Vermilion Energy Inc. (VET) Q2 2016 Earnings Report, Transcript and Summary

Good morning. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Vermilion Energy Inc. Q2 Earnings Announcement Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there'll be a question-and-answer session. [Operator Instructions] I would now turn the call over to Anthony Marino, President and CEO. You may begin your conference.

Good morning, ladies and gentlemen. Thank you for joining us. I'm Tony Marino, President and CEO of Vermilion. With me today are Mike Kaluza, Executive Vice President and COO; Curtis Hicks, Executive Vice President and CFO; and Kyle Preston, our Director of Investor Relations. I would like to refer to the advisory regarding forward-looking statements contained in today's news release. These advisories describe the forward-looking information, non-GAAP measures, and oil and gas terms referred to today and outline the risk factors and assumptions relevant to this discussion. On today's call, I'm going to provide you with a brief summary of our Q2 2016 financial and operating results and then discuss some of the more notable items from the quarter as well as the preliminary budget targets we've outlined for 2017 and 2018. We achieved average production of 64,285 boe/d during the quarter. As we anticipated, this was a modest reduction from Q1. However, this production level is still well above our guidance range of 62,500 boe/d to 63,500 boe/d for 2016. The strong performance of Corrib, our Canadian assets, and our Netherlands assets made this possible. Because of these encouraging production results, we expect our average production level for 2016 to be around the top end of our guidance range. We achieved this Q2 production result despite voluntarily restricting our Canadian gas volumes by an average of approximately 1,000 boe/d during the second quarter. As of right now, we have restricted about 12 million cubic feet a day or 2,000 boe/d of Canadian gas. While the vast majority of the shut-in gas would provide positive cash flow at today's prices, we think it is likely that we can make substantially greater margins if we save it for a later time period. Our current plan is to bring back about a third of this gas by the end of 2016 depending on the course of North American gas prices. Our funds flow from operations increased 35% quarter-over-quarter to CAD 126.6 million or CAD 1.10 per basic share, thanks to a moderate recovery in commodity prices and ongoing improvements to our cost structure. We continue to see tangible cost reductions across our business, including well over CAD 100 million that has been realized from our profitability enhancement program, which we implemented in late 2014. Specifically regarding OpEx, we have reduced our year-to-date unit operating expenses by 18% versus the prior year. Looking forward, we anticipate full-year unit operating expense to be lower from – than 2015, which would result in four consecutive years of operating cost improvement. During the quarter, we invested CAD 71.7 million on exploration and development activities and paid out CAD 24.1 million in net dividends resulting in a net payout ratio of 78% of funds flows. This payout is net of approximately CAD 23.9 million of proceeds from the Premium Dividend component of our Dividend Reinvestment Plan, also known as the P DRIP. Including the equity raise via the P DRIP, our payout would have been 96%. As you can see, we were fully funded in Q2 without the P DRIP allowing us to maintain our current dividend while significantly increasing our production base. We implemented the P DRIP during Q1 2015 as a short-term measure to preserve our financial flexibility and to access equity capital at the minimum possible cost. We plan to prorate the P DRIP down by 25% starting in Q4 2016. Unless there are unexpected changes in the commodity price outlook, we intend to continue increasing the proration next year so that by the end of 2017, there would be no further equity issuance under the P DRIP. Now to get to some of the more notable operating highlights from the quarter. One, Corrib ramp-up. We're pleased to report that Corrib continued to ramp throughout the quarter and reached full plant capacity of approximately 65 million cubic feet a day or just under 11,000 boe/d net to Vermilion at the end of June 2016. The project is performing well with better-than-expected well deliverability and less-than-expected downtime since start-up on December 30, 2015. Production from Corrib for the quarter averaged 47 million cubic feet a day, 7,877 boe/d net to Vermilion from the five wells currently on line. The sixth well will be brought on line in Q3 2016 following the conclusion of an offshore work program to lay the required flow line. With the sixth well on line, we expect to maintain peak production levels for approximately 18 months before the field starts to decline at an annual rate of approximately 18%. Corrib production is not burdened with royalties and has relatively low operating expense. Coupled with high European gas prices and low expected maintenance CapEx requirements, this field generates high netbacks and substantial