Canacol Energy Ltd

Good morning and welcome to Canacol's first quarter 2020 financial results conference call. This is Carolina Orozco, Director of Investor Relations.

I am with Mr. Charle Gamba, President and Chief Executive Officer; and Mr.

Jason Bednar. Chief Financial Officer.

Before we begin, it's important to mention that the comments on this call by Canacol's senior management team can include projections of the corporation's future performance. These projections neither constitute any commitment as to future results nor take into account risks or uncertainties that could materialize.

As a result Canacol assumes no responsibility in the event that future results are different from the projections shared on this conference call. Please note, that all finance figures on this call are denominated in US dollars.

We will begin the presentation with our President and CEO, Mr. Charle Gamba, who will cover the operational highlights for the first quarter 2020.

Mr. Jason Bednar, our CFO, will then discuss financial highlights.

Mr. Gamba will close with a discussion of the Corporation's outlook for the remainder of fiscal year 2020 and beyond.

A Q&A session will follow. Mr.

Charle Gamba will follow-up. Mr.

Charle Gamba is joining us from the line from Bogota and Mr. Bednar is joining us from the line from Calgary.

I will now turn the call over to Mr. Charle Gamba, President and CEO of Canacol Energy.

Thanks, Carolina and welcome to Canacol's first quarter 2020 conference call. Q1 marked a milestone for Canacol as we achieved record natural gas sales of 202 million standard cubic feet per day, our ninth consecutive quarter of gas sales production growth.

In Q1, we increased our realized contractual gas sales by 65% to 202 million standard cubic feet per day, up from 122 million standard cubic feet per day during the same period in 2019. Our sales now supply approximately 25% of the Colombian gas market.

During the first quarter the Corporation completed the drilling of the clearing at Day 5 development well which encountered 309 feet of true vertical depth net gas pay within the primary Ciénaga de Oro sandstone reservoir. This represents the thickest gas pay section of any well drilled in the history of Canacol, and the well will be completed and tied in late May 2021 drilling operations resume in the field.

I also want to highlight that in addition to achieving a 224% 2P reserves replacement ratio along with a 12% increase in 2P gas reserves year-over-year, we subsequently in April announced a significant increase in prospective gas resources based on the new independent resource audit prepared by Gaffney, Cline & Associates effective December 31, 2019. Gas decline estimated conventional gas prospective resources of 162 individual prospects and leads which Canacol has aggregated to an un-risk mean of 4.7 trillion standard cubic feet, and a risk mean of 1.4 trillion standard cubic feet of prospective gas resource on our blocks.

Those estimates are significantly higher than the prospective gas resources that were audited by Gaffney, Cline effective at the end of 2017, despite the fact that we have since drilled a significant number of prospects that we're discoveries and included in the prior resource audits. I believe the new resource estimates are a testament to the quality of the land we have and to the ability of our exploration group, as well as ensuring that we have many years of exploration, drilling and reserve replacement and growth ahead of us.

I'd now like to turn the call over to Mr. Jason Bednar, Chief Financial Officer for Canacol to discuss some of the financial highlights associated with our first quarter 2020 results.

When he is done, I'll provide the outlook for the remainder of 2020.

Thank you, Charle. Q1 2020 was a great quarter for Canacol, both operationally and financially, as we continue to execute our plan to drive our growing natural gas business forward.

Largely driven by increased sales in Q1 that Charle has already spoken to, we reported approximately $45 million in funds from operations for the first quarter of 2020, a 51% increase from the same period in 2019. In combination with reduced capital expenditures, this allowed us to generate substantial amounts of free cash flow supporting our new quarterly dividend that was initiated in the fourth quarter of last year, while also continuing to improve our leverage ratios.

Focusing on the first quarter 2020 financial highlights include revenues increasing 44% to $71 million compared to $49 million for the same period in 2019, adjusted funds flow from operations increasing 51% to $45 million from $30 million previously, and EBITDAX increasing 48% to $59 million from $40 million in the previous period. Our operating netback increased 11% to $3.60 per Mcf in the three months ended March 31, 2020 compared to 403 per Mcf in the same period in 2019.

