Surge is an energy favourite in some crowds — a cult classic almost. The banks and advisory firms love them, retail shareholders love them, and senior management certainly love themselves, but behind the oil in place marketing gimmick, and the absurd performance promises — is a business that may not have lived up to its full potential over the past decade, and is on a path to repeat the same mistakes that led to their stock’s precipitous decline post-2014. I am here to lay out the facts as to why.
The Surge story started January 2010, when Zapata Energy Corporation raised $3.3m in a private placement offering of flow through units and common stock, then, in another offering in April 2010, Zapata brought their total funds raised to ~$10m with another private placement — and it was off to the races.
In June 2010, the Surge we know today was formed — Zapata Energy Corp. changed their CUSIP to 86880Y109, and their name to Surge Energy Inc., and they were in business with a handful of consecutive acquisitions with the proceeds raised earlier and a 2H10 bought deal.
At the crux of the thesis, since the original few years of glory — Surge has continued to prioritize short term gain, instead of long term value, which makes for a practically uninvestable equity. Throughout Surge’s history, in my estimation, their original 2014 land base of ~150,000 acres has churned approximately 2.3x through over a dozen acquisition and divestment transactions. Throughout all this churn, it’s astounding that >50% of their organic growth (at YE22) came from their original land base. While they have sold deals on large original oil in place, and accretive metrics — the lack of capital allocated towards purchased lands, in general, slowly erodes the asset level returns, and holistically, the business’ ability to generate full cycle returns on total capital employed. There is a distinct lack of capital discipline at Surge, and a long running history of decisions that do not reinforce shareholder value.
In this note I break down 9 of Surge’s key selling points, and provide fact-based counters for the consensus, and marketed talking points. Namely discussing Surge’s;
Repeated lack of financial discipline
Leverage will reemerge as a problem on the current trajectory
Growth has been mainly through dilutive acquisitions
Current core areas are not conducive to growth (including a detailed review of Surge’s four main growth areas)
Waterflood promises have failed to materialize leaving assets that have generated negative economic profit
OOIP marketing has very little effect on well level economics
Bad habits from previous cycles continue to manifest today
Discipline could have made Surge into a much better company
The price for Surge in the market today, is fair given historical performance
Finally, I offer some unsolicited, though perhaps useful thoughts for both management, and stakeholders — as to how Surge may be able to improve their long term business, reintroduce sticky capital positions, and refresh their strategy into something more aligned with long-term value creation.
If you want to break this post down into multiple, more manageable parts, I would recommend coupling sections as 1&2, 3&4, 5, 6&7, and 8&9.
Repeated Lack of Financial Discipline
There is a lot of jawboning you can do over the share price, and relative declines — “it’s a commodity based business, and volatility is to be expected” would be an easy deflection instead of answering to the fact that Surge has seen their stock trade from split-adusted highs of $100/sh, down to just $8/sh today — but the numbers don’t lie. Over the past decade, Surge’s stock is down 80%, with the only two worse performers being Baytex, and Penn West. While the oil patch is littered with bankruptcies that zeroed shareholders, Surge has been on the brink of that, needing to sell assets or refinance debt counter-cyclically — not a good position to be in.
Senior management will tell you that they are motivated to run the best company in Canada — but with a history of consistently eroding value, I don’t see that as likely, their opportunity the be the Whitecap of the SMID space, was, well, back in 2010 when they both started out. Whitecap recapped Spitfire Energy, and Surge recapped Zapata, since then Whitecap has delivered a total shareholder return of 210% (a 10% CAGR), while Surge has delivered a total shareholder return of -55% (a -6.5% CAGR). Frankly, to be blunt, Surge has had their opportunity to be the best in Canada.
Since 2012, Surge, despite being a self proclaimed “disciplined acquirer”, has spent ~2.5x their market cap on purchasing assets, more than double their next peer, the notoriously reckless Baytex. Oftentimes, these assets are disposed of shortly after, to keep leverage in check (as we will discuss later, their true leverage ratio is oftentimes much higher than the reported 1.5x cashflow). The notable part of their acquisition strategy though, has been the reliance on floating credit facilities, over fixed term debt in their capital stack. There has been a noticeable lack of capital optimization throughout Surge’s history, as shown in the bottom right corner, Surge has relied heavily on equity raises through bought deal follow ons to finance acquisitions, with around 50% of their current consolidated (i.e. post reverse split) float having been equity issued through guaranteed underwriting — that comes at costs to shareholders, as we’ve seen in 2022, when the underwriters exercise their 15% over-allotment option, it is certainly a costly way of obtaining already costly capital (equity capital).
