ARC Resources: Strong Payouts And Growth With Industry Tailwinds Make It A Strong Buy

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Investment Thesis

ARC Resources (OTCPK:AETUF, TSX:ARX:CA) recently released its FY2023 results, achieving record production levels. The company owns a large acreage in the Montney area, where it is developing its Attachie project, which I expect will bring strong production growth in the coming years. I believe that investing in Attachie makes good use of ARC’s capital, with excess cash flow going back to shareholders via dividends and buybacks.

ARC’s superior margins for their gas and condensate make the company strongly positioned even in today’s depressed gas market, which I expect to improve through more coming LNG export capacity from North America and growth in demand for their condensate from oil sands.

The combination of the output growth, LNG industry tailwinds, Canada’s demand growth for condensates, and shareholder-oriented management creates a bright future for ARC’s shareholders. Based on a detailed analysis, I consider ARC undervalued, with a price target of C$26.17 per share, suggesting a 19% upside from the current price. Considering the low-risk profile, I rate the stock as a Strong Buy.

Introduction To ARC

When it comes to O&G (Oil and Gas) companies, you can invest for many reasons. You can speculate on higher commodity prices and choose a risky marginal producer whose FCF (Free Cash Flow) yield is highly sensitive to any moves in underlying commodity price. If you are lucky, you can make significant profits; if the thesis doesn’t work, you can lose your whole investment. Since we are in the middle of the cycle, I like the opposite approach: choosing a low-cost producer that makes money even at the bottom of the cycle prices.

ARC is precisely that: a Canadian large-cap company with years of profitable natural gas (NG1:COM) reserves, even under US$2/MMbtu. Next to 63% output from natural gas, the company focuses on condensates sold for a high premium in Canada. This makes the company highly profitable even at O&G prices, where other producers must limit their outputs.

ARC is not only about the stability of a low-cost producer, as it has a 5-year growth plan in place, which is expected to grow the per-share output by 10% annually. Further, we can expect a margin expansion due to the rising percentage of liquids in their production profile.

Since the COVID-era lows, ARC’s share price has nearly tenfold. Significant gains from rising commodity prices were made, and we are somewhere in the middle of the cycle regarding oil prices (CL1:COM). While gas prices recovered from 2020 and reached highs in 2022, they have recently crashed due to oversupply, making almost the whole gas industry unprofitable in the short term.

ARC seems to have a bright future despite the short-term gas oversupply. In this article, I’ll take a deeper look into its production profile, reserves, market dynamics, and financials to assess a five-year projection and then build a DCF (Discounted Cash Flow) model to assess a fair price.

ARC’s Reserves & Production Profile

ARC Resources is Canada’s third-largest gas producer and largest condensate producer. They recently released its FY2023 results with a total production of 351,955 boe/d (barrel of oil equivalent) consisting of:

• 8,364 bbls/d (barrels per day) of oil
• 75,516 bbls/d of condensate
• 47,760 bbls/d of NGL (Natural Gas Liquids)
• 1,321,887 mcf/d of natural gas (6 mcf = 1 boe (barrel of oil equivalent)

They solely focus on the Montney area, leveraging its experience and past successes. It has a long history of growth there, with a significant production jump in 2021 caused by the all-stock acquisition of Seven Generations for C$2.7B.

The growth driver for the next five years is investing in developing its Attachie project. This project is split into 3 phases, with the first phase expected to start production in 1Q2025.

The production profile is expected to be improved by 40,000 boe/d, of which 60% are condensate-rich liquids, all this just by phase 1. The second phase is scheduled to start production in 2028.

After 2028, ARC can start developing its third phase of Attachie, yet it has many more options with the long-term production outlook in the picture below.

As the company obtained the largest land base in Montney, it does not have to spend any capital for land acquisitions for many years into the future.

I believe that the opposite might actually become true, as when you think about the high decline rates of US shale producers, some might try to obtain more land by buying from resource-rich companies like ARC.

