Kicking Horse Energy Inc (KCK-V) Kicking Into High Gear. Resuming Coverage BUY $5.00

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1 Kicking Horse Energy Inc. (KCK-V) Kicking Into High Gear April 6, 2015 Michael A. Zuk (403) We are resuming coverage of Kicking Horse Energy. The company is a junior-sized oil and gas producer focused on liquids-rich gas development in the greater Deep Basin of Alberta. Compelling arguments are: Bigger is Better - With the merger of Contact and Donnycreek, we believe the institutional relevance of Kicking Horse heightens as the company effectively has more leverage to an outstanding project in East Kakwa, improved spending capacity and still vision to longer term option value with ancillary acreage in Alberta, as well as upstream and LNG export opportunities in New Brunswick. Timing the Risk/Reward Pendulum Along the spectrum of Montney producers with several years experience drilling hundreds of wells, versus others drilling their first wells, we contend Kicking Horse is at an enviable stage whereby the productivity of the rock has been well proven (with 19 wells drilled) and still upside potential remains with development of the Upper and Lower Montney in addition to drilling/completion efficiency improvements. Upcoming completion of the 16-7 plant expansion should also help corporate netbacks in the range of ~$7/boe. Economics - At $50/bbl oil and $3.00/mcf gas we estimate a payout of 2.8 years for its East Kakwa Montney project. The company continues to refine its drilling and completion results, yielding better productivity for proportionally less capital but even using public data for historical wells we believe economics are robust. We are resuming coverage of Kicking Horse with a BUY recommendation and a 12-month price target of $5.00. Our target is based on a sum-of-the-parts valuation. Previous Close 12-month Target Price Potential Return Resuming Coverage BUY $5.00 $2.66 $ % 52 Week Price Range $ $7.47 FYE Dec 31 Assumptions 2014A 2015E 2016E WTI (US$/bbl) $0.00 $50.00 $60.00 AECO (CDN$/mcf) 2009E $3.22 $3.83 US$/CDN$ $1.00 $0.81 $0.81 Production Crude oil & Liquids (bbl/d) - 1,628 1,927 Natural Gas (mmcf/d) 2009A Total Production (boe/d) 3,964 3,256 3,854 Oil & Liquids Weighting 0% 50% 50% Financial ($MM, except Per Share item) Cash Flow $26.9 $43.6 CAPEX $36.0 $40.0 Net Debt $32.9 $29.3 Net Debt/CF 1.2x 0.7x CFPS - Fully Diluted $0.45 $0.72 EPS - Fully Diluted $0.05 $0.24 Valuation P/CF 6.0x 3.7x EV/DACF 6.9x 4.2x EV/BOEPD $58,892 $48,815 Stock Data Shares Outstanding, Basic (MM) 59.7 Shares Outstanding, Diluted (MM) 64.7 Insider Holdings, Basic 3.5% Market Capitalization (MM) $158.8 Enterprise value (MM) $189.6 About the Company Ownership of Kicking Horse Energy leverages investors to prolific Montney natural gas in the Deep Basin, as well as longer term option value in various New Brunswick projects. 1,600 1,400 1,200 1, All prices in C$ unless otherwise stated Stock Performance Kicking Horse Energy Inc (KCK-CA) Volume (Thousands) Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Volume Kicking Horse Energy Inc Price (CAD) Source: FactSet Prices Beacon Securities Ltd. 66 Wellington Street West, Suite 4050, Toronto, Ontario, M5H 1H

2 Table of Contents Investment Rationale... 2 Company Overview... 2 Our Key Questions... 3 Asset Overview... 5 Growth and Efficiency... 8 Valuation Appendix I April6, 2015 Page 1

