Canacol Energy Ltd

Good morning and welcome to Canacol's second quarter 2021 financial results conference call. This is Carolina Orozco, Vice President of Investor Relations.

I'm with Mr. Charle Gamba, President and CEO; 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 can include projections of the corporation's future performance.

These projections neither constitute any commitments 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 U.S. dollars.

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

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

We will close with a discussion of the corporation's outlook for the remainder of 2021. A Q&A session will follow.

Today, Mr. Charle Gamba is joining us on the line from Bogota and Mr.

Bednar is joining us on the line from Calgary. I will now turn the call over to Mr.

Charle Gamba, President and CEO of Canacol Energy.

Thanks, Carolina. Good morning and good afternoon to everyone, and welcome to Canacol's second quarter 2021 conference call.

In the second quarter of 2021, we realized natural gas sales of 171 million standard cubic feet per day, slightly lower than in the first quarter of this year, but substantially higher than the low 152 million standard cubic per day we reported for the same period in 2020. That was, of course, when the then very novel coronavirus was at its worst.

Q2 2021 volumes were almost exactly in line with our midpoint of our guidance for the full year of 2021 of 153 to 190 million standard cubic feet per day. We also reported another quarter with a strong and stable operating margin of 77%, as well as a very respectable return on capital employed of 10%.

We remain committed to our return of capital to shareholders with the payment of the seventh consecutive quarterly dividend of CAD0.052 per share, $7.4 million in total, because the current share price represents an annual dividend yield of approximately 6.6%. We also repurchased $2.8 million large worth of shares under our normal course issuer bid, taking advantage of what we perceive as unfounded weakness.

During the second quarter, we completed the drilling of four wells. Most significant drilling results during the quarter came with the Aguas Vivas 1 exploration well.

We've encountered 412 feet of net gas pay, confirming a significant gas pay within the Cienaga de Oro formation. This is the biggest net pay we have ever encountered in any of our wells.

The well test at a final rate of 35.5 million standard cubic per day and well have been tied in and is on permanent production. Due to the very encouraging results achieved at Aguas Vivas 1, we're liked to immediately shift our exploration drilling program to focus on delineation of this significant new gas discovery.

We're planning to drill two appraisal wells back to back, the first of which Aguas Vivas 2, was spud in June and completed in late July. This well encountered 229 feet of net gas pay, confirming a significant gas discovery.

We're currently casing the well and plan to tie it in. And upon completion, we plan to merely spud the next appraisal well, Aguas Vivas 3.

During the second quarter, we also provided an update on our ESG strategy and published our 2020 sustainability report, which showed continued improvement in our already strong reporting and performance. As we highlighted in the press release, we have been focused on increasing diversity and inclusiveness.

I'm particularly proud of the 88% satisfaction score we achieved in our 2020 work-climate survey. It's worth highlighting that we produce almost pure methane 97% without any significant quantities of natural gas liquids, condensate, light oil, water, carbon dioxide, nitrogen, sulfur or any other gas or impurities.

The pure nature of our produced gas stream allows sales via the gas distribution grid after only minimal energy efficient processing, thereby reducing operating costs and supporting high rates of return and low carbon footprint. Our GHG emissions intensity, which was already industry-leading in 2019 was reduced by a further 25% in 2020, thanks to reduced use of diesel for power generation, which has now been almost completely well as the efficiency achieved with increased production levels.

Per dollar of revenue generated, our greenhouse gas emissions in 2020 were not only significantly lower than the vast majority of oil and gas producers globally, but were also significantly lower than the average for broad market indices and stock indices focused on carbon-efficient stocks. And these measures don't take into account that we are producing a fuel that produces significantly less CO2 emissions when consumed than all other hydrocarbons do.

Natural gas is also highly complementary as a backup fuel and electricity generation to support the development of unconventional renewals as part of the energy transition here in Colombia. We're happy to note that our ESG ratings have been steadily improving, and we've also seen a growing recognition of our ESG credentials.

I will now turn the presentation over Jason Bednar, our CFO, who will discuss the financial results in more detail. When he is done, I'll discuss the outlook for the remainder of this year.

Thanks, Charle. We continue to execute our plan to develop our growing natural gas business in Q2 of 2021.

