Encana – PetroChina deal fallout not that bad

I notice natural gas titan Encana (TSX: ECA) traded a bit lower after they announced that their previously announced joint venture with PetroChina for a shale gas field fell through.

I do not view this as being too adverse an event – Encana’s management has typically been quite long-range viewing and they are dealing with a very difficult situation in the natural gas market, with spot prices currently CAD$4.30ish and typical marginal costs of extraction higher than this. They have frequently stated that they believe the natural gas marketplace is artificially low and the best thing for resource companies with plenty of reserves on the ground is to wait for higher commodity prices before drilling. My guess is that PetroChina’s management had more of a short term focus.

Back in fiscal 2008, spot natural gas went well above $10 and Encana had a banner year on earnings, reporting over $8/share (note the 2008 number is not a direct comparison with the present company because the company split off Cenovus in 2009 which also benefited from $150 crude oil). If we ever see higher natural gas prices, Encana should be well positioned to capitalize. Currently with shale gas drilling there is a huge supply glut in the marketplace.

In 2010 the company earned $2/share on an average spot natural gas price of about $4.25 per mmBtu. Encana at present values appears to be a fairly good “grandmother” type stock that should retain its value even in adverse market conditions. Even in the depths of the 2009 economic crisis (which is generally what I use to gauge maximum downside) the stock did not trade lower than 20% below existing market values.

It is an interesting comparison to look at a company like Microsoft and ask oneself whether it is likely in the medium range future whether licenses for Windows and Office will be more or less valuable a commodity than natural gas.

Connacher – Short term yield

Connacher Oil and Gas (TSX: CLL) is a small oil sands producer. Like OPTI (TSX: OPC), it is heavily in debt. Unlike OPTI, there is a valid business case to be made that would suggest that it could actually pay its debt without bankrupting its shareholders. The forecast does depend on the price of oil (and specifically bitumen) continuing to be high. The bulk of the capital expenditures on its two primary oil sands projects (Pod One and Algar) has been completed and so the cash requirements have been primarily maintenance and additional exploration.

The company is capitalized with roughly $500 million in equity and $1 billion in debt. The company was able to perform a term extension on its first lien and second lien notes, pushing the maturity away from 2014/2015 to 2018/2019 and incurring less of an interest rate bite (in exchange for some capital – the loan went up from roughly $800M to $900M).

There is also a $100M senior unsecured debenture (TSX: CLL.DB.A) which is due to mature on June 30, 2012. Given the company’s cash flow situation and available credit (having extended a credit facility for $100M for three years, a facility currently not used) it is quite probable that the debentures will be redeemed at maturity.

At a 98 cent price that would imply a yield to maturity of about 6.8%. The primary risk to the successful maturity of this issue would be if the price of bitumen dropped significantly beyond existing levels. Closer to the maturity date, it is likely the company will float another convertible debt offering to refinance.

My assessment is that there are probably worse places to put short term investment money than the debenture issue.

Disclaimer: I own some of these debentures from the economic crisis (early 2009) when they were trading under 40 cents.

Petrobakken – Bank Debt – Due 2012?

Investors in Petrobakken (TSX: PBN) are continuing to discover why yield is not something that should be chased lightly – although they are probably looking at their 6.7% current yield on the $14.27 share price are feeling smug, the approximate 36% depreciation in share price over the past year is something they likely would have not wanted in conjunction.

The latest news out of Petrobakken is something they didn’t announce. Specifically, the following comes from their last quarterly financial release (for the 3 months ended March 31, 2011):

Note 9 – Bank Debt
The Company maintains a covenant based revolving credit facility with a syndicate of banks. The facility’s lending amount has a borrowing capacity of $1.2 billion. The current term for the facility ends June 3, 2011 and can be extended by the lenders for an additional year. If the lenders were not to extend the term, the drawn amount would become due on June 3, 2012. The credit facility bears interest at the prime rate plus a margin based on a sliding scale ratio of PetroBakken’s debt to earnings before interest, depletion, depreciation and amortization (“EBITDA”). The facility is secured by a $2.0 billion demand debenture and a securities pledge of Company’s assets.

June 3 has come and is nearly three weeks past. No extension of the credit facility has been announced so it is probable that the $966 million in bank debt (which will be higher for the second quarter financial release) will be called on June 2012. So this means that the clock has started for PBN to shop around for a billion dollars of financing – will they sell more debt? Or will they give the banks some more interest?

In terms of the rate that is being charged by the banks for the facility:

The applicable margin charged by the bank is based on a sliding scale ratio of PetroBakken’s debt to earnings before interest, taxes, depletion, depreciation and amortization (“EBITDA”). The facility is secured by a $2.0 billion demand debenture and a securities pledge on the Company’s assets. The credit facility has financial covenants that limit the ratio of secured debt to EBITDA to 3:1, limit the ratio of total debt (total debt defined as facility debt plus the value of outstanding debentures in Canadian dollars) to EBITDA to 4:1, and limit secured debt to 50% of total liabilities plus total equity. The Company is in compliance with all of these covenants.

I couldn’t find explicitly what the rates were from the financial statements, but doing some arithmetic on the 2010 annual financial statements and subtracting the interest they paid from their US$750M convertible debenture issue, I believe Petrobakken paid prime (3%) for their bank debt in 2010.

You can be sure that the banks want something more than prime for this round of financing – if the renewed credit facility charges prime plus 100bps, this will be another $10M/year in pre-tax cash that will be going out the window for PBN shareholders as the cheap financing dries up.

Petrobakken continues to remain on my radar, but as I stated in my “value trap” article, even at present valuations I will not be touching it. My guess continues to be that we will see a dividend cut or even floating a very unattractive (for them) equity financing in conjunction with a renewal of the credit facility. PBN still has a market capitalization of $2.6 billion and they could sell off 10-15% of the company and raise roughly $250-$500M which would reduce the debt-to-equity and keep their costs of borrowing at prime-like rates.

Markets in a brief rally mode

As much as I despise technical analysis, the following short-term pattern on the S&P 500 chart came to mind and is probably on the minds of technical traders out there:

It would suggest that we would see another couple percent of gain in the S&P 500 before this stalls out (to around the 1310-1320 level).

It is my opinion that we continue to be in a range-bound market and that index investors are not going to be making money on their investments. In order to seek outsized returns, you must be able to look at smaller cap companies, but these come with larger risks.