3 Investment Rationale We are resuming coverage of Kicking Horse Energy with a BUY rating and 12-month target price of $5.00 per share. The company is a juniorsized oil and gas producer focused on liquids-rich gas development in the greater Deep Basin of Alberta. Today, Kicking Horse is producing >3,000 boepd (50% liquids) and holds corporate reserves of 29.9 mmboe. As is typical for all companies under coverage, we focus our analysis only on the key assets that will see capitalization within a twoyear time frame. Company Overview What we like about Kicking Horse; Bigger Is Better With the merger of Contact and Donnycreek, we believe the institutional relevance of Kicking Horse heightens as the company effectively has more leverage to an outstanding project in East Kakwa, improved spending capacity, and vision to longer term option value with ancillary acreage in Alberta, as well as upstream and LNG export opportunities in New Brunswick. With more size, we would also argue the relative appeal of the company to acquirers also increases greater Kakwa is rich with competitor activity of at least six larger producers. Timing the Risk/Reward Pendulum Along the spectrum of Montney producers with years experience drilling hundreds of wells, versus others drilling their first wells, we believe Kicking Horse is at an enviable stage whereby the productivity of the rock has been well proven (with 19 wells drilled) and still upside potential remains with development of the Upper and Lower Montney in addition to drilling/completion efficiency improvements. Upcoming completion of the 16-7 plant expansion should also help corporate netbacks in the range of ~$7/boe. Cautionary Considerations; Very Little Room For Error The continuing theme for oil and gas investors is a subtle risk-off bias, while commodities remain depressed with preference to larger names April6, 2015 Page 2

4 (with more liquidity, in the case of a head-fake rebound) and/or proven junior names with strong stewardship and prior success in other iterations. The implicit implication for other junior names is that equity capital is somewhat limited, and cash flow is of course muted due to commodity prices; ergo the room for operational mishaps is very narrow. The capital intensity of the Montney play for most juniors is significant a poor well result at $8-12 million per well can be punitive to the balance sheet and raise the equity cost of capital. We believe this risk applies to most juniors in the space today, not just Kicking Horse but do cite it as one that investors should be aware of. Our Key Questions 1.What is the time-to-payout of the company s core project(s)? Kicking Horse has drilled 19 wells into its East Kakwa Montney project (majority in the middle Montney), of which 15 are completed. Among those with public data, we estimate a well payout of 2.8 years at our standard project price forecast of C$50/bbl and C$3.00/GJ (realized price). With strong gas-push and high levels of condensate-rich liquids ( bbl/mmcf) the play is still highly economic at these levels. Kicking Horse is also in the process of refining a sliding sleeve technology which allows more fracs and improved isolated frac port access (for re-entry etc). The first well using this process, and drilled to a record measured depth of 6,161m, had a total D/C/C cost of $11.5MM but produced ~5.7 mmcf/d + 1,250 bbl/d of liquid hydrocarbons on a ~2 day test rate (~2,400 boepd total) before running into flaring limits. We believe this is a meaningful step change in productivity relative to older wells (~1,000 boepd IP30) but one that is also not reflected in the company s engineering report. Therefore, the look-forward picture remains still brighter than the rear-view. 2. How much of that inventory does it have? The Montney play along the greater deep basin has several layers, and depending on which technical team one speaks to, the vernacular of which layer is which, tends to change. In our simple (albeit financial-orientated) view, we believe in some areas three layers can be mapped of which development and delineation of each layer varies geographically. As it pertains to Kicking Horse, the company cites three distinct layers (upper, middle, lower) and notes April6, 2015 Page 3

5 two sub-layers may exist within the thicker upper member. That said, the bulk of activity to date has been in the middle Montney where at least 17 horizontal wells have been drilled (remaining two in the upper). We estimate roughly a 50 well inventory in the middle Montney, which is notable because it has the most data and thus far the best results. At the current run-rate cash flow level of $20-25MM this implies still many years locations. 3. How much of it is unbooked or unspoken for in the third-party engineering report? If, as we suggested above, Kicking Horse drilled 2-3 wells per year, then our current estimate of 50 wells is still quite substantial. But we also need to consider those wells booked as PUDs/probables (the remaining being unbooked upside for the investor). Drilled and booked wells in just the middle Montney represent approximately 66% of said locations, which in our view seems fairly well booked. This however excludes the upper Montney, where again another 70+ locations could be drilled, and then of course the lower as well. We only point this out because the member with (thus far) the best results and the most data is fairly well spoken for already we will actively be looking for more well data in the upper layer(s), lower layer as well as other geographic areas to meaningfully add unbooked upside. This may come from offsetting producers, or Kicking Horse itself either in our mind would improve the company s relative posture in question number three. 4. What is the company s ability to capitalize that inventory? Kicking Horse holds current net debt of ~$30MM against a bank line of $70MM, or a D/CF of ~1.2x against our 2015 forecast. Therefore we view the company s financial standing in relatively good form. The Montney play in general is still however fairly capital intensive, and although the company can still fully fund ~2 wells within cash flow (at a notional bottom in the commodity cycle) it also remains somewhat undercapitalized relative to the potential prize in front of the company. Joint ventures or farm-outs may be an option to crystallize some of that latent value (but also entail sharing it s best project) so we look to an uplift in commodity prices as the most likely accelerant to the development of Kicking Horse s Montney play. April6, 2015 Page 4