The unfortunate part about Surge’s proclivity for equity raises, is they have alienated shareholders through bad decisions in the past, and bought deals now turn into something that more resembles a quasi-at-the-market offering, with short interest spiking before bought deals are announced, then firms that participated in the raise selling their blocks shortly after. Notably, Ninepoint Energy Fund was a key participant in the 2022 equity raise for Surge’s Enerplus transaction, though Surge was not present in fund holdings at year end. Since the previous cycle, institutional ownership in Surge has continued to grind lower, with 20% of outstanding shares owned by institutions in 2014, that number now sits around 3% today. The makes for a very retail heavy shareholder base, something that is not conducive to rational movement, and certainly not a good base makeup for a strong company. The noticeable lack of institutions does not bode well for the future outlook of Surge, and suggests that what is typically regarded as “smart money” (though some will argue that) has avoided the name — hence management’s consistent engagement with non-institutional shareholders.
Perhaps one of the reasons that institutions have continued to avoid Surge, even given the strong recovery in oil, is Surge’s consistent disregard of existing shareholders. In March 2023, Surge issued ~$20m of flow through shares (page 3 of 1Q23 AFS), though did not issue a press release coinciding with this dilution. They issued the shares through a non-brokered private placement, but did not press release the equity raise. Though, in April 2021 they press released a $15m flow through offering, and in April of 2019 they press released a $30m convertible debenture offering.
If I had to guess, it had to do something with the chart in the bottom left above — where small companies that issued flow-through shares were punished the next day in the markets. While press releasing a raise of that size could be considered immaterial, it’s the right thing to do, and the fact the company did not, only continues to tell the story that senior management focuses on short term share price appreciation, rather than long term value creation.
Below is a chart of all capital raises that Surge has completed, and whether it got mentioned in a press release, if it was mentioned in a press release headline. The historical precedent, generally is, anything above ~1% of equity gets press released. The flow-through raise in 2023 represented 2.5% of outstanding equity, and based on historical precedents, should have been press released.
There is no doubt Surge has been generally reckless with their equity structure, tapping bought deals when something interesting comes to market, but they have been equally careless with the debt structure as well, as mentioned, often opting for revolving credit facilities over structured debt instruments, which has come around to bite them twice, almost leaving them out for dead in 2020 had it not been for BDC.
It’s a predictable story, and is a tail risk of Surge’s current leverage position — going into 2019 and 2020, Surge had increased the dividend post-Mount Bastion acquisition, which meant very little cashflow to delever with, on a revolving facility no less. When COVID rolled through, US syndicate members threatened to pull bank lines, and Surge’s debt to equity ratio ballooned to almost 7x — only to be taken down by the 50% float dilution that coincided with the Fire Sky and Astra acquisition (and helped by the commodity price).
There is a cost to leverage, and Surge has paid the price before, and it’s precisely why they aren’t a top performer over multiple years. I believe, that the unspoken strategy is to gain as much leverage to oil as possible, then hope benchmark commodity prices increase — this is grossly unsustainable.
While management has touted their current fixed money as a benefit, and something that differentiates themselves from their peer group, compared to peers, they have significantly less long term capital on their balance sheet, and have been slowly removing it, again, in favour of shorter cycle credit options, and this is the issue when you get the dividend high, and grow the company using debt — it eventually breaks. Notice that the path of implied forward dividend yield, and revolver utilization/availability are practically identical — that is no mistake. Surge has a track record of adding production (and cashflow) on debt, using the cashflow to make enticing dividend payments, while not meaningfully reducing leverage. An entity like that becomes a structural call option on oil, with little downside to management, but, as seen repeatedly, major downside for shareholders, especially those being sold on a sustainable business. Debt is, and should be a part of a healthy business, even in a commodities name like Surge, but they have continued to use leverage irresponsibly. Since 2014, their borrowing base is down around 50%, while peers have expanded their borrowing base, and are in a better position to capitalize on opportunities in ways much more meaningfully than Surge could, with their current access to capital (expensive debt, or more expensive equity). This is again, continued disregard of long term business goals.
At the core of things, and a continued jumping off point throughout this post, Surge has continued to grow their capital base through equity issuances, but have not grown their earnings base in tandem. To increase return on capital employed you have to in some capacity grow organically — something Surge has not done. This results in a cashflow return on capital employed that has significantly lagged E&P peers, and barely beaten out oil sands peers over the last decade. The reason I make the distinction between E&P and oil sands peers, is that it’s expected, as an oil sands, or otherwise long life asset producer to have a poor cashflow return on capital for the first phases of project development (which is capital expenditure heavy), but that ends up flipping into the later life of the developed assets — Surge has seen long life returns on capital employed, without the long life cashflow profile to come.
Put this all together — the poor return on capital, the constant dilution, misuse of leverage, growth that has come through acquisitions, and what do you get — a decline in debt adjusted production per share of over 40% since 2012, and a decline in production per share of almost 70% during the same sample period. While corporate production is up ~200%, that growth has come at the expense of historical shareholders. Almost all peers that still exist today, have grown production per share, and debt adjusted production per share since 2012. You can certainly claim that there have been numerous bankruptcies not shown on this chart — but if the rebut is then, “they are only marginally better than bankrupt”, well, that’s not a very strong bull case.
