Management matters: Peyto Exploration & Development versus ARC Resources
Good management manifests itself in higher returns
Peyto Exploration & Development (PEY.TO) and ARC Resources (ARX.TO) hold some of the best gas-prone acreage in the Western Canadian Sedimentary Basin, Peyto in the area known as Deep Basin and ARC in the Montney. Peyto is primarily a producer of dry natural gas while ARC has a richer mix with significant C5 condensate production which commands a price even higher than light oil most of the time. Condensate is in short supply in Canada and is an essential element in oil sands production of oil where it is used to make the bitumen capable of flowing easily in a pipeline. ARC has agreements that expose its gas to world LNG markets through U.S. based Cheniere, who liquifies the gas and ships it primarily to Japan where the price received per gigajoule is a multiple of that paid to Peyto whose markets are North American.
You would expect investors in ARC to be the beneficiaries of its advantages but the reality is that despite ARC having significant advantages in terms of product mix and access to higher priced markets, the reverse is true. It is worth exploring why. Here is a summary of the two company’s returns to shareholders since January 1, 2021.
Both companies have served their owners well with annual returns of 123% in the case of Peyto and 89% in the case of ARC since January 1, 2021. Despite higher operating expenses on a per barrel of oil equivalent (Boe) basis, ARC’s rich product mix and access to better markets have seen ARC’s cash flow per share for the past twelve months exceed that of Peyto, yet ARC shareholders have seen lower returns, quite a bit lower.
Both companies “hedge” using forward commodity markets. Since January 1, 2021 ARC has lost $1.9 billion on its hedge book, equivalent to $3.13 per share. In the same interval, Peyto has lost $520 million on its hedge book, equivalent to $2.95 per share. On a per share basis, that difference is immaterial.
Peyto pays out its profits in dividends and ARC pays a portion of its excess cash flow in dividends and uses another portion to buy back shares, betting that will benefit shareholders in higher returns. Since beginning its Normal Course Issuer Bid (NCIB) in November 2021, ARC has repurchased 124 million shares at an average price of $15.81, and the benefit of that lower share count is incorporated into the current share price. But the buybacks came at the cost of lower dividends.
The choice of buybacks was a poor choice, in retrospect. Peyto shareholders received 32% of their total return in the period in cash in the form of dividends, while ARC shareholders received only 17% of their total return in the period in the form of dividends, hoping for enough share appreciation to offset the lower cash income, and that didn’t happen.
The comparison of these two excellent companies is a lesson for investors. Even though ARC shareholders implicitly got a higher share price owing to the buybacks, they suffered lower returns and, if they held their shares throughout the period, 83% of the return they did “get” remains at risk since they continue to hold shares. Peyto shareholders got 68% of their return in cash and have less at risk than their ARC counterparts.
Buybacks need to be seen not only in terms of share price potential benefit but also in terms of exposure to risk. Dividends received in cash have zero risk. On a risk adjusted basis, the case for buybacks is weak and in the cases of Peyto and ARC punished the ARC shareholders whose management bet on buybacks and rewarded the Peyto shareholders whose management preferred cash payouts.
Management matters. And for me, I don’t want to invest in companies where a CFO is making bets on my behalf since the real benefit of management is its ability to turn in industry leading cost performance and operating economics. Bean counters are a dime a dozen and petroleum engineers are in short supply.
I will be on Peyto over ARC every time.
One of the few authors who back their opinions on figures and calculations.
Picked up some PEY the other day, I had a "cheeky" limit order that I'd forgotten about, and it filled a few days ago.