6 Asset Overview The merger of Donnycreek with Contact greatly enhanced the total land position of the newly formed entity. Below we show Kicking Horse s acreage which now sums 350+ net sections. The most prospective in our view, and those most likely to see growth capital in the near term are East Kakwa, Pinto (Notikewan play) and West Kakwa (prospective for Montney). Exhibit 1. Kicking Horse Land Overview With Competitors Source; GeoSCOUT, Company Reports April6, 2015 Page 5

7 In Exhibit 2, we present a zoomed-in map of Kicking Horse s greater Kakwa acreage as well as six-month cumulative production bubbles for all horizontal Montney wells. Our sample includes 13 horizontal wells in the defined area drilled by Kicking Horse and the remainder being industry data. We also note new licenses by several larger competitors on the West Kakwa block which will provide important well data in terms of the commerciality of Kicking Horse s western acreage. Exhibit 2. Kicking Horse Focus Area With Competitors Source; GeoSCOUT, Company Reports April6, 2015 Page 6

8 For visual comparison, we have compiled 13 horizontal Montney wells drilled by Kicking Horse. Newer wells are highlighted in darker grey, while the bold blue line denotes the cumulative production of the average productive curve in 2 years producing >160,000 boe. Exhibit 3a. Kicking Horse Hz Wells Cumulative Production Source; geoscout, Beacon Securities Ltd. Estimates Exhibit 3b. Kicking Horse Hz Wells Daily Production Source; geoscout, Beacon Securities Ltd. Estimates April6, 2015 Page 7

9 Growth and Efficiency The Montney play varies in a number of key facets; depth, sour content, relative liquids size and composition, as well as ultimate natural gas productivity. We have built our Kicking Horse type curve using publicly available data and our estimation of the aforementioned uplift in productivity seen on newer sliding sleeve wells. Our type curve utilizes an IP30 of 1200 boepd, 150 bbl/mmcf and contemplates a drill/case/complete cost of $10,000,000 per well. Below, graphically we show our base case as well as a curve 25% higher and a curve 25% lower each with payout and estimated reserves to reach payout also displayed. Our commodity price assumptions are C$50/bbl oil and C$3/mcf natural gas (realized wellhead prices). Exhibit 4. Kicking Horse Montney Type Curve Source; geoscout, Beacon Securities Ltd. Estimates April6, 2015 Page 8

10 Below we highlight an IP30 sensitivity, with our base case producing an NPV of $3.6 million, a 27% IRR and time-to-payout of 2.8 years. Our internal modeling suggests Kicking Horse s wells are still economic down to C$41.00/bbl and C$2.05/mcf (well head price). At the stated capital cost above, we estimate per-well finding costs of $11/boe based our model of 894,000 boe per well. Exhibit 5. East Kakwa Montney Type Curve Sensitivity Source: Beacon Securities Ltd. Estimates With the current depressed nature of crude oil, we also provide price and cost sensitivities. The Montney is by and large still a gas play but with relative liquids contents of >300 bbl/mmcf, some gas wells can even be categorized as liquids/oil wells. We would note just a C$5/bbl move in realized oil price adds $900,000 to well NPV s and reduces the payout by close to 6 months. An inverse and downward move on crude is however more elastic and a retrenchment to C$45/bbl adds almost 9 months to payout. As previously noted, as rig activity drops across the basin due to poor economics, we also expect energy service costs to decrease by 10-20% for most producers. In the case of Kicking Horse for example, a $1,000,000 reduction in well D/C/C costs (all other variables held constant), provides virtually the same benefit to NPV s (increasing $1,000,000 per well) while reducing payout ~6 months in our base case. April6, 2015 Page 9

