MEG Energy Takes a Shortcut to the Gulf Coast

 MEG Energy (MEG) reported its worst bitumen price realizations on record in the first quarter owing to wide Canadian heavy differentials. However, we expect realizations to move higher in the future thanks to additional takeaway options that should result in MEG bypassing congested Mid-Continent transportation routes. Ultimately, we expect average realizations (net of transportation cost) of CAD 59/bbl in 2017 versus CAD 53/bbl in our previous forecast and CAD 47/bbl in 2012. After a careful review of MEG’s transportation plans, including a discussion with management, we are maintaining our fair value estimate of CAD 48 per share, which reflects a long-term outlook with improved price realizations.

Supporting its improved realizations will be the Stonefell terminal. Construction is well under way, and we expect it to be on line by September 2013. This facility will provide access to all the major export pipelines out of Alberta, in addition to the Canexus rail terminal. As a result, MEG will be well positioned to export an increasing amount of blended bitumen to the U.S. Gulf Coast by late 2013, using a combination of rail, pipe, and barge. These exports will increase over time, eventually resulting in stronger price realizations, higher netbacks, and material improvements to its return on invested capital, or ROIC. Consequently, MEG can achieve realizations on par with its integrated peers without the need for refining capacity. The improving realizations, thanks in part to ownership of midstream assets, reinforce our view that MEG has a narrow economic moat and stable moat trend.

Gulf Coast Access
We believe MEG Energy is the best-positioned independent producer to take advantage of rail and barge traffic to achieve higher price realizations. Once completed, the Stonefell terminal will provide direct access to the Canexus rail terminal. Both of these assets will provide service for blended bitumen exports and condensate imports.

In addition, MEG has already secured two barges for long-term transportation to the United States Gulf Coast via Chicago. Its first barge is already operating, with the second scheduled for delivery in the second half of 2013. For blended bitumen to move by barge to the Gulf Coast, it is transported by pipeline or rail to the Chicago area, before being loaded onto barges for shipment through the inland waterways. By late 2014 we look for Enbridge’s Flanagan pipeline to come on line, and while this should provide MEG access to the Gulf Coast, we believe rail and barge will remain viable until 2016-17. We also look for its peers to benefit at this time. We expect a significant number of producers to have secured access to the Flanagan system, if they have not already done so. For producers without access to Flanagan, we look for higher price realizations in Alberta as incremental heavy volumes move to other markets, supporting more normalized prices for Canadian heavy crude, albeit at a discount to the Gulf Coast.

Gulf Coast Access Supports Higher Price Realizations
Following MEG’s first-quarter results, we took a deeper dive into the impact of the firm’s transportation plans on its price realizations, transportation costs, and netbacks. To this end, we held a conversation with MEG management to discuss their plans to move blended bitumen to market. The plan is as follows:

• Ten percent of the firm’s production is expected to be moved to the Gulf Coast in third-quarter 2013, using a combination of rail from Alberta and barge from Chicago.
• Once its second barge is fully operational, 40% of production should be evenly split between rail and barge in fourth-quarter 2013.
• Enbridge’s Flanagan pipeline is scheduled to come on line in late 2014. This should increase MEG’s access to the Gulf Coast market for 60%-80% of total production.
• By 2015 a significant portion of its production (60%-80% or more) will move to the Gulf Coast, primarily by pipeline, with some barge and rail.

We are taking a more conservative approach than management has indicated is possible by assuming 4% barge/rail in third-quarter 2013, increasing to 20% in fourth-quarter 2013. By the third quarter of 2014 we look for an increase to 40% barge/rail before the firm achieves 60% barge/pipe/rail exports to the Gulf Coast. We expect this level to remain relatively constant until third-quarter 2015, when MEG starts to reduce use of rail and barge transportation. By late 2016 we believe rail will remain a backup export option, providing MEG with long-term market optionality, while barge may remain in service until at least 2017.

Based on our analysis, MEG will place on average 66% of its annual production in the Gulf Coast by 2017. Price realizations in the Gulf Coast are tied to Maya less an assumed CAD 5/bbl discount. Our long-term Maya price assumption is CAD 87/bbl. The remaining 34% will be sold at Hardisty, Alberta, and thus will realize WTI pricing, less WCS and AWB differentials of CAD 21/bbl (midcycle) by our estimates (this includes a CAD 2/bbl AWB to WCS midcycle differential). This is a reduction from 2013, when 96% of production will be sold at Hardisty. Our long-term WTI price assumption is $90/bbl.

The following figures take into account blending costs, differentials, and transportation costs to market. The transportation costs from Hardisty to the Gulf Coast are estimated to be

• CAD 11.0/bbl by pipeline,
• CAD 17.5/bbl by rail, and
• CAD 13.0/bbl by barge.

We believe that through increased market access, MEG will be able to achieve the higher price realizations indicated in the figure below for each transportation method. At a consolidated level, we look for its price realizations to increase by 53% from CAD 55/bbl in first-quarter 2013 to CAD 78/bbl by 2017. Holding operating costs constant, and accounting for diluent, transportation, and royalty costs, we estimate that netbacks will increase from CAD 18/bbl in first-quarter 2013 to CAD 46/bbl by 2017.

Price Realizations (Net of Transportation and Blending Costs)

Source: Morningstar Inc.

Higher Price Realizations Translate Into Higher Annual ROIC
This shift in market access toward the Gulf Coast should have a material impact on MEG’s netbacks, and by extension ROIC as indicated in the figure below. As a result, we are maintaining MEG’s CAD 48 per share fair value estimate, its narrow economic moat, and stable moat trend.

We expect ROIC to increase from the low-single digits in 2013 to over 12% by 2016. This is a direct result of the greater access to the Gulf Coast. While these higher ROICs could indicate a positive moat trend--as the firm’s competitive position relative to its peers improves--in addition to a widening ROIC to WACC spread, we believe the ROICs could start to fall after 2017 for two key reasons. First, higher netbacks at Christina Lake could trigger payout royalties that are higher than current pre-payout royalties in Alberta. Second, increased spending at Surmont for the early phases of a second-stage expansion could drive down ROICs during construction.

ROIC Impact on Status Quo vs. Gulf Coast Access and Maya Pricing

Source: Morningstar Inc.

While we believe the overall strategy is achievable, we have nevertheless taken a more conservative approach than management has discussed. There are many factors that could impede MEG’s ability to successfully execute on its marketing plan, including reduced flow in U.S. inland waterways that would impact barge traffic, refinery access, and delays to the Flanagan pipeline or other pipeline outages. Ultimately we believe our analysis provides a reasonable path for MEG’s future netbacks and increasing ROIC.