“Any time we see a headline saying commodity X is trading at a 30-year low, we’ll be sure to look closely at the industry for the company or companies still doing okay, which are most likely to lead the way off the bottom…The more dependably cyclical the industry is, as the commodity price trend reverses itself the true value of the company is likely to come out”
– James Vanasek, VII 4-30-08
“Stay away from bad management”
Abacab Fund Sees Mispricing In Options As Black-Scholes Has Become “Inadequate”
Abacab Asset Management's flagship investment fund, the Abacab Fund, had a "very strong" 2020, returning 25.9% net, that's according to a copy of the firm's year-end letter to investors, which ValueWalk has been able to review. Commenting on the investment environment last year, the fund manager noted that, due to the accelerated adoption of many Read More
“They might say they believe in their ability to build a mine on budget, but nobody ever does that…You need to have capital contingencies so there are buffers at every stage”
“We’re the first ones in the base metals and energy space, and we’re hoping to get a multi-billion dollar market capitalization before anybody else shows up.”
– Nolan Watson
As a follow up series to my original post on Sandstorm, I’ve decided to put together a few posts that dig deeper into some of the underlying properties that undergird Sandstorm’s streaming portfolio. My goal with the following analysis is highlight the quality of these properties, which in turn, should hopefully put an exclamation point on the magnitude of Sandstorm Metals & Energy’s current mis-pricing and the overall attractiveness of the opportunity.
That, and given one of the primary attractions of investing in a stream finance company is the ability to participate in the monetization of future streaming, exploration, and acquisition gains before the general market recognizes there cash generative potential – I think it makes a lot of sense to look under the hood if you will to get a better idea of the quality of these assets and the reserve expansion and production upside (read cash-flow) potential at maturity. Hopefully this rational walk will prove enlightening.
So, without further ado let me introduce you to Thunderbird Energy and its low cost, long-lived NG shale play, Gordon Creek. Like with nearly all of SND’s streaming assets, the potential to increase value above and beyond the initial 2014 reserve/production estimates is substantial (to say the least) and the potential for a true moonshot type of home-run when all is said and done is very, very real. Of course, I would do a dis-service to not mention that SND shareholders at current prices are quite literally paying nothing for this high probability, heads I win, tails I don’t lose call option on natural gas, so definitely keep that in mind as we go.
Thoughts on Natural Gas
Before we dig into the transaction details, lets take a minute to discuss my thoughts on the NG outlook generally in order to put the recent price weakness in proper context of what is essentially a wonderful little 20+ yr natural gas annuity.
While I’m agnostic on NG pricing in the near to medium-term (meaning I don’t necessarily expect prices to recover anytime soon), I think its important to point out that not only is pricing currently at 10 year historic lows, its depressed to a level where further exploration and production at this point has become completely uneconomic (as evidence of this reality, note the announcement by Chesapeake recently that they plan to curtail drilling and future activities until prices recover).
So with a natural gas price lower than its cost of production it’s safe to say its only a matter of when (not if) pricing recovers as its a certainty that NG prices will eventually revert towards a more economic level – a level that in my opinion is likely to be reasonably north of the ~$4/mcf mid-cycle price assumption I use in the valuation section below.
Again, who knows where the long-term equilibrium will eventually balance out here or exactly when, but I’m willing to bet it’s higher than that ~4 per Mcf assumption given (1) the cost of production (2) a large and growing differential between U.S. gas prices and those around the rest of the world (3) the all time high spread between oil & gas on $ per energy equivalent basis and (5) all of the monetary and fiscal shenanigans currently taking place amongst the central banks of the developed world.
Keep in mind as well that from today’s trough levels, Sandstorm’s leverage to a sustained recovery in pricing is rather dramatic given the company’s perpetual fixed costs of $1 per Mcf. That, and while I’m no soothsayer, I wouldn’t be shocked if looking back 5 years from today Watson’s contrarian call on NG here ends up looking every bit as genius as some of his earlier silver streaming deals done at SLW. Regardless, lets dig in to the asset acquired in SND’s most recent stream acquisition, Thunderbird Energy’s, Gordon Creek.