free cash flow. Two, the Australian sidetrack drilling program. Following our successful sidetrack well drilled in Q4 of 2015, we executed a two-well drilling program in Q2 2016. The Wandoo sidetracks are quite challenging technically and are some of the most extreme long-reach lateral wells drilled in the world. While having true vertical depths of only 600 meters, the two most recent sidetrack wells have measured depths of nearly 3,000 meters and 3,800 meters, respectively. We are very pleased that the drilling program was completed ahead of schedule and under budget, while meeting all operational and health, safety and environmental objectives. Both of the wells appear to be very successful in terms of productivity with strong initial rates under choke-back conditions. The first well was placed on production at the end of June at an average rate of 2,000 barrels a day for the first month of production. The second well was placed on production during the last week of July at an average rate of 2,700 barrels a day. Despite the high deliverability of these wells, we still intend to manage Australian production at between 6,000 barrels a day to 8,000 barrels a day and our base budget planning doesn't anticipate a need for any more drilling until 2019. Three, Engie acquisition. As announced on June 28, we entered into a definitive agreement to buy interest in five oil and three gas-producing fields in Germany from Engie E&P Deutschland GmbH, for total consideration of €33 million, about CAD 48 million. The acquisition is expected to add approximately 2,000 boe/d, 50% oil net to Vermillion, and will provide us with our first operated production in Germany. This transaction offers very strong production, cash flow and FD&A metrics, and a number of organic opportunities to gradually increase oil production. The acquisition is part of our ongoing strategy of expanding our operational footprint in Germany where we now hold over 1.1 million net acres of undeveloped land in the prolific North German Basin. Upon closing of this transaction, which is expected towards the end of the year, our production from Germany will increase to approximately 4,500 boe/d, representing about 3% of Germany's total oil and gas production. We continue to view Germany as a strategic growth area for Vermilion both from an organic and M&A perspective and we would like to increase our share of this industry as we have done historically in France and the Netherlands. Four, 2016 outlook. As I've already noted, we continue to realize meaningful cost savings across our business. As a result, we have been able to reinstate several projects to our 2016 capital program during the latter part of this year with only a modest change to our 2016 capital budget. We've increased our 2016 budget by CAD 5 million to CAD 240 million and have reinstated a four-well drilling program in the Champotran field in France, three gross, 3.0 net Cardium wells and seven gross, 4.0 net Mannville wells in Canada. Because the activity will occur in the latter part of the year, the additional drilling will have little impact on 2016 production. Our full year production guidance remains unchanged at 62,500 boe/d to 63,500 boe/d. Although we do think it is likely that we'll produce around the top end of this range, this represents 15% year-over-year production growth or 10% on a per share basis. Five, preliminary production and E&D CapEx targets for 2017 and 2018. While we won't disclose our formal budget guidance until late 2016, we've been undertaking an earlier review of our budget alternatives than we have in the past. In addition, we have extended this analysis to a two-year period. And as a result, we are now able to establish some preliminary targets for 2017 and 2018 based on the current commodity strip. At present, we anticipate investing E&D capital of approximately CAD 295 million in 2017 and CAD 335 million in 2018. With these projected investment levels, we expect to deliver production of 69,000 boe/d to 70,000 boe/d in 2017 and 75,000 boe/d to 76,000 boe/d in 2018 representing year-over-year increases of approximately 9% for both years. Under the current strip, we project that we would be self-funded for cash dividends and E&D CapEx for both of the next two years. We're encouraged by our financial and operating performance to date and I would like to take this opportunity to thank our staff and our partners in the industry for their contributions to our success. I'd also like to acknowledge the advancements we have made from a corporate governance perspective. Vermillion improved its MSCI ESG or Environmental, Social and Governance rating from BB to BBB for 2016 and our Governance Metrics score ranked in the top decile globally. This follows our ninth place ranking in the 2016 Corporate Knights Future 40 Responsible Corporate Leaders in Canada list, which was the highest ranking for an oil and gas company. We expect to release our next Sustainability Report in August 2016 and we will discuss this in more detail during our Q3 2016 conference call. With that, I will conclude my formal remarks. Operator, please open the floor to questions. [Operator Instructions]

