Is Twin Butte Energy On The Operating Table?

Nathan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

"The best thing that happens to us is when a great company gets into temporary trouble...We want to buy them when they're on the operating table." - Warren Buffett.

Twin Butte Energy (TSX: TBE) is a yield play from the energy industry that is focused on large original oil in-place conventional heavy oil exploitation. The stock hit some speed bumps a few days ago and has plunged 25% since then on unusually high volume. Will the knife keep falling? To find out, let's take a close look at the Strengths, Weaknesses, Opportunities, and Threats now that the blood is in the streets, because this may be a big buying opportunity. 

Strengths 

Tax Pools: The company has $580 million in tax pools. To an acquirer, these tax pools can shield $145 million of income at a 25% tax rate. So a potential acquirer would have to pay $0.58 per share for buying only the tax pools. 

Production Growth: Production has been growing consistently during the last 6 years, and rose from approximately 1,000 boepd in 2006 to 19,200 boepd in December 2012.

Low Risk and Low Decline Wells
: The company has a low risk, heavy oil inventory of over 700 net wells that provides 5-6 years of high capital efficiency. Additionally, the base annual decline for these wells is as low as 28% in a concentrated asset base around Lloydminster with year round access.
 
Low Cost Wells with Short Payout Period: The average vertical well cost ranges from $515,000 to $615,000 with an average initial production of 40 - 80 boepd, average reserves per well of 45 - 80 mboe, and a short payout period of 0.8 years. 

Funds from Operations (FFO) Stability: The volatility of the operating cash flow for 2013 is significantly reduced because the company has a strong hedging position in place. 

Aggressive Bidder: Twin Butte was the most acquisitive Canadian energy company in 2012 after Crescent Point Energy, which acquired 6 smaller producers in 2012, expanding its core areas which extend from Canada (Beaverhill Lake, Viking, Bakken formations) to the USA (Uinta Basin). Twin Butte has also been on a consolidation spree and has acquired 5 peers (Swimming, Emerge, Avalon, Wildmere, Waseca) in the last 12 months, significantly growing its drilling inventory, which currently is estimated to be over 700 net heavy oil wells. 

Annualized Debt/FFO < 2: The company hasn't any debt issues, and year end 2012 net debt was $205 million, or 1.4 times Q4 annualized cash flow. 

Hefty Dividend: The shareholders are handsomely rewarded by the corporate dividend policy on a monthly basis, as the current annual yield is 8.5%. It is also worth noting that the dividend isn't at stake because the all-in payout ratio (dividend and capital expenditures) will be maintained at 100%, ensuring the dividend sustainability. 

Target Price: The average target price from the 15 analysts who cover the company is $3.46. 

Weaknesses 

Performance Issues: Since late December 2012, Twin Butte has been hampered by a number of operational and reservoir performance issues. Significant downtime was experienced early in January on the heavy oil operations, as the Lloydminster area encountered cold temperatures which created freezing, and run time-related issues on a number of the wells. The wells at Primate Property lost inflow or were experiencing high water cuts. Primate was one of the company's best performing properties in 2012, but over the last 40 days has seen its production drop from a high of 3,400 bbls/d, by 800-900 bbls/d. 

Opportunities 

Heavy Oil Differentials: Canadian heavy oil companies were severely hit in 2012 by the spread between WTI and WCS (Western Canadian Select) due to pipeline capacity constraints and refineries. This spread hit $42 per barrel in December 2012, which is the lowest in five years. Twin Butte's CapEx in Q4 2012 were reduced by $4 million from the company's budget due to the differential situation. However, there are several major pipeline projects currently under construction in North America with a completion date in 2013-2014. The recent Seaway's expansion is just one of these projects that aims to narrow the differential between WTI and WCS. BP's refinery resumption is scheduled for Q2 2013, further expanding the refining capacity in North America and increasing the operating netback of the heavy oil players. 

Significant Discount To Heavy Oil Producers: With a production of 17,100 boepd currently due to the downtime experienced in January, 2P reserves of 60 MMboe and Enterprise Value (EV) of $765 million, Twin Butte trades for $44,700/boepd (90% oil & liquids) and $12.75/boe of reserves. Twin's production is 83% heavy oil. Baytex Energy (NYSE: BTE) has 54,000 boepd production currently, along with 234 MMboe 2P reserves and EV of $6.2 billion. This gives $114,800/boepd (88% oil and liquids) and $26.5/boe of reserves. Baytex's production is 73% heavy oil.  Berry Petroleum (NYSE: BRY) has production of 39,500 boepd along with estimated 2P reserves of 360 MMboe and EV at $3.6 billion currently. Thus, Berry trades for $91,100/boepd (78% oil and liquids) and $10/boe of reserves. Berry's heavy oil accounts for 49% of its production.

Threats 

Performance Issues: The company views the Primate situation as an isolated performance issue, and it is currently deploying remedial efforts to address this issue. However, the result remains unknown at this point, and this uncertainty concerns investors. If the problem lasts for some months, the company will have to change its projections for 2013 and adjust its dividend policy downwards. 

Commodity Volatility: Twin Butte is oil-weighted and its operating cash flow is related to WCS. The commodity volatility can't be fully removed because the company's existing hedge position covers approximately 45% of the total oil production. If the oil price drops significantly in 2013 and WTI's premium over WCS widens further, the operating cash flow will decline substantially and the corporate capital plan will have to be modified accordingly. 
 
The bottom line is that any company encounters temporary operating issues, and this is what is likely going on with Twin Butte. The big picture is that the fundamentals havn't changed, and this is enough to allure fundamentals-driven investors to establish a substantial position at the current levels.


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