by Cole Smead, CFA, CEO, Smead Capital Management
Dear fellow investors,
The investors of Smead Capital Management believe, which we count ourselves among, that energy stock valuations in the stock market have become too depressed. Mr. Market gets scared, as he does from time to time. This can go on for a while, but we have seen a couple of private transactions in two different parts of North America energy markets that explain how attractive the pricing is for the assets that Mr. Market could own.
Permian Landman
APA Corp. (APA) is a stock that we discussed with our investors in great detail over the last 120 days. It’s primarily a Permian producer with a side of Egyptian assets. They also have future drilling options in Alaska, Suriname and Uruguay. They produce about 300,000 barrels of oil per day. Price action in their common stock shows the market is worried about low oil prices for the business. However, the lowest stock price was recognized after the initial tariff announcement in April. Economic fears seem to be the company’s worst enemy in the way the stock market prices APA shares.
APA has an average duration of its debt at over 14 years, with about $6 billion due over that period. Of that amount, $300 million in bonds is due in the next three years. They also have a $520 million line of credit included in this $6 billion that is due in 2027. Beyond the $6 billion in debt, the book value of the business is roughly $6 billion, leaving the business with $12 billion of invested capital. The business is producing about $1.2 billion in free cash flow (FCF) at today’s strip oil pricing. This leaves the current shareholders with a business producing 10% returns on invested capital (ROIC) based on this FCF. This makes us feel like Rip Van Winkle. We could fall asleep tonight and wake up in 10 years. The business could possibly pay off its debt in the first five years. At the end of the 10 years, you’d only have to trade at book value to make attractive returns. Let’s keep one eye open though to look at the most recent transaction they just executed.
APA just announced in their quarterly earnings that they had sold a piece of their Permian acreage for $600 million dollars. In talking with management, this land represented less than 5% of their current production in the Permian and they had multiple bidders. Management has stated that they plan to use this cash to pay off their revolving line of credit due in 2027, which would bring the total debt down from $6 billion to $5.4 billion.
If you calculate what this represents, it means the private operators bidding on that asset would represent a total value of more than $12 billion for APA’s entire Permian asset portfolio at the current depressed oil prices. If those assets are worth $12 billion, this would allow the shareholders to eliminate all their debt and pay the remaining $6 billion back to the shareholders in a special dividend. This would theoretically be 100% of the current market capitalization. We believe that this wouldn’t be the most effective way, because shareholders would pay taxes or withholding on that dividend. Buybacks would be the most efficient return of capital to shareholders. APA Corp. would still have their current Egyptian production as well as Alaska, Suriname and Uruguay at their disposal for future oil production. It’s crazy what you get when Mr. Market gets depressed about certain stocks!
Oh, Canada!
We have been watching one of the most interesting transactions go on among one of the most adaptable capital allocators in oil and gas in North America. Strathcona (SCR), controlled by Adam Waterous, sold gas assets in the Montney region for a $2.8 billion CAD (~$2 billion USD) to a consortium of buyers that included ARC Resources, Canadian National Resources and Tourmaline Oil for mostly cash and some stock also. This represented 40% of the market cap of Strathcona the day it was announced!
We quickly recognized that Strathcona did this based on the perception that the market was overvaluing natural gas assets, relative to oil assets. Everyone knows that we are going to use a lot of electricity with AI and natural gas is the central figure in that story. They are leaving oil for dead!
We believe Adam Waterous saw this pricing arbitrage and sought to crystallize it with this transaction. When asked what our thoughts were, we told the media that he wanted to focus on oil and we believed Adam may acquire MEG Energy (MEG) to focus on Strathcona’s remaining heavy oil business (link). The next day, Strathcona did just that by announcing a takeover bid for MEG Energy in a mostly cash and partly stock offer. The market has been trading MEG Energy’s shares above the offer price since then. While there are a couple of other bidders that are potentially out there, we see Strathcona closing on a deal with a small increase in its offer of 10% to make investors happy.
Adam Waterous is a force to be reckoned with in the North American Energy complex. Strathcona was already the fifth-largest oil producer in Canada. This deal cements his company into a scaled position in the space. He has been a counter-cyclical investor who built up the current business of Strathcona through patient capital and his willingness to be aggressive when others were scared, much like he is doing now. Mr. Waterous is already a billionaire from his actions, but people are doubting this transaction while he arbitrages the current positive view of natural gas versus the dour view that people have in oil.
Private Market Takeaway
Our investors should take heart by believing that the day in the sun will come when our operators, like APA and Strathcona, can get private market prices for their assets as though they are highly marketable securities. Not all real estate is the same. Office assets sit empty and illiquid while oil and gas assets trade hands at attractive valuations. Mr. Market is postured like a manic depressive, sitting scared in the corner. Mr. Waterous is showing what skilled capital allocators should be doing as he uses the private markets to allocate capital from natural gas assets to oil. Investors should be following his lead to take advantage of these large dislocations. He’s showing everyone that consolidation is coming. Strathcona will be a much more liquid stock after he closes on this deal. Our bet? There will be nothing to stop Adam from announcing his next deal to compound the opportunities that he has in the oil and gas business from the values that he is getting in the private assets. We recommend you do the same.
Play The Long Game,
Cole Smead, CFA
The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, CEO and Portfolio Manager, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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