The first question is from Patrick O'Rourke from AltaCorp. Patrick O’Rourke: Good morning, guys. Excellent quarter. Just a few quick questions here. You did talk about the P DRIP, prorating it down and eventually eliminating it depending on what happens with the commodity. Is there any commodity scenario where you would accelerate that phase-out of the P DRIP here?

Yes. That's a good question, Pat. We based this plan for getting rid of it over the next year beginning Q4 2016, ending Q3 2017 on the current commodity strip. And we didn't announce a specific schedule for how we would taper it down or what the proration percentages would be by quarter just to provide some flexibility regarding the commodity price. It is – I think it is possible, with no commitments on our part, that if the commodity environment turned out to be stronger than we would take it down faster and then potentially end up turning it off entirely earlier than that end of Q3 2017 target that we've established. Patrick O’Rourke: Okay. Thanks. And then just a couple of quick questions on Germany. On slide 21 on your new deck, you do a great job laying out the inventory across all the business units, but Germany is not in there. Are you guys able to give maybe a preliminary view of what you think the inventory could look like in Germany?

Yes. Another good question. The data that we have in the corporate PowerPoint that is on the website is all based on the GLJ reserve and resource reports that we have. It's kind of a long process over a period of several years to present these projects to GLJ, have them evaluate them and get them committed to the report. And in Germany, in the current land base that we have prior to the Engie acquisition, there's really two sources of potential inventory. One is the development and kind of semi-development drilling that occurs on our producing asset, operated by ExxonMobil in which we have a 25% asset known as the [indiscernible] that we acquired in early 2014. So that's one source. And there is some inventory, not a huge number of wells, but a moderate amount of inventory in those development and extension projects on that asset. There's a much larger potential inventory in the farm-in that we signed at the beginning of this year, which covers approximately half of the exploratory lands held by ExxonMobil in the North German Basin. That inventory, first of all, didn't really qualify to be in the report because the deal was actually signed at the beginning of 2016, so it's not really available for the inventory counts that are listed there. And furthermore, it takes some time to fully get these kinds of prospects committed to the resource reports. And we would hope over the next year, the year-end 2016 report, and certainly by the year-end 2017 report, that we could have that inventory described and available for inclusion in the drilling list that we show in the PowerPoint. But for those reasons, it's not really in there. There will be a third adder, and that would be the Engie acquisition that we hope to have closed by the end of this year. We think there are drilling opportunities on those properties although in the initial reserve report that we mentioned when we announced the acquisition, there weren't any – none of those drilling opportunities were yet included. There's a possibility that that could be a moderate adder by Q end – by year-end 2016 and if not, hopefully by year-end 2017. So gradually, I think what you'll see is a build-up of that German inventory and to have it at a meaningful enough level to be included in that list of drilling projects that we have. Patrick O’Rourke: Okay. Thanks a lot, guys. [Operator Instructions]

The next question is from Ray Kwan from BMO Capital Markets.

Hey, guys. Just a quick one on your guidance for 2017 and 2018. I know you mentioned that you're going to fund the capital program and dividend all within cash flow. But just wondering if you can put out like what your – is there going to be any free cash flow post kind of dividend and spending based on your forecast? Is it – and I don't know if you can even say what the total payout that you're thinking about based on the current strip prices are.

Yeah. Under the strip, there is some cash left after paying the cash dividends and the funding the E&D CapEx investment. A moderate amount at the strip that we had last week, it varies quite a bit day by day with the volatility that we've had in prices. But the answer is yes. Under the current strip, there's a modest amount of free cash flow generated. I think under the strip we had last week was kind of at the most recent drop in prices, we had – we were something like 95% used roughly, I think, during that period for cash dividends and E&D CapEx. And it's a – that's a number that varies everyday as the strip goes up and down.

No, that's good information, thank you. And just a second just on acquisitions, I know in your prepared remarks, you mentioned about focusing on Germany in terms of potential acquisitions there, but are you looking – is it strictly Germany or just around Europe that you guys are so focused on within the next kind of six months to 12 months here?

No, it's not just Germany. One of the advantages we have is that you know we're in these three regions and in several different jurisdictions and a couple of those regions that gives us a lot more sites for potential M&A. We're quite selective with it. We stick to a very disciplined set of criteria, and if those aren't met, we won't make a deal. We're not really very pressed to make a deal because we've got a really strong organic inventory. But we do look at really in each of these jurisdictions including in North America. We probably don't have quite as great advantages in North America as we have in the European market and that's why more of the deals over the past few years have tended to be in Europe. We can just make them higher rates of return than what North America typically provides. But the fact is that we're in the market all the time evaluating, screening, evaluating potential additions in all three regions even though the larger percentage of the completed transactions has tended to be Europe. And even with that, we don't really make a huge number of deals. Our M&A, I think, is pretty disciplined, and we're – again, we can be that because we have quite a strong organic inventory to provide the base growth.

Perfect. Thank you.

There are no further questions at this time. I will turn the call back over to the presenters.

Okay. Thank you again for your participation in our conference call. We look forward to speaking with you again in our Q3 2016 release.