Daily Letter | 1 11 December 2014______ Canacol Energy Ltd. Christopher Brown - Canaccord Genuity Corp. (Canada) BUY [email protected] Target: C$7.50 [email protected] CNE : TSX : C$1.63 COMPANY STATISTICS: Forecast Return %: 52-week Range: Avg. Daily Vol. (000s): Shares Out (M) basic: Shares Out (M) fd: Market Cap (M): Current Net Debt (surplus) (M): Current Enterprise Value (M): 360% C$1.53 - 8.77 694 107.8 114.4 C$175.7 C$131.4 C$307.1 EARNINGS SUMMARY: FYE Jun Oil & NGL (b/d): Natural Gas (mmcf/d): Total (boe/d): EPS fd: CFPS fd: CF/boe: EV/DACF: NAV fd: CAPEX (M): 2014A 7,660 2015E 11,941 2016E 15,170 17 18 56 10,437 14,982 24,489 US$0.11 US$0.34 US$0.95 US$0.85 US$1.00 US$1.87 US$22.99 US$23.72 US$25.28 10.3 3.1 1.4 C$9.25 C$10.40 C$11.10 US$141 US$185 US$144 SHARE PRICE PERFORMANCE: Source: Interactive Data Corporation COMPANY DESCRIPTION: Canacol Energy is a Canadian-listed oil exploration and production company with properties focused in Colombia and Ecuador. In late 2012, Canacol acquired Shona Energy, a natural gas producer with long-life reserves and strategic blocks immediately offsetting the company's heavy oil acreage in the Caguan basin of Colombia. With a new emerging unconventional shale opportunity, we believe the company is poised to renew shareholder interest. All amounts in US$ unless otherwise noted. 1.403.508.3858 Kimberly Hedlin - Canaccord Genuity Corp. (Canada) 1.403.508.3854 Energy -- Oil and Gas, Exploration and Production LED YOU DOWN A HOLE… TIME TO LEAD YOU OUT Investment recommendation Canacol’s share price retreated an additional 17% yesterday as selling pressure continues. However, in our view, the company has been overly penalized in a heavily negative market; while international oil-weighted E&Ps are off approximately 70% from mid-summer highs, Canacol is down approximately 80%. Although we believe valuations and peer comps have become less meaningful during this unrelenting sell-off, we also believe the time is ripe to capitalize on opportunities like Canacol, which have a line of sight on multi-year growth. Investment highlights By 2016, nearly 40% of Canacol’s production is expected to be natural gas with fixed long-term contracts. The company also receives fixed prices on Ecuador oil sales, which account for 15% of our CY2015 estimated production volumes. Approximately 45% of our C$7.50/share base 2015E NAV is derived from Canacol’s gas contracts. In conjunction with the company’s Ecuador oil contract, approximately two-thirds of our base NAV is derived from production with fixed price contracts. When the company releases its 2015 budget in January, we expect a half year outlook. H2/15 plans will likely be announced later in 2015. We believe the worst of the downward pressure on Canacol’s share price should conclude in the near term. We are also optimistic that oil-weighted E&Ps will begin to see a floor in trading this month. Valuation We use a DCF model to estimate base and risked 2015E NAVs of C$7.50 and C$10.40/share, respectively. Our C$7.50/share target aligns with our base NAV. Canaccord Genuity is the global capital markets group of Canaccord Genuity Group Inc. (CF : TSX | CF. : LSE) The recommendations and opinions expressed in this research report accurately reflect the Investment Analyst’s personal, independent and objective views about any and all the Designated Investments and Relevant Issuers discussed herein. For important information, please see the Important Disclosures section in the appendix of this document. Daily Letter | 2 11 December 2014 NO ONE CAN CALL THE BOTTOM, BUT HERE WE ARE Canacol’s share price retreated an additional 17% yesterday as selling pressure continues; in our view, the company has been overly penalized in a heavily negative market. While international oil-weighted E&Ps are off approximately 70% from mid-summer highs, Canacol is down approximately 80%. Although we believe valuations and peer comps have become less meaningful during this unrelenting sell-off, we also believe now is the time to capitalize on opportunities with a line of sight on multi-year growth. In our view, 2008 had a Darwinian impact on the surviving internationals today. Realizing the limited options for equity financing, most companies have been trained to live