1. What

On November 14, 2017, Canacol Energy Ltd. (OTCQX:CNNEF, CNE.TSX, CNEC.BVC) reported its financial and operating results for 3Q 2017. Currency is in United States dollars ($).

Financial and operational highlights of the quarterly results include:

  • Realized contractual sales volumes decreased 12% to 16,606 boe/d for 3Q 2017, compared to 18,908 boe/d yoy. The decrease is primarily due to three off-takers having scheduled plant maintenance for a combined 66 days of downtime during the quarter, resulting in lower production of 1,505 boe/d, or 8.6 MMscf/d. Production is stated as working interest before royalties here. The company pointed out during the 3Q2017 conference call that “We’ve seen a shift in gas production volumes in 2017 towards the lower-royalty Esperanza block as opposed to VIM-5 as we continue to seek to reduce our royalty exposure” (see here).

    The Esperanza block has roughly 8.5-9% royalty on it, whereas the VIM-5 block has 22%, thanks to the original bid that OGX submitted to the government. Therefore, it is preferred to produce from the block with the lower royalty, which at this time happens to have sufficient production capacity behind pipe. Going forward, as the company moves toward 230 MMcf/d, there will be more gas produced from VIM-5, which will consequently lead to a higher royalty rate, with the blended rate for the future production mix anticipated to be in the range of 12.5% and may creep up to around 14.5%.

  • Total petroleum and natural gas revenues 3Q 2017 decreased 15% to $38 million, compared to $44.4 million yoy. Adjusted petroleum and natural gas revenues, inclusive of revenues related to the Ecuador IPC, for 3Q 2017 decreased 15% to $43.3 million, compared to $50.9 million for the same period in 2016. The company signed a $50 million 10-year financial lease for compression stations with Interflex, which will lead to around $5.5 million per year, roughly half in capital lease and the other half in operating expenses equivalent to $0.06/Mcf of Opex under 130 MMcf/d and lower under 230 MMcf/d.
  • For 3Q 2017, on a per Mcf basis, the company generated $4.96 of natural gas revenues, which delivered $3.87 of operating netback after paying $0.51 of royalties and $0.62 of production expenses. In 3Q2017, two small interruptible contracts incurred transportation costs of $1.8 million, or $0.26/Mcf, which netted $4.70/Mcf.
  • Net loss decreased 82% to $1.5 million for 3Q 2017, compared to $8.4 million for the same period in 2016.

Table 1. The operational and financial results of Canacol, after company release.

Management remains focused on its primary goals for 2017, which include delivering a significant increase in gas production related to the completion of the Sabanas gas flowline exiting 2017, and adding to our gas reserves base via the successful execution of our exploration drilling program, which has yielded another discovery at the Pandereta-1 exploration well,” Charle Gamba, the CEO, commented. “In 2018, the management team will focus its efforts upon increasing production to 230 MMscfpd exiting 2018 via the second expansion of the Promigas gas pipeline to Cartagena and Baranquilla, and continuing to add gas reserves via the exploration drilling program we have planned for 2018.

2. So what?

2.1. A company transformation

The 3Q 2017 results should be viewed in the grand framework of company remaking, as we have previously described at length. Through acquisition and exploration, the company transformed itself in five short years into a locally important natural gas producer (Fig. 1).

On the exploration front, the company struck gas in eight of the nine wells drilled. Its trailing two-year average F&D costs are $0.44/Mcf, extremely low, highlighting the remarkable conventional gas prospectivity of its contract blocks and an efficient exploration and development program run by the company.

Fig. 1. Historical reserves telling a story of company transformation, after Canacol presentation in November 2017.

2.2. A natural gas franchise

The successful gas exploration program has catapulted the company into an envious position in the Colombian Caribbean Coast gas market, where the declining mature fields of Chevron (NYSE:CVX) and Frontera (OTC:PEGFF) cannot keep up with growing demand. Canacol is poised to replace Chevron as the largest supplier of natural gas there (Fig. 2). It has emerged as a natural gas franchise in that market.

Fig. 2. The competitive landscape (right) in the undersupplied Colombian Caribbean Coast gas market (left), after Canacol presentation in November 2017.

The company emphasized during the 3Q2017 conference call that “Canacol’s gas assets require very little capital and feature industry-leading reserve life indices. We spend little to no capital to maintain existing production of 2017. And we anticipate spending a total of $85 million for the remainder of 2017 and 2018 to lift and maintain 230 MMcf/d of production exiting 2018“.

