Peyto Drilling in Natural Gas Downturn Rewards Investors

Peyto Exploration & Development Corp. (PEY), Canada’s best-performing energy stock, is riding a rebound in natural gas prices after tripling output as peers shut wells and shifted to oil during an 86 percent slump in the fuel from 2008 to 2012.

The Calgary-based company, which will continue the drilling campaign this year with its largest-ever capital program, is the top performer in the 57-company Standard & Poor’s/TSX Energy Index in the last 12 months on a total return basis. It gained 71 percent through yesterday including dividends, compared with 12 percent for the energy index and a 0.7 percent decline for Canada’s largest gas producer, Encana Corp. (ECA)

“They drilled through a tough period which meant that as prices came back, they had more production to tie in,” Greg Dean, a Toronto-based portfolio manager at CI Investments Inc.’s Cambridge Global Asset Management, which oversees C$7 billion ($6.7 billion) including 3 million Peyto shares, said in a telephone interview May 24. Other producers were “more risk averse,” he said.

North American gas prices plummeted from a peak of $13.577 per million British thermal units in 2008 to a decade low of $1.907 in April 2012 amid the global financial crisis and a supply glut from shale. Gas prices have since doubled, closing at $4.174 in New York yesterday.

‘Less Competition’

“We have far less competition in the industry right now because most companies can’t make these gas prices work,” Peyto Chief Executive Officer Darren Gee said in a phone interview on May 24. Peyto also benefits from being the country’s lowest-cost producer, according to FirstEnergy Capital Corp.

Peyto’s low-cost advantage will to serve it well as continental gas prices remain historically low and “range bound” between $2 and $5, Gee said. Producers can quickly increase supply and power plants can reduce demand by switching to coal for fuel, he said.

The company keeps costs down by focusing on the Deep Basin in Alberta, an area with stacked gas-rich formations, and by building its own facilities, the CEO said. It doesn’t develop higher-cost oil and avoids producing so-called sour gas. About 10 percent of output is higher-priced gas liquids that boost returns, he said.

Production Boost

Peyto generates a 30 percent operating margin with gas at $2.00, Robert Fitzmartyn, a Calgary-based analyst at FirstEnergy who recommends investors buy the stock, said in a phone interview on May 24. Peyto fell 1.5 percent to C$30.60 at 11:06 a.m. in Toronto. It has risen 35 percent this year through yesterday.

The energy company, which tripled output in the last three years, plans to increase production to 100,000 barrels a day by 2017, from 60,000, Gee said, largely by drilling on its own land, spending as much as C$500 million this year. There aren’t any companies Peyto is looking to acquire, though there may be properties the company is interested in, Gee said, declining to be specific.

Encana plans to keep gas output unchanged in 2013, while directing 80 percent of its capital budget to almost doubling output of oil and liquids, the company said on Feb. 14.

“Our highest margins right now are in oil and natural gas liquids,” Jay Averill, an Encana spokesman, said in a phone interview on May 27. He declined to comment on stock performance.

North American producers are boosting gas reserves, and planning export plants to sell to Asia, after building facilities to import the fuel last decade. Canada has an estimated 664 trillion cubic feet of marketable gas, according to the National Energy Board. The figures represent 100 to 200 years of domestic supply, Joe Oliver, the nation’s natural resources minister, said in a Feb. 26 interview.

Upside Limited

Gains in Peyto may be limited with the company trading at a premium, according to figures from Salman Partners Inc., a Vancouver-based investment dealer. The stock’s price relative to 2013 estimated funds generated by the company is 9.7 times, compared with 9 times for Trilogy Energy Corp. (TET) and 6.9 times for Bonavista Energy Corp. (BNP), according to Salman Partners.

“We think Peyto is pretty close to full value,” Gordon Currie, a Calgary-based analyst at Salman Partners who rates Peyto a buy, said by phone on May 27.

Peyto has a C$32.40 average 12-month price target from 17 analysts, and 15 buy, 2 sell and 2 hold recommendations. Net income declined 26 percent to C$93.95 million in 2012 from a year earlier, as expenses rose.

Longer-term investors should buy Peyto on rising gas prices, according to FirstEnergy, which forecasts an average of $4.75 on the New York Mercantile Exchange next year.

“Because of the growth rate, because of the cost structure and our expectation of a natural gas price recovery, Peyto would look pretty compelling into 2015,” FirstEnergy’s Fitzmartyn said.

To contact the reporter on this story: Rebecca Penty in Calgary at rpenty@bloomberg.net

To contact the editor responsible for this story: Susan Warren at susanwarren@bloomberg.net

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