With all that said, Surge is a share printer, and a high margin debt lover — there is an obvious reason that dealer equity research is skewed to favour Surge, even if the true outlook is not as rosy as communicated in research notes — Surge is a fee machine. With much less revenue on the street for brokers and advisors since the 2014 downturn, banks and non-independent research firms (i.e. those with merchant banking divisions) have to remain positive on the name, or they risk a key customer. Surge is indeed a customer at these banks — and you know how the saying goes — the customer is always right.
The Wrong Path
For Surge, debt has not only been a historical problem, and catalyst for many unnecessary, shareholder unfriendly transactions at cycle lows — it is likely to once again become a problem going forward, as Surge management has telegraphed their intention to further increase the dividend, only more leveraging their equity performance to oil prices and starving the business of capital. This is something we have seen many times before from this team at Surge. Below visualizes the dividend payouts at dividend per share levels higher than today, compared to street expected free cashflow. The table on the right shows true implied leverage at various cashflow levels, and with various dividend amounts. Note, that true implied leverage is much better than the debt to cashflow metric that E&P management teams like to use, as, for a company that is staying flat (what Surge is essentially doing), it shows the number of years at flat production they would need to pay off debt, after paying for capital spending, and the dividend. For companies that are growing, the calculus is different, but Surge is not growing, note, they are expected to decline through year end (with year end exit guidance of 25,000 boe/d and 1Q production of 25,138 boe/d).
The table below runs through that true leverage ratio on the left, and on the right shows true discretionary free cashflow. Note, that in Surge’s case, in my opinion, it’s in their best interest to keep $50m in discretionary cashflow they can use to fund waterflood endeavours, pay down debt, and generally build a balance sheet moat which they have rarely had throughout history.
The left charts below shows historical net debt to cashflow, then shows the net debt to post-dividend cashflow metrics. Surge has typically increased their dividend when they make an acquisition (and issue debt or equity), which has made their debt to cashflow metric unreliable. Essentially, the dividend is a liability that accrues to shareholders (and in Surge’s case, much better than letting the company allocate that money), but nonetheless it’s still a liability and offset by an increase in share capital as equity owners pay forward for the income. So, adjusting for the dividend is prudent. The chart on the right shows Surge’s payout ratio, which has been above 100% for almost all of history — note the chart on the right does not include acquisition capital. Going forward, Surge is flirting very clearly with a 100% payout ratio, which would mean, no capital for asset development.
But wait — there’s more. Of course, there’s more.
Do you remember that reserve report that senior management loves to reference for their “independently arrived at net asset value” — in that reserve report is also an “independently arrived future development capital” line — a line where the independent reserve evaluator estimates the amount of capital a company needs to invest into their business — they are the capital expenditures required to develop and produce the remaining reserves of an oil field.
Well, Surge’s reserve report states they need to spend $240m in capital on their assets in 2024. Compare that to a company guided 2023 cashflow number of $335m at $80 WTI, and in 2024 (using that same cashflow number) FCF would be an estimated $95m. Now, 2024 strip is 15% lower than that, so without doing any adjustment to above-the-netback costs, and assuming a 10% flat decrease in cashflow, your free cashflow falls to $60m, or an 8% yield. This is rough, illustrative math, but an 8% yield on a stock like Surge, it’s really not compelling at all.
Management will say that the reserve report is too high, and the amount of capital they need to actually maintain their assets is much less, so lets take a look at that.
Well, underspending the FDC target doesn’t usually work out for Surge. I believe if management is going to stand so staunchly by the “independently evaluated NAV”, they should also stand so staunchly by the “independently evaluated FDC” — either way, both are wrong or both are right. Note, that the chart below correctly shows development capital attributable to existing production and adjusts for acquisitions and dispositions during a period which can skew true production movement.
So, if we do some really rough math, that $240m feels ballpark right. Surge was producing 24,000 boe/d in 2014, and they put $150m towards capital spending — if you assume 3%/yr inflation through 2020, and 5% to today (which is probably a bit light), you get to $210m in capital spending. Consider the fact the Surge’s 2014 assets similar to their current portfolio has a DECT cost of ~$1.1m, and it’s closer to $1.6m today, 45% total cost inflation for a present day capital spend of ~$220-$240m feels right in the ballpark. The reserve report also lists 2023 capital at $150m.
With that all in mind, the street, and management, is likely underestimating capital spending to maintain their asset base, and thus, overestimating free cashflow, which leaves the investor in a lose lose situation — Surge either underinvests in their assets, grinds production lower, shares grind lower, and eventually they issue equity in a dilutive acquisition (because they have little ability to delever with the current dividend), or, Surge truly takes a step back, and rights their development path to focus on long term value — given their pattern of behaviour, it’s not hard to guess what is going to happen.
Below are the same charts as above, but with reserve report capital spending swapped in, instead of broker consensus.