Gordon Creek (Uinta Basin, Utah)
Unbeknownst to many, Utah is one of the most attractive resource development states in America today, particularly as it relates to natural gas given the abundance of long-lived NG deposits in the state.
Interestingly enough then, the Drunkard’s Wash property operated by Conoco Phillips that borders Gordon Creek, is the largest and most prolific natural gas field in the state – having already produced nearly one trillion cubic feet of natural gas over the life of its operation. This thing’s a monster, clearly – and it’s reign of terror should continue for quite some time due to the 20-30 year, roughly two billion-cubic-foot projected life of an average well on its deposit.
So given its proximity, it shouldn’t be any surprise to SND shareholders that the story of Gordon Creek is set to be a similarly positive tale. This story is for the time being though, still primarily one of ongoing development activity – all of which is squarely aimed at reaching critical mass in order to optimally exploit the property’s consistent regional geology (nice), above-average well life (very nice), and in place infrastructure (cherry on top) for the benefit of both Thunderbird and Sandstorm shareholders. Thankfully, the rewards for successfully doing so should be tremendous, as the Gordon Creek natural gas field possesses the potential to be a low-cost, major natural gas producer for the next several decades. Sandstorm’s role in all of this is simple – they’ve brought the requisite financing firing power necessary to make it all happen.
So we‘re still early in this long-term story but with the exception of the implosion of natural gas pricing of late, it’s been one that has been progressing rather nicely since SND struck this deal in late summer of last year. While admittedly there has been a few hiccups here and there (contractor issues, etc.) – as there always is with these types of situations – nothing has happened that’s really out of the ordinary or that would make me worry that all is not as it seems. Going forward then, I expect more of the same consistent progress that has been the hallmark of this project since it began.
Anyhow, I find it hard to imagine that between (1) Thunderbird’s seasoned suite of proven executive’s presently captaining the Thunderbird ship and (2) the financial expertise and literal “wall of money” SND has at its disposal to facilitate the process, we should all be able to sit back and enjoy what is more likely than not to be a very happy ending when all is said and done.
As far as framing the terms of the deal and Gordon’s Creek’s ultimate potential, I thought Andy Hoffman of Torrey Hills Capital put it well last September, so rather than regurgitate it, I figure its better to just go straight to the source…
“…the company invested $25 million in Gordon Creek last month, targeting a production increase from roughly 900 mcf/day currently to an estimated 18,000 mcf/day by the end of 2012. The royalty agreement lets Sandstorm own 35% of the life-of-mine natural gas at a fixed price of essentially $1 per mcf in exchange for ‘development fees’ of roughly $500,000 for each of the first 50 wells; hence the initial $25 million commitment. Also requires is $325,000 per well for the next 100 wells. There are numerous other details in the agreement.
Due to the region’s consistent geology and the 2009 construction of the Rocky Mountain Express pipeline, Gordon Creek’s estimated breakeven operating cost is roughly $2 per mcf, among the lowest in the nation. This theoretically yields a 100% profit margin at current gas prices and strong long-term project economics.
The initial $25 million Sandstorm investment will fund the majority of the first 50 holes of delineation drilling (plus five work-overs). Turnaround time from completion to production tie-in is designed to be nearly instantaneous. The company’s plan targets 58 wells to be online by the end of 2012, each producing 350 mcf/day, on average. Currently, three wells produce. At a current natural gas price of roughly $4 per mcf, such production would yield to Thunderbird, net of Sandstorm’s 35% interest, a pre-tax cash flow run rate of approximately $13 million. This in turn could be reinvested into the next 50, or even 100, delineation wells in 2013, presuming Sandstorm continues to invest alongside.
The key valuation metric over the next 12 months is likely to be reserve growth given the company’s $20 million market capitalization and targeted eightfold reserve increase by the end of 2012. The key to this strategy probably is the pace of land acquisition in the Gordon Creek area, where Thunderbird aims to accelerate its efforts in the next year or so.
The pace of reserve growth will depend on how many adjacent blocks it can acquire, as the more land (with consistent or similar geology) the company can add to the property, the more dispersed the planned 50 drill holes can be. This allows for a wider volume of the deposit to be considered reserves under Canadian Instrument 51-101 reporting standards.