ARC’s Position In The Gas Market

North American producers’ expectations of new LNG export capacity boosted their gas outputs, making the NA gas market oversupplied. This resulted in very depressed gas prices, with several US producers already cutting their production outlook. Comstock Resources (CRK) is decreasing its operational rigs from seven to five. Antero Resources AR is slashing its drilling budget by 26%, reducing rigs to two from three, anticipating a 3% drop in gas volumes compared to 2023.

While gas in NA is very cheap, it is a different story in Europe and Asia due to many factors. The most significant being the Russia-Ukraine conflict. The same gas, which costs US$1.57/MMBtu in NA, landed in Europe costs 24.8€/MWh, translating to US$7.9/MMBtu.

If I consider the shipping cost of US$1-1.5/MMBtu, there is a lot of money to be made by exporting LNG (Liquified Natural Gas). The bottleneck here is the export capacity. It is presently being addressed, even though it requires time. The capacity is expected to more than double through 2027.

The AECO (Alberta Energy Company) gas prices already reflect this new export capacity, with future prices growing from below C$1.57/GJ to around C$3/GJ in 2025 and rising in 2026.

ARC obtained several long-term LNG agreements, recently with Cheniere Energy (LNG), where ARC supplies gas to the LNG facility. In return, it receives LNG prices based on European pricing after deductions for liquefaction, shipping, and regasification. ARC also has a long-term contract with LNG Canada, which is expected to start LNG export next year.

During the past decade, ARC has realized an average premium to AECO of 20%. If you combine it with their target of 25% future production exposed to the LNG global market, I believe this premium will grow further.

ARC’s Position In The Condensates Market

Canadian Oil Sands producers like Athabasca Oil (OTCPK:ATHOF) are producing large amounts of bitumen, which has way too high viscosity to flow to the US via pipeline. It needs to go through a process of dilution, which means you blend the bitumen with lighter hydrocarbons such as condensates from ARC to create “dilbit,” which then flows via the pipelines to the US.

Currently, the condensate in Canada is undersupplied, with about 35% of it being imported from the US to blend it in Canada with bitumen to be sent back to the US.

This demand for condensates is expected to grow further as the Trans Mountain expansion project, which will increase the oil export capacity to the US, is nearly finished.

This is causing the condensates to trade at a premium to WTI light oil and creates very high margins, which most producers can never achieve.

ARC’s Financials

For 2023, the company averaged a production of 351,954 boe/d. Realized O&G prices were lower compared to 2022 in line with the market, resulting in sales from production of $C5.26B.

Operating costs are extremely low, sitting at just $C4.59/boe. Combine the low costs with the industry-leading premium they receive on the gas and condensates, and you get very high margins, resulting in funds from operations of $C2.64B.

Debt

Like most O&G producers, ARC came through deleveraging after experiencing busted prices during the COVID era. Its debt currently sits at C$1.3B, which aligns with management’s long-term target, and further deleveraging would only cause increasing WACC (Weighted Average Cost of Capital).

Capex (Capital expenditures)

In 2023, they spent C$1.85B in Capex. If the management doesn’t target production growth and decides only to keep the production flat, the Capex would be approx. C$1.08B. The growth Capex is the remaining C$0.77B.

FCF (Free Cash Flow)

The FCF for 2023 was at C$789.8M. Compare it to the market cap of C$13.34B, giving you an FCF yield of 6%. That does not look stellar.

I also always calculate flat production FCF under the assumption of no growth Capex spending, which gives me a better idea of the company’s relative valuation. Summing FCF of C$789.8M with a growth Capex of C$0.77B gives me a flat production FCF of C$1.56B, representing a 12% yield. That’s not so bad anymore, but I still do not consider a 12% yield as a reason to invest, so I want to see a value accretive growth.

Projecting The Next Five Years For DCF Valuation

To value the company, I am building the FCF model for the next five years. I am assuming guided production levels by management. The final production will differ, but with long-term experience in the area, management will not be far from true.

