MEG Energy Corp

TSX:MEG

Earnings Call Transcript 2022-Q2

[Operator]

Good morning. My name is Pam and I will be your conference operator today. At this time, I would like to welcome everyone to the MEG Energy’s 2022 Q2 Results Conference Call. All lines have been placed on mute at this time to prevent any background noise. After the speakers’ remarks, we will have a question-and-answer session. [Operator Instructions] Thank you.

Mr. Derek Evans, CEO. You may begin.

[Derek Evans, Chief Executive Officer]

Thank you, Pam. Good morning and thank you for joining us to review MEG Energy’s second quarter operating and financial results. In the room with me this morning Eric Toews, our Chief Financial Officer; Darlene Gates, our Chief Operating Officer and Lyle Yuzdepski, our General Counsel and Corporate Secretary.

I would like to remind our listeners that this call contains forward-looking information. Please refer to the advisories in our disclosure documents filed on SEDAR and on our website. I will refer listeners to yesterday’s press releases for more detail beyond the comments we prepared for this morning.

Prior to jumping into the details of the quarter, I want to point out that this is Eric Toews last quarterly conference call before retiring on August 1st. On behalf of the entire board and management team, I want to thank Eric for his dedication and valuable contributions during his time in MEG.

Eric has led a number of strategic initiatives which have transformed MEG’s balance sheet, including the sale of the Alliance or the Access Pipeline, and the completion of a number of complex refinancing transactions which have been instrumental in getting us to the place we are today, while we are returning capital to shareholders. On a personal note, Eric has been an amazing partner. I’m grateful to have had the opportunity to work alongside him these last four years and wish them all the best in the future.

In the second quarter bitumen production average 67,256 barrels a day at a steam oil ratio of 2.46, compared to 101,128 barrels per day at a steam oil ratio of 2.43 in the first quarter of 2022. Production in the quarter was impacted by the scheduled major turnaround at the Christina Lake Phase 2b facility. Despite a tight labor market and supply chain challenges. The turnaround was completed safely on time and on budget.

Following the turnaround, the Christina Lake facility experienced an unplanned electrical event which resulted in a slower than forecast production ramp up during the month of June, which impacted full-year 2022, average production by approximately 2000 barrels per day.

Christina Lake facility has now returned to full production and make second half 2022, average production levels are expected to meet or exceed the record production levels the corporation reached in the first quarter of 2022.

Due to the slower post turnaround production ramp up, MEG revised its full-year 2022 average production guidance to 92,000 to 95,000 barrels a day from 94,000 to 97,000 barrels per day. MEG also revised its full-year non energy operating costs and G&A expense to 460 to 490 per barrel, and 175 to 190 per barrel respectively, reflecting lower full-year production guidance.

In the second quarter, MEG initiated its share buyback program and continue to make significant progress on debt reduction. Year-to-date, we have applied over 1 billion of free cash flow to debt repayment and share repurchases.

Highlight from the second quarter results include funds flow from operating activities of 412 million and adjusted funds flow of 478 million. Free cash flow of 374 million, total capital expenditures of 104 million primarily directed towards sustaining and maintenance activities, including approximately 44%, which was directed towards the completion of the major plan turnaround.

Net operating costs averaged $12.97 per barrel, including non energy operating costs of 565 per barrel, power revenue offset energy operating costs by 30%, resulting in energy operating costs net of our revenue of $7.23 per barrel. Year-to-date debt reduction of US$700 million, including US$379 million in the second quarter of 2022.

MEG initiated the share buyback program during the quarter and to date has returned 139 million of capital to shareholders through the repurchase for cancellation of approximately 7.24 million MEG common shares.

During the quarter, MEG renewed its existing modified covenant light facility credit facilities resulting in total available credit of $1.2 billion with a maturity date of October 31, 2023. And on June 16, 2022, MEG announced the hiring of Mr. Ryan Kubik as the corporation’s next Chief Financial Officer, who will succeed Eric Toews effective August 1 2022.

MEG realized an average AWB blend sales price of US$100.42 per barrel during the second quarter of 2022 compared to US$83.55 per barrel in the first quarter. The increase in average AWB blend sales price quarter-over-quarter was primarily a result of the average WTI price increasing by US$14.12 per barrel.

MEG sold 79% of its sales volumes in the U.S., Gulf Coast market in the second quarter of 2022 compared to 58% during the first quarter of 2022. The increase quarter-over-quarter is primarily the result of apportionment on the Enbridge mainline being 0% in the second quarter of 2022 compared to 10% in the first quarter.

On June 15, 2022, Canada’s majors oil sands producers announced the combination of three existing industry groups all focused on responsible development into an a single organization called the Pathways Alliance.

