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Investment Highlight



1.      Gear Energy will benefit from production cut exemption and reversion of WTI – WCS spread to its long-term average of CAD$17 per barrel as consensus flip from constrain to surplus in takeaway capacity in ’19. This is supported by an incoming 375 thousand barrel-per-day of capacity addition by Enbridge Line 3 slated in ‘19Q3, an 8% YoY based on ’18 base capacity of 4.6 million barrels-per-day. Moreover, crude-by-rail (CBR) capacity will increase 40% by October ’19, the equivalent of 120 thousand barrels-per-day as Alberta purchases additional rail tanker cars. In addition, the Alberta government had mandated a 325 thousand barrels-per-day of production cut in ‘19Q1 equivalent to 8% YoY of which the first 10,000 barrels-per-day of production is exempted. Altogether, Plains All America’s forecasted takeaway capacity deficit of 454 thousand barrels-per-day will flip into 269 thousand barrels-per-day of surplus in ‘19.



2.      Contrary to the consensus, WTI – WCS spread will narrow as Canada fills the void left by increasing demand for heavy crude oil by complex U.S. refineries to generate higher distillate yield for IMO 2020 as supply from Latin America falters. Although simple refineries will increase light crude oil feedstock at the expense of heavy crude oil feedstock to reduce its high-sulfur fuel oil and atmospheric residual yield, complex refineries such as those in U.S. will have to aggressively increase heavy crude oil feedstock increase its aggregate distillate yield particularly when it had already maximized its light crude oil feedstock intake. However, U.S. crude oil production has become lighter and lighter due to explosive growth in shale oil while heavy crude oil supply from Venezuela, Mexico and Colombia faltered due to years of mal-investment. Consequentially, Canada needs to fill the void and have increased its market share of U.S. crude oil import from 28% in ’12 to 43% in ’17. As Canada pauses production growth due to pipeline uncertainty while Latin American heavy crude oil production continues declining, it is inevitable for WTI – WCS to narrow further as IMO 2020 approaches.



3.      Gear Energy is severely undervalued as the market punishes its equity dilution due to trough-cycle value-accretive acquisitions. From ’14 to ’18, Gear Energy has diversified from a pure heavy crude oil producer to include 30% middle and light crude oil, 4% natural gas liquid and 13% of natural gas. Moreover, it lowered its operating cost by 40% while reducing its base production decline rate from a whopping 37% to 27%. With great self-funded growth prospect from ’19 onwards, the market implied ‘19E EV / EBITDA of 2.3x while our model with higher crude oil price had an implied multiple of 1.9x. Comparing to its ’16 (4.7x) and ’17 (4.1x) average multiple as well as its peers’ median NTM EV / EBITDA of 5.1x, Gear Energy deserves at least 4.5x to its forecasted ‘19E EBITDA of CAD$113 million, effectively providing a margin-of-safety of 70%.



Risks



1.      Concentrated market share structure in Canadian heavy crude oil production can possibly result in collusion to flood the market with excess supply in order to consolidate the market further. This is due to the fact the top six heavy crude oil producers in constitutes three-quarter of Canadian heavy crude oil production (Appendix 1). However, this is unlikely to occur in the near and mid-term given that Suncor Energy vowed not to sanction new projects unless there is physical progress on the ground for pipeline capacity. Similarly, Cenovus Energy pledged to keep heavy crude oil production stagnant for ’19 while Canadian Natural Resources have recently slashed ‘19E CAPEX by 20% versus earlier projection provided.





2.      The postponement of IMO 2020 can potentially be threatening to an investment position in heavy crude oil names depending on when the equity market realizes incremental demand for heavy crude oil by U.S. complex refineries in the face of collapsing heavy crude oil supply. If the equity market is aware of such dynamic before the end of ’19, a deadline extension will witness most of the gains leading up to IMO 2020 being sold-off. In contrast, heavy crude oil names can possibly soar if such dynamic was not factored into valuation before IMO 2020 as equity market consensus reverse their long light / short heavy crude oil trade.



3.      A severe delay in Enbridge Line 3 capacity addition and the delivery of rail tanker cars will turn the equity market sentiment more negatively. Hence, the development in these two stories will be a key risk for us to monitor going forward.

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