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Morningstar | Peyto Continues to Rely on Its Hedging Strategy Until New Pipes Are Built

Peyto Exploration & Development is a Canadian energy company involved in the development and production of natural gas. The company has operated exclusively in Canada's Deep Basin (Alberta) for more than a decade and has developed an extensive knowledge of the area's geology. This enables management to cherry-pick acreage, which the company requires to have definable and well-understood drilling opportunities before land is acquired. Capital outlays are further reduced by maintaining a countercyclical investment model--management accelerates activity when gas prices are weaker, capitalizing on reduced demand for rigs and services. The company estimates that over 20% of cost reductions can be retained after the recovery of downturn cycles. Finally, the firm boasts an extremely high degree of vertical integration and uses its own midstream infrastructure to transport and process essentially all of its production, contributing to best-in-class operating cost levels.As a result, Peyto's natural gas supply cost compares favorably with peers'. Lifting costs are currently below CAD 0.70 per thousand cubic feet, with peers typically paying at least 2 times more. As such, cash break-even prices on Peyto's production approximates U.S. $1.50/mcf Henry Hub, which allows the company to compete with production from the fast-growing U.S. Marcellus and Utica regions. Furthermore, reported finding and development capital expenditures are well below CAD 2/mcf, which doesn’t dilute the cost structure. However, near-term prices woes resulting from a pipeline shortage will impair the industry-leading cost structure, leading to lower price realizations. Peyto relies on its risk management program to mitigate its pricing exposure. Over 40% of the company's volumes are hedged in 2019. We consider Peyto to be one of the better businesses currently operating in the segment. However, the stock has moved down swiftly in the past few months, driven by lower AECO prices that have negatively affected the company's price realizations. Accordingly, the stock continues to look fairly valued and we suggest that investors remain on the sidelines.