Canadian energy stocks have fallen into disfavour with investors after crude collapsed sharply toward the end of 2018 to see the North American benchmark West Texas Intermediate (WTI) plunge to under US$45 a barrel. This has provided an opportunity for investors to access outsized returns by investing in quality oil stocks with proven assets, low operating costs and a credible history of growth. One upstream oil producer that stands out for these reasons and more is Gran Tierra Energy Inc. (TSX:GTE)(NYSEMKT:GTE).
Growing oil reserves
The driller, which is ranked among the largest privately-owned oil producers in Colombia, recently reported that its end of 2018 proved plus probable oil reserves had grown by 14% year over year to 145 million barrels. This gives Gran Tierra a very impressive reserves replacement rate of 140% and underscores the quality of its oil acreage, high exploration success and ability to expand production.
Those reserves were independently determined to have an after-tax value of just over US$2 billion, which equates to $6.88 per share — more than double the current price of $2.93. This highlights the substantial upside available to risk tolerant investors willing to make a contrarian play on higher oil over the coming year.
Lower geopolitical risk
Aside from weaker oil, another factor weighing on Gran Tierra’s market price is that its core assets and operations are in the Latin American nation of Colombia. The Andean nation’s name over the decades has become synonymous with drug trafficking, leftist guerillas, kidnapping, paramilitaries, drug cartels and violence. That sees the market baking in a higher degree of risk for those companies operating in the nation that once sat on the precipice of becoming a failed state. Medellin, its second-largest city, was known in the 1980s as the murder capital of the world.
Nonetheless, the historic peace deal and subsequent demobilization of FARC, the largest belligerent guerilla group, along with a range of improved security measures has seen violence fall significantly over the last decade. And this, combined with a business-friendly government and Bogota’s focus on enhancing security for Colombia’s oil fields as well as energy infrastructure indicates that much of the geopolitical risk attributed to the Andean nation is overblown.
That means the heavy discount being applied to Gran Tierra because of the markets fears regarding security and other related geopolitical risks is unwarranted.
Solid production growth positions Gran Tierra to fully benefit from higher crude and will boost earnings over coming months as oil moves higher. By early December 2018, the driller reported that oil production had reached a record high of 40,000 barrels daily and that for 2019 oil output would average 40,000 to 42,000 barrels daily which is a 12% to 18% increase over 2018.
The boost that such a notable increase in oil output will give to cash flow and earnings is enhanced by Gran Tierra’s low production expenses and ability to access Brent pricing. Currently, the international benchmark is trading at over US$9 a barrel higher than WTI. According to analysts, this wide price deferential will continue for the foreseeable future, giving Gran Tierra a handy financial advantage over those oil producers operating solely in North America.
If Brent averages US$65 a barrel during 2019, Gran Tierra expects to generate a netback of US$30 to US$35 per barrel produced and earn up to US$15 million in free cash flow after allowing for development and exploration spending. This will also allow it to maintain a strong balance sheet, with Gran Tierra intending to reduce net debt to below one-times operating cash flow. The strength of Gran Tierra’s balance sheet is illustrated by it finishing the third quarter 2018 with US$130 million in cash and US$399 million of long term, which is a very manageable 1.2 times 12-month trailing EBITDA.
Is it time to buy Gran Tierra?
Growing production, firmer Brent pricing and a robust balance sheet all point to Gran Tierra being an ideal levered play on higher oil. The fact that it is trading at a significant discount to the after-tax net present value of its reserves indicates that it is deeply undervalued by the market, further enhancing its investment appeal.