This case study is part of a continuing series prepared by Pangea Global in its ongoing research project on the business of oil and gas. The project examines the three key business dimensions of performance, People, Strategy and Business Processes for the North American exploration and production industry segment. The case study series illustrates specific sources of high performance within those three dimensions unique to each company. These case studies are used to help companies seeking to improve their performance by illustrating how high performing companies have found their way to success. The case studies are developed from public documents with requested clarification from the companies. As such, proprietary information is never collected and respect for full disclosure is strictly adhered to.
Peyto has achieved remarkable success in the challenging tight gas reservoirs in the deep Western Canadian Sedimentary Basin (WCSB). With only 50 people, the company has earned the second highest Excess Return to Capital of the 89 companies analyzed in the North American upstream (Figure 1). When the current industry chaos settles out, Peyto will be one of the survivors and possibly one that thrives in the meantime.
However, Peyto ranks 75th in Market Value Premium over Fair Value. That is, it has a Morningstar Fair Value of $11.2 Billion with a Market Value of only $4.0 Billion (Figure 2).
The company has created a premium of $7.2 Billion more in value than is recognized by the capital market. Fair Value is the NPV of its assets, including its large, high quality inventory of development locations net of debt. Even at today’s low prices and equity market pessimism on upstream companies, the low market value for Peyto is surprising, selling at discount of 179% of Fair Value (Figure 3).
Nevertheless, Peyto stands as a paragon for alignment of people, strategy and process. Market recognition should eventually equalize market and fair value, but in the near term Peyto is clearly a survivor.
Some companies have grown through acquisition, a perfectly viable strategy provided the acquired assets are complementary or the acquiring company can simply manage them better. Acquisition, however, is not Peyto’s strength. They made one acquisition in 2012 that has not materially improved performance. Peyto been more successful generating its own prospects as organic growth seems to generate better results.
Peyto has a very clear and tightly focused exploration strategy in the Alberta part of the WCSB. This focus results in:
Peyto has achieved its growth from concentrating in the Spirit River Group amassing a large, high quality development inventory. It has a significant opportunity for new acreage acquisition in 2015, ’16 and ’17 as existing leases expire. The company has significant gathering and processing infrastructure in the heart of its core area, allowing additional returns from this business segment in addition to higher dry gas netbacks, liquids credit and tolling revenue processing for others. It has opportunities to both expand and optimize this network, further enhancing returns. The decision to enter the processing segment has been reported as a recognition that the legacy processing infrastructure is aging and inefficient. This suggests a unique strategic perspective that seeks to optimize the entire value chain.
The focus on gas provides a hidden benefit. Gas prices did not rise to the level of oil prices and thus enforced a discipline oil producers are just now dealing with. Peyto has had to maintain cost control through the entire value chain that currently supports margins, but has also instilled a culture of cost control and further cost reduction gains. The stability of long term performance suggests this was a clear and specific intent from the company’s founding. Peyto has remained profitable even at currently depressed price levels. Nevertheless prices have negatively impacted Peyto’s Returns to Capital.
Another interesting and unique feature of their strategy is to operate counter to the cycle for services and supplies. The company has a history of scaling back during periods of high costs and opportunistically accelerating when factor costs decline.
In 2009 Peyto began using horizontal drilling in it is core area, dramatically increasing production. This seems to have opened new formations: Falher-Wilrich-Notikewin in the Spirit River Group.
It is clear that its business processes enable Peyto to shine among its peers. Cost discipline has been mentioned as an outgrowth of its strategy, but it is clear this is more than an ancillary benefit. It has been rare, until recently, to see a company promote cost discipline particularly in drilling and completion.
Peyto claims an average 26% IRR for its 2014 drilling program. Comparing commercial wells to marginal and dry holes suggest the company has a high success rate. It seems this is, in large measure, due to the substantial inventory that has allowed them to high-grade their investments.
With its tight focus, deep knowledge of the plays and its large drilling inventory, capital allocation should be highly rigorous and almost routine. This is a luxury enjoyed by only those employing the most focused strategies. It effectively removes one of the biggest variables in the business of oil and gas.
The question then devolves to capital deployment, which for Peyto includes the following tactics:
One potentially important new development is that in 2015 IP rates have increased by as much as 50% on average. This may be a sign of improved effectiveness of stimulation practices. If this is the case, Peyto may have significantly increased its fair value. It is also very likely due to high-grading development opportunities this year. Based upon Peyto’s stress testing of its operating areas, it appears that high-grading may be an effective tactic, focusing on better economics during this period of low prices.
Capital deployment appears to have improved significantly from 2007-10. Despite a reduced rate of gain capital efficiency improved even during the boom years. Significantly, capital spending nearly quadrupled, signifying a sustained cost discipline in the face of increasing opportunities and competition for services and supplies..
Despite the competition for services and supplies, during the past 5 years, Peyto has driven down drilling costs in its horizontal wells since commencing the practice in 2009. Some of this appears to be learning. In 2009 two horizontal wells were drilled, 32 in 2010 increasing to 114 in 2014. While cost is difficult to precisely measure, per foot rates seem to have fallen by about 1/3 since 2009 and drilling days from 25 to 14.
Completion costs are less well understood due to the relatively recent (2009) implementation of horizontal drilling and advanced stimulation techniques. The company claims a completion cost efficiency gain of 10% resulting from design changes and lower cost sand.
Exceptional operating cost discipline allows Peyto to lay claim to the title Low Cost Producer in Canada. Further, Peyto has not experienced the cost escalation and volatility experienced by its Canadian peers. The reasons are stated to be:
Other Operating practices cited by the company include:
The success of Peyto on the people dimension can only be inferred from the results. Fifty people generate nearly 100,000 BOED of production and ~C$700MM in revenue (C$14mm/employee). This is near, if not at, the top of the North American upstream. The company asserts its technical team generates more opportunities than it can develop. This is easy to believe given they have nearly 2000 locations yet to develop. (747 booked, 1237 un-booked)
What can be inferred is they seem to instill an owner operator mindset in their employees. With overall execution strong, the results point to effective-empowering leadership. Interesting to note is the attention paid on the website to the significant technical prowess of the senior team. However one mention points to an important and perhaps understated competitive advantage Peyto enjoys.
“Mr. Burdick has continued to develop his experience across many facets of operations and has successfully helped build the production operations group into an effective and cohesive team.”
The culture Peyto enjoys is summarized in the following points.
• Build it ourselves
• Operate it ourselves
• Focus on maximum return
• Stay concentrated, lean & efficient
While the details of how Peyto built this culture are opaque from a public perspective, the results affirm they have realized a significant accomplishment. This culture is probably the key reason Peyto has a very clear and strong alignment of the three pillars.
Return on Capital declined from 2005-12 with a slight retrace in ‘13 and ’14. This pattern closely parallels their realized gas prices, suggesting there is no immunity to commodity prices regardless of how talented, effective and efficient a company may be. That said, the question remains: What beyond focus and efficiency can be done to overcome price pressure? The true answer is to operate in areas you know, use the best talent and relentlessly improve your processes. Return on equity is claimed to be 34% for the 16 year period since 1999. Consistent with Morningstar’s 10 year average of 27%. This is a company that has returned consistently well over a good part of its history, by talented leadership, a well-developed strategy and executing well. This only happens with strong alignment.
 Morningstar Fair Value is an estimate of the company’s equity worth at the present time. Itis calculated with Morningstar’s proprietary statistical model applied to future cash flow projections developed through independent primary research.