Baytex Energy Offers Big Upside And A Growing Dividend But Beware Of The Risks

Note to readers: Figures in this article are in Canadian dollars except for WTI.

Baytex Energy Corp. (NYSE:BTE) isn't an obvious "energy income" investment. It currently pays a $0.09 per share dividend on its stock, which generates a 1.6% yield. That's not even in the ballpark of midstream dividends, which average more than 7%. But BTE's cash flow generation at current oil prices should allow it to pay multiples of its current dividend.

At the moment, BTE shares don't reflect this possibility, so investors seeking income generated from higher oil prices could consider buying them now in anticipation of a higher dividend.

Investment Thesis

In recent weeks, BTE transitioned to paying out 50% of its free cash flow for debt repayment and 50% in a mix of dividends and share repurchases. We estimate that at current oil prices, BTE generates a 30% free cash flow yield, which creates the potential for a 15% dividend/share repurchase payout.

At oil prices above US$80 per barrel WTI (CL1:COM), we expect BTE to pay out $0.25 per share annually as a dividend, which would generate a 4.5% yield on the current share price. As the remaining free cash flow is used to repurchase shares, the number of shares outstanding will decline over time and free cash flow per share will increase. Consequently, BTE's capacity to pay dividends on a per-share basis can grow as long as WTI remains above US$80 per barrel and BTE shares remain undervalued by the market.

From a capital appreciation standpoint, BTE shares offer multi-bagger potential due to the huge amount of free cash flow generated at higher oil prices. Our price target for the shares is $9.50, representing a 73% upside from the current price.

The challenge in analyzing the investment merits of BTE equity lies in the company's Eagle Ford assets. The long-term economics of depleting shale assets is receiving more attention, and investors have to be comfortable with the prospects for BTE's shale acreage to continue generating free cash flow. Particular attention must be paid to the longevity of the assets reserves and the sustainability of their current production mix. We address both issues in this article.

Introduction

BTE is a Canadian-domiciled oil-and-gas E&P that derives half its revenues from several oil-rich basins in Alberta and Saskatchewan and half from the Eagle Ford shale in South Texas. Its assets are shown in the map below.

BTE shares have been well known among Canadian oil investors for the company's tremendous cash flow torque to higher oil prices. As oil prices increase, its cash flows grow more rapidly than most of its peers. Of course, the flip side is that as oil prices decline, BTE's cash flow falls more rapidly.

BTE's Ranger Oil Acquisition

On February 28, BTE announced it would acquire Ranger Oil for C$3.4 billion (US$2.5 billion). In the deal, BTE paid Ranger shareholders 7.49 BTE shares plus US$13.31 in cash for each Ranger share, which represented a premium of 7.4% to Ranger's closing stock price the previous day. BTE also assumed Ranger's debt.

To finance the deal, BTE paid $732.8 million in cash and issued 311.4 million new BTE shares valued at $1.3 billion, or $4.26 per share. The newly issued shares increased BTE's share count by 54%. It funded the cash portion through borrowings on its credit facility, a two-year term loan and the issuance of $800 million senior secured notes due 2030. The deal closed on June 20, 2023.

The deal was transformative to BTE. After it closed, the company's Eagle Ford acreage was comprised of two largely contiguous blocks, allowing for optimal development and lower costs per barrel. The map below shows that its acreage is located primarily in the oily part of the Eagle Ford play, depicted in green.

The deal has clear benefits for BTE shareholders. It modestly extends the company's proved-plus-probable reserve life for oil, natural gas, and NLGs by approximately one year to 12 years. It also boosts the oil weighting of BTE's Eagle Ford production.

The before and after (pro forma) metrics for BTE's Eagle Ford acreage are shown below.

Importantly, the acquisition increases the percentage of Eagle Ford production that BTE operates. With greater control over its Eagle Ford operations, management can drill at its own pace and work to improve drilling techniques. We've heard an unsubstantiated-though we believe credible-claim that BTE's management believes it can improve the productivity of the legacy Ranger acreage through its operatorship of the property. CEO Eric Greager was previously the CEO of Civitas Resources (CIVI), a Colorado-based shale E&P. No doubt his experience can prove valuable in optimizing BTE's Eagle Ford drilling. Improved productivity holds the potential for improving shareholder returns and turning the Ranger deal into a bargain purchase.

The deal improves BTE's realized crude oil pricing by enhancing its access to the U.S. Gulf Coast while it increases BTE's light oil production in its total production mix. Light oil near the Gulf Coast fetches a US$2 per barrel premium over WTI.

As part of the deal, management pledged to increase the amount of capital BTE will return to shareholders. The company had not paid a dividend since 2015 in order to focus on debt reduction. After the deal, BTE shifted to allocate free cash flow on a 50%/50% mix between debt reduction and dividends/share repurchases. It instituted an annual dividend of $0.09 per share, which equates to a 1.6% yield at BTE's current market price.

