Surge Energy: Cheaply Valued And Positioned For Strong Upside (TSX:SGY:CA)

Investment Thesis

Russian government just ordered its oil producers to cut oil output to contribute to OPEC+ cuts. This comes at the same time when EIA dramatically lowered its production estimate for US shale oil. The current narrative is calling for an oil price of $100 a barrel this year.

The narrative drives the stock prices, and as a value investor, I would much rather invest in times when the narrative calls for $40 prices with no future for oil. Still, despite the bullish narrative, the stocks of Canadian O&G producers remain cheap.

Surge Energy (TSX:TSX:SGY:CA)(OTCPK:ZPTAF) has higher costs compared to its larger peers, which makes its FCF generation more sensitive to oil prices. In my opinion, Surge is one of the best ways how to play the thesis of a high decline in US shale oil production, driving the oil price higher for longer.

In the end, it all depends on valuation and your personal belief in future oil prices. With the current near $80 WTI strip price and required 12.5% return, Surge shares suggest a 39% upside, which makes it a Buy with a price target of C$11 per share.

While tempting, despite the cheap valuation and potential large gains in the case of higher oil prices, Surge does not currently make its way to my personal portfolio.

Introduction to Surge Energy

Surge Energy is a Canadian small-cap conventional producer with operations across Alberta and Saskatchewan.

Its average production over the last year was 24,438 boe/d (barrel of oil equivalent per day), with a profile consisting of 87% liquids. This generated $94M of FCF (12% FCF yield).

The company strategy lies in long-cycle, low-risk, low-declines reservoirs. While the base production decline rate is about 23%, the company offsets this with water flooding.

See the review of the conventional reservoir characteristics as presented by Surge in the graph below.

If you are new to the company, I would recommend to read through the company’s presentation first.

Underestimated Assets

Independent company Sproule assessed the value of Surge’s 2P (Proved+Probable) reserves at C$17.63 per share. This valuation assumes a 10% discount rate. Discounted by 15%, the value would be C$14.6.

Surge focuses on conventional reservoirs with high OOIP (Original Oil In Place) and low base declines. What exactly does it mean?

According to Surge’s internal estimation, the company sits on over 3 billion barrels of net OOIP, of which 7.7% has already recovered. In Sproule valuation, Surge only booked a recovery factor of 11.5%, which means only an additional 3.8% recovery of the OOIP.

These booked recovery factors greatly underestimate the potential and longevity of these reservoirs, as conventional reservoirs can typically reach up to a 15-20% recovery factor on primary production. Considering that secondary production via waterflooding is a core of Surge’s operations, we can add another 10% recovery.

This represents a significant amount of recoverable oil and is a key part of the investment thesis for long-term investors, as the share price does not reflect this reality.

With over 13 years of future drilling programs and additional potential for waterflooding, Surge does not need to spend a penny on acquisitions for a long time and can choose to increase Capex at any time to boost production in case of higher Oil prices.

2024 Guidance

In December, Surge released its budget guidance for 2024. Capex is expected to be C$190M, including C$10M for water flooding. The drilling program comprises 37 net wells in the Sparky area and 32 horizontal wells in SE Saskatchewan. This is expected to counter the declining production and not to increase production levels.

With a stable production of around 25,000 boe/d, US$80 WTI, we can expect FCF before debt repayment of around C$132M (17% FCF yield with a share price of C$7.7).

Improved Capital Allocation

Surge has outlined a strategic three-phase approach to its capital allocation framework.

Phase 1 focuses on debt repayment while keeping the current dividend of C$0.48 per share (6.2% yield).

With $80 WTI, they should reach phase 2 at the beginning of 2Q2024, and we could see a boost in the payout. The promised 50% payout could yield 8.5% via base dividends, special dividends, and buybacks, while the other half of FCF would go to debt repayments.

Phase 3 could be reached by the end of 2Q2025, assuming $80 WTI prices. We could then see a further increase in payouts.

Risks

Due to its low-risk approach and high production predictability, I assess the risks as below peers’ average. While the production risk profile is low, it cannot be said about its sensitivity to oil prices.

I calculate the WTI price needed to earn enough cash flow to offset the production decline in a range of $55-60 WTI. While prices are currently higher and the company generates healthy FCF, it quickly reverses when the price moves lower.

Since 2015, when oil prices dropped and stayed lower, the company was running FCF negative, and the CEO had to issue new shares and significantly dilute shareholders. This is typical for many small-cap companies and a good reason to demand higher returns for taking this risk.

Operational leverage is a double-edged sword. While threatening in a low-price environment, it can make for substantial gains in rising oil price times. Since the 2020 lows, the stock is up over 500%.

Valuation

While I’ve already presented the case of 2P-NAV valuation, I find most Canadian O&G producers undervalued based on this metric. It seems to me that the market does not fully appreciate the long-term life of reserves, as if assuming the world does not need oil 20 years from now.

Simply comparing DACF (debt-adjusted cash flow) yields does not tell the whole story either, as it does not account for growth Capex.

My approach is via standard DCF (discounted cash flow) valuation. I am building the base-case projection model with the following:

• WTI of US$80 with a WCS differential of only US$11, reflecting the coming TMX expansion.
• AECO following the strip pricing, reaching C$3.5 in 2026. With a 13% gas production on a “boe basis,” the AECO pricing has very little relevance in Surge valuation.
• Capex of C$190M for next year with flat production levels, as the capital spending suggests.
• Zero tax as the company has a C$1.2B tax pool
• Total debt of C$290M with capital allocation following Surge’s framework
• Fully diluted share count of 101M

The graph above summarizes the projection. While flat production is nothing to write about, the large 60% jump in 2026 FCFE is interesting. C$112 allocated towards dividends and buybacks gives you a 14.4% yield.

That’s when I expect only 25% of FCF to be allocated to debt repayments. This is further enhanced by lower interest payments. Considering that Surge currently pays around C$35M, this should save around C$20M in 2026.

You can review all assumed numbers in the projection table below.

The next step to assess the value is to discount the resulting dividends and buybacks by 12.5%, which I use across the Canadian O&G upstream sector so I can easily compare companies inside the industry.

After discounting, the base case scenario, assuming $80 WTI, results in a fair price of C$11 per share, suggesting a hefty 39% upside to fair value.

The table below represents the fair price of Surge stock for a 12.5% return under different long-term O&G prices. This shows that Surge is currently fairly priced for $75 WTI.

Investment Decision

The long-term potential is there, with undervalued high-quality assets and things impring with debt repayments. The company has further ways to highly expand its reserves due to enhancement in its recovery factors via water flooding.

The short-term potential in share price appreciation is as well. With high sensitivity to oil prices and the current bullish narrative for oil prices, Surge could be the best performer in such times.

While valuation results point to undervaluation, I have my favorite in Crescent Point Energy. You are welcome to review my CPG write-up.

Put it simply – while trading at a similar yield, Crescent is growing its production by 10% yearly while Surge production stays flat.

Here is the comparison of the up/downside in share price with the required 12.5% return, based on my DCF valuation models under different pricing environments.

I know that CPG is gassier, but even if I assume the AECO price of C$0, CPG still gives me higher expected returns.

Investors have different approaches, and I believe that Surge’s stock, with its current price, makes a great fit for many portfolios, especially if you want to bet on higher oil prices. I rate the stock as a BUY with a price target of C$11.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.