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Vermillion Enery has strength in diversity

The oil and gas producer benefits from having a variety of assets in a variety of places

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

Mar 31, 2017

by Jody Chudley

The Play

Usually in this part of my monthly write-up I tell you about “the play” that the company I’m profiling is operating in. This month I can’t really narrow it down like that since I’m talking about a company with an extremely diversified asset base.

“When we started, we were drilling and casing those wells in 21 days. Now, we drill and case them in about nine days.”
– Anthony Marino, CEO, talking to Digital News Group about a play in Alberta’s West Pembina region

In investing, diversification is good. When it comes to running an oil and gas producer, I’m not sure that it is. This is an industry in which being a low-cost producer is critical for any significant level of long-term success. If you have spent any time investing in this sector, you will know this is the case.

Finding one good play to base your company around is hard enough, given what you are competing against. Trying to find several so you can offer a diversified asset base to investors is that much harder.

That makes the mid-sized company in focus this week a bit unusual. It has an asset base that is diversified in almost every way imaginable. In terms of plays, there is diversification since the company operates shale and conventional assets, and both onshore and offshore. By commodity there is diversification since the company sells both oil and natural gas, as well as hydrocarbons with different price points (WTI, Brent, Aeco, European natural gas). There is geographic diversification as the company’s assets are spread across not only countries but continents hitting North America, Europe and Australia.

Most importantly, all of this is diversification an investor should like.

The Pick

Vermilion Energy (TSE:VET)

This oil and gas producer is Vermilion Energy and it is a very well-run company. Vermilion has the kind of diversified assets that you might expect to find in an oil and gas major rather than a mid-sized producer. Vermilion receives significant portions of its production from Canada, France, Ireland, Australia and the Netherlands.

While diversified, Vermilion’s production combines for high after-tax cash flow netbacks. That is how much money each barrel of production generates after operating expenses. Having high netbacks means that you are generating a lot of cash flow from your production. On this measure, Vermilion ranks as one of the most profitable Canadian-listed producers.

That isn’t all there is to like about Vermilion’s production. It also has one of the lowest decline rates in the industry. Having a low decline rate means that you don’t have to spend as much cash drilling new wells to offset production declines. Put high netbacks with low decline rates and you can generate some serious free cash flow, something rather uncommon in this capital intensive industry.

Vermilion refers to its “effective” corporate decline rate as being at 13 per cent. Compare that to a pure-play producer like Raging River (a good company) which has a decline rate of over 40 per cent and you can appreciate
Vermilion’s advantage.

Vermilion’s effective rate of decline is lower than its natural rate because Vermilion creates the effective rate by restricting production in the Netherlands and Australia. By restricting production on those two properties (done to maximize long-term recoveries) the decline rate is zero.

Since good things come in threes, I’ll point out one more thing to like about Vermilion’s production: It doesn’t cost much to bring it online. In 2015, Vermilion’s finding and development cost was just $9 per barrel. That has come down from $35 per barrel in 2011 and is a level that Vermilion believes it can maintain due to reduced drilling times.

The Postscript

Add these three attributes together (high net­back, low declines, strong capital efficiencies) and good things are bound to happen. That is exactly the case at Vermilion, where free cash flow has surged in 2016 and will continue higher in 2017 and 2018.

By free cash flow I’m talking about cash left over after deducting all capital expenditures (including growth spending). Vermilion’s free cash flow will nearly quadruple this year from where it was in 2014, quite an achievement considering oil prices are about half what they were back then.

Vermilion shares provide a dividend yield of 4.7 per cent and the company expects to grow production by four to eight per cent in the years ahead. It will do this with a healthy balance sheet and its debt to cash flow should be under 1.5 by the end of this year.

After using free cash flow to improve the corporate balance sheet over the next six months I would expect that we could see Vermilion hike its dividend by up to 25 per cent near the end of 2017. That could be a welcome catalyst for Vermilion’s share price.

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