As a result of higher oil prices and falling costs, Baytex Energy Corp. (TSX:BTE)(NYSE:BTE) was able to generate free cash flow last quarter. In fact, the oil company produced $39 million in excess cash from operations, which it used to chip away at its debt. Despite that step in the right direction, the company is not yet on solid ground and won’t be until oil tops $55 a barrel. Here’s why.
The sustainable formula
While Baytex generated free cash flow last quarter, that was in large part because it cut capex below a sustainable level. That is evident by looking at its production, which declined from 75,776 barrels of oil equivalent per day (BOE/d) in the first quarter to 70,031 BOE/d in the second quarter because it is not spending enough capital to offset declining production from legacy wells with new ones.
According to the company, the magic number to tread water is about $300 million annually. Given its current capex budget of $200-225 million, it is well short of that level. Further, it doesn’t expect to generate enough cash flow to comfortably invest $300 million per year until oil is well over $50 a barrel.
As things currently stand, $55 a barrel would enable the company to generate enough cash flow to maintain production and have some left over. Meanwhile, crude would need to go even higher than that before the company would be in the position to restart production growth.
Falling to the back of the pack
Because of that, Baytex has a much higher pivot point than its rivals. For example, shale-focused Encana Corp. (TSX:ECA)(NYSE:ECA) recently put out its growth projections for the next five years. According to the company, it can deliver a 60% increase in production and 300% more cash flow at $55 oil over the next five years.
Fueling that growth is Encana’s ability to earn stronger drilling returns at lower oil prices than Baytex. For example, Encana’s top four core plays can generate a 35% after-tax rate of return at $50 oil, while two of Baytex’s three regions need oil over $45 a barrel just to break even.
Meanwhile, light oil-focused Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) recently announced plans to return to growth mode at sub-$50 oil prices. In fact, at current prices the company can deliver 10% compound annual production growth through 2021 while still generating some excess cash flow. Meanwhile, if crude moves up to $60 a barrel, Penn West could ramp up its production growth rate to 15% compounded annually while still generating excess cash.
Another reason why both Encana and Penn West are in a position to restart growth is the fact that they already addressed their balance sheet issues. Each sold billions of dollars in assets over the past year to cut debt, while Baytex has only chipped away at a fraction of its debt via small non-core asset sales and excess cash flow. Because of that, the company will likely need to divert the bulk of its excess cash flow as prices rise to pay down debt before it is in a more comfortable position to resume production growth.
While crude’s rise above $50 a barrel will certainly help Baytex Energy, it really needs crude to move another $5 a barrel higher to be in the clear. That is because $55 oil is the pivot point for the company, whereby it can sustain production and start generating excess cash flow. Still, that puts it well behind rivals Encana and Penn West, which are returning to growth now that oil is above $50 a barrel.