Thunderbird’s current land position at Gordon Creek is roughly 12 “sections,” or square miles. It aims to increase its holdings to 40 sections by the end of 2012, the large majority of which are USA federal lands and the remainder privately held.
Given the company’s position in the area, its pipeline infrastructure and relationship with government agencies thanks to the SWP partnership, it appears likely the acquisition strategy will be viable and I believe successful. Thunderbird’s management anticipates such acquisition costs to be $1.5 million to $2 million based on recent transaction statistics. Given the relationship with Sandstorm, most likely SND would contribute 35% of said costs to maintain its royalty interest.
If such transactions are not consummated, the company expects the 50-hole drilling program to increase the current 25 billion cubic feet of reserves to roughly 100 bcf by the end of 2012 (net of Sandstorm’s 35% interest), most likely at the 2P level. If the additional 28 sections are acquired, the more dispersed drilling targets would yield a “base case” expectation” of closer to 200 bcf, or eight times the current level. Assuming 119 million shares outstanding (79 million shares outstanding plus 40 million warrants with an average strike price of $0.25/share), and an average “per mcf” valuation based on 2008-2010 transactions, it is plausible that a stock revaluation will occur.”
While the above is somewhat dated given recent time-table changes such as the production deferral (which btw was imo not only a very savvy move given current NG prices but a prime example of the types of value added flexibility that only SND provides), the terms of the transaction and the size and potential scope of the Gordon Creek natural gas field are the same. So ya, clearly I wasn’t bullshitting about the value of the embedded resource optionality in these types of deals after all .
I mean, the first time I realized that not only were the initial run-rate production estimates relatively easily achievable, but that there was a reasonably high probability that normalized production run-rates at maturity could be something like ~2-3x higher than my initial expectations, I had a hard time believing it (maybe this Watson guy is the insightful contrarian home run hitter that his track record indicated after all). So a quick “boomshakala” and few fist pumps later (kidding) I rechecked my work and the underlying premises of my assumptions, and again, found that a multifold increase was indeed a reasonably achievable, if not probable goal over a longer time frame (3+ years). Remember, this isn’t some pie in the sky “wildcatting” best-case scenario that I’m talking about, its basic blocking and tackling oil & gas exploitation – i.e. no one is reinventing the wheel here. So we know the gas is there in a BIG way (as is the requisite infrastructure), the geology is consistent and the optimal extraction methods well known, and last but not least, the planned acquisition of additional acreage has for the most part gone-off without a hitch.
Not to imply that this isn’t a complicated operation that will periodically run into issues and/or temporary roadblocks, – or that a ton of experience, skill, long hours, and hard work aren’t absolute requisites to bringing this deposit from A to Z, because it is. What I’m saying is that with a seasoned, highly competent management team leading the charge and a strong, patient and flexible financial partner to fund it (as is the case here), it’s eminently doable over a reasonable time frame. Anyhow, I will put together a range of values later on but first lets take a look at the underlying deal economics of SND’s most recent stream.
My understanding of the deal is that SandStorm gets to purchase 35% of production at $1 per mcf for $500,000 per well for the first 50 wells. For the next 100 wells, Sandstorm gets to purchase 35% of production at $1 per Mcf for only $325,000 per well and any additional wells drilled thereafter. Then there are the minimum guaranteed payments and Thunderbird has an option to repurchase 50% of the working interest for $16.25 million. Since 100% of the working interest costs $25 million, the repurchase option would increase Sandstorm’s IRR on the project, however this option significantly reduces SandStorm’s optionality to higher gas prices – and at this point, it doesn’t even appear possible given both the recent year long delay in production and the cancellation of the CO2 sequestration project by the U.S government. In other words, Thunderbird lacks the excess cash to get it done so buying back SND’s interest is not likely an option.