So, if Surge is to do truly right by their shareholders (making the right long term business decisions), they will increase capital spending next year — but the already initiated dividend then leaves little money for delevering. On a true leverage ratio basis, Surge may be up to 20x net debt to 2024e PDFCF using the reserve report FDC.
Below, all in one chart, you can compare the street estimates for capital spending, the reserve report stated capital spending, and the flow through effect on free cashflow estimates. The street is currently calling for $135m of FCF in 2025, which would equate to a respectable 17.5% FCF yield. Staunchly different — the reserve report, and futures strip is calling for $5m of FCF in 2025, which would equate to a <1% FCF yield. Perhaps this is why the FCF yield feels so high compared to peers, FCF is coming at the expense of true underinvestment, and if the right investment is to take place, FCF would be lowered significantly.
Below, side by side, are the free cashflow dividend payout charts, with the left using street consensus capital spend, and the right using reserve report capital spend.
Surge is on the wrong path with their dividend promises. They are going to pay investors now at the long term expense of their assets, and end up on a razors edge balance sheet wise if they continue to acquire, undercapitalize, and recklessly make promises of payout increases to captive retail audiences.
Acquirers, not Growers
Since 2010 exit, Surge’s production has grown ~20,000 boe/d — quite impressive, and no small feat in of itself, though, when you back out the sources of major growth wedges, and adjust for legacy production acquired, vs. organic production added on acquired assets — it’s not hard to see why this growth has been in a manner wholly unfriendly to shareholders.
Below are the major acquisitions surge has made, and in the lighter colour above, the organic production they have added throughout their ownership of the asset — notice, for the most part, acquisitions made after 2011 have very little production growth that was driven by Surge.
Below I have broken out legacy production — the takeaway from the chart below, is that acquisitions post-2011, haven’t added much “grey” — to say, Surge has grown from assets they’ve already owned, and simply put the asset’s they’ve bought on the shelf, which is not a good strategy.
Below is legacy and organic production broken out by ultimate parent, and the base for the next few charts where we can identify how much value Surge has truly added to their acquisitions.
Today, around half the company is legacy production from acquired assets (i.e. production that Surge itself did not drill, but was simply ‘already on the asset’ when purchased). This would actually be a totally fine model (and mimics a roll up strategy you see in other asset classes) if they had been strategic with their acquisitions, used termed leverage responsibly to improve returns, and included a modest growth wedge to fight declines — instead, they have not at all been strategic, and leverage has worked against their acquisition efforts. As much as Surge would not like to admit it, as they tout their incredible geology, they have been in and out of almost every major play in Canada, with no consistency. They now have legacy production in all 6 of the meridians — from Manitoba to the Montney, which is not something that many companies in Canada can say (and no, that is not a good thing for a 25,000 boe/d E&P).
While they have added around 11,500 boe/d of organic production, majority of the organic production adds have been from original land positions — meaning, without any acquisition activity, Surge could have capitalized their original assets, and at year end 2022, have only added 22% less organic production. Yes, what a crazy figure, after all the deals Surge has done, organically, they are more or less, no better off.
The recent growth wedge from their asset base has been from the Fire Sky and Astra Oil acquisitions in 20221, though it is misleading, as the legacy production on that asset has declined an equal amount — in total, Surge has added <300 boe/d net of declines on the SE Saskatchewan assets — putting their true organic growth, without original asset positions (in the Sparky, and at Valhalla) at less than 2,000 boe/d. Insane.
Below is my broken down production, with Surge’s reported corporate production superimposed, as an audit of the work I have put together.
SE Saskatchewan Core Area
Surge’s selling point, for the last decade, has been their “elite, high oil in place reservoirs” being unlike shale with their high decline, high costs, and tight rock — so it’s ironic that Surge’s Frobisher asset economics are almost the same as shale. While it’s true, that the Frobisher, for Surge is cheap, conventional, and relatively quick to pay back — what the company will not tell you, is their results are highly variable, the play itself is ageing and becoming less reliable — and, most importantly, on average their wells do not pay back more than 1.5x, and below $60 WTI, most of their wells will not pay back more than once.
The Frobisher is a very old field, and despite what senior management may say, it is not a repeatable, reliable cornerstone asset — quite the opposite — it is a treadmill capital suck with poor full cycle economics that you have to almost over-capitalize to drive per-barrel efficiencies. Their recent drills have targeted the west part of the Steelman pool, and while their positioning within the play would be considered relatively ideal, their recent well performance would certainly not be.
Despite senior management claims that the Frobisher is a very repeatable asset, the production statistics would beg to differ.
