The Colombian, Caribbean Coast gas market is expected to move into gas deficit in the absence of LNG imports, incremental piped gas or the development of recent deepwater discoveries. We expect Canacol’s market share to increase materially in 2019 and 2020, with management expecting production to ramp-up to 215mmscfd by mid-2019 (+89% from FY18). This is currently underpinned by a YE18 2P reserve base of c 559bcf, implying a reserve life index (RLI) of 7.1 years at 215mmscfd. High exploration and appraisal success rates (historically above 80%) and over 2.6tcf of unrisked prospective resource should enable Canacol to enhance RLI and provide the basis for further production expansion. Realised gas prices are largely fixed (forecast FY19 c US$4.75/mcf post-transport and pre-tax netback of US$3.73/mcf), providing visibility of free cash flows. Our 2P + risked exploration NAV stands at C$6.28/share.
Growing RLI to extend production plateau
With over 2.6tcf of net unrisked prospective resource (Gaffney Cline estimated Pmean), Canacol has sufficient acreage to continue to replace produced reserves while extending and enhancing production plateau. Additions are likely to be key drivers of NAV, as prospective resource is converted to behind-pipe reserves.
FCF funds growth and shareholder returns
At forecast FY20 215mmscfd plateau production, we estimate that Canacol will be generating annual free cash flow (FCF) of US$170m after interest and maintenance capex (capex required to replace produced reserves). With our net debt forecast at 1.5x EBITDA at end FY19, capacity exists to expand the exploration programme, in addition to potential shareholder cash returns. Indicatively, assuming Canacol pursues a policy of shareholder distributions broadly in line with peers, this would imply a cash return yield of c 3.7% for FY20.
Valuation: DCF-based and relative valuation
Edison has valued Canacol using a conventional E&P risked NAV approach, with a base case valuation of C$6.28/share. Canacol currently trades at FY20 (post-ramp-up) P/CF 3.8x, versus its Canadian peers on 2.5x. We believe this premium is driven by certainty of price realisations, strong FCF yield and high production growth relative to peers. Key risks are around Canacol’s ability to replace reserves, somewhat mitigated by its strong track record of exploration success. Colombian geopolitical risk will drive differentiated views on cost of capital; we provide sensitivities to this key valuation input using 12.5% in our base case.
Business description
Canacol Energy Ltd. (TO:CNE) is an oil and gas company involved in the exploration and production of hydrocarbons with operations in South America. The company intends to focus on continuing to grow its Colombia natural gas business and reach 215mmcfd production by June 2019.
Investment summary
Company description: Colombian gas pure play
Canacol offers investors a pure-play on the Colombian, Caribbean coast gas market, a market expected to move into gas deficit over the course of the next decade in the absence of LNG imports, incremental piped gas or the development of recent deepwater discoveries. Canacol is a key component of regional demand with an estimated c 50% market share. This is expected to increase materially in 2019 and 2020, with management forecasting production to ramp-up to 215mmscfd by mid-2019. Based on 215mmscfd of plateau production, Edison estimates a reserve life index (RLI) of 7.1 years based on a year-end 2018 559bcf 2P reserve base. High exploration and appraisal success rates (historically above 80%) and over 2.6tcf of unrisked prospective resource should enable RLI expansion. Low well costs at sub US$5m, excellent reservoir quality and high unconstrained flow rates combined with largely fixed gas pricing (we forecast a realised price post-transport of US$4.75/mcf for FY19) provide for a company that has material FCF generation potential after investment in new well inventory. We expect to see increasing shareholder returns (dividend and buyback) after Canacol reaches a target 215mmscfd in June 2019.
Valuation: Expanding behind-pipe resource to enhance 2P value
Canacol currently trades at a premium to our 2P NAV, with the market ascribing some value to risked prospective resource. We expect the continued conversion of prospective resource to behind-pipe reserves to drive 2P NAV as Canacol leverages a historical exploration success rate of over 80%. We estimate the market is ascribing only 200bcf of incremental discovered resource, despite c 2.6tcf of unrisked prospective resource. In 2019, a planned six-well exploration and appraisal campaign should continue to expand the company’s reserve base. Edison’s risked NAV of C$6.28/share (C$6.90/share using a 10% WACC relative to Edison’s base case 12.5%) includes an estimated five-year exploration drilling programme with 800bcf unrisked prospective and assumes a post-3D commercial success rate of 45%. We also look at valuation scenarios based on a sustained 215mmscfd and 315mmscfd plateau, which stand at C$7.62/share and C$9.22/share respectively.