TransGlobe Energy (NASDAQ: TGA) the share price “exploded” upon the company’s official announcement that the new, more profitable contract with Egypt had finally been approved.
This announcement is a very good Christmas present for investors. But for those who have followed management’s announcements since the negotiation of the new contract, it was clear that management had assumed that the contract would be approved. Consequently, activity levels have long pointed to a year of growth in 2022 and beyond.
No contract is as important as the working relationship between two parties and the actions taken by those parties. Mr. Market may not like uncertainty. But it was clear that management was acting as if the contract approval process would be routine (even if lengthy).
As the stock price action above leading up to today’s announcement showed, there was rampant speculation that the contract had been approved or would be approved. This led management to announce that there was no formal word on December 1. Nevertheless, it is clear that speculators had a blast with rumors that greatly increased the volatility of the price.
Since the day of this announcement, the title has behaved rather well, still chaining a few good days. The company traded at a relatively low value relative to cash flow. It was almost as if the market believed that the Egyptian government would cancel the contract entirely rather than sign a completely new, more profitable contract.
Now that the new contract is signed, this cheap stock has become much cheaper because the new contract is much more profitable at the different price points. Few common stocks that I follow can say that they have become cheaper even though the stock price has not fallen.
The reason for the market excitement is the immediate “pay raise” the company receives, as shown above. The company receives at least an additional $2 per barrel of oil produced in Egypt when oil prices are relatively low. As long as Egyptian production averages over BOD 10,000, that extra $2 per barrel means the company is immediately earning (more than) an extra $20,000 a day. In an average quarter, that would be about an additional $2 million, as all expenses have already been paid under the current contract.
Some of the other contract terms that merge concessions and extend the life of the concession make much of the long-term investment feasible. This means that current benefits will likely increase significantly as production increases. The graph above also shows considerably better margin at lower prices. Therefore, the company is encouraged to produce when oil prices are relatively low.
Above are some of the key details. TransGlobe is a heavy oil secondary recovery specialist. Heavy oil tends to be a discounted commodity compared to the more desirable light oil. To complicate matters further, secondary recovery tends to be more expensive and recovery periods are often longer. Therefore, the company needed certain concessions so that the profit opportunity was similar to that of other Egyptian companies that engage in primary recovery. Otherwise, it just wasn’t worth the extra effort to get that oil back.
The latest production forecasts and capital budget forecast production growth of around 14% in Egypt. Some new things that have become feasible include horizontal drilling as well as “modern completion techniques” which could involve fracturing type procedures. This is the first time the company has released growth forecasts in a few years. This production growth should also propel the stock higher.
Egypt needs the currency generated by the export of oil. Therefore, the country benefits from any profitably produced oil. Even though it was more expensive to produce this oil, the country and society were able to achieve their respective goals by adding to the available oil to earn foreign exchange through export.
Egypt is one of the most stable countries in the Middle East. The country also generally stays away from the feuds that seem to bind the region forever. (Yes, there are also some notable exceptions to this). The country also has a favorable and conducive environment for the oil and gas industry. All of this combined makes the country a very reasonable place to do business.
Management has already started to take advantage of the contract by starting to drill new wells. This part now complete should influence the first quarter report a bit and maybe also the fourth quarter report. Since the market tends to look to the future, management should update investors on the progress of all 2021 activities. Investors should understand that completed activities do not affect reporting until they are completed. not become large enough to overcome the rates of natural decline.
I get asked all the time why something like the schedule above doesn’t produce results right away. The reason for this is that the wells need to “clean up” (or sometimes additional stimulation is needed for example) before they fully produce and the production itself needs to be optimized. Sometimes there is also a connection delay. Ongoing drilling activities often significantly affect reporting for the future quarter or even further into the future. But cash flow would improve due to better margins thanks to higher commodity prices, even if there were no new contract to approve.
The current commodity price environment has likely limited the above capital budget risk. Much of what was budgeted would have been profitable under old and new contracts. But it was also a show of faith on the part of the company to start the activity before the contract was approved.
There are now some secondary recovery techniques like polymer flooding that are possible with the longest concession period. Management also considered trying horizontal drilling with “modern completion techniques” as part of secondary recovery efforts. So it should be very interesting to see how much the new contract affects growth prospects going forward.
These fields don’t have enough cheap oil to really attract big companies doing business in Egypt. Therefore, this company faces less competition by specializing in secondary recovery. Still, there is more than enough oil left to keep a small business like this busy for quite some time.
Most likely, a business like this can grow by avoiding competition with large producers. At some point, management will likely add more, more profitable leases. Egypt has many places with relatively small deposits (or even medium deposits) that are ideal for a growing small business like this. All that was needed was the right contract to enable adequate profits.
The Company drilled one well subsequent to quarter end on the acreage noted above. Most likely, the fourth quarter report will contain some of the results from the wells drilled so far.
The start of the new contract will first show the cost of the initial payments. Therefore, the cash flow and maybe the earnings won’t look so great, depending on how management decides to account for that upfront payment. But the wells have been drilled and the new margins would point to much more profitable quarters ahead.
Cash flow of $47 million (reported for the third quarter) will clearly be much higher in the next fiscal year under the new contract. This makes the current market value rather low considering the potential cash flows under the new contract. Rising commodity prices will provide a further increase in cash flow.
Mr Market can wait to see the capital budget for the new year and clarification on a long-term growth rate under the new contract. Individual investors, however, need not wait. This is the best offer for which the management has long demanded. The Egyptian government knew in advance that there were not as many companies interested in these older areas as companies interested in other parts of Egypt. Investors can deduce from the resumption of drilling that it is a “win-win” situation for both the Egyptian government and the company.
The balance sheet has long maintained a negative net debt. It really hasn’t changed. Probably the most important element is that Egypt decided to pay for the oil before production. If this practice continues, this business will have greatly reduced working capital requirements. This would greatly improve the growth prospects.
Oil sales in Egypt are made periodically and not as a product in North America. This small company has a management that navigated the Egyptian revolution with the resulting slow payments. Now things are back to normal and management is ready to cash in. Investors can join management in sharing a very promising future.