In 2022, Surge drilled 43 gross SE Saskatchewan wells which exited 2022 producing 2,540 bbl/d — in just 3 months, through the end of March 2023, those wells have declined 26%, and the IP rates of those wells — anything but consistent. Some came on at 300, 400, even close to 500 bbl/d, but others came on at 30, 40, or 50 bbl/d — that is a huge difference. The ones that come on <50 bbl/d need oil prices of $250/bbl to even pay back once, and herein lies the issues with inconsistency — if you can constantly drill okay, or good wells, like, perhaps in the Viking, you can work with that, but if your great wells are constantly subsidizing your bad wells, you are on a never ending cycle that leaves you needing to reinvest all your cashflow, doesn’t provide an engine to grow elsewhere, and doesn’t ultimately create value.
Below are the 2021 drills by Surge, and those purchased from Fire Sky and Astra Oil — and it’s much of the same — while the 50th percentile is close to the booked type curve, your good wells are subsidizing your bad wells, while on average, the first year decline rate is in the mid-60% range — ironic that management criticizes the expensive, high decline rock, when this is a core asset.
Finally, all wells drilled on current Surge Frobisher lands, after 2019. The P(50) result is below the booked type curve, and the first year decline for great wells is 80%. Only the ~65th percentile of wells pay out more than once, and the best of the best only pay out >2x at $85 WTI. Don’t get me wrong, these are great in a high oil price environment, where that tail 30 bbl/d production post-payout means something.
The main issue with the Frobisher is the very misleading return profile. Senior management has said that “the Frobisher is one of the best plays in Canada”, and while that might be true on an IRR basis, on a rate of return basis, it’s much worse than the Duvernay or Montney. See, the issue with the Frobisher, if your well doesn’t come on at ~250 bbl/d, you likely won’t see your money back, and referencing the charts above, Surge has drilled a lot of wells that don’t start out strong. The reality is, for Surge’s assets, the 50th percentile of their wells drilled between 2019 and 2022 will pay back in 3 years, with the second payback after year 8. They certainly have some great wells, which, at current prices, would pay out twice within 18 months, but those are the exception, not the norm.
Below is a chart of Canadian play payouts in weeks, along with Surge’s Frobisher well percentiles. The 90th percentile of their wells are competitive with core Clearwater, while, when you scale back to just the 75th percentile, the economics fall closer to Deep Basin gas, and the 50th percentile rivals the Bakken, and the Duvernay, with payouts at $60 WTI taking 5 years. I actually really like what Surge did with the Frobisher, it was strategic, gave them leverage to oil prices at a time they needed flexibility, in the way that, if oil ran post acquiring this asset, they could ramp production fast to generate cashflow, and worry about declines later, essentially, this asset helped them survive, but going forward, the Frobisher should not be a core asset in any mature E&P.
Tying the thoughts from above through — recall the note that Surge’s SE Saskatchewan organic growth is misleading due to high legacy declines — well, the chart below succinctly shows the treadmill they are on with their Frobisher efforts. While individual well results may be occasionally very impressive, the field has added ~60 wells since 2021 (and Surge has added ~35 wells since closing the acquisitions in late-2021), over both periods, production is essentially flat, due to the high initial declines when drilling in the Frobisher Steelman area.
The Frobisher is not a play that you can grow from — it’s not a resource play, and while management will critique the tight, expensive rock, there is a reason that large companies have scaled into the Montney, and Duvernay. Yes, the initial costs are expensive, but with scale, and pad drilling, you can drive incremental synergies, improve margins, design, optimize infrastructure, and it’s repeatable — you have much more control over what you want to do — in the Montney, a good operator controls their rock, in the Frobisher, the rock rides the operator.
Valhalla Core Area
For 10 years after Surge’s Zapata recap, their Valhalla asset targeting a really cool Doig oil pool has been a real winner. They organically grew production from the area to almost 7,000 boe/d at its peak, though unfortunately for them, this core area is quickly running out of inventory. The pool which they have been targeting, is only a few sections wide, and after spending almost a decade drilling there, new locations are sparse. For Valhalla to continue to remain a core area, Surge has to engage in secondary recovery methods, or make an acquisition, likely targeting Charlie Lake zones, or targeting inferior assets to the northwest — either way, the Valhalla play has run its course, and while it has served Surge well, it’s unlikely to continue as a core area in its current state.
The interesting thing about Valhalla’s recent production, is that it’s one of the few truly repeatable and predictable assets in Surge’s portfolio — and thus, as seen below, Valhalla is often tapped as the year ends, to add quick production in order to meet guidance, or street targets. I view this as continued short-term ignorance by management. Valhalla was originally marketed as an asset that was accessible year round (and their original growth ramp came during the mid spring). It’s prudent, capital allocation wise, to take advantage of an edge like year-round access, and have your drilling capital spent during early spring, when activity (and service pricing) is generally softer. Now, the fact that Surge has decided to capitalize Valhalla in the winter, to me, means one of two things — they simply made poor capital allocation decisions, or, they are using it as a fallback asset for end of year window dressing.
Both would be completely plausible to me.
