Gran Tierra Energy: Swinging For The Fences (NYSE:GTE)

imaginima How many times in your life do you get to swing for the fences with a stock, knowing that if you are right, you could make multiples of your money and if you are wrong, you probably won’t lose much money? This is exactly how I view investing in Gran Tierra Energy Inc. (NYSE:GTE), a micro-cap Canadian oil drilling company that operates in South America. Gran Tierra Energy is trading at a massive discount to its net asset value, as well as at an extremely low multiple of its free cash flow. Gran Tierra is taking advantage of the lack of love for it by repurchasing large quantities of its own shares. It is also growing its oil production as well as its oil reserves. I believe this combination of an extremely low valuation, aggressive stock buybacks, and oil production and reserves growth creates one of the best setups I’ve ever seen, and all that really needs to happen for shareholders to win big is continued status quo for a few years, followed by a simple change in investor sentiment. A Nearly 100% YTD return, but only following a 90% drawdown Anytime you bring up a stock, everyone immediately wants to look at the chart, and there are two ways I could present Gran Tierra Energy to the reader. On one hand, I could show a year-to-date chart, which shows a nearly 100% increase from January. Data by YCharts On the other hand, I could present a very long-term chart that could cause some readers to immediately dismiss the stock and move on. Data by YCharts The reality is that both charts tell us something. The long-term chart tells us Gran Tierra Energy has been a dismal investment for anyone who has bought and held over long periods of time. But the YTD chart tells us that something may have changed and it may be time to investigate further. I’ve spent the last year studying this company, trying to understand if investors are correct in being so pessimistic, or if investors are simply ignoring the story because the story is completely out of favor. What I have come to believe is that while Gran Tierra has made its share of mistakes, has been dealt its fair share of problems, and operates in a truly unloved sector, underneath the surface the company is doing almost all of the things I would do if I were in control of the company myself. I believe Gran Tierra has the potential to generate serious alpha, if they play their cards right. Why is Gran Tierra trading so cheap? I believe it’s always best to look at all the negatives first when you are researching a stock. That way you don’t get swept up in a great story and end up being wrong because you overlooked problems. So what are the problems that I hear about most often from investors? For starters, one thing investors cite as an issue is the impression that the company is too small. The market capitalization is just $304 million, meaning most large funds won’t bother with it as it’s not large enough or liquid enough for them to even bother. I totally get this. It’s a common problem for small companies. My only pushback would be to say that the company is taking matters into its own hands by aggressively repurchasing its own shares, and the widespread lack of interest actually allows Gran Tierra to take advantage of low valuation and buy their shares at prices that are unimaginable for a larger competitor. Second, investors often mention Gran Tierra’s debt levels as being too high. The current net debt is $510 million, which is greater than the market capitalization of the company. And debt can be a killer in a commodities business. I partially agree with this argument and partially disagree. Yes, we have to be mindful of debt levels. But Gran Tierra has actually reduced its net debt by 34% since 2020. Also, if the market were valuing Gran Tierra appropriately (higher), that market cap wouldn’t look so small compared to the level of debt. While other companies might prefer to have little or even no debt, I view debt as what gives Gran Tierra the torque I want to make the stock outperform going forward. Third, I often read about and hear about how investors worry about oil prices declining as a result of a global move away from fossil fuels. While price volatility is always a possibility, I personally believe these concerns are overblown as the entire industry has shifted away from maximizing production and moved towards debt reduction and capital returns to shareholders. This industry-wide trend puts a limit on supply growth, meanwhile, regardless of what people say about fossil fuel demand going away, demand growth continues to set records year after year with the EIA projecting 1.1 million barrels per day of growth this year, followed by 1.5 million barrels per day of growth next year. In addition, OPEC+ seems determined to support oil prices through continued voluntary production cuts, and Gran Tierra has had downside hedges in place for much of this year, at times locking in $80 puts on nearly half their production, which means that even if oil prices fall in the back half of this year, the company could still hit or come close to its free cash flow forecast. Finally, there is political risk. Gran Tierra operates in Colombia and Ecuador, and Colombia’s President Gustavo Petro has been hostile to the industry, pushing for increased taxes and reduced drilling. Of all the risks, I personally felt this one was the greatest, but I am beginning to change my opinion. I believe the worst of the threat is behind us and the damage is already fully priced into the stock. Shareholders recently won a small victory when the Colombian Supreme Court struck down a portion of the new tax increases. In addition, Gran Tierra is shifting more towards