I’ve run the numbers and assuming a reasonable mid-cycle price of $4/mcf, SND should generate a 28% IRR on the initial 50 wells that cost $500,000 each. For the 100+ additional wells thereafter (at a cost of $325,000), I get a 1yr 43% return and a long-term IRR (adjusted for depletion) in the mid thirties. So the deal starts to look considerably better after the initial 50 wells are drilled, but the long-term IRR’s are definitely solid as a whole and attractive on an absolute basis. The exercise also gives you a good feel for the relatively low-risk and highly visible runway of high return reinvestment opportunity this stream provides SND.
Also, keep in mind that any increases in gas prices above and beyond my middle cycle estimate will all fall straight to the bottom line (given fixed costs). So SND should start to see rapid improvements in the gross profitability of this deal due to the high incremental margins on wells drilled after the first 50 and any NG price increases thereafter.
Well Unit Economics
Initial 50 Wells:
Initial Production: 370mcf/day
Gas Price: $4.00
Purchase Price: $1.00
Year One CF to SND: $141,803 (370 mcf * 365 days * 35% interest * $3 spread)
Year One Return: 28%
Long-term Decline: 8.2%
Long-term IRR: 20.16%
Total CF $253,894
SND CF $141,803
Well Revenues $540,200
Operating Costs $255,500
Well Cash Flow $284,700
SND Cash Flow $141,803
SND Interest 55%
Additional 100+ Wells:
Initial Production: 370mcf/day
Gas Price: $ 4.00
Purchase Price: $1.00
Year One CF to SND: $141,803 (370 mcf * 365 days * 35% interest * $3 spread)
Year One Return: 43%
Long-term Decline: 8.2%
Long-term IRR: 35.4%
Thunderbird Well Parameters:
Op Cost 0.45
MCF Cost $1.61
Annual Cost $12,000.00
Total Op Cost / MCF $1.70
Less: SND Override $0.00
All In Op Cost $1.70
Interestingly then, lets take a look at the potential annual cash generation to SND upon the completion of 200 wells, a goal that seams reasonably achievable over a long-term time horizon. If we assume 200 wells producing at 370Mcf /day at a $4 per Mcf, and hence a $3 spread to SND, we get annualized cash flows of ~149k per well. So with 200 well in operation, SND’s interest in Gordon Creek should generate a cool $29.8m in annual gross profit. Ya, I’d say that qualifies as a rub your eyes and check again data point given you can purchase SND in its entirety at the moment for a total EV of ~$90m.
As value investor that always tries to adhere to Rule #1, I think its important to look at this stream from a downside protection point of view, so lets take a quick look at Thunderbird’s existing reserves in order to get a better understanding of the worst-case value of the NG reserves backing SND’s minimum payment guarantee.
First, I think the details of SND’s guarantees are definitely a critical issue to understand as far as appropriately sizing up the risk/reward equation. Remember that – as I mentioned in the original write-up – SND is able to mitigate the risks typically associated with M&E operating companies through its minimum payment guarantees. These guarantees are enforced through the securitization of its investments in PPSA agreements, which provide collateral for SND based on the entire asset base of their streaming partners. In other words, if these companies go bankrupt and their assets are seized and sold by a bankruptcy trustee, SND is first in line as far as getting it’s money back (i.e. ahead of senior creditors, suppliers, etc.).
Rest assured then that these securitization’s really are senior secured as they are collateralized by ALL of the company in questions assets, i.e. the value of the infrastructure + the mineral deposits – which are worth substantially more in total than the total liability’s owed to SND. These contractual guarantees are fully covered and then some (as we will see below), so the odds of suffering a permanent loss seem very, very low even in the event of bankruptcy. Also, Watsons team is experienced with workouts and has the network/expertise/team in place to properly deal with a restructuring, so they have the processes in place/skill set necessary to recover what they are owed if it should come to that. Also, while I wouldn’t assume they receive anything more than their principal in a BK, its of course entirely possible that such an event could actually be beneficial in the long-run if say, post BK SND was able to emerge with ownership of the entire property outright in lieu of their claim (or at least with a more valuable asset than what they entered with).
So with all of the above in mind then, Thunderbird has booked reserves of ~25 Bcf today. What’s that likely worth?