Greater Sawn Core Area
What I would consider to be Surge’s biggest missteps in recent history, has been their purchase of Mount Bastion Oil and Gas, an asset they paid $320m for in 2018. After closing the deal, management had said it was “an asset we spotted several years ago, [but] could never get our hands on it” (which sounds eerily similar to the pitch for the Enerplus transaction in November 2022). With so much excitement, and a hefty price tag, almost 35% of capitalization, one might think Surge decided to dedicate a rig to drilling year-round, and pushed to capitalize the asset immediately (oil price was flat to increasing through 2020 and amount Bastion was primarily light oil and less impacted by heavy spreads) — no — instead, they drilled four wells during the drilling season in which they acquired the asset, and have not revisited the lands since, except to convert one horizontal drill into an injector.
Below is a map that details the vast footprint of mineral rights, producing wells, and infrastructure acquired from Mount Bastion — today, an acquisition this size would represent >40% of their entire market cap. After being marketed as highly accretive to shareholders, it has not only been dilutive, but likely started the domino effect that led to further asset sales to reduce leverage during 2020 and 2021 when their lending syndicate was looking to dissolve, destroying much more value than one would be able to tangibly model.
In 2019, Surge had planned to drill 5 additional wells at Valhalla, plans which didn’t materialize.
So, herein lies the issue with Surge’s acquisition strategy — the failed capitalization of the Mount Bastion assets, means, while Surge certainly didn’t pay just blowdown value, it’s what they are realizing. At 1Q18, prior to the acquisition of Mount Bastion — Surge was trading at an implied 2P reserve to enterprise value ratio of approximately $8.50/boe. Given that Surge puts such emphasis on oil in place, reserves feels like an appropriate metric. Prior to the acquisition announcement, Surge was trading at an implied $0.30/boe of original oil in place — the Mount Bastion deal was dilutive to both reserve figures — clocking in at ~$13/boe for 2P reserves, and $0.55/boe for original oil in place.
Their noticeable lack of drilling hasn’t worked to make up that gap, indeed, meaning this was a highly dilutive acquisition. A laughably small amount of their Mount Bastion production has come from the four wells they have drilled. Purchasing quality assets at robust prices then letting them naturally decline is, simply put, an excellent way to assuredly destroy shareholder value.
Below, visually drives the undercapitalization point home. Planning and executing a proper drilling program, would have the estimated asset level free cashflow at ~$250m today, or an unlevered IRR of ~15% — not exceptional, but not awful given the modelling window includes COVID. Instead, it sits in the mid-single digit IRR range, which is simply unacceptable for an entity with a cost of capital well into the double-digit range.
The Mount Bastion failure, strongly highlights the issues of undercapitalization, and dividend increases for the sake of dividend increases (or to sell a deal). Surge bought this asset, when they didn’t need to, increased their capital stack by ~$300m (or 35%), but only increased their cashflow, or earnings by 25% — a far cry from the 11% accretion this deal was sold on. Now, the issue that announcing a dividend increase with this deal brought about, is they didn’t have the cashflow to go in, and properly drill the asset — their very own kneecapping, led to what has essentially been, an asset level return lower than their cost of capital.
Bulls will cheer the Mount Bastion assets as hidden upside, though the fact is, it’s been dilutive to return on capital employed, and while, yes, it is honestly good if you are a new shareholder — it’s only good if you believe that management can break from their long established habits of acquiring dilutively, and begin to run the business properly, and I don’t believe that to be the case. Frankly, bulls will likely cheer Surge as having huge exploration upside, and I would suggest that any successful exploration will be certainly counteracted by declines elsewhere. Engineers and geologists like to have the vast land bases, though the issue arises when you pay a premium for land, and never drill. Surge has a deep inventory of exploitable lands, but not explorable lands.
Sparky Core Area
The Sparky is a very interesting play, and an area that Surge is familiar with — they’ve been in the play for a decade now, and it has been reasonably successful for them. Recently, their Enerplus acquisition added around 2,000 boe/d of production at deal announcement, but Surge has let that production (roughly half of the package) decline by 12% since November, which is 52% on an annualized basis. According to management, they haven’t drilled a well yet on the Enerplus Sparky assets, and if they continue to stick to their history of undercapitalizing acquired assets, the Enerplus package’s production will be <3,000 boe/d by YE23 — which would imply a purchase price of $82,700/boe — not ideal. Surge needs to get to work on these assets, and fast.
Overall, I question the ability to significantly scale, or even grow the Enerplus assets, implying a mostly PDP weighted transaction, money that I believe Surge could have spent much, much better within their existing asset base. Since 2000, the production on the asset that Surge acquired from Enerplus, was essentially flat (down ~5%), while the well count was up 80?% — you can see the oscillations late in the chart where individual wells are drilled, but only serve to keep production flat. If Surge continues to ignore this asset, they will have to spend years to grow production back above 2,000 boe/d — and much like the Mount Bastion acquisition, the capital is better spent sooner than later, ignoring it simply eats away at your asset level return. Given Surge’s history, it’s uncertain if they will act. This is a core area for Surge, and given the claim they have been evaluating this asset for “7 years” — I would expect (and hope for) a quick to act drilling program — it will be something to watch closely.
