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Baytex Energy stock is a sleeper pick

While the energy company is highly overleveraged, it will turn quickly with rising oil prices

Jody Chudley is is a contributor to Agora Financial’s Outstanding Investments and Real Wealth Trader.

Dec 30, 2016

by Jody Chudley

The Play

Baytex Energy has three core assets: Two of them are Canadian heavy oil plays located near Lloydminster and Peace River, Alberta, and the third is the Eagle Ford shale in Texas.

The Eagle Ford is capable of turning a profit at lower oil prices than the Lloydminster and Peace River properties. With a typical $15 differential between West Texas Intermediate pricing and Western Canada Select (heavy oil) pricing, $45 WTI equates to just $30 WCS for the heavy oil assets. To make money generating oil at $30 per barrel a field would need to have virtually no production costs.

Baytex’s operating cost for producing a barrel of Canadian heavy oil in Q1 of this year was $10.91. That compares to $8.17 in the Eagle Ford, and the heavy oil operations barely generated positive operating netbacks in the first quarter. That is bad considering that operating netbacks don’t include any of the cost of drilling the wells.

There is something else you need to know: The economics of heavy oil get better quickly as oil prices increase. If WTI prices were to recover to just $60 per barrel, the Canadian heavy oil wells actually generate better economics than the Eagle Ford. At $70 per barrel these wells generate world class returns on investment.

The reason for this is partially because these heavy oil wells have a much higher fixed cost component which doesn’t rise as oil prices do. The other factor is just how low the WCS differential drives heavy oil prices down. Just a $5 per barrel oil price increase is a 26 per cent increase in Baytex’s Q1 WCS sales price.

The Pick

Baytex Energy (TSX: BTE)

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Baytex Energy did well by shareholders for years as a reliable dividend payer with a focus on Canadian heavy oil. But being basically a pure heavy oil producer meant the company was fully exposed to WCS pricing.

With pipelines in North America overflowing with surging production, the pricing of WCS often suffered from huge negative differentials to WTI. What’s more, with environmental groups stifling progress on not just the Keystone XL but various Canadian pipelines, the future for WCS pricing looked ever worse.

That led Baytex to make the sensible decision to diversify its operations.

On February 6, 2014 Baytex announced a $2.8 billion acquisition of Eagle Ford focused Aurora Oil & Gas. The acquisition was funded by a $1.5 billion equity issuance, $800 million of debt (senior notes) and the sale of Baytex’s interest in the North Dakota Bakken.

While the idea to diversify away from Canada’s pipeline issues was likely a good one, the timing involved in adding debt to the balance sheet couldn’t have been worse. By the time the deal closed, the price of oil had already headed into decline.

Prior to the Aurora acquisition, Baytex’s balance sheet was pristine. After the acquisition, it had a significant but sensible amount of debt for a $90 per barrel environment. At sub-$50, that new debt load was not so sensible.

Despite an equity issuance in April 2015 and the elimination of its dividend, Baytex still finds itself with far too much debt for current oil prices. The good news is that the company has loads of liquidity and zero debt maturities until 2021.

While significantly overleveraged at current oil prices, this company has time to let oil prices rise.

The Postscript

With Baytex’s leverage on its balance sheet and the leverage to higher oil prices, the company’s debt structure could make it an interesting way to play a future oil price increase.

There is something else to be aware of: The operator of almost all of Baytex’s Eagle Ford acreage is Marathon Oil. As operator, Marathon gets to make all of the decisions about how much drilling to do.

This year, Marathon acquired a large position in the STACK play in Oklahoma. This is significant for Baytex because Marathon believes the STACK has better economics than the Eagle Ford. That could present a situation where Marathon chooses to greatly reduce how much it spends in the Eagle Ford to focus on the more profitable STACK.

If Marathon curtails Eagle Ford activity, Baytex has to as well. That would leave the company with only Canadian heavy oil as a place to invest new capital. At current oil prices, that is not a great position to be in.

This company needs oil prices to rise.

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