11 Exhibit 6a. Oil Price and Capital Cost Sensitivities Source: Beacon Securities Ltd. Estimates Exhibit 6b. Natural Gas Price and Capital Cost Sensitivities Source: Beacon Securities Ltd. Estimates April6, 2015 Page 10

12 Exhibit 6c. Commodity Price Sensitivities Source: Beacon Securities Ltd. Estimates April6, 2015 Page 11

13 Valuation In Exhibit 7 below, we compare key metrics for four of our names under coverage. Referencing our preferred investor recycle ratio, we see Kicking Horse offers a 1.5x ratio at current trading levels, which is commensurate with the other small cap name, Striker. Part of this, in our view reflects a distinct risk-off bias from investors whereby capital is flowing to names with a proven track record of success in prior iterations, pristine balance sheet, and expeditious recycling of capital. In the case of Kicking Horse, we have used data from the last five quarters to calculate corporate-time-to-payout, but even that slightly trails the larger, oil-levered names. One of the key strengths of the business model as we see it is its net debt position of 1.2x D/CF (53% bank line unutilized) giving the company flexibility to withstand depressed commodity prices. Exhibit 7a. Relative Valuation on Key Metrics Source: Company Reports, Beacon Securities Estimates. Also, we highlight the multiple of EV to its engineer s PDP NPV10 at 2.5x implying the market is giving the company a multiple of the capital already deployed (and wells on production), in line with other companies under coverage. April6, 2015 Page 12

14 Below we would highlight the PDP NAV10 of $0.81/sh (basic) which we view as more of a floor for the stock at current levels. Excluding debt, the share price is trading at ~3x the PDP NAV10/sh value, which again is coincides with other companies. Exhibit 7b. Kicking Horse Reserve Scorecard Source: Company Reports, Beacon Securities Estimates. As shown in Exhibit 8, we have used our standard sum-of-the-parts valuation for Kicking Horse. The foundation of our target enterprise value and target price is a function of forecast reserves as of the end of Unlike other P/NAV models, we only give the company credit for reserves which can be financed within cash flow and available bank line capacity. Our expectation of market value of reserves is derived from the cost base of the Kicking Horse business model. April6, 2015 Page 13

15 Exhibit 8. Sum-of-the-Parts Valuation 2014 Reserve Value 2014 Reserves (mmboe) 29.6 Quality Adjustment 0% Adjusted 2015 Reserves (mmboe) 29.6 Cash Flow Factor ($/boe) $26.29 Reserve Value Factor $/boe (1.4:1) $18.78 Current 2014 Reserve Value $ Exit Net Debt ($mn) ($23.9) Future Capital ($mn) ($246.0) Dilution Proceeds ($mn) $11.7 Current Value of 2014 Assets ($mn) $296.9 Fully Diluted Shares (mn) 64.7 Per Share (FD) Value $ E Value Add 2015 Gross Capex ($mn) $36.0 Less: Land, Seismic & Facilities ($mn) ($6.0) Drilling Spending ($mn) $30.0 Average Cost per Well ($mn) $10.00 Forecast 2015 Net Wells 3.0 Success Factor 95% Forecast Successful Wells 2.9 Average Reserves/Well (boe) 850, Forecast Depletion (mmboe) 1.2 Wells to Offset Depletion 1.4 Net Growth Wells 1.5 Net Reserve Growth (mmboe) 1.2 Forecast Revisions (mmboe) 0.0 Acquired Reserves (Net of Depr., mmboe) 0.0 Forecast Net Reserves Growth (mmboe) 1.2 Cash Flow Factor ($/boe) $26.29 Reserve Value Factor $/boe (1.4:1) $18.78 Value Add ($mn) $23.2 Change in Net Debt ($mn) ($9.1) 2015 Value Add ($mn) $ Net Risk Adj. Equity Value Add ($mn, 90%) $12.7 Fully Diluted Shares (mn) 64.7 Per Share (FD) Value $ E Value Add 2016 Gross Capex ($mn) $40.0 Less: Land, Seismic & Facilities ($mn) ($6.0) Drilling Spending ($mn) $34.0 Average Cost per Well ($mn) $10.00 Forecast 2013 Net Wells 3.4 Success Factor 95% Forecast Successful Wells 3.2 Average Reserves/Well (boe) 850, Forecast Depletion (mmboe) 1.4 Wells to Offset Depletion 1.7 Net Growth Wells 1.6 Net Reserve Growth (mmboe) 1.3 Forecast Revisions (mmboe) 0.0 Acquired Reserves (Net of Depr., mmboe) 0.0 Forecast Net Reserves Growth (mmboe) 1.3 Cash Flow Factor ($/boe) $26.29 Reserve Value Factor $/boe (1.4:1) $18.78 Value Add ($mn) $25.1 Change in Net Debt ($mn) $ Value Add ($mn) $ Net Risk Adj. Equity Value Add ($mn, 75%) $21.6 Fully Diluted Shares (mn) 64.7 Per Share (FD) Value $0.33 Sum of the Parts Value $mn Per Share 2014 Reserve Value $296.9 $4.59 Interest/G&A Expense ($6.4) ($0.10) 2015E Value Add $12.7 $ E Value Add $21.6 $0.33 Fair Value Estimate $324.8 $5.02 Source: Beacon Securities Ltd. Estimates April6, 2015 Page 14