The decrease is primarily due to lower spot market gas sales prices than originally anticipated in Q1. Charle will comment later on some positive gas fundamentals in the Colombian market which were detailed in our press release.

Further analyzing netbacks, we see the increase in royalties per unit of $0.08 per Mcf due to increased natural gas volumes being produced in the Corporation's VIM-5 block, which is subject to a higher royalty rate. However, the increase in royalties, which were anticipated is offset by a 27% reduction of operating expenses per Mcf to $0.22 per Mcf for the three months ended March 31, 2020 compared to $0.30 per Mcf for the same period in 2019.

We maintain strong operating margins of 79% during the quarter. As expected, increased gas sales allowed us to substantially decrease our operating costs and G&A expenses on a per unit basis.

While the main driver of this is gas sales growth, we shouldn't underestimate the achievements of our operations teams in their continuous efforts to achieve increased operational efficiencies. We have built a culture of continuous operational learning that we expect to continue yielding positive results.

We recorded a net loss of $26 million for the first quarter of 2020. However, the net loss is solely due to the non-cash deferred tax expense of $41 million, which is primarily due to the effect of the reduction in the Colombian peso exchange rate on the value of the currently unused tax loss assets and tax cost pools as further explained in the income tax section of the MD&A.

This non-cash expense results from the 24% devaluation of the Colombian peso during the three-month period. Without such non-cash expense net income would have been a robust $15 million for the quarter.

Should the peso normalize in the coming months as it has strengthened by approximately 5% since March 31 quarter-end, a portion of the expense would effectively be reversed adding to net income realized in future periods. The Corporation does have a small $2.5 million to peso financial hedge in place that expires in July 2020.

This amount represents approximately 15% of the Corporation's peso expenditures on a monthly basis. Should the financial statements mark-to-market value as of March 31 reported -- sorry, the financial statements mark-to-market value as at March 31 reported an unrealized loss on this of $2 million.

Should this amount be settled at today's peso value it would be approximately $1 million. There was also a $4.3 million FX losses, but notably $3 million of that amount was unrealized and subject to reverse should the peso continue to strengthen from it's March 31 value of 4,065 to 1 [ph].

We continue our quarterly dividend payments of $0.052 per share with the last dividend payment in mid-April, a dividend which we remain committed to on an ongoing quarterly basis. We also spent just over $1 million buying back stock during the first quarter of 2020 and recently announced an automatic share purchase program in early April.

Our net debt to EBITDAX ratio has been reduced to 1.8 times at March 31, 2020, down from 2.5 times at March 31, 2019. Also, our cash and cash equivalents decreased from $41 million at December 31, 2019 to $49.2 million at March 31, 2020.

Charle will speak in more detail about the recent potential impact of COVID-19 on our gas demand in our operations, as well as adjustments to our CapEx budget. With respect to our go-forward production and financial guidance for the remainder of 2022, two possible scenarios were outlined in our press release.

The first scenario contemplate zero interruptible sales for the remainder of 2020. Under this unlikely scenario, sales would essentially be limited to the Corporation's take-or-pay contracts of approximately 162 million cubic feet a day, and therefore bring annual sales to 170 million cubic feet per day.

But more likely scenario, labeled as our best estimate on these slides, is one in which the demand for interruptible gas sales begins to recover in July and August from the recent quarantine depressed levels, and our average contractual sales for the year being an average of 197 million cubic feet per day. Under this scenario, we are now predicting EBITDA of approximately $233 million, which is approximately 10% lower than previous guidance.

However, we do expect lower EBITDA to be offset by a decrease of $6 million of CapEx, as well as a significant reduction in 2020 income taxes as we begin to utilize our tax assets in the latter half of 2020. As a result, we are still projecting free cash flow of approximately $80 million, unchanged from our original guidance.

