This week’s bond review focuses on an intermediate Canadian oil and natural gas producer with excellent cash flow, decreasing costs and debt levels and a sound hedging strategy. Pengrowth Energy recorded solid performance in 2015, despite continued low oil prices. Its 2015 performance highlights included:
$280 million in debt reduction, mainly through asset dispositions.
Significantly decreased expenses via an 80% capital expenditures reduction and a 30% workforce reduction.
$327 million in commodity risk management gain from the company’s brilliant use of hedging.
Bond investors should be encouraged by the fact that Pengrowth also registered solid cash flow in 2015 of $459.3 million. In addition:
The company has a fully available credit facility of $1.0 billion that could be used at any time to repay these bonds at the company’s discretion.
With the company’s recent decision to buyback up to 10% of the outstanding value of these bonds, bondholders should see also these bond prices begin to appreciate.
Pengrowth has hedged a majority of its 2016 oil and gas production, which should help moderate the effects of commodity price swings on revenues.
While it is difficult to predict the timing of the oil industry’s recovery, Pengrowth Energy is taking the necessary steps to remain viable during this period of low oil and gas prices. Pengrowth’s convertible one year (March 2017) loonie bonds (denominated in Canadian dollars) are indicating an high 17% yield when discounted to about 90, providing investors with an excellent opportunity to increase portfolio returns in both our FX2 and FX3 global high yield fixed income portfolios.
About the Issuer
Pengrowth Energy is an intermediate Canadian oil and natural gas producer with over 27 years of operating history. Headquartered in Calgary, Alberta, its asset base provides the company with exposure to large oil-in-place conventional plays, large low-risk resource plays, and early-stage development plays. These assets include the Cardium light oil, Lindbergh thermal bitumen, Swan Hills light oil and Montney natural gas projects.
Bond Repurchase and Repayment
In February 2016, Pengrowth issued a normal course issuer bid to acquire up to 10% of the outstanding amount of these convertible notes by next February. With a current outstanding balance of approximately $137 million, the company intends to repurchase up to $13.7 million in the next twelve months. This is a smart move for the company given the currently reduced trading price of these bonds. Not only will this shore up Pengrowth’s balance sheet by reducing debt and interest expense, but this should also increase the trading prices of these bonds.
Another critical piece of information for bondholders, is the value of Pengrowth’s current revolving credit facility. The company currently has access to $1.0 billion in credit facility, which is fully available. Pengrowth could, at its discretion, pay off these bonds in total at any time. Indeed, in the company’s latest quarterly results conference call, Pengrowth’s CFO Chris Webster indicated that, if needed, this could be used to repay these convertible debentures.
Healthy Cash Flow and Interest Coverage
Despite the recorded $811 million loss for 2015 (mainly due to a significant non-cash impairment charge of over $1.0 billion) Pengrowth registered a healthy funds flow from operations for 2015 of $459.3 million. With 2015 annual interest expense of $103.9 million, this calculates to an interest coverage ratio of 4.4x. With the company’s continuing commitment to debt reduction in 2016, along with its hedging strategies, this ratio should continue to improve.
Asset Dispositions and Debt Repayment
In an effort to shore up its balance sheet last year, Pengrowth made the strategic decision to sell some of its producing oil and gas assets in order to reduce debt. After several asset dispositions in 2015, the company raised $263 million from the proceeds of these sales. These funds, along with additional funds from operations, were used to reduce Pengrowth’s debt in 2015 by $280 million. The company has identified other assets it intends to sell, forecasting an additional $300 million in asset sales for this year. According to Derek Evans, Pengrowth’s President and CEO, in 2016 the company will use all excess cash flow from its hedging program, disposition proceeds and funds flow from operations towards debt reduction
Despite the unrivaled drop in oil prices in 2015, Pengrowth Energy’s funds flow from operations was down only 9% year over year. This was due in large part to the company’s smart hedging program. Because Pengrowth had hedged much of its oil and gas production in 2015, it was able to realize higher prices for its production. The net effect of these hedges in 2015 was a realized gain of $327 million.
Moving forward, the company has continued its hedging program into 2016 and beyond. In fact, for 2016, the company has hedged 74% of its planned oil production at $88.57 per barrel. It has also hedged 93% of its planned natural gas production at $3.28 Mcf. The company also has significant hedges in place for 2017 and 2018. This strategy should help the company to keep revenues more consistent in the face of the continuing fluctuations in the commodities markets.