In other parts of the Sparky — they have seen declining well results and parent child issues with infill drilling. While senior management has said that “[in the Sparky] the P(10) is the P(90), there’s no variability”, the data tells a different story across Surge’s two core areas — results have been highly, highly variable, and their push for infill drilling, along with converting previous producers into injectors, has possibly lessened the quality of their remaining locations which they have marked, and marketed, at equal quality to prior drills. Below are a few recent examples of even the leg to leg variability across drills. In the below graphic, the legs with blue text labels have been converted into injectors. Recent drills, into the same zone, at the same vertical depth, have been, well, highly variable. Legs on the outside, with no neighbouring penetrations (Surge, or otherwise) have come on with strong first year production rates, far exceeding 2017 rates, though legs that have been drilled into prior production in the same zone have been noticeably weaker. The middle leg of figure 2, and the entire leg of figure 1 produced less oil in the first year than the outside legs in figure 2 produced in the first six months. When you consider that Surge, over the period between 2018 and 2022 (excluding 2020 due to COVID) has drilled an average of 53 gross wells per year, a 10% loss in well productivity in just the Sparky is akin to 3 fewer drills — a 30% loss, as implied by the results below, would equal ~10 fewer wells drilled each year, and a ~$20m decrease in free cashflow (by way of less revenue, or by way of increased capital expenditures required to keep production flat) — this does not instill confidence. Just the 2 wells underperforming like below, likely resulted in a 1-2% hit to free cashflow.
Below is another example of a Sparky drill, where the unbounded legs outperformed those on the inside, and historical drills, outperformed recent drills. The legs on the inside, drilled into a previous well (the one running diagonally), and the legs at the bottom ran adjacent to the well pictured above. There is a clear trend of infill drilling being less productive than unbounded, new drilling, and this isn’t only on Surge’s land, it’s across the play. At 16-27-044-05W, the 2014 horizontals drilled came on well over 100 bbl/d, while the wells drilled years later, at the same TVD, only came on at ~40 bbl/d. West of that, at 28-044-05W5, the three horizontals drilled to 2,100ft came on great, but the two horizontals drilled years later came on around 50 bbl/d, rather than the parent’s 175 bbl/d. The same story repeats itself many times throughout the Sparky, 12-29-044-05-W4, another great example — you don’t have to search very far.
IP rates for the wells drilled in 2023, so far, are on track to significantly underperform Surge’s internally modelled type curve.
If we have established, that true unbounded drilling is important for success in the Sparky, then we can look at Surge’s asset map, and decide a true net inventory number, adjusted for inferior locations. There is a chance, that Surge management has been assuming equal productivity across their land base, and we can see further below, that is not the case by any means. The map immediately below shows Surge’s mineral rights in blue, along with wells drilled on, and around their lands.
The map below outlines the approximate oil pools.
For the fun of it, the map below transposes their original 2014 land position, onto their current land position. The Wainwright area is mostly unchanged, they gave up some land in the southern parts of the play, though Surge has had a strong position in the Sparky since day one.
Zooming into individual pools, there is some running room here, with the top right area, recently acquired from Enerplus, being under waterflood, with perhaps some room to add additional capacity.
At Wainwright, Surge has been generally successful converting producers into injectors for waterflood purposes in the west part of the play, with producing wells gaining 10-15 bbl/d of incremental production, and flattening out when under waterflood. The legacy vertical waterflood comprising the bulk of their position has little room for growth given it’s existing success, though goes to serve as a litmus to what Surge could be if they truly decided to buckle down and implement waterflood at scale, instead of the occasional injector conversion.
Macklin and Provost have been recent areas of focus for Surge, with Provost results being the ones sampled above for the consistency issues graphics. Again, production has been fine, generally slightly better under waterflood, but not without inconsistent results when drilling into highly penetrated sections.
Surge has continued to market their Sparky areas assets as highly repeatable, and highly economic, but, according to a 2021 disclosure, their weighted average internal Sparky type curve has an IP180 (6 months) of 105bbl/d — 2019 was the only year where they averaged close to that. Currently, their average IP180 is closer to 75-80bbl/d, and has been trending downwards year over year. The Sparky zone is much thinner, with around 15 feet of net pay, compared to 40 feet in the Clearwater. I would suggest this is something to watch — if Surge resumes delivering strong well results, the idea of declining inventory may be incorrect, but, at now, there is a clear trend of lower, more sporadic, and variable inventory being drilled every year.
