Why I Own MEG Energy

Attractive de-leveraging story and potential takeover target

MEG Energy (MEG) is an oil sands producer based in the southern Athabasca oil region of Alberta. MEG uses in situ oil production methods such as steam-assisted gravity drainage (SAGD) to produce the Access Western Blend (AWB) which is sold to customers all over North America. AWB is essentially a mixture of bitumen and diluent that MEG transports from its producing areas to Edmonton transportation hub. AWB is typically sold at a US$10 - $11 discount to WTI given its heavier API (22 degrees).

The company has an impressive asset base. Its flagship Christina Lake Project stores roughly 2 billion barrels of proved and probable (“2P”) reserves and currently produces roughly 100,000 bbl/d which implies a reserve life of 50+ years. Given the large asset base, the company doesn’t need to worry about exploration and can instead focus on maintaining the current base for decades to come. Maintenance capex is roughly C$400mm and operating cost of production is roughly C$30 / bbl, which means that at US$100 / bbl WTI oil price the company produces roughly C$2.6bn of Funds From Operations (FFO) and roughly C$2.2bn in Free Cash Flow (FCF). The company has chosen to leave its production unhedged, allowing investors to get leveraged exposure to oil prices.

As of yesterday’s close, the company’s market cap was ~C$6.4bn and enterprise value ~C$8.3bn. This implies a FFO multiple of 2.5x and a FCF yield of around 35%. In other words investing in the equity today means you are getting paid back your capital in less than 3 years along with ownership of an asset with 50 year reserve life! Even if oil price dropped to US$80, you’ll be getting a FCF yield north of 20%.

Christina Lake is not the only property that MEG owns. If oil prices remain supportive, MEG could consider increasing production by exploring its Surmont and Growth properties. At the current market cap you get a free option on future production growth as well as C$6.7bn of tax pools.

The management team has recognized the severe undervaluation in its stock price and initiated a capital return strategy that includes a share buyback program. With net debt between US$1.7bn and US$1.2bn the company will be deploying 25% of its FCF to share buybacks and 75% towards debt reduction. Between net debt of US$1.2bn and US$600mm the company will deploy 50% of its FCF to share buybacks and 50% to debt reduction. After reaching the floor debt level of US$600mm, 100% of FCF will be returned to shareholders.

If oil prices hold at US$100 / bbl, the company will reach its US$600mm net debt floor next year. If the company then decided to allocate 50% of its FCF to share buybacks and the remaining 50% to dividends, it would be able to retire 17% of its fully diluted shares outstanding in a year and pay out a 17% dividend yield at the current stock price. Canadian share buyback rules restrict companies from purchasing more than 10% of their shares outstanding in any given year, so this is just a theoretical exercise. But it shows just how undervalued the company is if one believes current oil prices are here to stay.

If you’re still not convinced, consider that MEG is also an attractive takeover target for a larger company like Suncor, Canadian Natural Resources (CNQ) or Cenovus due to its size, long reserve life and significant tax pools whose present value can be realized upfront by these larger players. A 5-6x FFO multiple, which is in line with historical levels, would re-rate the stock to C$40 - C$50 / share which is roughly 100% upside from today’s price. One could argue for a higher multiple since MEG is not a conventional producer with a 7-10 year reserve life and 30% decline rate. A 7-8x multiple might be more appropriate. Add a takeover premium and C$3 - C$5 / share in value from tax pools and you’re looking at a potential 3+ -bagger.