2.3. Accumulation of local exploration know-how

The company has successfully applied the AVO technology to the gas‐charged sandstones in the area. This practice helped reduce exploration risks greatly; the company had an 89% exploration success rate. In 14 producing wells, tested production rates average 33 MMcf/d from an average net pay of 78 feet TVD (Fig. 3). The accumulated knowledge of local geology and exploration know-how give the company an edge in securing more gas reserves going forward.

Fig. 3. A map showing the AVO extraction over the Middle CDO (left) and a fluid factor (AVO) section (right), modified after Canacol presentation in November 2017.

The company’s use of the AVO technology has led to the successful addition of 25 Bcf of 2P reserves from the Porquero Formation. In November 2016, the company struck gas in a 39 feet TVD of net pay in the Porquero Formation and tested 23 MMcf/d; in December 2016, it again flowed gas at 13 MMcf/d in well Nelson‐5 from a re-completed 79 feet ney pay in Porquero; in June 2017, it flowed 46 MMcf/d in Toronja‐1, further exposing the prospectivity of the formation. This opens up follow-up locations, including Aranadala‐1, Breva‐1, and Carambolo‐1 (Fig. 4).

Fig. 4. The AVO extraction over the Middle Porquero SST marker, after Canacol presentation in November 2017.

The company is currently executing on multiple fronts, from exploration via pipeline construction to field development, to monetize the competitive position it has secured over the past five years.

2.4. Potential divestment of conventional oil assets

Management confirmed during the 3Q2017 conference call that the company has engaged a bank to look to divest or spin off into a new company its entire conventional oil portfolio, both in Ecuador and Colombia. Both of those options are currently being evaluated with respect to which would yield the best value for shareholders. A choice of either one of those two courses of action is expected in 1Q2018.

This strategic move is a continuation of its transformation into a gas franchise. As Charle Gamba, the CEO, said, “As you know the percentage mix of our current production and future production is becoming increasingly more heavily gas weighted and it’s really a reflection of the materiality of our gas portfolio compared to our conventional oil portfolio. So just from an investment decision perspective, it makes a lot more sense for us to deploy capital towards exploring and developing our gas assets where the margins are 80% and netbacks $25-26, much better than the margins and netback associated with oil production and at much lower level of investment of course”.

The company seems to lean toward keeping its unconventional oil assets.

3. Now what

Investors should keep an eye on the company’s exploratory drilling and the progress of the Sabanas gas flowline in the coming weeks.

3.1. Exploratory drilling

For the remainder of the year, Canacol still has two more wells to complete, namely Pandereta-1 and Cañandonga‐1 (Fig. 5).

Fig. 5. A map showing the wells to be completed in the remainder of 2017, also shown are existing gas fields, prospects and leads, and surface facilities, after Canacol presentation in November 2017.

The company spudded exploratory well Pandereta-1 in late October 2017, targeting the CDO sandstone with a scheduled MD of 9,300 feet. The well is drilled on the Pandereta closure located some 10 km to the southeast of the Clarinete discovery. The well, using the Pioneer 302 L/R, has a drilling and testing budget of $5.5 million.

Using Pioneer 302 L/R, Pandereta-1 was spudded on October 25, 2017, and reached a TD of 9,347 feet MD in 15 days. The well encountered 64 feet TVD of net gas pay with an average porosity of 20.5% within the primary CDO reservoir target; in the secondary and shallower Lower Tubara reservoir target, 34 ft TVD of net gas pay with an average porosity of 15% was encountered. Furthermore, the well encountered strong gas shows and gas pay over a 51 ft TVD interval in a zone interpreted on logs to be the fractured basement, pending additional technical work (Fig. 6). The well is currently being cased ahead of production testing. Planning for an extensive production testing program for the well is presently underway as of November 15, 2017, which shall commence within one week. On success, the well will be tied in through a 6″ flowline to the Jobo gas processing station.

Mark Teare, senior VP of Exploration, commented, “We are very pleased with the results from the Pandereta 1 exploration well, which, having successfully encountered gas pay in the primary Cienaga de Oro sandstone target, also encountered gas within the shallower Lower Tubara sandstone reservoir and deeper naturally fractured basement. These latter two reservoirs could potentially represent additional gas resource upside on Canacol’s blocks in the Lower Magdalena Basin. In this respect, the outcome of the Pandereta-1 well has exceeded expectations in terms of its potential to book new reserves over the Lower Tubara and the basement, as well as the Cienaga de Oro reservoir intervals” (see here).

