New Event-Driven/Special Situations Stock Idea
A case where a stock might be cheaper after the stock price went up 80% in a matter of a week
Today, I would like to discuss an event-driven investment opportunity. The company is called Tenaz Energy and they recently announced a transformative acquisition. The stock price subsequently increased 80% and this might cause many to think the market already fully reflected the event. In this Substack, I attempt to argue why I think this could be the beginning and much upside remains.
Before I move on, this is a friendly reminder to do your own research as this is not investment advice.
Company Overview
Tenaz Energy (TSX: TNZ) is a Canadian-listed exploration and production company targeting acquisitions and operational improvements of international, producing oil and gas assets. Tenaz insiders own approximately 20% of fully diluted shares outstanding with extensive experience in the energy sector. Before the acquisition, Tenaz held Canadian oil assets and European natural gas assets. However, these assets are no longer significant in size.
Acquisition Details
CAD246m acquisition consideration to purchase a collection of offshore natural gas assets in the Dutch North Sea from Nederlandse Aardolie Maatschappij B.V. ("NAM"). NAM is a decades-old 50/50 joint venture between Shell and ExxonMobil. The assets bought are owned by an entity called NAM Offshore B.V. (“NOBV”). NOBV has been in operations since 1964, with a 22-year remaining economic production life. After the acquisition, Tenaz will operate 20% of Dutch offshore gas volume.
NOBV is expected to generate CAD134m of free cash flow (“FCF”) in 2024, meaning Tenaz is acquiring the asset for less than 2x FCF. Since 46% of natural gas production from 2024-2026 is already hedged, there is a degree of comfort for the FCF estimate. There are contingent and earnout payments associated with future asset performance, part of which incentivizes additional exploration.
The beauty of this deal is the FCF generated between the effective date (January 1, 2024) and the closing date (expected to be July 1, 2025) can be used to fund the acquisition consideration. Tenaz estimates CAD186m of FCF during this interim period. This reduces the upfront capital deployed to close the deal. Tenaz arranged up to CAD110m of delayed draw term loan facilities from the National Bank of Canada to close the transaction if required. This acquisition did not have any equity dilution.
The assets will increase Tenaz’s production from 2,800 barrels of oil equivalent per day (“boe/d”) to 13,800 boe/d, a 3.9x increase. Total proved and probable reserves (“2P reserves”) will increase from 14.6 million barrels of oil equivalent (“mmboe”) valued at a 2P NPV10 ATAX of CAD142m to 68.2 mmboe valued at CAD931m.
Terminologies
Before we move on to the next section, I can see some heads scratching with so many terminologies. I will try my best to explain in simple terms what they mean if you are interested in learning more.
Joint venture: a business arrangement in which two or more companies agree to pool resources together for operations. In NAM’s case, the assets are 50/50 owned by Shell and ExxonMobil.
Free cash flow: a metric that measures cash flow earned by the company after deducting all expenses required for current operations and business expansions, including near-term working capital requirements and capital expenditures for long-term assets.
Equity dilution: in acquisitions, shares could be issued as part of the purchase. If shares are issued, existing shareholders’ percentage ownership of the company will decrease, meaning their equity stakes are diluted.
Barrel of oil equivalent (“boe”): a unit representing the amount of energy equivalent to the energy found in a barrel of crude oil. This metric is used to compare the amount of oil and gas reserves across companies. Natural gas is typically measured in cubic feet. Approximately 6,000 cubic feet equals 1 boe.
Proved and probable reserves: the quantity of oil and gas reserves reported by companies are measured based on the economic feasibility and probability of recoverability. Proved reserves (1P reserves) are reserves with at least a 90% chance of being recovered while probable reserves (2P reserves) are reserves with at least a 50% chance of being recovered.
2P NPV10 ATAX: a dollar figure estimate of how much the proved and probable reserves are worth on an after-tax basis, discounted at 10%, the typical rate for the industry.
Earnout payments: an obligation to pay the seller based on the sold assets’ future performance. In the case of NOBV, Tenaz agreed to pay 50% of 2025 and 2026 after-tax cash flows and 25% of 2027 after-tax cash flows to NAM, subject to a cumulative maximum of CAD180m and not subject to any minimum payment.