We reported the following key results during the quarter. $54 million of revenue, net of royalties and transportation effectively unchanged from levels reported for Q2 of 2020, $34 million in funds from operations, which represents an 8% increase from the same period in 2020 and EBITDAX of $45 million, which represents a 10% increase from the same period in 2020.

We reported net income of $2.4 million, or $0.01 per share for Q2 of 2021. The reduction in net income for the comparable period in 2020 is attributable to a lower deferred income tax recovery compared to the same period in the prior year, as well as expenses for the unsuccessful Milano 1 exploration well.

Our operating netback was $3.14 per MCF in the three months ended June 30, 2021, which was 13% lower than in the same period of 2020 and 6% lower than the prior quarter. Our realized gas price of $4.09 per MCF was slightly below our guidance for the 2021 year average of $4.10 to $4.50 per MCF.

The production allocation of the Esperanza block was lower during the second quarter of 2021 as the corporation continues to perform routine maintenance. The maintenance is expected to increase the production of Esperanza block going forward.

And as such the overall royalty rate is expected to decrease for the remainder of 2021. The decrease in the average gas sales price in the second quarter of 2021, compared to the first quarter of 2021, was mainly due to offtakers under a higher fixed price contracts, performing regular maintenance during the three months ended June 30, 2021.

In addition, the Q2 2021 spot market average sales price was negatively impacted by, first of all, the Columbia experiencing La Nina climate phenomenon during the quarter, which increases rain fall and as such decreases the demand for natural gas. And secondly, the shutdown in Colombia due to the recent political unrest also resulting in lower demand for natural gas.

Subsequent to the quarter end, the demand for spot market volumes has increased as evidenced by the July 2021 realized contractual natural gas sales volumes of approximately 190 million cubic feet a day, mainly due to first of all the political unrest in Columbia has recently improved and the COVID vaccination rollout in Columbia is well underway. And lastly, the La Nina climate phenomenon has weakened all of which results in higher demand for natural gas.

In turn, the spot market average sales price has recently significantly increased with recent interruptible pricing being approximately $5 net of transportation. Also recall that the majority of our guidance is based on fixed sales – fixed price take or pay contracts with an average fixed price of $4.50 per MCF.

Our operating margin at 77% for the quarter was effectively unchanged from the prior quarter, again demonstrating the remarkable stability and high-margin nature of our business. To further highlight the strength and stability of our business, we want to, again, highlight the return on capital employed implied by our financial statements over the last 10 quarters.

Our return on capital employed remains high by E&P industry standards at 10% in the second quarter and slightly higher than that on a 12 month trailing basis. During the second quarter, we continued to manage our debt in order to minimize our interest payments.

In June, we entered into a three year term credit agreement with Banco Davivienda for a principal amount of 12.9 million, which is denominated in pesos, which is subject to an annual interest rate of IBR plus 2.5%. The Columbian bank debt was used to repay the corporation's litigation settlement liability, which was subject to an 8.74% annual interest rate.

As a result of this lower interest rate, we expect to realize annual interest savings of approximately $600,000 annually. With cash position of $35 million, a working capital surplus of $45 million and undrawn credit facility availability amounting to almost $100 million.

Canacol has a lot of financial flexibility to adjust our investment plans when we find good reasons to do so. During the second quarter, we restarted buying back shares under our normal course issuer bid, taking advantage of what we perceive as unfounded weakness in our share price.

Adding the $2.8 million we spent on buying back shares during the quarter to the $7.4 million we paid with our quarterly dividend means we returned over US$10 million to shareholders in the second quarter. And as we outlined in our press release on August 2, we continued buying back shares during July totaling an additional US$2.5 million in the month of July alone.

In closing, our Q2 financial results were strong and relatively stable despite the challenges that the coronavirus pandemic continued to present, and we remain well positioned to continue growing our business and returning cash to shareholders going forward. At this point, I'll hand it back to Charle.

Thank you everyone.

Thanks, Jason. For the remainder of 2021, we expect to continue delivering results within our previously stated guidance, allowing us to continue operating from a position of financial strength and returning capital to shareholders while also investing in growth.