Fig. 6. The structural map (left) and seismic profile of the Pandereta closure with the location of the Pandereta-1 exploratory well shown, after Canacol presentation in November 2017.

The Cañandonga‐1 well was spudded on November 4, 2017, and is drilling ahead as planned, and the company anticipates drilling through the primary CDO sandstone reservoir target later this week. Canacol will provide testing results for both wells when flow testing operations are completed.

Cañandonga‐1 is drilled on a fault-dependent closure in the Nelson Fault structural trend, along which the company has found 240 Bcf of reserves in the Nelson, Nispero, and Trombon gas fields, in addition to the 378 Bcf in the mature fields Castor, Sucre, and Tablon (Fig. 7). The well was spudded in November 2017 with stacked multi‐zone objectives in the CDO and Porquero formations and AVO‐supported new play in the Tubara sandstones. The well is scheduled to reach the MD of approximately 10,000 feet, with a drilling and testing budget of $5.5 million.

Fig. 7. A geological structural map showing the fault-dependent closure the Cañandonga‐1 exploratory well is being drilled on, after Canacol presentation in November 2017.

3.2. Sabanas gas flowline

The Sabanas gas flowline project remains on schedule and is expected to be completed by December 1, 2017 (Fig. 8). Once completed, the flowline will add 40 MMscf/d of pipeline capacity, to allow for 130 MMscf/d of gas sales.

The Sabanas flowline will have an initial transportation capacity of 20 MMscf/d on December 1, 2017, and a final transportation capacity of 40 MMscfpd in mid-January 2018, once final compression has been installed and tested.

The productive capacity of the company’s current gas wells is 195 MMscf/d, and that of the Jobo gas processing facilities is 200 MMscf/d.

Fig. 8. The Sabanas gas flowline installation, modified after Canacol presentation in November 2017.

4. Investor takeaways

4.1. The anticipated growth

The completion of Sabanas on December 1, 2017, and a second flowline, which is to be built by Promigas, by December 1, 2018, will result in a CAGR of 49% in gas production over the next 14 months. The increased gas production will, in turn, lead to the EBITDA expand from $135 million to $300 million in 2019, thus clocking in a CAGR of 20% (Fig. 9).

Fig. 9. Projected Production and EBITDA, modified after Canacol presentation in November 2017.

4.2. Financial outlook

Canacol is in robust financial shape. Net Capex including acquisitions for the three months ended September 30, 2017, was $25 million. At September 30, 2017, the company had $35.8 million in cash and $54.5 million in restricted cash and continues to be well within all of its banking covenants.

The anticipated cash flow will put it in an even stronger financial position. The Libor + 5.50% senior secured term loan taken from a syndicate led by Credit Suisse is expected to be paid down between March 2019 and March 2022 in 13 consecutive quarterly payments each of $24 million. In addition, the company will have extra cash to either start to pay dividends and/or pursue organic growth through exploring and developing its shale oil projects in the Middle Magdalena Valley Basin in Colombia, which has been put off to divert resources to natural gas E&P so far.

4.3. Risks and reward

The greatest risks I can see with Canacol is execution uncertainty and security concern. Will the company be able to turn on the Sabanas gas flowline on schedule? Is Promigas going to build the second gas pipeline in 2018? Will the guerillas surprise us by blowing up the gas pipelines?

All indications, nonetheless, point to the Sabanas gas construction being on schedule. This is a management that has a track record of delivering exploration successes. There is no reason to think it will fail on the gas flowline installation. As for the Promigas flowline, it is a win-win-win for Promigas, Canacol, and the gas consumers to have it built on schedule. It seems this pipeline is likely to be on schedule.

I also believe all the security risks have been priced in, and that things are looking up, not down, from this point onward. The top three executives of the company, Charle Gamba included, moved their families to Bogota to live. That speaks volumes about how much the on-the-ground security risk level deviates from the conventional wisdom held by those of us who live thousands of miles afar.

In summary, the operations of Canacol are proceeding as expected. The company is poised to escalate gas production to 130 MMcf/d, which will significantly improve its cash flow. The stock price, in my opinion, will not hesitate for too long to close the yawning gap with the intrinsic value. Therefore, I think Canacol is a strong buy at the current stock price.

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Disclosure: I am/we are long CNNEF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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