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What to Expect From This Oil Sands Stock Over the Remainder of 2018

After a near-death experience in 2016 at the height of the oil slump, oil sands company Pengrowth Energy Corp. (TSX:PGH) has roared back to life, primarily because of the unanticipated surge in the value of crude. The stock has gained an impressive 7% over the last month, and despite a range of concerns, including the widening differential between Western Canadian Select (WCS) and West Texas Intermediate (WTI), it appears attractively valued. 

Now what?

Key to Pengrowth’s success is its flagship Lindbergh thermal oil project. The operation has nameplate capacity of 12,500 barrels daily, but Pengrowth has regulatory approval to expand that to 40,000 barrels daily.

Importantly, in an operating environment where crude has firmed substantially, Pengrowth has been able to boost production at the facility to 17,500 barrels daily, placing it on track to achieve the company’s goal of 18,000 barrels. That production is forecast to expand to up to 20,000 barrels a day by 2020.

What makes Lindbergh particularly appealing is that it is a long-life asset, which, like most oil sands operations, has particularly low decline rates. This means that capital expenditures to sustain production are typically lower than for conventional or shale oil assets. It follows that steam-assisted gravity drainage (SAGD) projects like Lindbergh have relatively low breakeven costs when compared to bitumen mining and other oil sands operations.

Back in early 2017, the Canadian Energy Research Institute estimated that SAGD operations have an average breakeven cost of around $43 per barrel, meaning that with WTI trading at over US$68 a barrel, they can be quite profitable.

That profitability will grow at a decent clip, even if oil prices remain flat or even decline moderately over the remainder of 2018.

Not only has Pengrowth implemented a hedging strategy to minimize the downside risk associated with weaker oil, but it remains focused on reducing costs. For 2018, operating costs are forecast to be $10.50-11.50 a barrel, which is up to 22% lower than 2017. General and administrative expenses are also forecast to fall by up to 19%, further boosting overall profitability.

In the case of Lindbergh, because of the additional investment required to bring the project up to full operational capacity, Pengrowth stated that it needed WTI to be at US$55 a barrel. Now that WTI is trading at close to US$70 per barrel and has been at well over US$55 for a sustained period, Pengrowth is in the position to direct further capital to Lindbergh, which should speed up its development.

According to Pengrowth’s strategic road map, if crude averages US$65 a barrel during 2019, the company can boost spending on the project to $125 million — more than double the amount planned for 2018.

The company’s focus on strengthening its balance sheet, which saw it reduce debt by US$1.1 billion during 2017 to US$662 million, has improved its financial flexibility.

Nonetheless, Pengrowth is still not out of the woods with regard to its massive debt pile. This is because despite being substantially less than what it was at the end of 2016, it is still more than 13 times funds flow from operations, indicating that Pengrowth remains heavily levered. Fortunately, a large amount of that debt totaling $456 million is not due for repayment until 2020 or thereafter. This gives Pengrowth some breathing space to benefit from higher oil and boost its cash holdings so as to continue reducing that debt to a more manageable level.

So what?

Pengrowth is an appealing but risky play on higher oil. While its flagship Lindbergh operation is an attractive asset, it remains highly dependent on oil continuing to trade at over US$65 a barrel, so it can generate sufficient cash flow to fund project development and comfortably meet debt repayments.

However, there is every sign that higher oil is here to stay because of emerging supply constraints in the Middle East and infrastructure bottlenecks in the Permian, which — along with greater demand growth — are supporting higher prices. This means that Pengrowth stock should soar once it reports stronger operational and financial results for a sustained period.

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Fool contributor Matt Smith has no position in any stocks mentioned.

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