Spartan Delta: Trading at 20% Free Cash Flow Yield at Current Gas Price (DALXF)

Introduction

Spartan Delta (Toronto Stock Exchange:BDS: CA) (OTCPK: DALXF) is probably one of the most exciting stories of the past three years. An experienced management team that divested its previous three oil and gas companies companies took control of gas assets in 2020 of a company that went bankrupt and used it as a platform to build a major natural gas producer with an expected production rate of over 80,000 barrels of oil equivalent per day in 2023. In this article, I’ll dig a little deeper into the 2023 forecast and recently released reserves update to see what shareholders and investors can expect this year.

Forecast for 2023 remains unchanged, but the price of natural gas must cooperate

Spartan Delta has not updated its forecast for 2023 since the initial forecast was released in November. As as a reminder, the company plans to have an average production rate of 80,000 to 82,000 boe/day, of which approximately 61% is natural gas.

Spartan Delta expects to generate C$885 million in adjusted cash flow, while it will spend C$430 million on investments, which is expected to result in a free cash flow result of C$455 million. As there is currently 171.4 million shares outstanding (Spartan Delta expects to end 2023 with 173 million shares outstanding), this would represent a free cash flow result of C$2.65 per share, indicating that the company is trading at only 5 times free cash flow foreseen.

There is an (important) caveat here. Commodity prices used by Spartan Delta for these forecasts are rather “optimistic”. Using a Henry Hub price of US$5.31 and an AECO natural gas price of CA$4.50 is significantly higher than current prices. The price of AECO natural gas is currently trading at just CA$3.50 after an average of only C$2.50 in February while Henry Hub is currently at US$2.60 while the futures market indicates a price of US$3.90 for delivery in December. Of course, I realize that can change quite quickly, but I expect Spartan Delta to tone down its full-year expectations when the company releases its first quarter report.

Spartan Delta sells its natural gas on the AECO market (in the fourth quarter, its sales mix was 50/50 based on AECO 5A and 7A price levels), and the company’s presentation shows sensitivity analysis on what happens when you use a price of inferior natural gas (and oil).

So if I used an average oil price of US$70 per barrel and an average natural gas price of CA$3.50, the adjusted cash flow would decrease by about CA$155M. That’s a relatively small difference, thanks to the extended cover book.

About a third of 2022 production has been hedged at a Henry Hub price of US$4.74 while swaps for AECO exposure have been locked in at US$1.09. This means that the realized net price for these 85,000 mmbtu/day is about US$3.65 and at the current exchange rate, that’s about C$5 in Canadian dollars. An additional 55,000 GJ/d has been hedged at C$4/GJ from the second quarter, meaning approximately half of the production rate is hedged at a weighted average of C$4.60. and this explains why the sensitivity analysis results in a decrease of only C$65 million in the event that the AECO price trades at only C$3.50 throughout the year. The volumes currently covered throughout 2023 represent approximately 38% of the average forecasted natural gas production.

Assuming the average realized oil price is US$70 and the average realized (unhedged) natural gas price is CA$3.50 this year, net free cash flow would fall to CA$300M, which of course is still a very respectable result, considering the CA$430. M in planned capital spending also includes growth initiatives as Spartan Delta plans to increase its production rate by a mid-single digit percentage per year.

And this growth is supported by the updated calculation of resources and reserves. At the end of 2022, the total amount of reserves stood at nearly 580 million barrels of oil equivalent, of which around 60% was natural gas.

The company also provided the summary of the PV-10 calculations. While more detailed calculations and results will be published in the AIF expected to be filed before the end of this month, Spartan Delta has already released summary results of the pre-tax value of reserves.

Applying a 10% discount rate, the pre-tax PV10 value is C$5 billion. And even if you used a 20% discount rate, the 2P reserves have a pre-tax value of C$3.2 billion.

You can also apply a combination where you use a discount rate of 10% for PDP (proved developed production) reserves and 15% or 20% for other reserve classifications. If I used a 15% discount rate for proved undeveloped reserves and a 20% discount rate for probable reserves, the pre-tax pro forma present value of cash flows would be $3.72 billion. Canadian dollars. On an after-tax basis, this should certainly exceed C$2.5 billion and therefore be worth north of C$15/share. I can’t wait to see the official after-tax results, but it’s clear that the current share price is supported by the value of the reserves. Using the standard 10% discount rate, the pre-tax NPV of 10% per share is nearly C$30.

The only caveat here is that the value of the reserves was calculated using relatively high natural gas prices. But if Spartan Delta continues to hedge some of its production during a period of temporarily high prices, the prices used below may not be unreasonable.

Investment thesis

Spartan Delta is still my strongest position in the natural gas space. I’m glad to see that the company has finally started to hedge some of its natural gas production rate and those hedges will likely come in very handy this year. I like the strong balance sheet (which should contain net cash by the end of this year), the PV10 calculation and the strong reserve base. Based on the expected production rate for this year, the reserve life index is approximately 19 years on a 2P reserve basis.

The company is also still working on its “Strategic Review”, and since this management has sold its previous three companies, I’m not sure Spartan Delta will still be around by the end of this year.

I have a long position on Spartan Delta and wouldn’t mind adding additional weakness.

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