Every kid knows there are two kids that you don’t mess with on the school yard. The first and most obvious is the Bully (Alpha) who is so much bigger and stronger than the others (Beta) that winning a fight with the Bully is an exceptionally low probability.
The second and perhaps less obvious is the crazy kid. He is like the rest of the Betas except maybe built a little leaner and a little more volatile. If set-off under the right conditions he can take the bully. The trick is timing, or the consequences will be once again more of the same.
This analogy is useful because it gets us thinking in terms of probability. Generally, with cyclicals and commodity type businesses, you only want to own the Alpha stocks of a given sector (see last week’s blog). The risk of a permanent loss of capital in these industries is so great, you can be taken out of the game easily if the winds were to quickly change. Beta stocks should be treated as trades as at their core they are simply premium free long-dated call options on the underlying. The lower the quality the company, the less time you have for your underlying thesis to play out.
Lucky for us, this is the current macro position of one industry in particular: Energy. I expect that Beta stocks in this industry have a good chance to outperform in the near-term, just as they did at the bottom of the great financial crisis ending in 2009.
As shown in the chart below, the red line represents the XOP (Beta small caps) vs. XLE (Alpha large caps) U.S. energy names. The XOP outperformed from 2008 to the cycle top in 2014 and then got crushed from the top to the eventual bottom which I expect to be at the depths of the pandemic in 2020.
Enter Tamarack Valley Energy Ltd.
Tamarack is a Canadian Junior oil and gas company with operations in the Cardium and Viking formations. Today they also announced an acquisition to gain access to the high-quality Clearwater area in northern Alberta. The acquisition will be financed with a non-brokered bought share deal at $1.15/share and a 2% gross overriding royalty, financed by Topaz Energy.
The company is a small producer of hydrocarbons with approximately 59% of its production in oil and liquids and the rest being natural gas. Liquids represent 86% of revenues.
An interesting part of the Clearwater asset acquisition is that the purchase will result in increased liquids production: up to 68% by exit 2021. It will also provide the company with an even lower corporate decline rate of between 22 – 24%, down from 25% currently. As production grows in this area, these decline rates should continue to fall.
Moreover, the acquisition took off the table one large concern investors had with Tamarack, in that the company lacked a serious growth driver. Management’s prudence allowed the company to go into the pandemic with a relatively stoic balance sheet compared with its peers. The timing of this acquisition could not have been any better, right when the market is starved for capital.
In fact, as shown above, the company believes they will exit Q4 2021 with a net debt of just 1.2X cashflow, which is top tier in the Canadian junior space. Furthermore, expectations are that they can grow production from these assets up to 12,000 boe/d (from 2,000) by 2025. Looking ahead to 2021 the company estimates $38M in free funds and a 12% growth rate at strip. Not too shabby..
Put another way, Tamarack is that crazy kid, recently juiced up on steroids, ready to take advantage of the reflation coming to the economy. The acquisition gives the company Alpha-like characteristics, making it attractive in the current environment.
Financials:
Ninepoint Partners, a long-only energy fund (so take this with skepticism) released their sensitivity analysis of the company’s metrics post-transaction. In my opinion, if the actual numbers come anywhere close to their 2022 estimate of $168 million free cash flow generation at $60WTI, this is a highly attractive opportunity. Those figures would represent a 47% free cash flow yield at current prices!
Alternatives:
When buying into a theme like higher energy prices, it’s often a good strategy to take a basket approach, given that companies are individually exposed to other risks (beyond the commodity price). I have employed this strategy with Tamarack being the greatest weighting in my basket.
Some other interesting securities for this trade could include some of the following Canadian small caps: Parex, Whitecap, Crescent Point, MEG, or Enerplus. They are all likely to trade in a relatively tight range over the short-term and only offer idiosyncratic returns over the medium to long-term. With these types of positions stops one should employ some risk management tools (stops, hedges).
Technicals:
Last week, Tamarack broke-out from the June intra-day high of $1.09 on heavy volume up to $1.39. The move ticked the top of its current ascending channel pattern. I’m awaiting further price confirmation before further action.
I expect Tamarack to trade in parallel with WTI in the near term (which could come under some near-term pressure) but as we inch closer to a 2021 re-opening, I believe there is the potential for leveraged returns relative to the commodity. Disclosure: I’m long Tamarack, Whitecap, and Parex as a reflation trade.
Merry Christmas,
The Dutch Explorer