within their financial means for growth. While Canacol was successful at recently completing a financing at a non-dilutive share price, the share price has subsequently fallen nearly 80% since the financing. In our view, those with a long-term investment horizon on Canacol should enjoy the benefits of a strong 2016 combined with a growing inventory of exploration locations in both conventional and unconventional oil plays. Investors that are suffering include those having to report month-to-month gains/losses and traders with short-time horizons. Either way, we believe that the company is at or near an excellent accumulation level particularly given its ability to decouple revenue streams from Brent in 2016. The value of international gas… Canacol’s gas contracts going forward should not be underestimated. If Brent prices remain weak through 2015 and North American gas prices remain soft, there are few options in the energy sector for commodity price upside other than internationals. Canacol currently has 18 MMcf/d locked in at approximately $5/MMBtu with a 2% escalation factor. In December 2015, the company is expected to initiate two new contracts of 35 MMcf/d at ~$5.40/MMBtu and 30 MMcf/d at $8.00/MMBtu. Management forecasts 2016 EBITDA of $170 million associated with its 83 MMcf/d of contracted production. The company is also pursuing incremental opportunities for upwards of 60 MMcf/d that would likely be contracted at or above $8/MMBtu. As we stated earlier, 45% of our C$7.50/share base 2015E NAV is associated with Canacol’s gas contracts. In our view, investors are selling the shares, to some degree, due to an over-emphasis on debt levels. However, it is our opinion that the market “can’t see the forest for the trees” as the market ignores longer-term opportunities. We believe debt is only an issue if the company cannot repay or renegotiate it, or if the repayment of nearterm debt impacts future growth. In our view, the company should be able to refinance current debt and should be able to grow into 2016 with current sources of funding. As such, we maintain that Canacol’s current share price provides a solid entry point for investors going into 2015. 2015 outlook As we stated in our, “Reduction in Guidance; Reducing Target”, publication November 13, 2014, “We believe soft Q1/F15 financials, along with reduced production guidance, will weigh heavily on the stock through year end”. Now that we believe the worst of the share price correction is behind us, we think there is a solid opportunity to accumulate the stock at these levels. Daily Letter | 3 11 December 2014 Based on our sensitivity analysis, the company could execute a self-funded $200 million capex program in 2015 with Brent prices of $50/bbl. In this scenario, 2016 would be a rebuilding year (in terms of the balance sheet). However, by this time ~40% of the corporate production should be from long-term gas contracts. We expect the company will likely provide a two-stage budget to remain dynamic in the face of volatile Brent prices. As such, Canacol should be able to re-allocate funds accordingly. The major unknown is where Brent prices will go in 2015. It is our belief that Brent will be under pressure through Q1/15. However, as commodity traders begin to speculate on a positive outcome from the OPEC meeting in June, futures contracts should trend higher. This, combined with ongoing capital cutbacks from North American producers, should put upward pressure on oil from the supply side. When oil prices eventually turn around, we believe international oil producers should be well positioned to capitalize on improved pricing through increased spending in H2/15 (versus the Majors, which tend to be less dynamic in deploying capital programs). VALUATION We have made no changes to our DCF model or NAV estimate for 2015E. The company is expected to release its updated 2015 capital program in January, which will impact both our capital estimates as well as our production expectations. In the interim, we believe the company can manage within its means with a capital budget under $200 million. As we stated earlier, we believe that most international companies will give six-month capital guidance with some optionality to increase H2/15 capital guidance