The new organization incorporates the oil sands pathways to net zero alliance launched in 2021. Canada’s Oil Sands Innovation Alliance COSIA created in 2020 12, and the Oil Sands Community Alliance OSCA, created in 2013.

Combination of these industry groups integrated into a single organization with combined leadership will enhance the alliances collaborative efforts to advance responsible oil sands development and to progress the Alliance’s goals, including achieving net zero greenhouse gas emissions from oil sands production.

Key focus of the new Pathways Alliance will be to continue the considerable work already underway to reduce greenhouse gas emissions from oil sands production by 22 million tons annually by 2030, and ultimately achieve its goal of net zero emissions from oil sands production by 2050.

MEG’s capital allocation strategy is designed to provide increasing return of capital to shareholders as progressively lower net debt targets are reached. MEG reached its US$1.7 billion net debt target in the second quarter of 2022.

At net debt levels between US$1.7 billion and US$1.2 billion approximately 25% of free cash flow generated is being allocated to share buybacks with the remaining free cash flow applied to ongoing debt reduction.

In the current commodity price environment MEG expects to reach its US$1.2 billion net debt target in October of 2022. And to reach its US$600 million net debt floor in the second half of 2023.

During the second quarter of 2020, MEG repaid US$379 million through the redemption of the remaining US$171 million of MEG second quarter or second lien notes and through the repurchase and extinguishment of US$208 million of MEG’s outstanding senior secured notes due February 2027. MEG has repaid approximately 2.3 billion U.S. of outstanding indebtedness since 2018.

During the quarter, the corporation initiative initiated its share buyback program in the second quarter, MEG purchase for cancellation 4.45 million common shares returning 94 million to MEG shareholders. Year-to-date MEG his purchase for cancellation 7.24 million common shares returning 139 million to MEG’s shareholders.

During the second quarter, MEG amended and restated its revolving credit facility and its letter of credit facility agreement guaranteed by Export Development Canada and extended the maturity date of each facility by 2.3 years to October 31, 2026. Total credit available under the two facilities was reduced from 1.3 billion to 1.2 billion and is comprised of 600 million under the revolving credit facility and 600 under the EDC facility.

The revolving credit facility retains this modified covenant light structure meaning it continues to contain no financial maintenance covenant, unless MEG is drawn under the revolving credit facility in excess of 50%. If drawn in excess of 50%, or 300 million, MEG is required to maintain a first lien and net debt to EBITDA ratio of 3.5 or less. MEG continues to have no first lien debt outstanding.

As I bring my remarks to a close, I once again want to extend my thanks to our team for their commitment and perseverance. I’m proud of what we have been able to accomplish and confident in our future and our commitment to sustainable, innovative and responsible energy development.

On behalf of Meg’s Board of Directors and our management team, I want to thank you for your support. With that, I will turn the call to our operator to begin the Q&A.

[Operator]

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] First question comes from Neil Mehta at Goldman Sachs. Please go ahead.

[Neil Mehta, Goldman Sachs]

Good morning team and Eric congratulations on your retirement and thank you for the partnership over the years. The first question is on the macro, Derek, we have been a little surprised to see WCS widen out as much as it has in light of inventories in Alberta. And I guess part of it is Gulf Coast fuel oil, but part of it seems to be the SPR, would just love your perspective on the sustainability of that wider differential how you guys are thinking about the 2023 in 2024 outlook there and anything you are seeing real time in terms of being able to get the barrels out of the market? Thank you.

[Derek Evans, Chief Executive Officer]

Neil thanks for the question. It is very appropriate and topical one at this time. One of the things that has happened as a result of Russian Ukrainian sort of conflict is that Russia has head to find a home for its year old barrels and it head to find a home quickly.

What we have seen happen in the market is there [euros] (Ph) barrels, which are heavy sour barrel, have been marketed to both China and India. And what we have seen is they have been marketed at a fairly deep discount, a deep enough discount to stop some of those U.S. Gulf Coast barrels moving across the dock and moving to Asian markets in particular India.

So if we look at that dynamic that existed in late Q4, and early in Q1 of this year, you would have seen two million to four million barrels a day or a month of product heavy product moving across the dock to Asia, those volumes have dried up. As you know, Indian companies and Chinese companies source those barrels from the deeply discounted Russian market.

So that would be the number one factor that is driven an increase of sort of supply on the U.S. Gulf Coast of our product that is broadened as a differential. You are right, the SPR releases have had an impact, but that impact was about a million barrels a day, it is winding, as they get towards the end of the program, it is currently down at about 700,000 barrels a day. And in that September 16th to October 21st period it is going to drop down to about 550,000 barrels a day a product, and that product is now going to be predominantly light as opposed to heavy.