Assuming a reasonable discount rate, a normalized mid-cycle NG price of $4 and full cycle operating costs of ~$2 per Mcf (in line with similar properties and management’s expectations), Gordon Creek’s 25 Bcf translates to 25m Mcf, which if we multiply by the $2 per Mcf in expected profit ($4 gas price less ~$2 in full cycle avg. costs), we get ~$50m in un-discounted gross profit. If one applies a reasonable discount rate here I think a reasonably conservative present value is roughly half that to a larger acquirer (say an upstream MLP), so lets say ~$25m conservatively. Given there is valuable infrastructure and significant resource expansion potential worth many times that amount at Gordon Creek, I’d say its a near certainty that Sandstorm’s invested capital is money good and then some under any reasonable future scenario.
So now that we have a better feel for the downside protection, lets take a look at what these assets are likely worth assuming they are proved out and developed as management expects.
If 3-5 years from today a mature Gordon Creek has ~100 Bcf and we assume a 20 year reserve life, that 100 Bcf translates to 100m Mcf which, when divided by 20 years gets us to normalized production estimate of ~5m Mcf per year or 1.75m Mcf to Sandstorm. At a reasonable $3 spread ($4 gas price less $1 per Mcf in fixed costs) SND’s interest should generate ~$5.25m in annualized gross profit. Given this high margin annuity-like cash flow stream is derived from a low cost producer with an asset that has a 20 year life and substantial potential to still meaningfully grow its reserve base I think applying a 10 multiple to this stream is on the low side of reasonable. So in our base case we are dealing with an asset worth at least $50m or more than half of SND’s current EV.
If five years from today a mature Gordon Creek has ~8x its present reserve base of ~25 Bcf or ~250 Bcf, and we assume a 20 year reserve life, then that 250 Bcf translates to 250m Mcf which, when divided by 20 years gets us to normalized production estimate of ~12.5m Mcf per year or 4.8m Mcf net to Sandstorm. At a reasonable $3 spread ($4 gas price less $1 per Mcf in fixed costs) SND’s interest should generate ~$13m in annualized gross profit. Given this high margin annuity-like cash flow stream is derived from a low cost producer with an asset that has a 20 year life, I think applying a 10 multiple is definitely on the low side of reasonable. So in our best case we are dealing with an asset worth at least $130m.
The takeaway then is that SND has put ~$25m at risk to get the option to finance the development of a high quality, low cost NG asset potentially worth ~$130m to SND, a sum that’s – ridiculously enough – greater than its entire present EV. That’s attractive, but especially so when you consider that SND’s investment is senior secured by ample collateral, offering substantial downside protection to shareholders in the form of Gordon Creek’s infrastructure and 25 Bcf of existing reserves. This innovative feature of stream finance makes the risk of permanent loss practically nil. So I’d say its fair to characterize this as a highly attractive deal no matter which way you slice it and a pretty sweet way to bet on the inevitable turn in the NG cycle.
As I said in the original write-up, the asymmetry of these deals can be stunning.
Thoughts on Private Market Value
One aspect to ponder here is what this world-class asset would be worth to an upstream MLP focused on the exploitation, development, and acquisition of oil natural gas properties such as Linn Energy. Most Upstream MLP’s, produce natural gas at the wellhead for sale to various third parties and do not generally partake in exploratory drilling…rather, like Thunderbird, they own and operate assets in well known mature basins that exhibit low decline rates and possess long reserve lives (i.e. assets that are appropriate for the MLP structure). Of course its no small point that Thunderbirds Gordon Creek asset has the lowest all in costs of any shale basin in the country as well (no pun intended) as a stable, relatively predictable production profile. This is a 20+ year high quality energy asset that requires relatively small amounts of capital to fund low-risk development drilling opportunities that offers a relatively high degree of visibility.
My point is that the Gordon Creek asset would be inherently very attractive to any upstream MLP looking to acquire an attractive low-cost, long-lived natural gas asset to their existing portfolio. First, because once the cycle turns (again a matter of when, not if) they can go along way in mitigating the inherent commodity risk via an actively managed hedging program which should lock in a stable, consistent cash flow stream over the full cycle. Second, because upstream MLP’s typically trade on a yield basis and therefore at very high multiples of EBITDA and cash flow (perhaps unjustifiably but I don’t see this changing anytime soon given our yield starved world), so the arbitrage available to them to acquire these types of assets on an accretive basis is significant. This is an important point. So take it for what its worth, but it seems obvious to me that Gordon Creek’s PMV to a strategic acquirer is almost certainly much, much higher than the worst case numbers outlined above.