Last year, in an effort to curtail costs, Pengrowth slashed its capital expenditures (capex) budget by 80% to $183.8 million – a paltry amount when compared to 2014’s capex of $904 million. And while this action normally translates to significant output reduction for an oil and gas company, Pengrowth actually ended 2015 with average daily production of 71,409 boe (barrels oil equivalent) per day, on the high end of its 2015 guidance of 70,000 to 72,000 boe per day. A big reason for this is the fact that Pengrowth’s oil and gas assets have a very low decline rate (around 16-17%). This allows the company to reduce capex without significant production decreases.
In 2015, Pengrowth, like many oil and gas companies, made adjustments to the expense side of its balance sheet in the wake of the sharp decline in commodity prices. Anticipating the continued decrease in oil prices, the company not only slashed its 2015 capital expenditures (capex) budget by 80%, it also slashed its dividend in 2015 by 50%, eventually suspending the its dividend altogether in January 2016. Pengrowth also reduced operating expenses in 2015 to $372.1 million, 10% lower than its 2014 operating expenses. Another expense reduction for the company came in the form of workforce reduction, with a 30% reduction in the company’s workforce last year. This move will translate to a cost savings of $25 million annually.
These very short 12-month bonds are convertible to common shares of Pengrowth Energy at a conversion price of $11.51 per share. Like many oil and gas companies, Pengrowth’s stock has decreased in value, somewhat mirroring the decrease in oil and gas prices. However, we feel the excellent 17% yield on these loonie bonds provides an adequate incentive for investors to consider them as an addition to their portfolios.
Pengrowth has set its 2016 capex budget at $60 to $70 million, an amount that is largely aimed at safety, asset integrity and maintenance. The company expects average volumes of 60,000 boe per day, down from an average of 71,400 for 2015. Pengrowth’s newest producing asset, Lindbergh, began production in late 2015, and has exceeded expectations for levels of production. Management fully expects that Lindbergh’s production will continue to increase throughout this year, which will help offset some of the company’s planned asset dispositions. In terms of free cash flow, the company expects to generate about $355 million of free cash flow in 2016 (before capex) which should provide a significant contribution to its goal of debt reduction.
The default risk is Pengrowth Energy’s ability to perform. Pengrowth has made many difficult decisions in the past year, including slashing capex, reducing staff, and disposing of non-core assets, all directed at paying down debt and improving its balance sheet. The company’s smart hedging strategy will continue to provide a measure of stability in the face of commodity volatility. In addition, its undrawn revolving credit facility provides the company with excellent liquidity to use for operational needs and / or debt repayment. The convertible feature also serves to significantly mitigate its default risk.
As Pengrowth is an oil and natural gas producer, price movements of these commodities have a direct effect on the company’s revenues and profits. Although we have seen oil begin to increase in price since the beginning of 2016, it is difficult to predict if oil is truly on the recovery path. Natural gas prices have also been under pressure in the last 12 to 18 months. And while it is uncertain when oil and gas prices will recover from this prolonged decline, Pengrowth’s hedging strategy will provide significant benefits for the company moving forward.
These very short, 12 month convertible bonds have similar duration and yields to other bonds reviewed on Bond-Yields.com, such as the 8.8% CanWel and the 17.7% Transglobe Energy convertible debentures.
Summary and Conclusion
Pengrowth Energy has been working diligently to position the company for future success. Although prices for oil and gas are still recovering from the steep declines experienced since mid-2014, Pengrowth has done a brilliant job with its hedging strategy, asset dispositions, cost and staff reductions, and debt reductions even as prices remain low. It has wisely set its 2016 capex budget at a level that will allow it to largely maintain its production while still continuing to improve its balance sheet. Its significant, undrawn $1.0 billion credit facility should assure bondholders of the company’s ability to repay these bonds before or at maturity. As the markets are still showing wariness of the oil sector, these bonds are selling at a significant discount which translates to an excellent yield for investors. These Canadian dollar bonds provide a significant boost for an investor’s portfolio, and will make an excellent addition to both ourFixed-Income2.com and Fixed-Income3.com managed income portfolios.
Issuer: Pengrowth Energy
Ticker: PGH (NYSE); PGF.TO (Toronto)
Conversion Price: 11.51 / share (CAD)
Yield to Maturity: ~17.7%
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Disclosure: Durig Capital and certain clients may have positions in Pengrowth Energy 2017 bonds.
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