depending on the status of Brent pricing by mid-2015. We note that even with a $50-55/bbl Brent price deck, we do not foresee liquidity issues based on our current production projections. In our view, the expected boost in sales from gas volumes (starting December 2015) should be a significant driver of cash flows going forward. Given Canacol’s significant resource inventory, solid base development program, and discounted valuation, we maintain our BUY recommendation. Daily Letter | 4 11 December 2014 Figure 1: Fiscal 2015E NAV 2015E Net Asset Value (US$ unless otherwise stated) Resources After Tax 10% Disc. (MM$) 62 After Tax 12% Disc. (MM$) 62 After Tax 15% Disc. (MM$) 62 LLA-23 Esperanza gas Libertador & Atacapi (Ecuador) Other (Colombia) Serrania Coati + Working Capital - Debt + Corporate Items Net Asset Value 260 341 160 31 49 4 37 (153) 35 764 219 308 153 32 43 4 37 (153) 35 678 199 275 137 26 36 3 37 (153) 35 595 7.50 $ 6.65 $ 5.85 104 104 104 83 211 1,059 66 173 917 48 129 772 10.40 $ 9.00 $ 7.55 2015E Base NAV (C$/sh) $ Total Resources Conventional upside Unconventional upside Upside Net Asset Value 2015E Risked NAV (C$/sh) $ Assumptions: Production (b/d) Funds from Operations (US$ MM) Capital expenditures (US$ MM) Brent (US$/bbl) F/D Shares O/S (MM) Source: Company reports, Canaccord Genuity estimates 2014E 10,437 76 141 109 114 2015E 14,982 108 185 86 114 2016E 24,489 202 144 87 114 Daily Letter | 5 11 December 2014 The following section was taken from our November 13, 2014 publication titled ”Reduction in Guidance; Reducing Target” LLA-23 – Likely drilling inventory into 2016 The company highlighted that, despite the downturn in global commodity prices, that LLA23 block remains highly profitable due to the high deliverability and its lower-cost structure. The company intends to drill two development wells and additional exploration wells before year end (Maltes-1 and Pastor-1). The company is in the process of shooting 400 square kilometres of 3D seismic with a target to firm up the 12 currently identified exploration leads shown in Figure 2. The inventory of locations has the potential to provide drilling inventory into 2016. Figure 2: LLA-23 prospect map Source: Company reports Daily Letter | 6 11 December 2014 SHALE – Up to 30 shale exploration wells expected through to the end of 2015 The company has benefited from conventional discoveries on its shale blocks via “free looks” due to the deeper shale drilling on block VMM-2. The company plans to drill an additional appraisal well into the shallow Lisama discovery prior to the end of 2014. (subsequent to our November 13, 2014 publication, the company has decided not to drill) On the VMM-3 block, the operator (Shell) spudded the Pico Plata-1 exploration well in early October 2014. The well will target the La Luna shale formation. As shown in Figure 3, there is a substantive number of shale locations planned into 2015 by various operators. Canacol’s northern shale blocks have ConocoPhillips, Exxon and Shell as operators, with the company being carried on 19 total locations in this region. The company’s independent auditor has identified a net mean prospective shale resource of 185 million barrels with estimated value of $1.3 billion (on the three northern blocks alone). Figure 3: Shale proximity map Source: Company reports Daily Letter | 7 11 December 2014 Gas upside late 2015 – Canacol’s gas production should greatly reduce commodity price volatility in 2016 and beyond The company has successfully drilled the Corozo-1 gas exploration well and is awaiting a production test. The Canandonga-1 exploration well is expected to be drilled next, likely before year end. Management estimates that Canandonga could be as large as 67 Bcf on an unrisked recoverable prospective resource basis. In 2015, the company intends to follow with up to five appraisal/development locations in order to deliver the 83 MMcf/d of contracted gas by the end of 2015. In our view, this property should bring stability to the cash flow statement in future years as the company has contracted the gas at various fixed prices (from $5 to $8/MMBtu) for up to five-year terms. The company is currently pursuing an additional 60 MMcf/d of fixed contracts to capitalize on the high gas prices that