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A top pick in the Canadian oil and gas sector

Jean-Francois Tardif is the founder and portfolio manager at Timelo Investment Management Inc., and lead manager of JFT Strategies Fund. He is also a contributor to Capital Ideas Digest, a weekly compilation of investment ideas based on a variety of research reports. The Globe and Mail provides marketing services and receives compensation from its parent company, Capital Ideas Research. Try it now to enter the $25,000 winner-take-all stock picking contest.

Birchcliff Energy Ltd. is currently one of our top picks within the oil and gas space. The company completed a transformational acquisition with EnCana Corp. last summer, allowing it to de-lever its balance sheet through an equity issue, while increasing corporate production by roughly 67 per cent.

As a result, we see Birchcliff as being one of the better-positioned companies in the gas sector due to its free cash flow generation and production growth. Among the names we follow, Birchcliff generates a better-than-average free cash flow yield after maintaining its current production.

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Despite screening better than peers on this metric, the company trades at a cheaper valuation to the group. According to National Bank's latest numbers, Birchcliff trades at 7.4 times 2017 estimated debt-adjusted cash flow versus its peers at 8.5 times. We think this discount is unwarranted.

At current natural gas pricing, we estimate that the company can generate a 4-to-5 per cent free cash flow yield. This could act as a catalyst for Birchcliff shares as management can redeploy the funds into its asset base.

Management recently released a five-year plan that could see production more than double from 61,000 barrels of oil equivalent per day to 130,000 by 2021. While this 15-per-cent compound annual growth rate (CAGR) is impressive, it's even more pronounced near-term as Birchcliff expects to be able to grow production at a 30 per cent CAGR to the end of 2018.

The company expects to fund this growth within cash flow and notes that at $55 (U.S.) a barrel oil and $3 (Canadian) per gigajoule of natural gas, it will also generate extra cash flow that can be used to reduce its debt.

Birchcliff's cash flow has allowed it to start paying a quarterly dividend of 2.5 cents a share. Although small at a 1.1 per cent yield, we believe the dividend could attract a new investor base to the stock, which may result in a higher valuation for the shares.

Even though Birchliff recently introduced a hedging policy of locking in pricing on 50 per cent of 2017 production, we think the company has upside potential from higher prices. Some forecasters, including the Farmer's Almanac, are calling for a cold and long winter following the break we got last year. During the last Polar Vortex in 2013-2014, gas prices spiked above $6 per million British thermal unit.

While this is not our base case scenario, our numbers estimate that if gas increased to $3.50 and Birchcliff traded at current industry average multiples, the stock could be worth around $15 a share. If we are lucky and get a prolonged rally in gas prices above the $3.50 level like we did the last time we had a cold winter, we think there is potential for upside even above this level.

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While we do not currently assume any cost savings in our numbers, we think Birchcliff has the potential to surprise on costs as the company has a track-record of reducing operating expenses per barrel. Historically, Birchcliff has always owned and operated its own gas processing facilities.

However, its most recent acquisition came with a two-year processing commitment with a midstream operator on the acquired lands. Once the contract expires, we think Birchcliff may look to go back to controlling its own processing. According to a National Bank research note, this could result in an additional $50-million in annual savings.

Many risks have the potential to impact the price of Birchcliff shares. One of the biggest risks is weather. If we get a warmer than average winter (similar to last year) natural gas prices could fall, and the stock prices of natural gas producers could decrease, too.

Apart from commodity risk, Birchliff is also exposed to operational risks. For instance, a material increase in corporate decline rates of its wells or a reduction in capital efficiencies could require the company to invest more capital into its assets to keep production flat. It could also impact its ability to maintain high growth rates using existing cash flow.

We believe these risks are reduced given that Birchcliff has been successfully operating in the Peace River region for more than a decade, and management often restricts well-rates in order to ensure corporate decline rates stay around 20 per cent.

This commentary is published by Timelo Investment Management Inc. and is intended for informational purposes only and is not, and should not, be construed as investment advice to any individual.

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