My hunch is that a takeout transaction by an upstream MLP could be the ultimate end game for Thunderbird, once they (with the help of SND) have finished taking care of all of the heavy lifting so to speak. Notably, SND’s stream under such a scenario would remain in force. Also, Thunderbird’s existing management has done this successfully 3 separate times in the past, so rest assured they know how to develop high quality assets to the point where a sale will generate maximum value for their shareholders. This is a rinse, repeat, rinse, repeat type of situation for them.
Payment Deferral & Production Delay
Lastly, with that short back of the envelope overview of the Gordon Creek deal out of the way, I wanted to quickly discuss the recently announced minimum payment deferral and production push back because I think it (1) optically looks at least somewhat negative to the untrained eye and (2) because it signaled to me that Watson is indeed one smart cookie.
Now most would have looked at these changes and worried because, again to the untrained eye they appear to be your typical delay(s) and bumps in the road that is so common with these difficult businesses. My take was very different. With gas prices where they are I wondered why either Watson and/or Thunderbird’s management would to ramp up production when that production would likely be breakeven to marginally profitable for Thunderbird (which is saying something given we are talking about a low cost producer here).
I mean why not just wait to prices revert towards an economic level given the low turnaround time required to get said production up and running and the fact that funding concerns aren’t an issue. I looked at the production delay as confirmation that we are indeed dealing with a management team that understands capital allocation and maximizing the risk/reward equation. I mean why waste the NG in the ground by unnecessarily ramping up production at such an unsustainable price level when there isn’t any good reason why they can’t just sit on there thumbs and wait for the cycle to turn? Especially when SND can do what it did, which was to wave Thunderbird’s yearly minimum cash payment till next year so they can utilize that time/money to continue to prove up and expand Gordon Creek’s highly attractive resource base/getting things perfectly in order. Why not just be patient when a delay is obviously the right call? Why not optimize and prepare this annuity like natural gas cash generating machine for better times given there’s no real downside and quite a bit of upside to doing so?
What’s even better though for SND shareholder’s regarding these changes is that, while they didn’t get the cash payment (which wasn’t forgiven btw, just delayed a year), they did get an equivalent $ amount in Thunderbird’s dramatically undervalued equity simply for doing the right thing – read being patient in order to maximize long-term business value. So everyone wins – Thunderbird’s management can make the right move for shareholders because they have intelligent financiers that can see the value of the decision as they aren’t dealing with short sighted bankers worried about the optics of it all and SND gets equity that will in all likelihood be worth many multiples of the cash payment they were owed. It’s a beautiful thing really.
So to conclude…
Watson has made a stunningly asymmetric contrarian bet on natural gas at the bottom of the cycle (love it) that should eventually pay off many multiples of his invested capital over time. This initial investment of $25m comes with a put option in the form of a 7yr guaranteed payback and a low-risk, high-return visible runway of high return reinvestment opportunity that should last for at least a decade if not longer.
Initial Production come 2014 should approach an initial run-rate of 5 Bcf a year or ~ $5m in profit to SND’s bottom line (5m Mcf * .35% = 1.75m Mcf to SND or ~$5.25m in annualized gross profit assuming a 2013/14 NG price of $4 per Mcf. And as I’ve outlined above, this annual run-rate of ~$5m in gross profit could easily double or more as Thunderbird’s management continues to tackle the abundance of low hanging fruit on its properties over time.
Last but not least, the Gordon Creek natural gas field possesses the potential to be a low-cost major natural gas producer for the next several decades and is hence a scarce, hugely valuable natural gas asset given its low cost operations, consistent regional geology, above-average well life, and in place infrastructure.
So while I put together an overview of the next significant stream that SND investors are currently getting for free, let me ask, what’s not to love here?
Recent Thunderbird presentation