Further, I am assuming US$75 WTI oil prices, a consensus among most large analysts, and C$3 AECO prices currently reflected in futures prices.

In the model, I am accounting for inflation of 2%, driving up operational costs, transportation costs, G&A costs, and commodity prices.

Finally, I do not consider any gains or losses from hedging, as it may be important in near-term numbers but close to irrelevant in long-term projections.

Here is the table with projection for your review, with a representative graph below in case you don’t need to go through so many numbers.

I am valuing the company based on its FCF, which, as you can see, I expect to grow from C$891M in 2024 to over C$2B in 2028.

Discounted Cash Flow Valuation

As a discount rate, I am using a WACC calculated from the pre-tax cost of debt of 3% and the cost of equity of 12.5%. Keep in mind that this is likely a higher cost of equity than the market might attribute to the company. I universally use 12.5% for all O&G producers, as I wouldn’t invest my capital for less than that. The final WACC stands at 11.68%.

I then discount the FCF available to shareholders, which I expect to be paid as dividends and buybacks. The resulting sum of discounted cashflows per share for the next five years equals C$8.6.

The terminal value is based on the final year FCF of C$2,030.5 million, which I offset by the growth Capex in 2028 as I value the company based on potential FCF, not considering any future growth after 2028. I arrive at the terminal value of C$2.3B, which, after discounting, accounts for C$17.57 per share.

Put it together, you arrive at a fair price of C$26.17 per share, which, compared to today’s price of C$22.08, stands at a 19% upside.

Risks

Due to high depletion rates, ARC must replace a significant portion of its production each year, and any future drilling issues might cause harm to the value of the company.

Any delays or regulatory complications on the LNG export terminals will harm the gas pricing environment.

While long-term global LNG demand is expected to grow by as much as 50% by 2040, as projected by Shell in its LNG Outlook 2024, Reuters highlights the presence of multiple scenarios where emerging countries will be deciding between cleaner LNG and cheaper coal energy.

The main risks with any O&G producer are the commodity prices. I will now conduct a sensitivity analysis under different O&G prices to determine prices under which the company remains profitable, how the company’s value changes, and when the growth Capex is value-creative or value-destructive.

The first heat map assumes maintaining the current growth Capex and examines its influence on the stock’s value. Compared to reality, this only reflects the upside correctly, as, in the case of long-term low prices, which would result in ROIC (Return On Invested Capital) lower than WACC, the company would change its growth plan.

The comparison of its ROIC and WACC is addressed in the second heat map. I had to change the numbering on the WTI and AECO because the prices under which the growth brings higher returns than the company’s WACC are incredibly low. The growth creates value for shareholders even at AECO prices of C$2/mcf and WTI US$25/bbl.

The last heat map addresses what happens if the company cuts its growth Capex to stay FCF positive. We can see that the company’s 2025 FCF is still positive even under AECO prices of C$2/mcf and WTI US$45/bbl.

Investment Decision

ARC has demonstrated strong performance in 2023, achieving record production levels. It distributed all FCF above growth Capex back to shareholders via dividends and buybacks.

The company’s strategic focus on the Montney area makes ARC appealing to those seeking stable long-term growth with reliable dividends.

Given these factors, and based on a detailed DCF valuation analysis, I consider ARC undervalued, with a fair price estimation of at least C$26.17 per share, suggesting a 19% upside from the current price. I say “at least” because my DCF model does not factor in any future growth after 2028, and as I explained, ARC’s growth prospects reach much further into the future.

I believe that due to the short-term weakness of NA gas prices and long-term market tailwinds, this is a great time to add ARC to one’s portfolio. I am doing so for my clients and might add it to my portfolio as soon as I find free capital that I could employ.

Please feel free to let me know in the comments if you have any questions or if you agree or disagree with my view. Remember to subscribe so you don’t miss any future updates about ARC and other great opportunities.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.