What to Buy: Baytex Energy Corp (TSX: BTE, NYSE: BTE)

Why to Buy Now: After hitting a 52-week high in mid-June, shares of Baytex have fallen in sympathy with the price of oil, and are now down nearly 14 percent since the aforementioned high. In fact, according to market technicians, Baytex shares entered oversold territory earlier this week.

Baytex is hardly alone in this respect, as many of its industry peers have suffered declines of equal or greater magnitude over that same period.

The Calgary-based energy exploration and production (E&P) company has historically operated mostly in Western Canada’s oil sands region, but in February it secured a substantial stake in Texas’ prolific Eagle Ford Shale formation through its CAD2.8 billion acquisition of Aurora Oil & Gas Ltd.

Baytex produces oil, natural gas and natural gas liquids (NGLs), but it’s primarily an oil company, with 86 percent of production derived from crude oil and liquids. And management expects the company’s foothold in the Eagle Ford to account for roughly one-third of production.

In the long term, Baytex’s rising production and management’s disciplined approach to capital allocation should deliver enduring growth.

Indeed, Baytex boasts firmly bullish analyst sentiment, at 18 “buys,” three “holds,” and one “sell.” The consensus 12-month target price is CAD53.13, which suggests potential appreciation of 23.1 percent above the current share price.

Bullish sentiment in the financial sector extends beyond the analyst community: Institutions have increased their holdings of the stock by 26.4 percent over the past six months, bringing their total holdings to 57.2 percent of shares outstanding.

In the near term, however, there’s considerable uncertainty as to the future direction of oil prices due to a number of factors ranging from the supply-demand balance to geopolitical tensions in certain oil-producing regions to the surging US dollar.

But while the price of oil could continue to decline in the near term and take E&P stocks even lower, we’re betting that the commodity now trades near a long-term base of support.

Fortunately, we don’t have to sweat calling the precise bottom for oil or the E&P sector because Baytex offers an ample payout. With a monthly dividend of CAD0.24, or CAD2.88 annualized, for a forward yield of 6.7 percent, we’re content to bide our time until the inevitable reversal.

Baytex had a conservative payout ratio of 63 percent of funds from operations for the six-month period ended June 30. And the firm has grown its dividend by 6.7 percent annually over the trailing five-year period.

Baytex Energy Corp is a buy below USD46.

Khoa: So before we discuss Baytex in greater detail it seems like we should talk about where the different energy commodity benchmarks are presently and what factors are driving that performance.

Ari: As we mentioned in the summary that precedes this dialogue, oil prices have fallen since their trailing-year high on June 20.

Over the ensuing period, Brent Crude, the global benchmark for oil prices, has fallen 13.8 percent, the North American benchmark West Texas Intermediate (WTI) crude dropped nearly 14.3 percent, and natural gas is down 15.3 percent (all based on pricing for the generic front-month contract according to Bloomberg).

Interestingly, Western Canada Select (WCS), which is the benchmark price for the heavier grade of crude produced from Canada’s oil sands, has only fallen by 9.7 percent over that same period.

WCS typically trades at a discount to WTI, but lately that differential has been narrowing, from a high of USD42.00 last November to a low of USD12.95 earlier this week.

According to analysts with National Bank Financial (NBF), prices for WCS held up better than other benchmarks due to improved access to key markets where there had formerly been bottlenecks, investment in several oil sands maintenance projects, and further weakness in the Canadian dollar.

NBF believes prices for WCS will likely average CAD87 per barrel in 2014, up 13 percent year over year. Baytex is among the heavy crude-oriented E&Ps to which the firm recommends increased exposure.

Khoa: How do currencies factor into all of this?

Ari: Most commodities, including oil, are priced in US dollars on the global market. So when the dollar rises, that tends to depress the price of oil. In fact, the US Dollar Index, which measures the dollar’s performance against a weighted basket of six other major currencies, is up about 6.2 percent since its interim low in late June.

According to Bloomberg, the index’s 10-week advance is its longest rally since 1967.

The rebound in the dollar is courtesy of the US Federal Reserve, which next month is set to conclude its extraordinary stimulus, the third round of so-called quantitative easing, with one final USD15 billion bond purchase.

To the delight of the equity market, the Fed maintained its existing language about when it expects to finally hike short-term interest rates. Most central bank watchers anticipate that action to occur sometime next year, though naturally that’s dependent on the trajectory of the economy.

In contrast to many of its developed-world peers, the Fed has adopted a comparatively hawkish stance toward its future monetary policy, and that’s lifted the dollar against a number of other currencies.

On the other hand, even with the Eagle Ford acquisition, the bulk of Baytex’s production is still derived from Canada’s oil sands and benchmarked to the price of WCS. And since the US is the primary foreign destination for Canada’s energy products, the depreciating Canadian dollar has been a boon to the country’s exporters.

The loonie has declined by 3.2 percent, to USD0.91, since its interim high in late June, but its down even further from its cycle high of USD1.06 back in mid-2011.

Khoa: What about supply-demand factors?

Ari: The glut of supply from the prolific US shale plays along with weakening global demand are the other reasons for oil’s recent weakness.