can currently be locked in for long-term contracts. In the short term, Canacol also announced a price increase on current sales. Canacol currently sells approximately 18 MMcf/d of gas from the Nelson Field to a local ferronickel producer under a 10-year contract that expires in 2021. That contract was linked to the Guajira price index, which changed effective October 29, 2014 from $3.97/MMBtu to $5.08/MMBtu. This should benefit production netbacks starting this quarter. Figure 4: Esperanza block Source: Company reports Daily Letter | 8 11 December 2014 TARGETING 35,000 BOE/D BY 2016 The company has ambitious plans to achieve 35,000 boe/d by 2016. With gas production already contracted for 14,561 boe/d, the company needs to grow its oil production to ~20,400 b/d by 2016. The company indicated that its 13 existing fields currently contribute 43 million boe of 2P reserves with an NPV of $887 million shown in Figure 5. Figure 5: Canacol long-term production estimates (November 12, 2014) Source: Company reports Daily Letter | 9 11 December 2014 APPENDIX I: FINANCIAL STATEMENTS We outline our current financial projections for Canacol below (effective December 10, 2014). Figure 6: Canacol’s income statement (US$000s) June 30 YE Oil and Gas Revenue Royalties Share of joint venture profit and other Total Revenue 2013A 160,154 (12,488) 147,666 2014A 229,074 (21,287) 3,532 211,319 2015E 278,568 (27,142) 9,481 260,906 2016E 458,346 (41,783) 10,070 426,633 Operating General and Administration Depletion, Depreciation and Accretion Stock Option Compensation Other Total Operating Expense 75,628 22,236 48,240 8,041 137,140 291,285 67,559 27,045 38,740 7,290 11,731 152,365 89,125 26,225 83,645 4,121 266 203,383 118,481 40,416 122,231 3,959 109 285,196 (16,211) (523) (2,818) (19,552) (9,656) 2,057 (19,402) (27,001) (21,548) (2,485) 5,130 (18,903) (21,072) (21,072) Income (Loss) Before Income Taxes (163,171) 31,953 38,621 120,365 Current Income Tax Future Income Income Taxes Non-controlling interest Net Income 2,033 (44,592) (42,559) (120,612) 24,823 (2,807) 22,016 9,937 16,140 (14,411) 1,729 36,892 39,140 (21,537) 17,603 102,762 (1.61) 0.11 0.34 0.95 Finance Income (Expense) Foreign Exchange Gain (Loss) Other Net Finance Income (Expense) EPS - Fully Diluted, Continuing Source: Company reports, Canaccord Genuity estimates Daily Letter | 10 11 December 2014 Figure 7: Canacol’s cash flow statement (US$000s) June 30 YE Net Income Depletion, depreciation and accretion Deferred income Impairment, loss (Gain) on acquisition Stock-based compensation Finance Costs Deferred Income Tax Unrealized (gain) loss on Commodity Contracts Unrealized loss on financial Instruments Unrealized (gain) loss on foreign Currency Translation Other Other (inc. E&A write off) Cash From Operations Changes in Non-Cash Operating Working Capital Cash Flow from Discontinued Operations Cash Flow From Operations CFPS - Fully Diluted 2013A (120,612) 48,240 3,731 1,000 8,041 16,211 (44,592) 1,184 (295) (18,759) 157,007 51,156 (21,611) 29,545 2014A 9,937 38,740 7,290 9,656 (2,807) 24,288 (959) (17,777) 10,963 75,799 2,145 77,944 2015E 36,892 83,645 4,121 9,104 (14,411) (5,130) 3,383 176 108,299 22,930 131,229 2016E 102,762 122,231 3,959 4,496 (21,537) 109 201,949 (757) 201,192 0.68 0.85 1.00 1.87 Issue of common shares Borrowing (Repayments) Other Financing Activities Cash From Financing Activities (354) 102,043 (8,874) 92,815 120,405 74,045 (6,679) 187,771 434 6,000 (2,144) 4,290 (34,367) (34,367) Additions to intangible E & E assets Additions to Petroleum properties Divestitures/(Acquisitions) not assigned to PP&A or E&E Additions to Other Assets Changes in Restricted Cash Change in non-cash Investing working capital Other Investing Activities Cash Flow From Investing Activities (24,813) (49,267) (34,781) (3,159) 2,861 8,300 (100,859) (25,358) (107,523) (8,314) (40,433) 27,352 (154,276) (66,479) (118,816) (36,891) 13,434 207 (208,545) (10,623) (133,647) (144,271) Foreign Exchange Gain (Loss) Increase/(Decrease) in Cash Cash - Open Cash - Close Source: Company reports, Canaccord Genuity estimates 21,501 30,789 52,290 111,439 52,290 163,729 (73,026) 163,729 90,703 22,555 90,703 113,258 Daily Letter | 11 11 December 2014 Figure 8: Canacol’s balance sheet (US$000s) Cash