16 Based on our sum-of-the-parts valuation, we derive a 12-month target price of $5.00 for the company. Exhibit 9. Sum-of-the-Parts Valuation Waterfall Chart Source: Beacon Securities Ltd. Estimates April6, 2015 Page 15

17 Appendix I Kicking Horse Energy Inc. P/CF: 10.1 P/CF: 6.0 P/CF: Apr-15 EV/DACF: 12.2 EV/DACF: 6.9 EV/DACF: 4.2 Debt adj. target price multiple: 3.0 Debt adj. target price multiple: 1.2 Debt adj. target price multiple: E 2015E 2016E Q1 Q2 Q3 Q4E 2014E Q1E Q2E Q3E Q4E 2015E Q1E Q2E Q3E Q4E 2016E DAILY PRODUCTION Liquids (B/d) ,500 1,653 1,670 1,687 1,628 1,827 1,883 1,936 2,060 1,927 Natural gas (MMcf/d) BOE production per day (6:1) , ,000 3,305 3,340 3,373 3,256 3,654 3,766 3,872 4,120 3,854 Commodity price assumptions Exchange rate (C$/US$) $0.91 $0.92 $0.92 $0.88 $0.91 $0.81 $0.81 $0.81 $0.81 $0.81 $0.81 $0.81 $0.81 $0.81 $0.81 WTI (US$/Bbl) $ $98.99 $ $50.00 $ $60.00 Natural Gas (US$/mmbtu) $4.72 $4.58 $3.95 $3.83 $4.27 $3.25 $3.25 $3.50 $3.75 $3.44 $4.00 $3.75 $4.00 $4.25 $4.00 Company average liquids price (C$/Bbl) $ $ $95.41 $75.86 $93.86 $57.56 $63.73 $63.73 $69.90 $63.94 $69.90 $76.07 $76.07 $82.25 $76.29 Company average gas price (C$/Mcf) $6.74 $5.67 $4.85 $4.41 $5.42 $3.50 $3.25 $3.50 $3.75 $3.72 $4.00 $3.75 $4.00 $4.25 $4.33 UNIT VALUES ($/BOE) Total sales Royalties (incl ARTC) (4.06) (6.59) (5.21) (4.09) (4.74) (3.14) (3.33) (3.39) (3.70) (3.40) (3.76) (3.94) (4.00) (4.31) (4.01) Transportation (8.10) (4.57) (3.71) (6.00) (5.81) (5.50) (5.00) (4.00) (3.50) (4.46) (3.50) (3.50) (3.50) (3.50) (3.50) Operating expense (7.18) (13.06) (12.84) (8.00) (9.59) (10.00) (10.00) (10.00) (10.00) (10.00) (10.00) (10.00) (10.00) (10.00) (10.00) Operating netback G & A expense (15.21) (10.64) (7.75) (3.26) (8.04) (1.11) (1.00) (0.98) (0.97) (1.01) (0.91) (0.88) (0.84) (0.79) (0.85) Interest expense (0.88) (0.96) (1.03) (0.96) (0.96) (0.90) (0.87) (0.79) (0.69) (0.81) Current tax Other (cash expenses) (0.63) (0.49) (0.23) Cash flow netback ($/BOE) Total cash costs ($/BOE) (22.35) (23.42) (20.46) (11.26) (17.54) (11.99) (11.96) (12.00) (11.93) (11.97) (11.82) (11.74) (11.63) (11.48) (11.66) Earnings ($/BOE) (1.35) Total revenue ($MM) Cash flow ($MM) Net income ($MM) (0.365) Net capital spending ($MM) Net debt ($MM) (2.913) D/CF - trailing 0.7x NA 0.8x 2.2x 3.0x 1.5x 1.4x 1.3x 1.0x 1.2x 1.0x 0.8x 0.7x 0.6x 0.7x Weighted average shares outstanding Weighted average shares fully diluted EPS basic $0.05 $0.06 $0.08 $0.02 $0.16 ($0.01) $0.01 $0.02 $0.04 $0.05 $0.04 $0.06 $0.07 $0.09 $0.26 Diluted EPS $0.05 $0.05 $0.07 $0.02 $0.16 ($0.01) $0.01 $0.01 $0.03 $0.05 $0.04 $0.05 $0.06 $0.09 $0.24 CFPS basic $0.11 $0.09 $0.07 $0.05 $0.27 $0.08 $0.11 $0.12 $0.14 $0.45 $0.15 $0.17 $0.18 $0.22 $0.73 Diluted CFPS $0.11 $0.08 $0.07 $0.05 $0.26 $0.08 $0.11 $0.12 $0.14 $0.45 $0.15 $0.17 $0.18 $0.22 $0.72 April6, 2015 Page 16

