MEG Energy is undervalued

Debt levels are no longer a threat

MEG Energy (MEG.TO) has an impressive asset base. MEG’s Christina Lake SAGD property has 2 billion barrels of reserves capable of delivering about 100,000 barrels of oil a day for the next 50 years or more at an all in cost of about CAD$30 per barrel. With oil prices in the CAD$100 range, MEG enjoys annual cash flows of about CAD$2.5 billion which translates into free cash flow of approximately CAD$2.1 billion after CAD$400 million capital expenditures.

Since there is no exploration risk, I value that free cash flow at about 10 times for an enterprise value of CAD$21 billion. Debt is now CAD$2.2 billion and there are 308 million shares outstanding yielding a value per share of CAD$60.00

Lots of investors will argue that a multiple of 10 times free cash flow is too high, although streaming companies like Freehold Energy (FRU.TO) or Prairie Sky (PSK.TO) trade at even higher multiples. Applying a 4 X EBITDA multiple yields a share price of around CAD$20, or about where the stock now trades.

The market is valuing MEG today as if it were a conventional producer with a 7 year reserve life and a 30% decline rate, as I see it. Canadian E&P companies trading at 4 X EBITDA differ from MEG in that they need to find and replace reserves and spend capital to sustain production losses arising from their decline rates, while MEG is assured it can sustain its production with capital spending in the CAD$400 million range and has no exploration risk.

Of course, MEG’s Christina Lake project is not its only property and Christina Lake has been sanctioned for production of up to 210,000 barrels a day by Alberta regulators. With its debt rapidly disappearing, MEG will be in a position to not only distribute capital to shareholders but also slowly expand its production by adding more SAGD pairs in its excellent properties. MEG’s Surmont and Growth properties comprise real value not assessed in this article.

MEG has a “hidden asset” that may attract the attention of Canadian oil majors such as Canadian Natural Resources (CNQ.TO), Suncor (SU.TO) or Cenovus (CVE.TO) - it has $6.7 billion in tax pools immediately accessible to a qualified acquirer and all three of the listed majors are entering a taxable phase of development. For example, Suncor paid over CAD$800 million in income taxes in the first quarter of 2022. Most companies would pay about 10 to 20 cents on the dollar for tax pools, adding about CAD$3.00 to CAD$5.00 per share to the value of MEG stock.

The real risk in MEG is a collapse in commodity prices before it has paid down its debt, something that should be virtually complete this year. MEG is free from adverse hedges but has been wise enough to lock up the natural gas it needs to fuel its steam injection at a price of $2.50 per Gigajoule through 2023, freeing the company from any risks of further surging in prices of natural gas. By 2023, MEG should be a debt-free steady cash generator at all oil prices north of $40 a barrel, and investors who buy the stock at $20 should be well rewarded over time.

I (and my family) own 5,000 shares.