and Cash Equivalents Restricted Cash Accounts Receivable Inventory Deposits and Prepaid Expenses Derivative Commodity Contracts Other current assets Current Assets Exploration and Evaluation Assets Property and Equipment Other Assets Total Assets 52,290 7,127 38,141 3,261 11,331 1,875 114,025 92,753 238,278 24,536 469,592 163,729 7,379 60,981 1,936 12,405 5,254 251,684 133,510 301,398 69,995 756,587 90,703 35,697 43,520 1,338 10,997 3,417 185,672 173,923 364,297 101,324 825,216 113,258 35,697 78,816 1,338 10,997 3,417 243,523 184,437 377,313 132,931 938,204 Accounts Payable and Accrued Liabilities Current Portion of Long Term Debt Other Short Term Liabilities Current Liabilities Asset Retirement Obligations Long Term Debt Deferred Tax Convertible Debentures Other Long-Term Liabilities Total Liabilities Share Capital Contributed Surplus Accumulated Other Comprehensive Income Retained Earnings (Deficit) Subtotal Equity (Shareholders Equity) Total Liabilities and Equity 37,219 6,100 43,319 7,995 134,316 3,861 22,091 18,707 230,289 408,770 40,074 347 (209,888) 239,303 469,592 75,814 44,000 18,912 138,726 10,518 166,688 1,054 25,395 13,919 356,300 551,049 48,842 347 (199,951) 400,287 756,587 94,825 84,367 24,931 204,122 11,759 162,517 4,402 382,801 551,590 53,537 347 (163,059) 442,415 825,216 129,363 58,667 24,931 212,961 13,359 158,347 4,402 389,069 551,590 57,496 347 (60,297) 549,136 938,204 Source: Company reports, Canaccord Genuity estimates Daily Letter | 12 11 December 2014 Investment risks Investors need to be aware of the risks inherent in the oil and gas industry. Without limitation, these risks include: Trading liquidity risks. Geological, engineering, regulatory and environmental risks related to the exploration for and development of crude oil and natural gas resources. Volatility in crude oil and natural gas prices that can materially affect financial performance and the accuracy of estimates. Access on favourable terms to oilfield services, equipment and labour. Favourable access to external capital. Country risk -- the majority of the company's producing and potential properties are presently located in Colombia. The company's operations, financial results, and valuation could be adversely affected by events beyond the company's control taken by the current or future governments with respect to policy changes regarding taxation, regulation, and other business environment changes. Daily Letter | 13 11 December 2014 APPENDIX: IMPORTANT DISCLOSURES Analyst Certification: Compendium Report: Site Visit: Each authoring analyst of Canaccord Genuity whose name appears on the front page of this research hereby certifies that (i) the recommendations and opinions expressed in this research accurately reflect the authoring analyst’s personal, independent and objective views about any and all of the designated investments or relevant issuers discussed herein that are within such authoring analyst’s coverage universe and (ii) no part of the authoring analyst’s compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the authoring analyst in the research. Analysts employed outside the US are not registered as research analysts with FINRA. 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Box 10337 Pacific Centre, 2200-609 Granville Street, Vancouver, BC, Canada V7Y 1H2; or by sending a request by email to [email protected] The reader may also obtain a copy of Canaccord Genuity’s policies and procedures regarding the dissemination of research by following the steps outlined above. An analyst has not visited Canacol's material operations. Price Chart:* Distribution of Ratings: Coverage Universe Global Stock Ratings (as of 1 October 2014) IB Clients Rating # % % 627 60.2% 36.7% 53 5.1% 54.7% Hold 317 30.5% 13.9% Sell 43 4.1% 2.3% Buy Speculative Buy 1041 100.0% *Total includes stocks that are Under Review Daily Letter | 14 11 December 2014 Canaccord Genuity Ratings System: BUY: The stock is expected to generate risk-adjusted returns of over 10% during the next 12 months. HOLD: The stock is expected to generate risk-adjusted returns of 0-10% during the next 12 months. SELL: The stock is expected to generate negative risk-adjusted returns during the next 12 months. 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