Uncovering an E&P Gem

Have investors missed the rally in  Tourmaline Oil (TOU)? We think not, even though shares are at a 52-week high, up more than 18% year to date. While the stock is by no means cheap--currently trading at more than 12 times 2013 earnings before interest, taxes, depreciation, depletion, amortization, and exploration expenses--we still believe it could be a stellar performer over the next 18-24 months. In our view, Tourmaline is a classic "build to sell" exploration and production firm, thanks to management's history of building attractive acquisition targets. Even in the absence of a takeout offer, however, Tourmaline remains one of the best natural gas names for investors to hold, thanks to its low-cost structure, best-in-class production growth trajectory, and rock-solid balance sheet. We estimate Tourmaline's fair value at CAD 50 per share, implying nearly 40% upside from the current stock price.

A Brief Overview of Tourmaline
Tourmaline Oil is a rising star in the Canadian oil patch, with a history of stellar production growth and a low-cost operating structure. The company operates primarily in the Deep Basin region of Alberta, just east of the Rocky Mountains.

Thanks to readily available capital and the fortunate timing of low natural gas prices, Tourmaline has assembled a low-cost and attractive acreage portfolio, in our view. The majority of its acreage is a highly contiguous position in the western portion of the Deep Basin, the thickest area of this play, and provides for the greatest number of target formations. We believe this gives Tourmaline tremendous opportunity to expand production and reserves through the drill bit.

The target rock formations are mainly shallower tight gas rather than shale gas. Consequently, Deep Basin wells are generally less expensive than those in other unconventional plays, since it takes less time to reach total depth. The shallower wells are also less pressurized, which results in lower production levels and cash flow. However, Deep Basin wells still exhibit favorable economics. We estimate that Tourmaline's current Deep Basin horizontals deliver returns over 50% at current gas prices and have a payback period of less than two years.

Tourmaline has reinforced its low-cost acreage position in the Deep Basin with investment in gathering and processing infrastructure, including six processing facilities. Operating its own processing has allowed the firm to control operating costs and will prevent bottlenecks as additional wells are drilled, providing ample runway for production growth. Additionally, all the facilities have the ability to recover liquids from the Deep Basin's high-heat-content gas, which improves selling prices by about 10% over AECO (the Alberta gas trading price) and allows the firm to generate additional cash flow.

Tourmaline also has development prospects in the Montney region at Dawson and the Spirit River oil region. The firm is operating on a much smaller scale there, with one rig in each play, but the potential in each is encouraging. Tourmaline is on track to be the fifth-largest producer in the Montney by the end of 2013, with production of more than 20,000 barrels of oil equivalent per day, as additional processing facilities come on line. Spirit River wells possess the best economics in the firm's portfolio, and we think Tourmaline would jump at the chance to bolt on to its existing acreage and add to well inventory.

Could Tourmaline Be an Acquisition Target?
We think that Tourmaline fits the mold of a classic "build to sell" E&P firm, and given its production and earnings growth potential, it could attract suitors seeking to establish or accentuate a North American natural gas portfolio.

Tourmaline is a long-term growth story, and its opportunity to deploy capital at favorable returns far outstrips its current operations. We estimate that Tourmaline's well inventory in the Deep Basin could last upward of a quarter century, even if the company adds drilling rigs as natural gas prices rise. With the exception of investors with very long-term horizons, this attribute is a nonfactor. We think it's a different case for acquirers, which are willing to look longer term, as we have seen with BHP Billiton's acquisition of PetroHawk, Exxon Mobil's acquisitions of XTO Energy and more recently Celtic Energy, and CNOOC Ltd.'s bid for Nexen Energy (while not a build-to-sell, still a long-term investment).

Tourmaline's size is a positive factor as well--the firm is small enough to avoid funding headaches for a buyer. Most transactions we have seen in the build-to-sell category have had enterprise values of CAD 15 billion or less. At current prices, Tourmaline has an enterprise value of just over CAD 6 billion, while our CAD 50 fair value estimate would place the firm at roughly CAD 9 billion.

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Management's massive ownership interest in the firm provides us another indication of its possible desire for an eventual sale. Currently, insiders own 25% of common stock, most of which has come from direct and repeated investment in the firm, not merely stock option awards. Our communications with Tourmaline's management indicate the firm is not being shopped at this time. We believe, however, that there is only one reason that management would tie up so much wealth in such a concentrated investment, and we do not think it is in anticipation that the executives can one day pay themselves a stream of dividends. A sale of the firm would directly benefit them in the place that matters most: their wallets.