Below, I have compiled and aligned the progression of Surge’s land base in the sparky — most of their chunky positions (movement in large positions outlined in blue) either remain from 2015, or have been acquired, and since sold in the distressed asset sale to Tamarack Valley that took place in 2021. Surge could have stayed the course with their 2015 asset base, grown production per share by >80% compared to the actual 40% decline — instead they chose to move around, chase hot plays, and lost control of a solid cornerstone asset in the area. This is self-inflicted pain, and what happens when you play carelessly with leverage.
The ironic part about senior management’s comments, with respect to waterflood opportunities that only come around every so often, is their very desire to chase assets, then over leverage themselves, led to the selling of two very, very high quality waterflood assets to Tamarack. At deal close, their Slave Point waterflood (in the Clearwater, near Nipisi), and Eyehill waterflood (in the Sparky, near Provost) assets were producing 2,700 boe/d, and sold for ~$150m, or $55,600/boe — an estimated 3.2x current strip forward cashflow to total deal EV (including discounted, inflated ARO).
Ultimately, Surge replaced these assets with the Enerplus deal in 2022, which they paid $~250m for 3,800 boe/d (including the implied excess costs of a bought deal upsizing) — or $65,800/boe, representing an estimated 4.5x current strip forward cashflow to total deal EV (ARO inclusive). Now — Surge needed to sell these assets to stay alive, but have no doubt, they put themselves in a situation in the first place where an asset sale was necessary. As I mentioned in the beginning, Surge’s asset base has churned unnecessarily over the past decade, and along with poor cashflow management, they end up in situations where good assets are stripped from the company for far less than they paid, only to eventually be replaced at a higher price.
“Waterflood Potential”
It’s a favourite line of senior management that ‘waterflood can increase the recovery factor to 20%, and an incremental 1% recovery is equal to $1bn of cashflow at a $40 netback” — and while there are a few things wrong with that statement, the jarring one, is the simple fact that Surge has not at all been committed, proactive, or even aggressive with their waterflood projects — and if I was to posit, I would suggest it’s because, while the rate of return is higher (the total value of the project divided by the initial investment) the internal rate of return (how quickly the initial investment is returned) is lower — favouring IRR is not a good way to approach an E&P business. Surge has only covered a dozen injectors into producers over the past few years, which is a piddly amount considering the emphasis they put on waterflood upside.
The asset level forecast of the Cenovus Shaunavon asset has not even lived up to the blowdown forecast published by Surge in 2015 — let alone their development, or waterflood forecasts. This should speak volumes to their continued failure to properly capitalize assets. While some people will say that this simply leads to more inventory net to the current shareholder (and I agree, in a vacuum that is true) — continued ignorance by Surge to develop their acquired properties is not a one-off pattern, and may continue into the future. The NPV according to the slide below, at blowdown production, was $290m. In 2013 they paid $230m for the asset (excluding ARO). Since the acquisition, and after a handful of drills, they have sent it into essentially blowdown mode (actually, less than their own minimum forecast) — implying, at best (granted, commodity prices didn’t average their modelled $68/bbl WTI) they earned an undiscounted, unlevered, asset level return slightly more than 10% (NPV10 is cashflows discounted back at 10%, and if they paid the NPV for it, they are essentially rolling forward the discount factor). This is the same situation as the Mount Bastion acquisition — acquire, fail to capitalize, rinse, repeat. There is no place in a SMID cap E&P for 10% return projects, it’s simply not compelling risk wise.
The left was their development plan for the asset dated 2015 (the chart starts in 2014), the right is actual production overlaid. Surge forecast the asset would be producing, with waterflood, 6,800 boe/d today, with the potential to reach almost 10,000 — they also modelled end of life production at 1,800 boe/d in 2038 — today it produces <1,500 boe/d. You have to question, if this was so great in 2013 — why Surge decided to buy another asset from Enerplus, instead of properly capitalizing their current portfolio. There is a clear trend in behaviours here.
The key thing about a successful waterflood, is it’s not “waterflood upside”, it should be a “waterflood project”. Take the highly productive Weyburn Unit in Saskatchewan, a field that has produced over 30% of its oil in place (a target that Surge management has articulated before, for their assets) — it was not a day one asset start up. From the day that the asset owners (originally piloted by PanCanadian, known as EnCana, then sold to Cenovus, and eventually Whitecap today) started injecting carbon and water into the reservoir, significant production increase results weren’t seen for 2-4 years. While you can bring on waterflood projects ‘here and there’, you are not realizing the true incremental value of a high OOIP asset base unless you actively work towards a larger project. To truly have a successful scaled waterflood within a business, you need to have multiple sections, perhaps a unit agreement, and infrastructure in place. Waterflooding isn’t simple as pumping water into a hole, you have to have the correct water, or else you can turn the formation sour, and corrode the steel. With waterflood at scale, you can optimize flood pattern voidage replacement, and improve the fields overall efficiency, while benefiting from scale and operational synergies — which is not something that you get with individual flood efforts. While “waterflood upside” is not false, Surge can only meet their lofty targets of unlocking an additional 1% of OOIP, by coordinated, and methodical planning.
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