Surge Energy (SGY-TSX) Q2 Results - July 31

[dan_s]

Surge's Q2 production came in below my forecast and they reported a loss for the quarter, but operating cash flow beat my forecast. This year Surge is focused on meeting their final debt reduction goal. When they do, the dividend will be increased. I will probably move Surge into our High Yield Income Portfolio. It pays monthly dividends with annualized yield now 7.6%.

Q2/24 HIGHLIGHTS

During the second quarter of 2024, Surge:

Increased AFF by more than 32 percent from $62.5 million in Q1/24 to $82.8 million in Q2/24;

Increased cash flow from operating activities by 10 percent to $73.6 million, as compared to $66.8 million in Q1/24;

Reduced net debt by $61.2 million while also spending $36.1 million on property, plant, and equipment, and distributing $12.1 million in cash dividends to shareholders;

Repurchased more than 143,000 shares in the last two weeks of Q2/24 for approximately $1.0 million following the recent approval and implementation of the Company's NCIB;

Increased the Company's First Lien Credit Facility by 40 percent, from $150 million to $210 million;

Drawn only $33 million, or 16 percent, on the Company's $210 million First Lien Credit Facility as at June 30, 2024;

Strategically acquired a 50 percent working interest and operatorship of the 6-8 gas plant in Surge's core Betty Lake (Sparky) area for $3.5 million;

Reduced net operating expenses by 7 percent, down to $20.31/boe in Q2/24 from $21.81/boe in Q1/24;

Spud 11 gross (11.0 net) wells and rig released 9 gross (9.0 net) wells, with all wells expected to be completed and brought on stream in mid-Q3/24; and

Safely completed three oil battery turnarounds, positioning Surge to maximize operational runtime during the second half of 2024.

OPERATIONS UPDATE: CONTINUED DRILLING SUCCESS IN SPARKY AND SE SASKATCHEWAN CORE AREAS

Surge began the Company's post-breakup 2024 drilling program in May, with two rigs drilling in the Sparky core area and one rig in the SE Saskatchewan core area. Surge remains on track to meet the Company's 2024 production exit rate target of 24,000 boepd.

Surge's post-breakup 2024 drilling program consists of a total of 51 gross (50.0 net) wells, with 32 gross (32.0 net) wells planned in the Sparky core area and 19 gross (18.0 net) in the SE Saskatchewan core area. Two drilling rigs will be utilized in the Sparky core area, one of which will be drilling 8 gross (8.0 net) multi-lateral wells. Six of these multi-lateral wells will be drilled on Surge's large, new Sparky crude oil discovery at Hope Valley.

The second quarter is traditionally a slow drilling activity quarter for Canadian oil and gas companies as counties impose annual spring road bans for moving heavy trucks and drilling equipment. Accordingly, after a successful and active Q1/24 drilling program, Surge focused a significant portion of its Q2/24 capital expenditures on facility, pipeline, and well maintenance work, as well as further land consolidation in SE Saskatchewan. Subsequent to road bans being lifted in late May/early June, Surge resumed drilling activity in both the SE Saskatchewan and Sparky core areas, with three rigs currently running.

During Q2/24, Surge safely executed three operated oil battery turnarounds in the Sparky and SE Saskatchewan core areas. In addition, the Company experienced several unplanned turnarounds, outages, and restrictions at facilities operated by third parties, the impact of the unscheduled turnarounds reduced production in the quarter by approximately 400 boepd.

OUTLOOK: THE PATH TO VALUE MAXIMIZATION

Surge's strong cash flow from operating activities, excellent production efficiencies, and 24 percent corporate production decline, together with an annual capital budget of $190 million, combine to generate a forecasted $100 million of FCF2 based on the Company's 2024 budget pricing estimate of US$75 WTI pricing per barrel3. On this basis, FCF represents 34 percent of the Company's estimated cash flow from operating activities for 2024.

Surge is well positioned to continue delivering attractive shareholder returns in 2024 and beyond, based on the following key corporate fundamentals (at US$75 WTI pricing)3:

Estimated 2024 exit production of 24,000 boepd (87 percent liquids);

Estimated 24 percent annual corporate production decline;

Estimated 2024 cash flow from operating activities of $290 million;

Estimated 2024 FCF of $100 million;

$52 million annual base dividend ($0.52 per share annual cash dividend, paid monthly);

More than 900 (net) internally estimated drilling locations providing a 12 year drilling inventory; and

$1.4 billion in tax pools (providing an estimated 4 year tax horizon).

Given the early achievement of Surge's Phase 2 net debt target, the Company now forecasts having $48 million of excess FCF annually to allocate after paying its current base dividend of $0.52 per share per annum to shareholders, at US$75 WTI pricing. The Company has allocated the full $48 million of this excess FCF to share buybacks and continued net debt reduction.

As Surge reaches its Phase 3 "terminal" net debt target of $170 million, the Company's Management and Board will consider adding an annual production per share growth target (3 to 5 percent per year), as well as assess the efficacy of additional share buybacks and/or special dividends to further enhance shareholder returns.

