neither do I) and Birchcliff shares trade at about CAD$8.00 a share. The Deloitte calculation is accurate but suffers from two weaknesses - first, a 10% after tax rate of return is insufficient for the risks in energy companies and second, the calculation depends on forecast prices for natural gas, oil, condensate and natural gas liquids which may not be realized. The NI 53-101 approach frequently overvalues the reserves of an oil & gas company and in parallel implicitly overvalues the shares of that company. But the number should not be ignored. If future commodity prices were at or higher than projected and operating costs tracked the reports assumptions, the value would be realized.

A stochastic approach to valuation of those reserves provides a more reliable benchmark since it takes into account the volatility of commodity prices. I use a modified Black Scholes approach. For Birchcliff based on year end 2022 data, here is my estimated value of the shares - about CAD$23 a share.

The modified Black-Scholes approach I use ignores dividends since the holder of the shares gets the dividends. Black-Scholes applied to stock options needs to include terms for dividend rate since option holders do not receive the dividends.

The value returned by my approach is the equivalence between the future commodity prices being so low that the reserves have no value and high enough that they return positive cash flows throughout the development period with the range of commodity prices encountered based on a log-normal distribution around current prices. There is a lot of empirical support in the literature for the conclusion that commodity prices are log-normally distributed.

The conclusion is that Birchcliff shares are deeply undervalued. There is a possibility commodity prices will become and remain so low Birchcliff is unprofitable and its shares virtually worthless and a possibility commodity prices will become and remain so high that Birchcliff will enjoy very high profits, and the Black Scholes approach arrives at the most likely (but by no means certain) outcome.

Putting the result in the context of Eric Nuttall’s explanation of value, at 2022 commodity prices Birchcliff had cash flow of CAD$950 million and “free cash flow” after $270 million sustaining capital of $680 million. With 267 million shares outstanding Birchcliff at CAD$8 a share has a market capitalization of just over CAD$2.1 billion and current free cash flow is equivalent to the cost of taking the company private (if everyone would sell at the $8 price) in about three years and the next 25 years of free cash flow would be “free”.

Whether an investor likes the Deloitte calculation, the Eric Nuttall explanation of value, or a modified Black-Scholes, the inescapable conclusion is that Birchcliff stock is under valued at CAD$8.00 a share and investors who hold the stock should enjoy a long term dividend paying investment. At present the company pays a dividend of $0.80 per share and yields about 10%.

The real value of the company is the long duration reserves it holds. Don’t ignore it. Commodity prices will fluctuate and short-term traders will flee when they are low and pile in when they rise, but the real money is made by buying in sell-offs. Natural gas has dropped to about CAD$3.00 per gigajoule (AECO) and light oil in Canada is now about CAD$95 barrel with condensate at about CAD$73. Running the same financial model at those ~40% lower prices (a blended price of CAD$29.45 a Boe based on Birchcliff’s product mix) results in an estimated value of over CAD$9.00 for each Birchcliff share.

I did not adjust operating expenses for lower royalties at the lower commodity prices (for simplicity) because I simply wanted to make two points - first that Birchcliff is undervalued even at today’s somewhat depressed commodity prices and second that commodity prices are volatile and result in mispricing by investors unwilling to or incapable of estimating their impact on value. The old adage in the oil patch is that the best cure for low prices is low prices.

Natural gas prices today in North America are close to decade lows. They can certainly go lower (and likely will if the coming recession emerges as expected) but over time those prices are more likely to rise and investments in companies like Birchcliff with long-lived reserves, little debt and low costs shoud prove rewarding.

Source: Macrotrends.

For all those reasons, I own about 130,000 shares of Birchcliff.