Headwater or Obsidian?

Which is the better play on heavy oil?

Headwater Exploration (HWX.TO) has been a great investment, building a strong position in the prolific Clearwater play, growing through internally generated cash, keeping a more or less debt free balance sheet and now paying a dividend of over 6%. What is not to like?

Obsidian Energy (OBE.TO), the successor to Penn West Energy which was a disaster, has been a bit of a dog, despite efforts by CEO Steve Loukas to rebuild the company’s credibility. Still carrying over $400 million debt, not paying a dividend, and buying back shares into a declining commodity price environment are not policies most energy investors would embrace as sensible.

Obsidian is better value by a wide margin. But I prefer Headwater. Let me explain why.

I see Obsidian exiting 2024 with output of about 38,000 barrels of oil equivalent (boe) per day, about 26,000 of which comprising light and heavy oil. Based on a price of CDN$90 for light oil, CDN$75 for heavy oil (WCS), CDN$45 for NGL and about $13 per boe for natural gas, I estimate average revenue per boe for 2025 will lie in the area of CDN$60 per boe. Royalties, operating costs and transportation run about CDN$27 a barrel so field netbacks in the CDN$33 per boe are a sensible guess, and EBITDA in the CDN$450 range is a reasonable expectation.

Those metrics are more or less consistent with Obsidian’s 2024 guidance rolled forward into 2025. Here is that guidance which points to year end 2024 debt of CDN$400 million before a normal course issuer bid to buy back shares.

Headwater Exploration is another kettle of fish. Conservatively managed, and primarily a heavy oil producer, Headwater’s output is about 20,000 boe/day and it lives within its cash flows.

But while Headwater has almost 240 million shares outstanding, Obsidian has less than 80 million.

A summary head to head comparison is set out below valuing both companies shares at a 4 X EBITDA enterprise valuation.

So why is the market valuing HWX more or less correctly and undervaluing OBE by about half? In my opinion, it has to do with management.

Headwater pays a dividend it can well afford and steadily increases production from internally generated cash flow, leading to an expectation that dividends will keep rising. Obsidian needs to spend virtually all of its cash flows to inch production higher while making little progress in repaying debt, squandering scarce capital on share buybacks, and putting itself at risk to a dramatic fall in commodity prices (needlessly in my opinion).

Here is what happens in oil prices collapse to the $50 range and both companies limit capital outlays to their cash flows to preserve balance sheet integrity. In terms of value, both shares drop dramatically.

If oil prices drop even further, as they have in the past, Obsidian faces a possible insolvency problem, but Headwater does not.

Headwater can pretty well maintain output at $133 million capital outlays while Obsidian output will start to fall quite quickly if the low prices persist for a full year, would drop from the 40,000 boe/day range shown to somewhere in the mid-35,000 boe/day range and the downhill slide begins. Companies that get on the wrong side of the debt/output curve often disappoint and occasionally fail.

I think Obsidian is deeply undervalued and if managed well would be a winner, but with a management team incapable of learning from history, I wouldn’t touch it with a barge pole. I see Canadian oil prices in the CDN$50 range next year as a serious possibility, not just a tail risk, and very low prices for months if the world economy falls into recession. If Kamala Harris wins the White House, the economic damage to America will be severe and a deep recession is a possible outcome.

Wise investors consider risk as well as return. Weak managers file NCIB’s to prop up their stock options with a one-sided risk where if it works, they make a pile and if it doesn’t, shareholders take it on the chin and they award themselves new options at the lower trading prices and blame the decline on “world oil prices” rather than institutional stupidity.