GABRIEL LOWENBERG. Special to The Globe and Mail, Published Tuesday, July 19,
I do not invest in options or derivatives on behalf of clients as they always seem to expire a little too early.
However, periodically I find a company that represents a de facto, long-term option on an asset. Enter MEG Energy Corp., which owns a 100-per-cent working interest in two oil sands projects in the southern Athabasca region of Alberta; a 50-per-cent interest in the Access Pipeline (from Fort McMurray to Edmonton); and an Edmonton storage terminal.
MEG Energy owns leases on 2,331 square kilometres of land – the Christina Lake and Surmont projects – that contains 1.5 billion barrels of proven oil reserves. The oil will be recovered using a process called steam-assisted gravity drainage (SAGD). This is not conventional strip-mining, which destroys large swaths of forest. This approach creates a mining pad about the size of a football field. Steam is injected to loosen the oil and let it flow out into pipelines for processing and sale.
When oil was $100 (U.S.) plus a barrel, the net asset value (NAV) for MEG Energy hovered around $60 a share. With the sharp decline in oil prices, these values have been drastically reduced. Any sustained recovery in oil prices is likely to bring MEG’s NAV to the mid-teens or higher, more than double its current share price. Effectively, MEG Energy is a long-dated option on the oil recovery, and it’s a doozy.
Let me elaborate. MEG has access to more than 30 years of reserves at current production rates. True, over the past five years, it has accumulated significant debt to build infrastructure – terminals, pipelines and processing plants – and bringing its assets on stream. All in all, about $5-billion of high-yield debt and more than $3-billion of equity was issued.
So here is the option value. MEG Energy spent a huge portion of the money upfront – other people’s money. But the expensive part of the game is over. And the price of oil has crashed to levels that few experts believe are sustainable. The incremental capital needed to bring on new production as oil prices rise is much less. New equity investors, I submit, will be beneficiaries.
The obvious comparison is real estate. The developer of a major shopping centre buys more land than he or she initially needs, and uses the excess for parking. When demand justifies expansion, more stores are built on the parking lots; the core infrastructure is already there. The heavy lifting has been done. Returns on the expansion project are almost always significantly higher than initial costs.
So back to MEG. The company is close to cash-flow neutral and – this is the best part – none of its debt is due before September, 2020. This is what makes MEG an option on oil prices. As oil prices rise, the rate of change on the company’s free cash flow will be exponential.
The second-best part is that its pipeline partner, Devon Energy Corp., recently sold its 50-per-cent stake in the Access Pipeline to an entity backed by the Canada Pension Plan Investment Board, for $1.4-billion (Canadian). MEG has publicly contemplated doing the same, and could, in a pinch, thus monetize its 50-per-cent interest for a similar amount. That would provide cash to repay the bonds due in 2020, and extend the option value out to 2021. You might think about this kind of transaction as a sale-lease back, similar to what companies do with real-estate properties or airplanes.
So where are the risks? The biggest, clearly, is the commodity price itself. If the price of oil falls again to $25 (U.S.) a barrel, MEG will not be financially viable. Even if it stays flat, in the $45 to $48 range, the clock moves toward the 2020 bond-renewal bullet. Moreover, investors must also weigh the risk of lost opportunities. MEG shares pay no dividends, so you will not be getting paid to wait.
There is also ecological risk, though I regard this as marginal. Some facts are in order. Mining in Alberta has, to date, disturbed less than 1 per cent of Canada’s boreal forests. As well, provincial governments hold securities tendered by companies, which will only be refunded when sites are restored to their prior status. The SAGD process is the most favourable environmentally. Over all, Canada accounts for about 2 per cent of global greenhouse gas emissions; the oil sands sector represents a mere 5 per cent of that total. So there is an environment risk, but it is small compared with the headlines.
There are other risks, of course, including additional environmental regulation, the prospect of all cars becoming electric and governments mandating the use of only nuclear fuel for electricity tomorrow. These changes will eventually transform the industry, but not soon and certainly not by September, 2020.
For now, MEG Energy is irrefutably trading at levels ridiculously below its net asset value. I cannot believe that the smart money and its strategic shareholders – China National Offshore Oil Corp. and Warburg Pincus LLC who together still own just less than 30 per cent – are going to let it stay this way for long.
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Gabriel Lowenberg is CEO and president of Lowenberg Investment Counsel Inc., an independent wealth investment management firm, which owns MEG Energy for the benefit of its clients.