In what we believe is the unlikely scenario of no interruptible sales for the remainder of the year, this free cash flow would be decreased by approximately $25 million, still ending with robust $55 million of free cash flow for 2020, and the cash build on a year-over-year basis. During 2020 the Corporation plans to use excess cash to maintain our quarterly dividend payment, which has been set at CAD0.052 per share, being approximately 6% dividend yield at current share prices totaling $6.6 million for the first quarter of 2020, as well as modestly reduced debt levels and continue to repurchase common shares of the Corporation under it's normal course issuer bid.

Also, notable is a significant forecast decrease in the Corporation's net debt to EBITDAX ratio, which stood at 1.8 times at March 31, 2020 and is anticipated to be approximately 1.3 times on December 31, 2020. At a time of increased volatility in the energy commodity prices globally, we're going to keep reminding you that we are very fortunate to have high and stable gas prices that underpin the strong financial results we reported for the first quarter.

As you can see in this slide, our realized gas price of $4.54 per Mcf was relatively unchanged from prior quarters while Henry Hub prices declined, and as you know world oil prices have been under unprecedented pressure. Minor variation in realized prices are exclusively the result of lower interruptible prices as 80% of our volumes are contracted at stable long-term prices.

In closing, our Q1 financial results were remarkably strong with record EBITDA of $59 million continuing the long-term trend of growing revenues and netbacks as shown on this slide. This increasing EBITDA in combination with the stability of our operations and financials is likely fundamental to our share price outperforming peers over the long-term, and also since the beginning of the year.

At this point, I'll hand it back to Charle.

Thanks, Jason. Most energy companies worldwide have been heavily impacted by both a drastic drop in world oil price, obviously and demand related to the measures taken to limit the exposure to the COVID-19 pandemic.

Canacol has been insulated from the effects of low oil prices given our focus on gas production, the blend of our gas sales being weighted towards 80% fixed volume and price take-or-pay contracts. As a result of the country-wide shutdown imposed in Colombia on March 26 which remained largely effective until April 27, we saw industrial construction and commercial demand for gas decrease significantly as workers in these industries remained at home.

During this period, there were virtually no interruptible gas sales. With return of manufacturing and construction activities in most of Colombia on April 27, and the country-wide shutdown scheduled to be lifted completely for all sectors on May 26, we expect interruptible demand to continue to increase and stabilize through the summer months of July and August.

We also expect demand for natural gas to increase in the near-term related to the current 20-year low level of the hydroelectric reservoirs due to an unusually dry winter in Colombia, and of course in the medium to long-term related to the continued decline of Colombia's main producing gas strips [ph]. Canacol's take-or-pay natural gas contracts have seen no instances of force majeure with payments for deliveries being up-to-date with no events of default.

For the months of April, May and June Canacol has allowed take-or-pay off-takers to defer a maximum of 20% of their contracted volumes to be delivered in the last six months of 2020 with cash collections either occurring in April, May or June for the time of delivery. Additionally, all parties have agreed that the annual contractual downtime of these contracts shall be taken during the months of April and May, if not already taken earlier in the year.

These concessions impacted the month of April in the following manner; April total contracted sales volumes were 150 million standard cubic feet per day, and an additional average of 13 million standard cubic feet per day for the month of April was deemed contractual downtime by seven off-takers which will have the effect of increasing sales in the latter half of 2020. As a result of the country-wide shutdown imposed in Colombia on March 26, which remained largely in effect until April 27, we saw industrial construction and commercial demand for gas decrease significantly as workers in these industries remained at home.

As a result, as I mentioned earlier, there were virtually no interruptible gas sales for the month of April. Our revised sales guidance for 2020 for both take-or-pay and interruptible gas sales contracts is 197 million standard cubic feet per day, 4% less than our original guidance of 205 million standard cubic feet per day.

This reduction in expected sales volumes does not materially change our expectations for EBITDA or free cash flow generation for the year. If however interruptible demand does not return to the Colombian gas market as anticipated, the period of July forward, once the off-taker deferred period expires would have natural gas sales of approximately 170 million standard cubic feet per day for the year, reflecting the volumes related only to the existing take-or-pay contracts during the second half of this year.