So our view is on both of these factors is that you know, a deeply discounted Russian barrel is what you would do if you were Russia and trying to find a home for your product quickly. But we don’t think that that is going to persevere or continue, the market will take or tighten up that arbitrage. And we do believe that Asian suppliers will be back buying product across the dock. And we are seeing early indications of that already in the coming month.

With respect to the SPR, that program is winding down, I think the Biden Administration pointed to how they were going to start refilling the SPR as early as 2023. So we fully expect that these differential levels will return to where they were prior to the conflict, the Russian, Ukrainian conflict.

[Neil Mehta, Goldman Sachs]

Alright. Well, that is kind of the follow-up is to the extent you think that some of this macro distortion is temporary. And you have seen while the stock has been an extraordinary over the last two years, it has pulled back meaningfully from over the last six weeks. How does that influence your thinking around leaning into the buyback and taking advantage of any dislocation?

[Derek Evans, Chief Executive Officer]

I think any dislocation provides a an opportunity for us to continue to buy back shares. You know, I don’t think we are going to lean in it lean into it disproportionately. We have a program that we have articulated to our shareholders that you know, at this juncture, 25% of cash flow goes to share buybacks, and it is very mechanical in terms of, we look at what we have available in any given month for free cash flow 25% of that goes into the market.

So, I would love to, obviously buyback more shares that day, as this as we have seen this pullback in the market, but we are not timing the market. We have a program that we have articulated, and we are going to continue with them.

[Neil Mehta, Goldman Sachs]

Okay. That is helpful. Thanks Derek.

[Derek Evans, Chief Executive Officer]

Thanks Neil.

[Operator]

Your next question comes from Menno Hulshof with TD Securities. Please go ahead.

[Menno Hulshof, TD Securities]

Yes, thanks and good morning everyone. I will start off with a question on vertical integration, we have seen a big move in Aiko and even the Condie premium is sitting at roughly $5 a barrel, which are both obvious inputs in your business. But then there is still this massive are between Aiko and pretty much every other global benchmark that many things will tighten in the coming years. So I guess my question is, how much time are you spending thinking about vertical integration these days and would you ever consider an acquisition to hedge out some of the price risk on those key inputs?

[Derek Evans, Chief Executive Officer]

The short answer is, we have thought about vertical integration in this life and in past lives and Menno I would tell you that, we are not in the natural gas business or the condensate business. Yes, they are big inputs. But they are not ones that we feel there is very efficient and effective markets out there. We are delighted with our brethren in the natural gas business.

As you look at Aiko production, today, it is reaching all time highs. As the natural for the Canadian Natural Gas business responds to the very strong price signals that we see. So we are not planning on vertically integrating the business. We are very good and very effective at controlling our cost structure inside of inside of the oil sands space.

All that being said, we do look for opportunities to take advantage of dislocations in the market on the condensate side and on the natural gas side. And I think if you in reviewing our core you’ll see that we have locked in 7000 barrels a day of condensate prices for 2023 at a very significant discount to the market.

And if you are looking for us to take action in terms of how we are going to manage those input costs. It will be through strategic hedging of those and opportunities that dislocations in the historic pricing patterns that we can take advantage of.

[Menno Hulshof, TD Securities]

Got it, thanks for that Derek. And then I guess the second question would be related to the federal discussion paper on oil and gas emissions reductions that was recently published. And maybe this is specific to me. But it came a bit out of left field from my perspective and reopens the debate on cap and trade, among other things, and certainly surprising given how aggressive the pathways targets already are. So how much of a risk is this from your perspective and how long could this hang up? Therefore what is your understanding of the next steps?

[Derek Evans, Chief Executive Officer]

Menno, you are not the only person that was surprised last Monday, I think everybody in Calgary is going where did this come from? We knew there was obviously the emissions cap paper is we expected something we just did not expect such a strident sort of focus on the 42% reserve targets, our emissions reduction target in that paper.

I guess I would started off by saying, we share the government’s goal of tackling the challenge of climate change. I mean, the pathways group is been up front, we have been at this now for over 18-months, we have set our own ambitious targets for oil sands sector to achieve a 22 megaton annual reduction by 2030. And that is a very ambitious goal on its own. And obviously that the net zero goal by 2050.

So, we have a plan, and we think it is one of the few plans out there, it is ambitious at 30%. I don’t know how we get to 42%. I think that personally is in my humble opinion, is almost unrealistic. And it is not that we wouldn’t want to try and get to 42%, if we could, but you can’t ignore the reality of the regulatory environment in this country.