18 Disclosure Requirements Does Beacon, or its affiliates or analysts collectively, beneficially own 1% or more of any class of the issuer's equity securities? Yes No Does the analyst who prepared this research report have a position, either long or short, in any of the issuer s securities? Yes No Does Beacon Securities beneficially own more than 1% of equity securities of the issuer? Yes No Has any director, partner, or officer of Beacon Securities, or the analyst involved in the preparation of the research report, received remuneration for any services provided to the securities issuer during the preceding 12 months? Yes No Has Beacon Securities performed investment banking services in the past 12 months and received compensation for investment banking services for this issuer in the past 12 months? Yes No Was the analyst who prepared this research report compensated from revenues generated solely by the Beacon Securities Investment Banking Department? Yes No Does any director, officer, or employee of Beacon Securities serve as a director, officer, or in any advisory capacity to the issuer? No Yes Are there any material conflicts of interest with Beacon Securities or the analyst who prepared the report and the issuer? Yes No Is Beacon Securities a market maker in the equity of the issuer? Yes No Has the analyst visited the head office of the issuer and viewed its operations in a limited context? Yes No (Calgary office) Did the issuer pay for or reimburse the analyst for the travel expenses? Yes No All information contained herein has been collected and compiled by Beacon Securities Limited, an independently owned and operated member of the Investment Industry Regulatory Organization of Canada (IIROC). All facts and statistical data have been obtained or ascertained from sources, which we believe to be reliable, but are not warranted as accurate or complete. All projections and estimates are the expressed opinion of Beacon Securities Limited, and are subject to change without notice. Beacon Securities Limited takes no responsibility for any errors or omissions contained herein, and accepts no legal responsibility from any losses resulting from investment decisions based on the content of this report. This report is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell securities discussed herein. Based on their volatility, income structure, or eligibility for sale, the securities mentioned herein may not be suitable or available for all investors in all countries. Dissemination Beacon Securities distributes its research products simultaneously, via , to its authorized client base. All research is then available on via login and password. Analyst Certification The Beacon Securities Analyst named on the report hereby certifies that the recommendations and/or opinions expressed herein accurately reflect such research analyst s personal views about the company and securities that are the subject of the report; or any other companies mentioned in the report that are also covered by the named analyst. In addition, no part of the research analyst s compensation is, or will be, directly or indirectly, related to the specific recommendations or views expressed by such research analyst in this report. Beacon Securities Ltd. 66 Wellington Street West, Suite 4050, Toronto, Ontario, M5H 1H