Management instituted a new debt target of $1.5 billion. Once it reduces debt to that level, it will transition to paying out 75% of free cash flow in the form of dividends and/or share repurchases. Management has guided to production growth of 3% to 5% over the next few years.

Are Risks Lurking in the Ranger Assets?

Despite these positives, investors panned the deal since it was announced. After a short-lived rally, BTE's stock declined by more than 25% over the ensuing months. Only recently has it recovered to its pre-deal price in the mid-$5 range. Over the same timeframe, the major Canadian E&P index, the iShares S&P/TSX Energy Index ETF (XEG:CA) is up 12.1%.

BTE's price action since the deal begs the question of whether the market perceives problems with the Ranger assets. The main contenders would be issues relating to Ranger's reserve life and the sustainability of its production mix between crude oil and condensate, natural gas liquids, and dry natural gas.

Shareholders could have extrapolated production trends ongoing in the greater Eagle Ford to BTE's future production. For instance, Eagle Ford production peaked in 2015 and has since declined by 60%.

Source: EIA.

BTE should have no problem maintaining its production over at least the next five years. Its oil reserves are substantial, while future extensions to its proved reserves should allow it to replace a significant percentage of produced reserves.

Perhaps more concerning for Eagle Ford oil producers is the increasing percentage of natural gas relative to oil in the basin's production. The gas-to-oil ratio has climbed since oil production peaked in 2015, as shown in the chart below.

Since natural gas is a lower-value product than crude oil, an increasing percentage of gas in a production mix can hurt an E&P's financial results. If investors began to suspect that an E&P's production was about to get gassier, they would send its shares sharply lower. The same would happen with BTE.

To investigate the prospects for BTE's acreage becoming gassier, we looked into the asset quality of Ranger Oil's predecessor companies, Penn Virginia and Lonestar Resources.

The legacy Penn Virginia assets are superior to BTE's legacy acreage due to their relatively high oil cut of more than 70% and their low operating costs. Fortunately, these assets represented roughly 60% of Ranger Oil's reserves. Penn Virginia's production and reserves both demonstrated stable oil weighting over many years, and its current reserves imply it can continue to do so.

We're more concerned about the legacy Lonestar Resources acreage. These assets are inferior to BTE's legacy Eagle Ford assets.

Lonestar initially targeted natural gas and NGLs for development. For years prior to its acquisition by Penn Virginia, it had grown its natural gas production rapidly to prove up its acreage. Year after year, most of its discoveries and extensions were of natural gas. Then in 2016, Lonestar purchased oil-weighted assets from a defunct Sanchez Energy. The deal increased the oil weighting of Lonestar's reserves and production. But the increase only proved temporary. Despite the Sanchez asset acquisition, in the following years, Lonestar's production and reserves became progressively gassier.

These are the assets at greatest risk of exhibiting increasing gas content. Fortunately, they only represent 20% of BTE's Eagle Ford reserves. We therefore don't see them as an obstacle for BTE to maintain its oil weighting over the next five years.

On balance, we believe the Ranger acquisition improves BTE's prospects for maintaining its Eagle Ford production, as well as the oil weighting of its production mix. We consider it to be a net positive for long-term shareholder value.

Other Reasons for BTE's Post-Acquisition Selloff

We don't believe the decline in BTE's stock is attributable to real or perceived problems with Ranger's assets or production prospects. Rather, it was likely due to BTE's decision to take on debt to finance the acquisition. The new debt increased the risk to shareholders amid an oil-price downturn. In addition, investors were probably disappointed by the company's new capital allocation plan, which calls for allocating 50% of free cash flow to dividends and share repurchases. In doing so, it will reduce the pace of debt reduction just after the company tripled its net debt balance.

Another negative that may have caused the stock's swoon was the large number of shares that BTE issued at a severe discount to its intrinsic value in order to fund the acquisition of assets of arguably lesser quality. The deal also limited BTE's ability to benefit from today's high oil prices due to its requirement to hedge 40% of its oil exposure for 12 months to secure financing on acceptable terms.

Lastly, the market may have drawn ominous parallels to BTE's disastrous acquisition of Aurora Oil and Gas in 2014 at the top of the previous cycle. That deal saddled BTE with onerous debt obligations that put its equity at risk for the next six years.

Valuation

We value BTE shares in the range of $8.50 to $10.50. Our price target is the midpoint of the range, or $9.50, which implies a 72.7% upside from the stock's current price of $5.50.

We value BTE from two perspectives: the free cash flow yield on its equity at a given oil price and the discounted cash flow net to shareholders over the company's life. All our valuations assume that the AECO natural gas price is $2.50 per mcf and that the WTI-WCS differential is $16.50.

Turning first to the free cash flow yield, the results for BTE are nothing short of spectacular. The shares possess tremendous free cash flow torque to higher oil prices. The table below shows the amount of free cash flow the company generates at different oil prices.

Using a generous 12% free cash flow yield for valuation purposes, at US$85 per barrel WTI, our estimates imply that BTE shares offer 112% upside.

With regard to BTE's free cash flow downside, we estimate that free cash flow goes to zero at US$58.33 per barrel WTI.

