Upstream Exploration Stock: Cash Flow Cascade (OTCMKTS: CDDRF)

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(Note that this is a Canadian company and reports in Canadian dollars unless otherwise specified.)

Headwater Exploration (OTCPK: CDDRF) has started a major project. In the second year of the project, management expects cash flow to exceed project needs. This is a significant advantage over many new projects which take years to generate more cash than is invested. Management also noted that the entire enterprise value of the business will return as excess cash flow in about 6 years. It’s also better than many projects.

Headwater Core Exploration Area Development Guide

Headwater Core Exploration Area Development Guide (Current presentation from Headwater Exploration, February 2022)

As shown above, the kernel will begin to generate more cash flow than is needed to expand production. That in itself is quite an achievement. The company has no debt and plenty of cash which management intends to use in a consolidation strategy. For new investors, it’s corporate language for a disciplined shopping spree.

An acquisition strategy always involves some risk in that management may overpay or for some other reason the acquisition will not work. Again, this management builds and sells Raging River at Baytex Energy (OTCPK: BTEGF) [BTE]. So there is some experience in executing the proposed strategy which should reduce normal risks in the future.

Characteristics of Upstream Exploration and Results of Core Area Activities

Characteristics of Upstream Exploration and Results of Core Area Activities (Headwater Exploration Current February 2022, Presentation)

As noted above, Headwater currently has ample opportunity to expand current operations. Even the slide above, which captures only a small portion of the basin, shows plenty of unclaimed acreage that will likely be available at some point for potential development. The whole basin itself has a lot of area that will likely be subject to government bids in the future.

One of the advantages of acreage in Canada is that it is very cheap compared to the Permian and some of the other warm basins in the United States. Moreover, it is a conventional opportunity that recent advances in well completion and design techniques have transformed (this conventional opportunity) into a very profitable opportunity.

There are so many areas that have been explored for a long time in North America. Therefore, the industry knows where the oil is. But until recently, some of these deposits were not profitable to exploit. This seems to be changing rapidly as North America becomes a major oil producer in the world. This means that any exploration is more about verifying that new techniques result in a profitable cost structure. The “good old days” of wild fishing are slowly heading towards sunset as many oil deposits do not need to be discovered. Instead, they wait for these profitable production techniques to be discovered.

Management has proposed test pits on the remainder of the acreage. Success in these areas should offer considerable growth prospects for the company. In terms of long-term growth, Canada is full of oil and gas opportunities. Therefore, the only real question is whether the company is growing through acquisition or organic growth from successful lease deals.

Recently, management reported a few successful exploration wells. There will likely be growth in addition to the central area indications noted above once management determines the significance of the findings.

Much of the industry is currently focused on consolidation. This was brought about by the history of the past five years. There is a big drive for companies to have a minimum optimal size in the future so that surviving industry downturns is not such a challenge.

This consolidation attitude is likely to propel the current recovery into a surprisingly long duration. There are definitely companies like this that are all about growth. But the market’s focus on improving the balance sheet and returning earnings to shareholders could prompt many directions to pursue slower growth. Then, as long as the forward curve remains discouraging, outside money will not flow into industry to accelerate output growth to the point where another cyclical downturn will begin.

Still, it’s worth monitoring management like this to determine the right time to exit a cyclical investment. When several of these managements decide to sell their companies, it will be time for investors to lighten their presence in the industry. Right now, this direction is clearly focused on building a business that would be a suitable acquisition for someone at the right price. Therefore, now is not the time to worry about a target sell price unless the stock price becomes “absurdly” overvalued.

Meanwhile, Cenovus Energy (CVE) has exercised his warrants in the company to again provide a meaningful position in Headwater Exploration. Cenovus may monetize its position in Headwater in the future, as the company may have a much larger use of funds than an investment in Headwater Exploration.

Cenovus is a very large company, and this project is probably not important for a company the size of Cenovus. Therefore, management is probably right to consider liquidating its position so that it can pursue projects of a scale that would benefit its shareholders.

Headwaters Exploration Guide

Headwaters Exploration Guide (Headwater Exploration Current February 2022 Presentation)

Finances are very conservative as this company has no debts while maintaining a large cash balance. Projected cash flows are at considerable downside risk unless oil prices decline significantly.

Companies without debt rarely encounter serious financial problems. Instead, they can often try again if the first try doesn’t work. Much of the risk would instead relate to stock liquidity issues when attempting to buy stocks. Therefore, investors are strongly recommended to use limit orders and exercise patience. Investors can also try buying stocks on the more liquid Toronto Stock Exchange if their broker allows it.

Given the caveats above, this stock is likely much less risky than many of its larger peers. Management has experience in building and selling a business. Therefore, management has the experience to handle rapid production growth at the current production level. Relatively generous cash flows combined with a conservative balance sheet further reduce investor risk.

A company like this can easily handle an industry downturn simply by living on the cash balance if management wishes to halt production until prices improve. In fact, without debt, there are plenty of assets that can be loaned until the next inevitable industry recovery. Few companies are in this position.

For now, high commodity prices appear to usher in an era of rapid growth for the company while limiting downside risk. Just beware that the industry has notoriously low future visibility. Thus, any investment in oil and gas should be carefully monitored. The profitability of the core zone indicates that management is well underway. There is a reasonable future just from the area already controlled. Any accretive acquisition is likely to be “the icing on the cake”.

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