exploration in Ecuador, which has lower taxes and is more industry-friendly. Finally, President Petro’s approval rating has fallen from 56% shortly after his election to a low of just 26% in December, and he is unable to run again after his term ends. No company is without risk, but in the case of Gran Tierra Energy, I see these often-cited risks as either less threatening or fully priced in. And with that out of the way, let’s discuss the positives. A look at free cash flow and share repurchases Back in January, Gran Tierra Energy released its 2024 guidance for production and free cash flow. Based on an $80 Brent oil price, the company projected $75 million of free cash flow for 2024. At the time, the stock was trading about half of where it currently trades and had about a $150 million market cap, which implied an eye-popping 50% free cash flow yield! Since that time the stock price has almost doubled, meaning this same $75 million of free cash flow now equates to about 25% of the current market cap. Not as eye-popping, but still quite impressive. After all, with this level of free cash flow, an investor could earn their entire investment back in just four years. if that doesn’t grab you, think about that in terms of buying a rental house. Imagine buying a $300,000 house and having it generate $300,000 of positive cash flow in just four years, after which, you still own the house. That’s incredibly cheap! So what does Gran Tierra do with all this free cash flow? Well, the main thing they have been doing in recent years is repurchasing their own shares. And in my opinion with such a low valuation that’s exactly the right thing to do. Gran Tierra has bought back about 14% of its shares in just the last two years. Data by YCharts The company has an active buyback in place for 10% of the float, and once they complete this, the remaining share count should be just under 30 million, representing about a 17% decline since the summer of 2022. One fun thing for investors who are cheering for buybacks is the fact that Gran Tierra actually posts their weekly buyback activity to their website, with the raw trade data broken out for investors to see. A look at Net Asset Value Per Share Okay so we all love free cash flow, but we also want to know that there are enough oil reserves to support that free cash flow for many years into the future. That’s where we go look at the estimates for reserves, as well as the net present value of those reserves. This data, which is third-party audited by McDaniel & Associates, also comes out annually and can be found on the Gran Tierra website. And if you thought the free cash flow yield was impressive, wait until you see the NAV calculations that came out this year. Gran Tierra Reserves Data (Gran Tierra Energy) As of Dec 31, 2023, Gran Tierra had 147 million barrels of 2P (Proven & Probable) reserves. Using pricing assumptions that are roughly the same as where oil is trading today, the NPV10 (Net Present Value after discounting by 10% per annum) for these reserves is $1.888 billion. Subtract net debt and we see a NAV (Net Asset Value) of $1.377 billion. On a per share basis, this amounts to $42.71/share of after-tax, fully discounted, net present value per share. With the stock currently trading at roughly $9.71, the market is valuing Gran Tierra at less than 1/4 of its NAV. And again, this isn’t based on some crazy far-fetched oil price. The assumed price of oil for these assumptions is between $78-$83 per barrel. Right where it’s currently trading. Hypothetical scenarios and their impact on NAV It’s fairly easy to conclude that a stock trading at 1/4 of NAV with a 25% free cash flow yield is cheap. But that’s not really the point of this article. As I said, I think this stock could potentially be a bases-loaded, knock it out of the park grand slam homerun. Or maybe a Powerball lottery ticket where you could potentially win huge, but if you don’t you at least get your money back. So how could that play out? Perhaps by the future NAV growing to levels that make today’s NAV look downright puny. Remember, the per share NAV of the company is nothing more than the after-tax net present value of oil reserves, net of debt, and divided by the share price. Adjust any of those figures and the per share NAV changes. For example, if Gran Tierra were to grow its reserves through successful exploration and drilling, NAV would rise because the NPV10 numerator would rise. If Gran Tierra were to pay off a portion of their debt, NAV would rise because debt is subtracted from NAV in the calculation. And if the shares outstanding fall, the net asset value gets divided by fewer shares, and NAV on a per share basis rises. Finally, changing oil price assumptions impact NAV as well. Fortunately for shareholders, three out of four of these inputs are likely to improve going forward. Gran Tierra has grown reserves for several years in a row, and are sitting at the highest levels in company history. And with that estimated $75 million of free cash flow this year, net debt is certainly going to decline this year. Also, as I stated earlier, Gran Tierra is buying back stock almost daily, so with that, I’m going to make some assumptions and present them in a table format similar to the earlier reserves/NAV slide. For starters, we can build in a lower share count into our future NAV calculations. After all, the company-issued numbers are already outdated as Gran Tierra has repurchased 1 million shares since Dec 31st, and should repurchase 1 million more by year-end. Using just that simple change we can see per share NAV would rise to $45.52 Dec 31, 2023 Dec 31, 2024*Estimate Reserves 147 million barrels Unch NPV10 $1.888 billion Unch Net Debt ($511 