You can’t ignore the reality of the - what I’m going to say is that the carbon pricing regime and the ability to trade carbon credits from a Pan Canadian perspective. And you can’t ignore the reality of the fact that the federal government and the provincial government aren’t talking.

Without those three issues being addressed, you can set whatever ambitious plan you want, but you are never going to be able to achieve them. And this is where to me Pathways has differentiated in distinguished itself, it has a target out there, it has got the 30%.

Yet those three items that I mentioned, stand in our way of us even getting to the 30%, let alone the 42%. So do I think these things are managed or that we can fix these things and move forward? Yes. Do I think we can get to 40%, 42%? Yes, we will get to 42% over time.

But unless there is a concerted effort to address all three of those issues in the very near-term, and to bring a sense of urgency to fixing our regulatory environment, better communication between all levels of government and creating a price of carbon that we can take to the bank and finance some of these projects on. If that does not happen, then these targets are unrealistic.

[Menno Hulshof, TD Securities]

I agree with all of that. Thanks Derek.

[Derek Evans, Chief Executive Officer]

Thanks Menno.

[Operator]

Your next question comes from Greg Pardy with RBC. Please go ahead.

[Gregory Pardy, RBC Capita]

Thanks, hey good morning. Derek, I hope the press on the line gets that in The Globe and Mail or other papers tomorrow morning to send the message. But look, just all the very best Eric and welcome Ryan. Just want to maybe just take it back to the company or maybe just hit three things. How are you thinking about hedging TI, does a dividend become a part of the conversation at that floor level of 600 million? And then how should we be sort of thinking about 2023 topics?

[Derek Evans, Chief Executive Officer]

Okay. Are we thinking about hedging WTI? No, our philosophy on hedging has not change and just to repeat it. We hedge to protect our capital program. And we look at what commodity price WTI commodity price would have to be for the year.

This year, it turned out that we would need at an average price of $45 WTI to have sufficient funds flow to cover our capital program, we thought that that was highly unlikely and decided the probability of that was very, very low, and we weren’t going to hedge. That will be the same way we look at hedging WTI and if we were going to hedge WTI on a go forward basis.

So not planning on doing that, but as you would have heard in previous color, where we were talking about condensate and a little bit about natural gas, we will hedge our inputs. If we are provided with sort of a dislocation or an opportunity in the market.

Obviously, condensate, as we talked, as you know, is our single biggest cost. So being able to lock down 10% to 15% of your condensate at a significant discount to historical market prices is important.

And on the natural gas side, that is another big operating costs for us, even though we can mitigate that with our power sales, we will look and continue to look and have targets in place to take advantage of the market, should it present the opportunity to do so.

With respect to your second question on the dividend, when we reach our net debt floor of US$600 million would we look to put a dividend in place. That is absolutely one of the tools that we are going to look at. And we will provide greater clarity on that, obviously, as we move forward and get closer to is to that target. So we should expect to hear more on us on that going forward.

Just to elaborate on that a little bit, what we have seen others do is put dividends in place and special dividends in place. We have a unique opportunity to be able to watch and see how those are reflected in the price of the underlying equity of those organizations.

So we will - you know, we are not sitting on our hands over here we are watching, we are looking at how the market is responding to dividends and special dividends. And those will help inform how we put in place of return of capital type structure on the dividends when we hit that US$600 million.

On the third part of your question, which I believe was, how do we see CapEx 2023. We are watching inflation very carefully Greg, oilfield tubular is drilling service drilling and service completion cost service route costs are up and up significantly, labor, steel are all continuing to move. And I wouldn’t say they have plateaued. So as we think about what our CapEx program for 2023 will be, it is going to be larger than it is today, just on inflationary basis.

But there will also be another element. As we move from our existing development area. In our core, we are going to move further south down to miser and that will require sort of an incremental level of sustaining capital that than what we had in our budget this year, as we build the emulsion lines, the steam lines, all the product lines in the infrastructure to move a significant difference out into.

Part of the reason why that is likely going to have a much lower steam oil ratio by virtue of the fact that we don’t see any underlying water there. So kind of excited about getting down there and continuing to not only expand the infrastructure, but move into, you know, another new area.

[Gregory Pardy, RBC Capita]

Superb. Thanks very much Derek.

[Derek Evans, Chief Executive Officer]

Thanks Greg.

[Operator]

[Operator Instructions] There are no further questions at this time. Please proceed.

[Derek Evans, Chief Executive Officer]

Thank you, Pam. And thank you, everybody that is joined us this morning for our second quarter call. We are excited about what we have been able to achieve in the first half of 2022 and look forward to report on our operational performance and our return on capital program when we released Q3 on November 10th. Have a great day.

[Operator]

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and asked that you please disconnect your lines. Have a great day.