CEO Michael Rose and his team have an established record of building attractive companies that generate interest from larger firms seeking to acquire. Of the firms this team has built, we think Tourmaline is the most attractive as an acquisition target, as it has increased production and earnings far faster than its predecessors. We think that in an acquisition scenario, Tourmaline would be worth at least our fair value estimate of CAD 50 per share and possibly upward of CAD 57 per share, based on several recent transactions of comparable E&Ps in the western Canadian sedimentary basin.

Is Tourmaline Worth Owning, Even if an Acquisition Doesn't Materialize?
Even if we are wrong about Tourmaline's prospects for an outright sale, we still think there is much to be gained from owning the shares. We believe Tourmaline offers the best combination of low-cost advantage, near-term production growth, and balance sheet strength relative to other natural gas-focused E&Ps in North America.

Much of our focus in evaluating E&Ps pertains to low-cost advantage as one of the pillars of our economic moat methodology. We think it is vitally important to look at full-cycle costs--those costs related to acquiring land and drilling wells in addition to the cash costs of lifting, transporting, selling, general, and administrative expense, and debt service. Tourmaline does not lead the pack in full-cycle costs, but it is substantially lower than other much larger producers.

In addition to being at the lower end of the cost curve, we expect Tourmaline will deliver the highest production growth in our sample set, based on our forecasts for 2012-14 for each firm.

Of course liquids productions can help offset higher costs. This strategy has been pursued by much of the oil patch as natural gas prices have pressured returns on dry gas production. To account for the economic uplift of liquids production, we've reviewed the same firms' break-even gas price, assuming West Texas Intermediate at $90 per barrel.

Source: Morningstar estimates.

Absent capital and drilling inventory constraints, we expect that firms with lower break-evens will increase production faster than firms with higher break-evens. Sometimes this message gets overlooked as management teams pitch a hot new play, or when the market gets hopeful for higher prices in the future. Ultimately, however, we find that in a low-price environment, companies with lower costs and superior break-evens--like Tourmaline--thrive, as they are able to increase production levels and cash flow faster than higher-cost, higher-break-even peers.

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Though we have been speaking in general terms, we think the implication for Tourmaline is that it will outperform other gas-weighted producers. We also think that having a low break-even means a firm contains lower downside risk and can be considered a flight-to-safety name. Consequently, having a low break-even means to us that Tourmaline is worth owning (or accumulating) even if natural gas prices fall, or are expected to fall.

Also, the combination of balance sheet weakness and low commodity prices can inhibit production growth. Tourmaline again shines in comparison, with ample breathing room on its balance sheet to take on additional debt and maintain its pace of development, should prices remain low.

What Could Make Tourmaline Less Attractive to a Buyer?
A potential acquirer could still pass on Tourmaline for a few reasons, among them erosion of capital efficiency or higher rents through either a change to the provincial royalty structure or a change in lease tenure treatment.

A change in the capital required for Tourmaline to add incremental production could represent a threat if rig and service companies increase rates or labor costs escalate without a similar rise in natural gas prices. The biggest driver of higher costs without higher commodity prices, in our opinion, would be increased activity in nearby plays such as the Duvernay shale, which could decrease rig availability. New oil sands projects also threaten to inflate labor costs, as Canada's labor supply is far more constrained than that of the United States, and oil sands development requires large numbers of man hours for engineering and construction.

Royalty payments to the crown are calculated on a sliding scale with the level of oil and gas prices, which has benefited producers but caught Alberta in a budgetary vise. The provincial government is facing multi-billion-dollar deficits and is facing pressure to fill the gap quickly. One solution would be to increase royalty rates in order to generate additional revenue. While Alberta is clearly dependent on the oil and gas industry (nonrenewable resource revenue was the government's largest source, at 27.8% of total revenue in 2012), it is not so beholden as to rule out increasing royalties, in our opinion. Natural gas revenue will be one seventh of total oil and gas royalties, based on the Ministry of Energy's 2012-13 estimates, and we think could be targeted for higher rates to bring revenue more into parity.

Also, mineral rights in Canada are leased from the crown and either held by production or can be extended with a nominal annual payment. Canada could to change the treatment of leases to closer resemble those in the United States, where acreage generally must, after a specified period, be held by production, leased again, or forfeited. In such an event, Tourmaline could be forced to drill at uneconomic rates or be forced to abandon undeveloped acreage.