This week, we take another well deserved look at a Canadian oil production and exploration company with operations focused in Egypt and debt issued in Canadian dollars (aka, “loonies.”) Since our last review of Transglobe Energy (TGA) in September 2014, the company has collected nearly all the receivables due to it from the Egyptian government, which has been nearly providential in providing it vital cash flow during this season of low oil prices. Also of great significance, TransGlobe Energy began in 2015 to directly market and sell its oil in the global marketplace. This marks a major departure from the Egyptian government serving as middleman for all oil transactions, which has meant shorter turnaround time between the sale and collecting of payments for it. Consequently, TGA has managed to maintain a very strategic and impressive cash balance, which is nearly 2x’s the amount of its total outstanding debt. This level of cash would seem to nearly erase a bondholders’ concern of default risk. While TGA prudently reduced its operating costs in 2015, it still has plans to continue exploration in 2016 and remain ideally positioned for growth once oil prices begin to recover. These extremely short 12-month Canadian dollar bonds, which appear to be more than adequately covered by TGA’s cash balance, are currently indicating a show stopping yield of over 17%, and we have therefore marked them for additional over weighting within ourFX2 and FX3 global high yield income portfolios.
An Update on the Issuer
Perhaps the most significant development since our last review of TransGlobe Energy in September 2014, is the company’s ability to now market and sell its own oil in the international marketplace. This agreement, which was made in December 2014 with the Egyptian government, allows TGA to directly contract oil shipments with international buyers. The company had three oil lifts (shipments) in 2015, corresponding roughly to one shipment per quarter for the first three quarters of the year. This arrangement has translated to more prompt payments for its oil, as these sales are shipped and paid for much quicker than sales made to the Egyptian government. The end effect has been more dependable cash flow as compared to when Egypt’s government was acting as middleman in every oil transaction.
Since the company did not have an oil lift in Q4 2015, it had a large inventory of oil at the end of 2015 of 923,000 barrels. The next scheduled lift was to take place in February 2016. Depending on how much oil was shipped and how much the company retained, oil still remaining in inventory might serve the company well, especially if oil prices continue to climb this year. This would bring a higher price per barrel and provide increased revenues and profits.
Egypt’s government has also made significant progress on its historically high balance of account receivables with TransGlobe. These receivables due from EGPC (Egyptian General Petroleum Corporation – the national oil company of Egypt) peaked in 2012 at $221 million. This was reduced to $118 million by the end of 2014. In the first nine months of 2015, TGA collected $88.1 million in receivables from EGPC and had just about $30 million still due from EGPC as of September 30, 2015. TGA expects that the Egyptian government will come current with its balances due to the company by mid-2016.
Please note that although Transglobe Energy is based in Toronto, its financial results are stated in US dollars unless specifically noted otherwise.
Cash is King
The most compelling case for these very short 12 month bonds is TGA’s outstanding level of cash. At the end of 2015, the company had an astounding $126 million in cash, nearly 2x the outstanding balance of its debt ($65.7 million as of September 30, 2015). With these figures, the default risk to the company’s bondholders is approaching zero.
Put another way, if for some reason TGA were to default and bondholders took ownership of the company, they (the bondholders) would not only get the cash assets, but also the value of the company. Current market capitalization with the most recent stock price is around $103 million, but the company’s most recent balance sheet values the company’s assets at $501.8 million. In addition, TGA’s assets (in the form of oil production) represent an annuity stream to its owners. Hence, TGA, as a company has value, both in cash / hard assets as well as the in oil still to be produced. In the very unlikely event of a default, bondholders might stand to gain a great deal, which is not the normal scenario for a bond default.
Falling Oil Prices and PSC’s
Since mid-2014, oil prices have declined dramatically. This dramatic decrease is principally due to a disproportionate amount of oil being produced. It’s a classic tale of supply versus demand. Supply has, by far, outpaced demand, hence the current state of the oil industry. The most recent prices have seen oil trading between $30 and $38 per barrel, almost a quarter of its peak price in 2014. And while oil prices affect all oil producers, TGA has a built in “shock absorber” when oil prices are low in the form of Production Sharing Contracts (PSC’s) with the Egyptian government (we discussed PSC’s in our previous Transglobe review).
All of the TransGlobe’s production is priced based on Dated Brent and shared with the respective governments through PSCs. When the price of oil increases, it takes fewer barrels to recover costs (cost recovery barrels) which are assigned 100% to the company. Conversely, when oil prices decline it takes more barrels to recover costs (cost recovery barrels) which are assigned 100% to the company. As illustrated here, the PSC has an allotment for “recovery oil”. This allows TransGlobe to recover its costs before it shares its revenues. In doing so, the PSC acts as a shock absorber when oil prices are low.
