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1 Cheap but Risky Driller to Play Higher Oil and Natural Gas

The outlook for crude improved significantly after OPEC and its allies agreed to a last-minute deal to shave 1.2 million barrels off their daily oil production after a contentious round of negotiations. After announcing the last-minute deal, the North American benchmark West Texas Intermediate (WTI) rallied modestly, although it is still down by 9% for the year to date. The growing uncertainty surrounding crude is weighing heavily on energy stocks, causing many to decline sharply in value since the start of 2018. One driller that has been particularly roughly handled by the market is Paramount Resources (TSX:POU), which has lost more than 67% for the year to date.

Attractively valued

Paramount has three million net acres with its largest landholdings being in the Montney and Duvernay plays. It has net reserves of 518 million barrels of oil equivalent, which are 36% weighted to oil and natural gas liquids. Those reserves after the deduction of net debt totaling $797 million have an after-tax value of $3.2 billion, which is equal to roughly $24.50 per share, or almost four times Paramount’s market value. That indicates the tremendous potential upside that exists should oil and natural gas prices rally for a sustained period.

The agreement between OPEC and its partners to cut production will help to buoy oil over the long term, while recent unseasonably cold weather has helped to bolster natural gas. Some analysts assert that move away from coal-fired power to natural gas combined with growing Asian demand for the low-emission fossil fuel will help to sustain firmer prices over the long term.

Latest results were credible

Paramount announced solid third-quarter 2018 results where it surprised the market with a better-than-expected net loss of $23.4 million, although that was still significantly lower than the net profit of $223.5 million posted for the comparable period in 2017.

The driller’s production for the period grew at a healthy clip, leading to higher sales volumes, which rose by a notable 64% year over year to 80,471 barrels of oil equivalent daily. That marked increase in oil and natural gas output can be credited to Paramount’s $487 million acquisition of Apache Canada, which was completed in August 2017, and the $1.1 billion merger with Trilogy Energy. Because of those results, the company reiterated its full-year 2018 production guidance of 88,000-92,000 barrels of oil equivalent daily.

Paramount’s production will continue to grow. The company has established an extensive drilling program focused on its Montney and Duvernay acreage, which, by 2021, is anticipated to add up to 140,000 barrels daily to its petroleum output. This significant increase in production, along with those assets breaking even with WTI at US$27 to US$38 per barrel, will give Paramount’s earnings a solid lift.

Paramount’s netback, which is a key measure of operational profitability, also grew substantially during the third quarter, rising by an impressive 33% year over year to $15.16 per barrel of oil equivalent sold. That can be attributed to significantly higher oil, which more than offset increased production expenses and weaker natural gas prices.

While the driller has worked hard to bolster its balance sheet, it still does carry a significant amount of debt. By the end of the third quarter, net debt totaled $797 million, which was 25% greater than at the end of 2017 and is almost 2.5 times Paramount’s trailing 12 months funds flow from operations. Despite this ratio illustrating that this level of debt is manageable, it indicates a degree of vulnerability in an operating environment where oil remains soft and its outlook is uncertain.

Why invest in Paramount?

Paramount appears undervalued once the intrinsic value of its oil and gas reserves is considered. That — along with its high-quality acreage and ability to grow low-cost production — makes it an appealing play on higher oil and gas prices.

Nonetheless, no investment in an energy stock is risk free, and there are considerable risks attached to Paramount. Key being the uncertainty surrounding oil and gas prices as well as its high level of debt, which increases its vulnerability in the difficult operating environment now being experienced.

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

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