For example, the US Energy Information Administration says crude supplies rose by 3.67 million barrels at the end of last week, to a total of 362.3 million barrels, which is near the highest level ever for this time of the year.

In the short term, traders could push oil prices even lower. But in the medium to long term, the 12 member nations of the Organization of the Petroleum Exporting Countries (OPEC), which supplies about 40 percent of the world’s crude, have become accustomed if not dependent upon oil trading above USD100 per barrel.

Earlier this week, OPEC’s secretary-general said the group is considering lowering its production next year by 500,000 barrels per day to support prices.

However, there’s considerable skepticism as to whether the organization will actually cut its output, since Saudi Arabia, OPEC’s largest producer, is seen as the only member nation that has the flexibility to lower production.

Indeed, the country announced that it had already reduced crude oil production last month by 400,000 barrels per day.

Meanwhile, the ongoing civil war in Libya has taken about 120,000 barrels per day of production offline.

Then there’s the significant pipeline bottlenecks that have kept Canadian crude from reaching key US markets. To that end, Canadian E&P firms have found alternative means to get their products to market, particularly by rail.

And Baytex has already hopped aboard this trend. The company reported that approximately 55 percent of heavy oil volumes were delivered to market by rail during the second quarter, compared to 42 percent for full-year 2013. In the third quarter, management expects this number to rise to 60 percent.

Khoa: Does Baytex hedge its production?

Ari: Yes. According to its most recent filing, the firm has hedged 51 percent of its third-quarter WTI production at a weighted average prices of USD96.45 per barrel. In addition, Baytex has hedged approximately 54 percent of its natural gas production and 29 percent of its exposure to currency movements between the US and Canadian dollars.

Khoa: Okay, so it looks like we’ve got the macro picture. Let’s get into a little more of the nitty-gritty at the company level, beyond what we’ve covered already.

Ari: First, let’s talk about what they’ve got in the ground.

The CAD7.2 billion company has 432 million barrels of oil equivalent in proved plus probable reserves.

Reserves have grown at a 12 percent annualized rate over the past 10 years. And based on the reserve life index, it’s estimated it would take 14.9 years for them to be depleted at the current rate of production.

Baytex’s production mix for the second half of the year is projected to consist of 51 percent heavy oil, 22 percent light oil, 14 percent natural gas, and 13 percent natural gas liquids.

In terms of geography, 66 percent of production comes from Western Canada, particularly its plays in Peace River and Lloydminster, with the balance from the Eagle Ford in Texas.

The Eagle Ford deal boosted Baytex’s production of higher-priced light oil. And it provides exposure to Gulf Coast crude oil markets via established transportation systems.

Management recently opted to sell the firm’s North Dakota Bakken assets for CAD357 million and redeploy the capital to its promising Eagle Ford assets. It’s currently scrutinizing the rest of the portfolio for other candidates for divestiture.

During the second quarter, Baytex produced 66,934 barrels of oil equivalent per day (boe/d), up 12 percent sequentially and 15 percent year over year, bringing oil and natural gas liquids to 87 percent of the firm’s total production.

Funds from operations were CAD202.5 million, or CAD1.49 per share, up 19 percent compared to the first quarter and 30 percent compared to the second quarter of 2013.

Operating netback–which is the sales price less royalties, production and operating expenses and transportation expenses–was CAD40.74 per barrel of oil equivalent, an 11 percent sequential increase and a 28 percent year-over-year increase.

Analysts forecast full-year 2014 revenue will jump 36 percent, to CAD1.9 billion, while adjusted earnings per share are projected to surge 110 percent, to CAD2.54.

Khoa: Alright then, let’s talk taxes.

Ari: Before proceeding, it should be noted that we’re not tax professionals, and that subscribers should consult their accountant or tax advisor to confirm the treatment of these dividends.

Our understanding is that thanks to the tax treaty between the US and Canada, the Canadian government withholds just 15 percent of the payout (as opposed to the 25 percent rate that would prevail without the agreement). Depending on their individual tax situation, most investors should be able to avoid double taxation by offsetting that amount in the form of a credit at tax time by filing Form 1116.

The Canada Revenue Agency (CRA) implemented a new rule in early 2013 that requires US investors to file Form NR301 through their brokers in order to receive the reduced rate of withholding. Follow this link to learn more about the form and its requirements.

It appears that the form must be filed for each company for which you’d like to receive the more favorable withholding rate. The forms expire after three years from the end of the calendar year in which the form is signed and dated, so if you’re still holding the security at that juncture, then you’ll have to renew the filing.

Finally, since Baytex is organized as a corporation, individual retirement accounts (IRA) and other tax-advantaged retirement accounts should be exempt from the Canadian government’s withholding. It’s not entirely clear whether filing form NR301 is sufficient to qualify for this treatment or whether a letter of exemption must be obtained.

If the latter, the page at this link instructs you on how to proceed, and also provides a searchable database for entities that have already received the exemption (in case your tax-advantaged account happens to fall under one of those entities).

Baytex is a buy below USD46.

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