million) Unch NAV $1.377 billion Unch Shares Outstanding 32.25 million 30.25 million NAV Per Share $42.71 $45.52 Click to enlarge We can also make assumptions about year-end net debt. If Gran Tierra hits its guidance of $75 million of free cash flow, it should still have about $50 million of excess free cash after buybacks. That would lower net debt from $511 to potentially $461 million, which would bring NAV per share to $47.17 Dec 31, 2023 Dec 31, 2024*Estimate Reserves 147 million barrels Unch NPV10 $1.888 billion Unch Net Debt ($511 million) ($461 million) NAV $1.377 billion $1.427 billion Shares Outstanding 32.25 million 30.25 million NAV Per Share $42.71 $47.17 Click to enlarge Things get really wild when you extrapolate the continued 10% annual reduction in shares outstanding and a continued $50 million improvement in net debt annually. This is how things would look by year-end 2028 using these continued assumptions Dec 31, 2023 Dec 31, 2024 Dec 31, 2025 Dec 31, 2026 Dec 31, 2027 Dec 31, 2028 Reserves 147 million barrels Unch Unch Unch Unch Unch NPV10 $1.888 billion Unch Unch Unch Unch Unch Net Debt ($511 million) (461 million) ($411 million) ($361 million) ($311 million) ($261 million) NAV $1.377 billion $1.427 billion $1.477 billion $1.527 billion $1.577 billion $1.627 billion Shares Outstanding 32.25 million 30.25 million 27.23 million 24.50 million 22.0 million 19.8 million NAV Per Share $42.71 $47.17 $54.24 $62.32 $71.68 $82.17 Click to enlarge Based on nothing more than a static $50 million per year improvement in net debt and a 10% per year reduction in shares outstanding, NAV per share soars to $82.17 by the end of 2028. But again, it gets better. Gran Tierra has actually grown its reserves for five years in a row. If reserves actually grew in addition to the above estimates, NAV per share could easily surpass $100/share. Please feel free to use your own estimates if you wish to. My estimates are very conservative in my opinion, as they are based on little more than the continued status quo. I would prefer to be conservative as opposed to wildly optimistic. Some other positive developments One area that I didn’t touch on or adjust in the previous NAV calculations is the actual in the ground oil reserves that Gran Tierra has. Gran Tierra has grown its reserves for five years in a row, and its daily oil production has been growing consistently for several years as well. In 2021 the company was producing just 26,507 barrels of oil per day. Currently, production is 33,400 barrels per day and is forecast to average 46,000 barrels per day over the next five years. Gran Tierra Forecast Oil Production (Gran Tierra Investor Presentation) Production growth will no doubt be supported by recent testing in the Arawana region of Ecuador, where test wells are showing greater than 1,000 barrels of oil per day. On the Q1 conference call management indicated they could have as many as fifty wells in this area, which alone would support significantly higher oil production and oil reserves going forward. Management’s projections for free cash flow Earlier I gave some rough projections for NAV per share, but I did not give any projections for free cash flow. For that, I turn to the Gran Tierra investor presentation. Forecast Free Cash Flow (Gran Tierra Investor Presentation) The reason I prefer to use management’s own forecast is because as you can see, management is indicating they could be generating $427 million of free cash flow by 2028. If I projected $427 million of free cash flow in 2028 most readers would think I was crazy. After all, the current market value of Gran Tierra is just about $300 million, so this implies a valuation of less than 1X free cash flow in 2028 based on the current stock price. Going back to the rental house comparison, this would be like buying a $300,000 house today and estimating that it will generate $427,000 in positive cash flow in 2028 alone! Never mind the free cash flow between now and then or how it’s allocated. If management is even close to their projections, the stock is insanely cheap. Next, think about what would happen if Gran Tierra hits their 2028 projections and you have significantly fewer shares outstanding by that time. Perhaps you might divide $427 million by just 20 million shares instead of the current 31 million. That implies $21 of free cash flow per share from a stock that trades for less than $10 today. It sounds too good to be true, but that’s exactly what Gran Tierra is projecting, and they have been in the market buying back stock nearly every day this year. What is a fair valuation for a stock that earns $21 of free cash flow? I’m not even going to make a guess. I’ll simply say that if management is correct with their forecast, and if they continue to execute the buyback at current rates, the fair value for the stock is A LOT HIGHER. Growth, capital returns, and a massive discount to NAV. Gran Tierra Energy has them all If you are looking for an opportunity to put some money into an overlooked, high-potential reward investment, Gran Tierra may be for you. I believe the risks are beyond fully priced into the stock, and the year-to-date rise in the stock is evidence that investors are starting to agree with me. Gran Tierra has grown production year after year, while in the process generating significant free cash flow, building reserves, and reducing debt. The company has the potential to drastically improve its future by doing little more than continuing to repurchase stock and pay down debt, which is exactly what they are doing. I am long Gran Tierra Energy and plan to use any future weakness in the stock as a buying opportunity so long as they continue to repurchase shares and grow NAV.