Contingent payments: additional payments to the seller based on the asset’s future potential. This term is included when the sellers want to participate in the potential upside even after the assets are sold. For example, Tenaz agreed to pay NAM additional cash flows on top of the earnout payments if NOBV’s future exploration discoveries exceed certain production thresholds and/or natural gas prices exceed a certain level.
Don’t worry, there will not be a final exam.
Market Reaction
The market liked the deal, sending the stock price up 80% in a week. Normally, this could be a sign that the market immediately recognized the value of the combined company. However, the company may still be significantly undervalued.
Reason #1: Valuation
As of July 25, 2024, Tenaz Energy’s market cap is CAD182m. Management expects the combined company (NOBV + existing assets) to generate CAD140m of FCF in 2024, meaning the company is trading at a pro-forma 1.3x FCF multiple. I would think of this opportunity as a >70% coupon convertible bond with a maturity of a few years. The >70% number comes from the company’s expected FCF yield (1 / 1.3 = 77%) and the maturity date comes from the assumption that NOBV can generate similar cash flows in the next few years. The convertible portion is the potential equity upside, based on future exploration and development.
Valuation on a reserves basis: CAD931m, minus CAD246m purchase price minus CAD180m maximum contingent payment = CAD505m, assuming zero exploration and development and no spikes in natural gas prices against a market cap of CAD182m. Be mindful that reserve estimates can change annually and only a crude approximation of valuation, therefore needing a large margin of safety when assessing the numbers.
Reason #2: Upside on Asset Development
NOBV has seen minimal increase in the number of new wells in the past 5 years and no capital expenditure has been planned for 2024. The reasons for the lack of investments are:
1) NAM is no longer a core asset of Shell and ExxonMobil. They have tried selling NAM since 2022.
2) seismic impact and the production limit/eventual shutdown of the Groningen gas field closure (NAM’s onshore assets that are not acquired by Tenaz) discouraging Shell and ExxonMobil from investing further into the joint venture, and
3) pressure to transition to cleaner energy and return excess capital to shareholders in the form of buybacks and dividends after a decade of underperformance relative to other industries.
NOBV’s future potential: Tenaz’s management identified at least 30 development drilling locations and 80 exploration prospects. Exploration and development potential is enhanced by the presence of 3D seismic surveys over substantially all of the asset base.
Reason #3: Overblown Concerns Regarding Natural Gas Usage and Energy Transition
Although Europe, including the Netherlands, is trying its best to move from fossil fuel to clean energy, the importance of natural gas cannot be understated as a transition fuel due to its lower carbon footprint compared to coal, its reliability relative to the intermittent wind and solar energy which requires complementary baseload energy, and massive investments in grid upgrade (Europe has the oldest electricity grid in the world) and battery storage required that can take at least a decade to come to fruition.
Equinor, the Norwegian energy giant supplying 30% of Europe’s natural gas, sees a positive outlook for natural gas in the next 5 years. They have secured long-term supply agreements with Germany, noted Europe’s increased emphasis on energy security after recent geopolitical events, and continued investments in natural gas assets.
In the Netherlands, LNG imports rose 33% in 2023, even after a massive increase in recent years, to partially make up for a 23% decrease in pipeline gas imports and a 35% decrease in domestic gas production (mainly the shutdown of the Groningen gas field previously mentioned). This signals natural gas is still in demand.
According to the REPowerEU report, Groningen accounted for 30% of gross available energy and 39% of gross electricity production as of 2022. The Netherlands is expected to compensate for the field shutdown by extracting 35 billion cubic meters (“bcm”) of natural gas from small onshore fields until 2047. Tenaz now owns 8.3bcm of natural gas reserves to supply the estimated energy required until 2047.
The graph below from the EIA shows the exponential increase in US LNG exports to the Netherlands.
Risk Factors
Although there is much to like about this acquisition, there are risks as well (as with any investment opportunity). For example, regulations surrounding fossil fuel, natural gas prices which are volatile and unpredictable, and exploration and development potential that do not materialize.
In my opinion, these risks are offset by the fact that Tenaz’s valuation is 1.3x FCF. I believe this multiple is very conservative and provides downside protection, even if production declines over time. In addition, Jenson Tan, Tenaz’s Chief Operating Officer, bought 100,000 shares at CAD6.99 per share after the acquisition was announced, signaling his confidence in the deal.
Closing thoughts
I was supposed to discuss Valeura and PetroTal according to my previous article but this acquisition took up much of my recent research time. I will discuss them in another article.
Thank you for reading!
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