As a result of the shutdown, the Corporation has experienced a two-month delay in the rig move from the last drilled well of Clarinete-5 to it's next scheduled location, Pandereta-8; this delay and a small delay in the commencement of the Corporation's planned second rig drilling program, now anticipated to be operational in July, has reduced the 2020 drilling program from 12 to 9 wells. Capital expenditures have been revised to $108 million, down from the original $114 million, explained mainly by the delay in our drilling activity due to the lockdown and as the Corporation has shifted it's near-term focus to facilities and flow line construction in preparation of increased gas production during the second half.

Thank you for attending this conference call, and please remember to take the necessary precautions for the safety of yourselves and others. We will now take any questions you might have.

Hi Charle, it's Luiz here. Thanks for taking the question.

Hope Canacol team is safe. My question would be more general in terms of the current natural gas environment in Colombia, right.

I mean, we have been taking some droughts, and that of course is no increase in the specific [ph] gas demand. At the same time we saw some of the -- I mean some of the players shutting down, exit from wells which in the end of the day produce some associated gas.

So how do you see the demand in terms of let's say -- over the next sort of couple of quarters on the natural gas? And how Canacol can benefit from that?

The second question is about the -- let's say the breakdown between your supply. I remember you have close to 80% of your production pretty much stable or fixed in terms of contracts, but 20%, it's more explicit to -- through spot market.

So -- and regarding the first question, how do you see this -- do you think that the credit company might be exposed in the year to be -- includes 20% product production? Thank you.

Thanks, Luiz. With respect to the question, the first question on demand and supply; we've seen coastal demands into our main coastal market, sort of average before in the period January, February, and most of March before really the impact of the shutdown.

You saw an average of consumption of around 400 million cubic feet per day, which is pretty normal for the coast. Since April, and now into May, we've seen production averaging around 300 million cubic production but demand averaging about 300 million cubic feet per day.

So we've seen about a 25% overall reduction in demand related to the closure of business related to the lockdown. We've been seen interruptible volumes start to pick up in the last week and a half, basically we're starting to sell some small interruptible volumes.

As I mentioned, manufacturing and construction were both opened on April 27, country-wide, including the coastal areas. So we're starting to see an uptick as those industries start to reopen and start to consume gas.

With respect to supply; supply remains -- in general, related to associated gas shut-ins and there have been a lot of oil shut-ins. I think the last update from the Ministry of Mines & Energy had 25 to 30 producing fields being shut-in, and those include some fields that produce associated gas.

So we have seen supply has been kind of tight and we anticipate going forward that that if oil prices remain relatively low and those fields remained shut-in, given the fact that most operators here including Ecopetrol have a breakeven north of $30 Brent. So, if oil prices remain low around those levels we expect that the associated gas production normally associated with these fields that are shut-in will obviously not be part of the supply.

So we see the supply situation been relatively tight as a result of these shut-ins. As I mentioned in the monologue as well, a very unusually dry winter here in Colombia, reservoirs are at a historic low since they started measuring levels actually, they've never been this low.

Electricity demand has been somewhat muted during the shut-ins as well, but as electricity demand starts to pick up again with the reopening of the economy, we see the need for gas to generate electricity has been very strong as well. And finally, the main producing fields, which would include the Guajira fields, now operated by Ecopetrol, entirely, to their purchase from Chevron are continuing to decline at 20% per year.

So, I think the supply-demand balance is always what it has been in our favor, perhaps a little bit more so now given -- given the fact that some of the associated gas fields have been shut in due to low oil price. With respect to the breakdown; I mean our breakdown as we've stated in our original guidance, 80% of our contracted volumes are delivered under take-or-pay with the remaining 20% being interruptibles.

We expect very solid take-or-pay delivery through the rest of the year as I mentioned. And any recovery of the economy, particularly in the heavy industry and manufacturing commercial side will hopefully generate additional interruptible sales for us as we move throughout the year.

