TransGlobe Energy: Cash Flow Forecast Under New Contract (NASDAQ: TGA)
TransGlobe Energy (NASDAQ: TGA) has been a very conservative microcap. It is one of the few companies that could afford to reduce its activities when these activities made no economic sense. So many others had to keep whatever money they might come to the door to meet debt and other obligations. Now all of this is going to turn into growth mode. Thus, the future of stock prices will likely be very different from the past.
What’s even better is that the first quarter announcement contained a statement about production exceeding expectations. This has led to speculation that there will be more oil sales in the current fiscal year than in the past. The first quarter got off to a great cash start and management mentioned that a second production sale would be completed in June. This kind of “cash-in” from production has been a long time coming. This will probably provide a lot of money for the increased business management that seems to be planned for the future.
Investors often ask me for a price target. But by nature, I am not a trader. Therefore, when a strategic shift like this happens, I tend to hang in there as long as the growth story lasts. The only way I would consider selling is if the stock price became so ridiculously overvalued that it would take years of growth for the investor to recover to current levels. This rarely happens with cyclical companies. Instead, the new growth strategy will likely result in a “buy on dips” investment strategy for those who are interested.
It is still a cyclical industry. So, oil prices will go up and down, and stock prices will be volatile as a result. But the growth story should translate into a consistently higher price throughout the cycle. The result is that the downside will be minimized, while the upside will increase with overall production. The company has a new contract with Egypt that allows greater profitability under different oil prices. Therefore, growth is expected to continue ahead of a global coronavirus depression or other shutdown. These extremes are not likely.
Cash flow at current market prices is likely to approach half of the company’s enterprise value. This alone does not make the investment cheap as no one expects current prices to last.
Instead, what makes the potential investment story easier is the investment budget that promises to dramatically increase production. Therefore, any decline in the selling price of oil will likely result in a significant increase in production. Oil prices are expected to remain in a very profitable range for some time to come.
It is one of the few companies to increase production at a decent rate while returning money to shareholders. The reason this may be happening is the negative net debt position that management has maintained for several years. The result of this position was plenty of cash on the balance sheet combined with a minimal amount of debt repayment requirements and interest charges.
This management was able to expand its business at its own pace of growth, instead of bending to the demands of the market. Lenders will lend to anyone who does not need the money. A negative net debt is considered a very important potential customer (for lenders) regardless of the size of the business. The new, more profitable contract with Egypt is “the icing on the cake” in that it allows even more loan security.
The stock price, like many in the industry, was shattered during the recession. There were also concerns about the drop in production during the three-year negotiation period for the new contract with Egypt. For Mr. Market, three years was far beyond any reasonable patience one could reasonably expect. Thus, the market simply assumed that production would decline and eventually force the liquidation of the company.
The advantage of such a negative assumption is that despite the return of the share price, there is still a long way to go to arrive at a growth-oriented valuation. A typical growth valuation is eight to ten times cash flow from operating activities, even if the price of oil settles at $80 WTI or slightly lower. This share price has nothing to do with it.
Mr. Market, as usual, will require an operating history before the assessment occurs. The process of starting the growth spurt is already in place. Management immediately “got the rigs drilled” the minute management was reasonably sure of the terms of the new contract and the contract would be ratified.
Some would expect a rather dramatic explosion in output growth of all the activity shown above from a relatively small company. However, this company is a secondary recovery expert. It is not uncommon for secondary valuation techniques to take a year to show the benefits of an investment made in the present day.
This kind of result can frustrate a market based on momentum. Thus, the stock price may stall at some point until the results of investing in secondary recovery techniques show results. In fact, it may appear to the market that a large portion of the capital budget has been “wasted” because production will not increase in proportion to the amount of capital spent (right away).
But spending now will likely ensure years of future growth with much lower capital expenditures. Secondary recovery often requires a fair amount of up-front capital, while requiring additional amounts to keep production growth on track.
The result of all of this is huge, low-risk growth for a company the size of TransGlobe Energy. The advantage of secondary recovery is that the oil is known. Exploration risk is minimal to non-existent. The only challenge is getting the oil out of the ground (and sometimes that can be quite a challenge). What’s even better is that the technology in the industry keeps advancing. It is therefore quite possible that the reserves indicated above may increase for a long time.
This makes the proposition presented above a very low risk proposition for upstream companies. The cost recovery provisions of the new contract with Egypt further reduce the risk. So many companies lose every time they drill a dry hole. This is not the case with this company due to the cost recovery provisions of the contract.
Interestingly, the light oil lease was put on hold so the company could develop the heavy oil prospects elsewhere. This should give investors an idea of the profitability of the new contract for these older fields.
Admittedly, the uncertainty is higher in this primary area of recovery. This area has a traditional exploration with all the usual risks. The only thing in favor of a small company like this is that the reserves discovered may prove unattractive to larger companies drilling in Egypt.
However, these reserves are also likely to be better known than traditional, higher-risk exploration drilling in areas with no previous production. This lower risk also means that secondary recovery techniques will likely be needed in this area as well fairly quickly.
On the other hand, light oil is likely to become a priority for the Egyptian business as the business grows. Regardless of how management chooses to grow the business, there are now many profitable ways to pursue that growth. Most of these ways are relatively low risk to an upstream business.
The management has been doing business in Egypt for a very long time. Egypt needs hard currency earned by exporting oil. Thus, the business climate is very favorable to oil and gas. This atmosphere of support is likely to be there for a long time as most politicians like to spend the money generated from a business like this. This business is likely to grow a bit larger than it is now as a result.