BTE's free cash flow yield is relevant for income investors because the company is currently allocating 50% of its free cash flow to a combination of dividends and share repurchases. If it allocated half of the 50% of free cash flow to share repurchases and paid out the other half to a common dividend-a portion of which will be fixed and the remainder variable-the company would pay an annual dividend of $0.35 per share with WTI was sustained at US$85 per barrel. The stock would yield an attractive 6.3% in such a scenario. The significant amount of share repurchases underway in such a scenario would rapidly shrink the number of shares outstanding, increasing free cash flow per share for the remaining shareholders and leading to larger dividend payouts per share in the future.

We estimate that with oil at $80 and the company allocating 50% of free cash flow toward debt reduction, it will reach its $1.5 billion net debt target in two years and one quarter. That timing shrinks to one year and three quarters at $85 per barrel and to one year and a half at $90 per barrel. Once BTE has achieved its debt target, it will pay out 75% of its free cash flow to shareholders.

Turning to discounted cash flow valuations, our conservative scenario assumes that oil remains at $80 per barrel and that BTE increases production by 3% through 2028 and then keeps production flat thereafter. It also slashes BTE's terminal value by two-thirds to account for the possibility that the company's production declines or becomes gassier after year 10. All our scenarios employ a 12% discount rate and a WTI-WCS differential of $16.50.

This valuation implies the shares are worth $8.68, representing 58% upside from their current price of $5.50.

To further address the risk of BTE's production becoming gassier, our next scenario illustrates what BTE's free cash flow would look like with WTI at US$80 per barrel, but with BTE producing 75% liquids-35% of which is heavy, 45% of which is light, and 20% of which is NGLs-and 25% natural gas. These assumptions are in contrast to our estimate that BTE will produce 84.4% liquids-of which we assume 59.5% is light crude, 26.0% is heavy crude, and 14.5% is NGLs-and 15.6% natural gas. This severe scenario implies that the shares are appropriately valued.

Incidentally, BTE's current free cash flow yield using these assumptions stands at 14.3%.

Of course, this scenario won't actually occur, but it illustrates what would have to happen to the company's production mix to justify its current stock price.

The next discounted cash flow implies that BTE shares currently discount US$73.32 per barrel WTI, a far cry from today's price of more than $90 per barrel.

Our bullish scenario values BTE shares with WTI sustained at US$85 per barrel. This scenario reduces the terminal value by half. It values BTE at $9.78, implying 78% upside.

For more extreme scenarios we don't consider in our value range or price target for BTE shares, at US$90 per barrel WTI, our discounted cash flow valuation implies the shares are worth $11.62, representing 111% upside from their current price of $5.50. At US$100 per barrel WTI, we value the shares at $15.28, implying 178% upside. Both valuations use a 12% discount rate and cut BTE's terminal value in half.

Clearly, all the reasonable valuations imply significant upside for BTE shares. The valuations based on free cash flow multiples indicate multi-bagger potential. And our discounted cash flow scenarios that incorporate a 12% discount rate and reduce the terminal value illustrate the substantial upside.

Conclusion

Baytex Energy Corp. has emerged from its Ranger acquisition with its operations split 50%/50% between the Eagle Ford shale and various oil-weighted plays in Canada, which include some of the most economic locations in the Western Canadian Sedimentary Basin. The company's operational risks stem primarily from its Eagle Ford acreage, so we dedicated most of our analysis to the region. Over at least the next three years, we expect BTE's Eagle Ford results to exhibit flat production and a stable commodity mix. Meanwhile, its Canadian production growth will drive companywide production growth of 3%-to-5% per year, in line with management's guidance.

Our BTE valuation and price target point to 72.7% upside from the current price. In fact, the shares possess upside potential at WTI prices greater than US$73 per barrel.

We're less confident about BTE's production more than three years out. For this reason, we currently wouldn't recommend investing in the shares for more than a three-year holding period.

Investors must be careful to balance BTE's potential returns with its risks. For one, investors should be wary of the downside of BTE's torque to oil prices. Operating leverage works both ways; cash flow grows rapidly as oil prices march higher, but it also shrinks rapidly as prices fall. BTE's debt load and reduced free cash flow at lower oil prices will significantly increase its risk to shareholders if prices fall below US$65 per barrel WTI. Due to this risk, investors who prioritize the safety of the principal and seek to avoid permanent capital losses at sustained low oil prices should avoid the name in favor of more conservative E&P holdings. Even investors who wish to own BTE for the next few years should only make the shares a small part of their investment portfolio due to the risk of loss if WTI falls below US$65 per barrel for more than a year.

Investors who can bear these risks in mind should consider BTE shares for their explosive upside amid current oil prices and for their potential over the coming quarters for paying a large and growing dividend.

Outperform!

At HFIR Energy Income, we strive to outperform with every pick recommendation. Since inception in 2021, the HFIR Energy Income Portfolio has returned 84.2%, versus its benchmark's return of 44.8%.

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