Okay. Okay, thank you.

Hi there, thanks for taking my question. I like a lot of Canacol shareholders, I'm a shareholders of Arrow Exploration.

When we spun this out 18 months ago, Arrow had a capitalization of $100 million, but now it's less than $2 million, and Canacol effectively sold it's piece for over US$40 million. Does it makes sense now for the company to buyback that Arrow is going through a strategic review?

I understand there is an intercompany loan, so we have a chance of -- if it goes into bankruptcy that we risk losing [indiscernible] company alone. And it just seems like buying oil inventory is super cheap right now, might make some sense given we have the flexibility from a capital perspective.

Thanks.

Yes, thank you for the question. I have no comment with respect to Arrow Exploration.

Good morning and thank you for taking my questions. So I got a couple of questions.

And the first one is, how can we think about the operating net-back going forward given that royalty expenses per Mcf; will they continue to increase as the company depends more on the production of the VIM-5 contract? And can we also see more dilution into the future of operating expenses?

[Technical Difficulty] And my second question is regarding the negotiations with customers due to the drastic reduction in energy; can you expand more on the details of those negotiations. Were much more 20% of their contracted volumes can be deferred?

And were gas sales price also negotiated? Thank you.

I can start with the original question with respect to the net-backs. Our net-backs have been relatively consistent, there were softened slightly by lower -- as I mentioned earlier, lower spot interruptible prices during Q1 but they are still consistent with Q4.

Specifically, you had asked about royalty rate, so our detailed models for the next several years out would anticipate royalty rates between 15% to 16% obviously, that's the blend of the several blocks together; so we don't anticipate any material increases in the royalty rates with respect to the upcoming years. Secondly, with respect to the deferral of near-term contracts being April, May and June where we allowed off-takers to defer up to 20% of their volumes and take them in the latter half of the year, those remain at unchanged prices; so the pricing was not negotiated.

Thanks for your answers. I just have one more question.

So this question is, taken into account depreciation of the peso, what is the amount of...

Sorry Daniel, I think we lost you there.

Right. I have taken a couple of questions to the take-or-pay gas questions.

First, I'd like to know if the structure of the contracts allow your off-takers to declare force majeure due to COVID-19? And therefore, as for early termination or change the terms of the contract, considering the current situation you have considered the risks of cash?

Okay. I will answer that question.

Thank you, Daniel. None of the current -- none of our contracts are in force majeure.

COVID-19 does not constitute a force majeure condition, really the only condition that satisfies force majeure is the inability of the receiver to physically take the gas that would usually involve damage to the clients facilities to physically accept the gas. So the answer to the questions are no, none of the contracts are in force majeure related to COVID-19 or could they be.

And secondly, the force majeure clauses are very rigid with respect to the off-taker physically not been able to take gas, that has nothing to do with them being able to resell the gas, physically they cannot be able to take the gas.

Thank you. And his follow-ups that are; what are your thoughts on imported gas?

Do you consider it to be a threat for your business? In the last weeks imported gas landed critically at a level below deportation.

Thank you.

Thank you. Thank you, Daniel.

Our information with respect to the pricing of loaded LNG destined for Colombia, and this is data that's really available on the EIA website; there were two loads destined for Colombia, one in January and one in February, and the loaded prices at Sabine Pass [ph] where that LNG was loaded were $5.17 and $5.34 respectively. So, although there might be the opportunity that LNG prices do fall below that, and you have to keep in mind that the liquefaction process alone at Sabine Pass [ph] is $3 an MMBTU, that does not include the cost of purchasing the gas in the US domestic.

So, we continue to view LNG in the long-term as not a significant threat to our business model but if cheap loads for whatever reason should arrive in Cartagena [ph], then that could certainly have a very short-term impact on gas sales.

Thank you for participating in Canacol's first quarter 2020 conference call. Please join us again for our second quarter results.

Have a great day.