Cost Cutting and Share Repurchase
In light of decreasing oil prices, TransGlobe has made efforts to significantly reduce its ongoing costs. In 2015, they reduced staff by 20% in both their Cairo and Calgary locations, and also divested high operating cost projects in Yemen and Egypt. (The company disposed of all of its remaining Yemen assets in Q4 2015). Also, the company is targeting a further drop in annual operating costs in 2016 to around the $50 million mark due to the merger of its two operating joint ventures in Egypt. (As a point of comparison, operating costs were $46.033 million for the first nine months of 2015). In addition, TransGlobe reduced its Q4 2015 dividend to shareholders by 50%. These cost saving initiatives should help TransGlobe remain viable while oil prices remain low.
On a separate note, in March 2015, TransGlobe initiated a normal course issuer bid (NCIB) to repurchase up to 6,207,585 shares (about 10% of its outstanding shares) until March 2016. As of September 30, 2015, the company had repurchased and cancelled 3,103,792 shares. This move may provide a stimulus to increase the share price of the remaining outstanding shares.
Although these bonds are convertible to common shares of the company at a strike price of $15.10 CAD, we feel the current excellent yield on these bonds is a sufficient motivator for current and potential bondholders. While the markets may have undervalued TransGlobe at its current share price ($2.27 CAD as of March 11, 2016), it doesn’t appear likely that the stock price will recover sufficiently to add any additional value to these convertible debentures prior to maturity. If for any reason the company should elect conversion (which is only an option for it at maturity) rather than redemption, the conversion would introduce an additional 5% return resulting from the discounted stock that noteholders would receive when held through maturity.
While TransGlobe will continue to look for opportunities to drive down its cost structure, it also continues its exploration program. In Q3 2015, the company disclosed its plans to drill and evaluate up to 22 prospects in the Eastern Desert (NW, SW SE Gharib Concessions) over the course of this year. Its capital budget for 2016 is $41 million (which will be funded from operating cash flow), with 54% earmarked for Exploration and 46% marked for Development. In terms of production, TransGlobe is estimating production for Q1 2016 to be in the 12,000 Bopd range, a 10% reduction, principally due to “natural declines, high cost / shut in producers and delayed workover investments in response to low oil prices in December and January” (from TransGlobe 2015 Year-End Reserves and Update).
The company continues to be positive on its growth prospects as stated in Q3 2015, “TransGlobe remains in a strong financial position and is well positioned to weather the downturn in world oil prices. TransGlobe’s management will continue to steward capital programs, focus on cost reductions and maintain a strong balance sheet through 2015 and beyond. In addition, management will continue to seek out opportunities to grow the company and diversify our risk so that we will be well positioned to prosper in the long term.”
The default risk is TransGlobe’s ability to perform. As discussed earlier, TransGlobe’s level of cash is more than sufficient to pay off this debt. And although the company’s Q3 results indicate a negative funds flow from operations, the company continues to receive cash infusions in the form of payments from EGPC ($42.6 million in Q3 2015) for its receivables balance. The convertible feature also serves to significantly mitigate its default risk.
TransGlobe’s oil assets are all located in Egypt, a country with a recent history of instability. However, since the election of its current president, Abdel Fatah el-Sisi, in 2014, the country now appears to be stable and looking to promote itself to the greater global business community. TransGlobe has successfully navigated doing business in Egypt even during times of turmoil.
As its only revenue source is from the sale of oil, there is continued risk for the company if oil prices remain at current levels or decrease further. TransGlobe has done a commendable job of balancing cost cutting with continued exploration with an eye to when oil prices begin their assured march upward. Its Production Sharing Contracts mean that the Egyptian government shares in the risk of continued low oil prices. Additionally, at the end of 2015, TransGlobe had a substantial inventory of 923 thousand barrels of unsold / unshipped oil due to the fact that they did not have a shipment of oil in Q4 2015. This represents a significant receivable for the company as soon as it is sold and shipped. Finally, the company has reduced its costs over the past twelve months and its PSC’s with Egypt provide a unique buffer for the company when oil prices are low.
Summary and Conclusion
There are few who could have anticipated this extended period of low oil prices. As a result of this unprecedented decline, companies that are affected, even indirectly, by the price of oil, have been challenged to reduce costs and / or redefine their business. In the wake of oil’s precipitous fall, TransGlobe’s conservative management of its cash and debt levels, its cost cutting initiatives and its successful oil sales in the international marketplace, have held the company steady while others have struggled. With the EGPC slated to come current on their receivables this year, TransGlobe can anticipate more regular payments from Egyptian government, which should moderate the timing of cash received for its oil. As the extremely desirable 17+% yield on these 12 month Canadian dollar denominated convertible debentures have in unusually low default risk, they should be especially appealing to any investors looking to decrease their income portfolios to an overweighting of US dollars, and increase the returns of their global currencies income portfolio. Therefore, we are targeting these for additional weighting in both our Fixed-Income2.com and Fixed-Income3.com global portfolios.
Issuer: Transglobe Energy Corporation
Ticker: TGL (TSX Exchange) / TGA (NASDAQ)
Stock Price: 2.27 (CAD) / 1.72 (USD)
Bond Coupon: 6.00%
Conversion Option Price: $15.10 CAD
Yield to Maturity: ~17.39%
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Disclosure: Durig Capital and certain clients may have positions in TransGlobe Energy bonds.
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