[Petroleum economist]

Introduction
Surge Energy is small Canadian oil and gas company (market value US$ 540 M), operating conventional medium heavy oil (>20 API) in Alberta and Saskatchewan in western Canada. Production will grow modestly over the next 6-8 years thanks to the recent Happy Valley oil discovery .

Summary
Surge Energy reported Q2 results, which were more or less in line with expectations. Surprise was the impairment charge for the non-core assets sold in Q2. Production was a bit low, but it will grow thanks to Hope Valley. The balance sheet is sound. Profitability is low in 2024, but it can jump up sharply in 2025 and beyond. Shareholder returns are high.

Production
• Q2 production (23.6 K BoE/d) was below Q1 (24.9 K BoE/d), mainly due to the sales of non-core assets with 1.1 K BoE/d.
• Adjusted for the sale, production was down 1%. I had expected a 500-1,000 bbl/d higher production
• Fluid composition (87% liquids, 13% gas) was unchanged versus Q1.
• Surge expects the production to grow to 24.0 K BoE/d towards the end of the year.
• I expect for 2024 a production of 23.9-24.1 K BoE/d.
• In 2025 production can grow to 25.5 K BoE/d thanks to 1 5 K BoE/d production from the Hope Valley discovery.
• In 2028 production can reach 29 K BoE/d with 5 K BoE/d from Hope Valley.
• Hope Valley is still under appraised, so production can be higher or lower.

Balance sheet
• Surge took a C$ 97 M impairment charge in Q2 on the non-core assets sold in the Q2. This was partially compensated by a C$ 29.7 gain on disposal of assets.
• Q2 solvency (57.5%) is still good. It even increased versus late 2023 (57.1%).
• Long term debt decreased$ 66 M from C$ 185 M (late 2023) to C$ 119 M (Q2).
• The 2024 debt/EBITDA ratio will be a very low 0.45.
• The balance sheet is strong and allows shareholder returns.

Profitability
• Royalties were at the usual high18% of revenues.
• Unit costs, including, overheads, interest and depreciation ($ 39.50/BoE) are medium high compared to others.
• Q2 net loss, including the impairment, was -C$ 64.7 M (eps -C$ 0.64).
• Excluding impairments, gains on disposal of assets, and non-cash hedging losses, the eps was C$ 0.14.
• For 2024 with WTI at $ 75-80/bbl, I expect a net profit excluding the items above of C$ 22-36 M (eps=C$ 0.23-0.36, PE=19-32).
• In 2025, with more production, higher oil prices due to the trans Mountain pipeline and higher gas prices, the eps can go up to C$ 0.76-1.09 (PE=6.3-9.0)

Shareholder returns
• Surge raised its monthly dividend in May from C$ 0.04 to C$ 0.043, equal to C$ 0.52 on an annual basis.
• The NICB cleared Surge in June to buy back 10% or 9.8 M of its shares.
• In Q2 Surge bought back 143 K share for C$ 1.0 M.
• I expect share buybacks to reach C$ 12 M by the end of the year.
• Total 2024 shareholder returns can be 7.2%cin 2024, increasing to 10-13% in the years thereafter.

Conclusions
Surge Energy reported Q2 results, which were more or less in line with expectations. Surprise was the impairment charge for non-core assets sold in Q2. Production was a bit low, but will grow thanks to Hope Valley. The balance sheet is sound. Profitability is low in 2024, but can jump up sharply in 2025 and beyond. Shareholder returns are high.

Surge dropped in my oil and gas company ranking from 18th to a still good 22nd out of 81. Listen to coming Fridays webinar to understand what this means.

[aja57]

"Surprises" have huge impacts on little companies. Like the dividend and relatively low debt but chart looks horrible short term. Wouldn't be surprised to see Surge test 4.25-4.50.

[dan_s]

I have updated my forecast/valuation model for Surge.
Here is why my valuation increases:
> Significant balance sheet improvement and final debt goal now achievable early in 2025, should raise dividends and increase stock buybacks.
> Hope Valley adds high-quality "Running Room". < ~100 development drillign
> Oil price differentials have significantly improved (over $10Cdn/bbl) since the end of March, thanks to opening of the TMX pipeline. < Surge's realized oil price went from $80.36Cdn/bbl in Q1 to $91.84Cdn/bbl in Q2. < 83% of Surge's production is oil.

Q2 Reported Net Loss included a lot of non-cash "noise". Adjusted After Tax Net Income was $23.2Cdn million ($0.23Cdn/share).

Key Stat for my valuation is that operating cash flow increased from $57.8Cdn million in Q1 to $80.4Cdn million in Q2. < This does not include $37.4Cdn million of proceeds from non-core asset sales.

My valuation increases to $14.53Cdn, which equates to $10.75US for ZPTAF. < Just 5X annualized operating CFPS.

As of July 30th there were ten Canadian based analysts that cover Surge. Their price targets range from $10.00Cdn to $14.00Cdn. This morning, I received an update from Mark Heim, a respected analyst at Velocity Trade Capital. He rates SGY as Outperform with a price target of $13.00Cdn. His 2025 forecast ($3.26 operating CFPS) is very close to my forecast.

My updated forecast/valuation model for Surge has been posted to the EPG website. Scroll to the right to see all ten current price targets.