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2019-10-18 19:24:17

For a very long time, Peyto (OTCPK:PEYUF) had a darn good business by forward selling its production and avoiding much of the AECO volatility. Management never worried about other markets because the company did just fine in Canada. All that changed when gas prices in Canada dove and then stayed low over a period of time longer than management was used to.

Everyone knew that the unconventional business would add a lot of gas to the supply of gas produced. But no one really knew the long-term effect on the supply-demand balance until it actually happened. Additional supplies had come on the market before and the gas market had always reached equilibrium relatively quickly (within a year or two), so the strategy Peyto used continued to work long term.

The unconventional business blew that strategy out of the water and caught a lot of gas producers by surprise. Some of the financially weaker gas suppliers are no longer with us because of that business condition change. Other companies that were considered well managed such as Peyto and Advantage (OTC:AAVVF) had lower costs and conservative balance sheets. They decided to wait out the latest downturn, which decimated their stock prices.

But it also gave management time to examine the strategic alternatives to find the most likely profitable future strategy. Many of the Canadian dry gas producers like Peyto are shifting carefully to a more liquids-rich production. Several of these are only doing so to the extent that they can maintain their low costs in the hopes of enlarging the margin sufficiently to recover the lucrative business they once had.

Others, like Encana (ECA), are exiting the gas business (and Canada) entirely to get into the more lucrative oil (and liquids) business with gas as an icing on the cake consideration. The biggest problem with Encana's strategy is that it is entering a business that it does not know quite as well. Encana acquired another company and now must become familiar with some basins that management really did not have much of a presence before. Investors should probably expect some stumbles along the way. The strategy Encana chose is relatively risky and often results in periodic losses until management familiarizes itself with the acquired company businesses.

Peyto and Advantage on the other hand are sticking close to what they know best. They are conservatively moving a little at a time to more liquids-based acreage nearby in the hopes of avoiding some of the pitfalls that may occur in the future for Encana. Peyto and Advantage are gambling that they can keep their costs as low as they are currently for dry gas while adding some further processing to enhance margins that will enable them to return to previous levels of profitability.

Peyto's management reported that the first year did not go quite as well as hoped. However, management appears to be staying the course to master the new strategy.

Margins

Peyto still has some of the best margins in the industry, even though gas pricing is lower than many producers would like to see. The margin for this dry gas producer compares favorably to many that produce a greater percentage of more valuable products.

Source: Peyto September 2019 Investor Presentation

Many producers besides the ones mentioned often decided they could outrun the pricing decline by adequate cost reductions through the changing technology sweeping the industry. It took a while for some of these companies to figure out more was needed than just cost reduction.

But Peyto has a decent balance sheet in addition to rock-bottom costs that remain an advantage in the natural gas production industry. Even though cash flow and margins are not what they were, that production can still function as an ATM to fund more profitable future ventures.

Naturally, the market has not been as patient as this management. So there is an investment opportunity to participate in what has long been regarded as above-average management as this management recovers the former profitability levels of the company.

Investing Strategies

There is an older investment strategy that has been around a long time, but it does not make the news as much as the flashing fast trading style. This older style involves picking top management and then investing whenever the price dips to a predetermined level. One of my deceased uncles was an Exxon (XOM) executive who practiced this for 40 years. He diversified and never really sold. Then he left millions to my cousin.

There was always disappointments and sometimes I would wonder if the companies would recover. But by and large, the good management recovered some sizable large losses to go on and post decent long-term records. It was almost like cyclical recoveries and he never sold the cyclical holdings either. The diversification always seemed to carry him through. But the key was good management plus he really knew the oil and gas industry very well.

Peyto is one of those industry leaders. But it is now a company in transition to accommodate changing natural gas industry supply conditions. It may be worth a look for long-term investors. Many times the most significant asset is management. At least as many times management is not valued by the market or investors except during times of extraordinary performance. Until the recent gas price plunge, this management did well. It should probably be able to compete profitably in the future.

Operations

This company is vertically integrated to save money paying third parties. It is also concentrated in one basin.

Source: Peyto September 2019 Investor Presentation

Management will definitely grow the more valuable parts of the income stream faster. That involves many things such as upgrading the plants to process the gas stream into more profitable products efficiently and drilling for more liquids.

But it also involves a new market scheme. This company is finally moving its production to higher-priced markets. Until the company stabilizes its margins, it will probably drill the minimal amount necessary.

Management already did not complete wells until the third quarter to maximize the initial production exposure to the relatively strong winter gas pricing. That will most likely continue when it is relevant.

This company is also a leader in industry automation to lower costs.

Future

As shown below, this company has considerable assets to use to launch the coming profitability comeback attempt. Most above average managements usually recover their footings. The odds favor Peyto making it to a brighter future.

Source: Peyto September 2019 Investor Presentation

All that is needed is the proper profits to justify the assets shown above. This is a company that has yet to record a lower of cost or market write-off during industry downturns. Very few Canadian companies can claim that.

Source: Peyto September 2019 Investor Presentation

Management is currently attacking the costs with goals to lower those costs in the future. Management is also diversifying markets to raise the average selling price of the gas.

Large companies do not change overnight. Peyto is a billion-dollar value company. However, the new strategies will take effect. At some point the market will notice that the profitability of this producer is improving. Last year was the first one this company drilled in a liquid-rich area. Peyto's management reported less-than-satisfactory results. But that should change as management gains experience handling liquids-rich wells.

In the meantime, the stock is at a pricing level that really expects no change from the current situation.

Source: Seeking Alpha Website October 17, 2019

The yield on this stock clearly anticipates a dividend cut in the future. The dividend is well covered. But that money could also be used to fund a potential recovery which the economics of growth are properly established and goals are set. Peyto has had a dividend policy for a long time that is among the more conservative. But management is not afraid to cut the distribution in order to preserve the balance sheet strength or exploit a solid business opportunity.

Given that many investors average about 8% over the long term, the current dividend offers a little more than that return all by itself. If the dividend were to be cut to fund growth prospects, most likely the stock price would respond positively.

The basin that Peyto operates in offers some of the lowest-cost production in the industry. That is a material competitive advantage. Even though parts of the Deep Basin in Canada are well known for gas production, the stacked play now offers enticing opportunities when new completion techniques are used.

The result is a lot of upside opportunity with very little downside for this stock. For long-term investors who do not like to sell, this may be an appropriate consideration.

I analyze oil and gas companies like Peyto and related companies in my service, Oil & Gas Value Research, where I look for undervalued names in the oil and gas space. I break down everything you need to know about these companies - the balance sheet, competitive position and development prospects. This article is an example of what I do. But for Oil & Gas Value Research members, they get it first and they get analysis on some companies that is not published on the free site. Interested? Sign up here for a free two-week trial.

Disclosure: I am/we are long PEYUF, AAVVF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.


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