Southern Pacific (STP) is a small company dedicated to developing oil resources using Steam Assisted Gravity Drainage (SAGD). It first came to my attention when it bought the Senlac project from EnCana in 2009 for $89 million. I came across the news release as I had an interest in EnCana, and the price they sold the asset for decreased my interest in EnCana. I realized if the price was a bad sell for EnCana, it was probably a good buy for STP. I bought the shares at that time, and have done well on them, but this write-up is about a debt security. STP did get a good buy in Senlac, as a recent investor presentation1 indicated they have taken out $180 million in funds from operations since that time. The asset is producing $56 million of operating income with $20 million of capital a year, which makes the purchase price a great bargain.
However, Senlac is the smaller part of the company. It produced approximately 3,300 boe per day of oil in 2012, compared to a nameplate capacity of 12,000 boe per day for their newly started Mackay project in Alberta.
The market has severely punished STP for the start-up of the Mackay project, which has been slower than expectations. The first well came on SAGD in Q4 2012, and recently announced production was only 1,400 barrels per day. Management expects the full capacity to be reached over 18 months, a position the market seems to doubt. STP also owns other undeveloped land that is highly prospective for oilsands production.
The company issued $172.5 million of convertible debentures, along with $260 million of long term debt to fund the construction of the Mackay project. Net of cash and working capital, they had approximately $385 million of debt at the end of 2012. Interest charges on the second lien debt are $22.75 million per year, and interest charges on the convertible debentures are $10.35 million. STP also has a first lien revolver, which has a 4.25% interest rate and a $75 million dollar maximum. This would have a maximum payment of $3.19 million. This gives a total maximum interest payments for 2013 of $36.28 million. That happens to be almost exactly my conservative forecast of free cash flow from the Senlac project. So whether STP does manage to get Mackay up and running or not, they should be able to make the payments on their debt. For additional safety, the convertibles I am discussing here mature in 2016, before the second lien debt in 2018.
So, STP will be able to make good on their obligations, but I hear you out there asking, “So what?“ STP.DB is currently trading at $69.50 per hundred dollars of par value, for a yield to maturity of over 19%. This large discount to par provides a margin of safety to STP.DB if my cashflow estimates are wrong or something unforeseen happens. It also provides the possibility for a large return if events unfold as expected. If the Mackay project does work out, the debentures are convertible into STP stock at $2.10, for additional potential upside. (The NAV of their reserves is around $5, so the upside is real). Those looking for a purer speculative upside could buy the shares directly at around $0.70, but the debentures provide a mix of safety and value I find irresistible.
Disclosure: Long position in Southern Pacific securities.
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