ARC resources: CAD 2 billion probable free cash flow in 2022
The past year has been excellent for oil and gas producers. High and rising prices allowed most companies to quickly clean up their balance sheets and stimulated mergers and acquisitions activity. ARC Resources (OTCPK: AETUF) has acquired Seven Generations Energy (OTC: SVRGF) to combine operations with one producer with average daily production of approximately 350,000 boe/day. Two-thirds of oil-equivalent production is natural gas and natural gas prices are trading at very high levels
ARC Resources is a Canadian company and I would recommend trading the shares of the company using the primary listing on the TSX. ARC trades with ARX as its ticker symbol and the average daily volume in Canada exceeds 3 million shares per day.
A quick look back at Q3 results explains what we can expect for 2022
Arc Resources has already published its investment forecast for 2022, which already allows us to project the anticipated free cash flow. A first step is obviously to calculate the expected operating cash flow, as this will ultimately determine the amount of free cash flow that ARC Resources will be able to generate.
As the company has yet to release its annual results, I’d like to use the third quarter results to get a rough idea of what ARC can achieve in 2022. In the third quarter, the company produced just over 335 000 boe/day, and 60% of oil equivalent production was natural gas. Crude oil accounted for less than 4% of the oil equivalent production rate and condensates and NGLs are much more important than crude oil. So, although ARC Resources publishes its production results in barrels of oil equivalent, it should be clear that the company is and should be assessed as a producer of natural gas.
The company reported an average realized natural gas price of $3.34/MMcf as it received C$74 per barrel of oil, C$78 per barrel of condensate and just over C$22 per barrel of NGLs . Applying normal conversion rates, this resulted in an average realized commodity price of C$34.90 per barrel of oil equivalent.
The company reported a net profit of C$54 million despite a loss of almost C$525 million on its hedge pool, and that’s why it’s more important to look at cash flow from operations. ARC Resources.
The image below shows that the reported operating cash flow was C$615 million, but we need to add the C$53 million investment in working capital as well as the C$97 million change. Canadian dollars of other liabilities, as they are non-recurring items. We would have to deduct the C$20 million rental expense from that result, and after that you end up with an adjusted operating cash flow of C$745 million. Note that the company reported an adjusted cash flow of C$765 million, but I think it’s fair to also deduct the cash outflow related to the lease.
Total capex in the third quarter was approximately C$266 million, resulting in a free cash flow result of approximately C$480 million.
That’s great, but rather than looking back, we need to figure out what 2022 will bring. The company has already provided rough investment forecasts as it expects to spend C$1.2-1.3 billion in investments this year, which should result in an average production rate of 335-350,000 boe/ day. Sustaining investments were budgeted at C$1.1 billion.
The next step is to determine the expected operating cash flow. Using the third quarter results, we end up with an annualized operating cash flow of approximately C$3 billion. I think the result may be higher than that. First, the third quarter results include a realized loss on the hedge pool of nearly C$200 million. Thus, excluding these realized hedging losses, adjusted operating cash flow would have been approximately C$900 million after tax.
Second, at the end of September, ARC had a total gross debt of approximately C$1.85 billion on the balance sheet. About half of that debt is represented by bonds, but there is about C$862 million in bank debt.
As ARC Resources will be generating over C$100 million of free cash flow per month, I assume that bank debt will be repaid accordingly, which should reduce interest costs and thus increase cash flow.
Based on the results reported in the third quarter, and including realized hedging losses and excluding potentially lower interest charges, annualized cash flow from operations will be approximately C$3 billion and after deducting investments of C$1.3 billion (including growth investments), ARC is expected to generate C$1.7 billion of free cash flow in 2022.
Given that the price of natural gas remains high and ARC’s hedges are shrinking, I would not be surprised to see ARC exceed C$3 billion in operating cash flow, even if realized losses on the hedging portfolio this year will be relatively high (unrealized losses reported in fiscal 2021 will be mostly realized in 2022). On an underlying basis, ARC’s assets generate over C$4 billion annually in operating cash flow at current commodity prices.
ARC Resources has pledged to spend 50-80% of its free cash flow on shareholder rewards. The current quarterly dividend of CA$0.10 costs the company just under CA$300 million per year. We can therefore expect ARC to spend a substantial amount of money on special dividends and/or share buybacks.
I hope the CRA will enforce a 50% payout ratio when times are good because that will allow enough headroom to keep shareholder rewards high when the situation changes and starting at an 80% payout ratio would put probably immediately the company under pressure. And while I’m not worried about net debt (and neither is the market given that both bonds have a yield to maturity of 2.7% and 3.5% for the 4 and 9 year bonds) , it’s times like these ARC can quickly reduce its net debt.
I don’t have a long position in ARC Resources, but it looks like a very valid investment idea to gain exposure to the Montney gas region of Canada. ARC Resources will generate almost C$2 billion of free cash flow this year (including losses on the hedge pool) at current commodity prices and it is now up to ARC’s management team to spend the money wisely.