For this heavy-oil producer, an outstanding hedge book is key to survival


The Play

I wonder what percentage of people who were following the oil market at the start of 2014 anticipated a West Texas Intermediate price for oil of under $30 per barrel in 2016. In fact, for Canadian heavy oil producers, $30 per barrel would have been a big improvement over the actual first quarter of 2016. With Western Canadian Select trading at a $15 discount to WTI, things were unimaginably bleak for heavy oil producers in the first quarter. At those prices, heavy oil should stay in the ground.

The brutally low selling price isn’t the only problem for heavy oil producers. They also must deal with significantly higher operating costs than the lighter-oil operators do. Heavy oil is, well, heavy, and therefore requires extra effort and cost to get it to the surface.

Since those operating costs are not impacted in any significant way by the price of oil they are more or less fixed regardless of what oil prices are doing. When fixed costs meet up with rapidly declining revenues, margins don’t just get squeezed, they flat out disappear.

But there is one potential saviour for heavy oil producers: hedges. If they’ve played their cards right, they have some balance-sheet-saving hedges on the books. Enter Northern Blizzard.

The Pick

Northern Blizzard (TSX: NBZ)


Northern Blizzard is a heavy oil producer that has kept its head above water during this oil crash largely due to an excellent hedge book. Sixty per cent of Northern Blizzard’s 2016 production is hedged at $60 per barrel. That $60 factors in the discount that heavy oil gets to WTI, so the effective WTI price is close to $80 per barrel.

I’m not sure there is a better hedge book than that in North America. And for 2017, Northern Blizzard has nearly half of its production hedged at almost $70 WTI. I’d love to think we see those oil prices by then and that those hedges aren’t so important, but we have a long way to go before we can say that.

If WTI oil prices average $40 in 2016, Northern Blizzard should generate $120 million in funds flow. That is significantly more than the $40 million the company plans to spend on capital expenditures and the $17 million going to the company’s dividend (currently an 11.5 per cent yield). Yes, a dividend that is still being paid!

Before you get too excited about it, though, note that 72 per cent of Northern Blizzard’s shares are signed up for the dividend reinvestment plan. That means those shareholders get shares instead of cash and, while it helps the balance sheet, it is dilutive at these share prices.

The high operating costs of heavy oil aren’t much fun, but the low decline rates are. While most shale producers struggle with decline rates of 30 to 40 per cent, Northern Blizzard’s is only 17 per cent, one of the lowest in the industry.

Despite the lower price that heavy oil fetches, these assets have top quartile break-even prices. This is because they produce relatively low-viscosity heavy oil, which works especially well with waterflooding.

Northern Blizzard says it has 153 million barrels of proved and probable reserves on the books and 2,000 drilling locations in front of it. There is a huge opportunity ahead to unlock as much of it as possible, and to do so into higher oil prices.

The Postscript

When Northern Blizzard went public in 2014, the dividend was set at eight cents per month or $0.96 per year. The plan was to take these low-decline, low-capex assets and use them as the base of a secure and growing dividend. It was a good plan; it just didn’t factor in oil prices getting chopped by 75 per cent. The dividend has been reduced to four cents per share per month, but even that’s remarkable. With Northern Blizzard’s outstanding hedge book, that dividend looks safe for the rest of 2016. If oil prices don’t recover by then, the prudent move would be to eliminate it. Investors should note that 70 per cent of Northern Blizzard’s shares are held by New York-based NGP Energy Capital Management and Riverstone Holdings, the two private equity firms that took this company public and represent almost all of the shareholders who are taking shares instead of cash dividends. Having these two firms holding 70 per cent of the shares creates a much smaller trading float and potentially more volatile share price.

Jody Chudley doesn’t own shares of NBZ

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