We're focused on the following objectives for the remainder of this year. Targeting drilling of up to 12 exploration appraisal and development wells and a continuous program with the objective of targeting a 2P reserves replacement ratio of more than 200%, to date the corporation has drilled several exploration and development wells with a significant gas discovery being made at Aguas Vivas, which is currently been appraised.

Secondly, the acquisition of 655 square kilometers of 3D seismic under corporations VIM-5 and SSJN 7 blocks to expand its exploration prospect inventory for future drilling. To date, the corporation has completely – has completed the seismic acquisition on SSJN7 and is currently in the process of acquisition on VIM-5.

Three, the execution of a definitive agreement to construct a new gas pipeline from Jobo, our gas processing facility at Jobo, through Medellin, Colombia, which will increase the corporation's gas sales by an additional 100 million cubic feet per day in 2021. Fourth, the continued strengthening of our environmental, social and governance strategy and reporting.

The corporation has released its 2020 sustainability report making substantial gains in all key metrics. And finally, the continuation of our return of capital program to shareholders.

The corporation has continued to issue quarterly dividends with no reduction in dividend amount. Since May 25th, we've also been buying back shares at a steady rate amounting to approximately 1 million shares per month on average.

I'd like to thank the entire Canacol team as well as our contractors, partners and clients for their continued support and hard work. We're now ready to answer any questions, you might have.

Hi, good morning and thank you for taking my questions. Canacol has delivered important returns to shareholders, but looking forward, can you provide more color on how we should be thinking on capital allocation for the next year and looking forward?

Should the market continue to expect these levels of returns in dividends and share buybacks, even as the company starts to think on new projects, such as the Medellin pipeline and the continuation of the drilling campaign? And that was my first question.

For my second question, more generally on the natural gas industry in Colombia; there has been a lot of news in the media with mixed signals pointing to a potential deficit in production in the country. What could justify a regasification plant in the Pacific?

How is Canacol seeing this movement? And can you provide a bit more color on the potential new supply for imports into Colombia?

And how that could affect Canacol in a two- to three-year or perhaps a longer-term time frame? Thank you.

I'll let Jason take the first question, and then I'll answer the second.

Okay. Thanks.

The question of capital allocation and specifically returns to shareholders, we answered that on the last conference call. My answer isn't going to be significantly different here.

Our debt levels are well under control at under 2 times and projected to decrease as EBITDA grows as the pandemic weakens, I suppose. So we're down to dividends and share buybacks.

We are at the tail end of six-year strategic plans that the Board has been reviewing. And at the end of that exercise, we hope to be able to relate to the market what our allocation will be moving forward with respect to the mix between dividends and share buybacks.

But we're not quite there yet. Having said that, it is of critical importance to us that we keep shareholder returns at high levels, but we'll be able to relay the exact formula in doing so at a later date.

With respect to the question about supply and demand, I mean, obviously, supply remains tight, with the continued decline of – in production of Ecopetrol's main producing gas fields in the Guajira and the Piedemonte. So those metrics have not changed basically, and those fields continue to decline without pause.

That puts us in a very strong position to backfill all of Ecopetrol's decline, which is essentially what we do. With respect to the importation of LNG, it's important to note that no LNG has been imported into Colombia this year via Cartagena.

The regasification terminal in Cartagena has not received any shipments of LNG. And that, of course, is due to the extremely high price of LNG globally, which in no means can compete with our pricing domestically.

So imported LNG currently, no threat whatsoever to our business in the near to medium term given the very high price of natural gas, liquefied natural gas globally. And that situation is predicted in all the future forecast for Japan and European loads.

Pricing is expected to remain very robust, certainly through the mid to long term. With respect to the Pacific regasification terminal, that project has been delayed now for six years.

That project will continue to be delayed due to how uneconomic that project actually is and to the recent issuance of a regulatory demand against the government of Colombia by the regulator here in Colombia, arguing that, that facility, which is going to be paid for with public monies as well as consumers having to pay increased tariffs, the project is simply not viable, and we'll likely never see the light of day.

Great. Thank you.

Thank you very much.

Hi. This is Roman from Robbins Capital.

So I have a couple of questions. First, if we are correct, Canacol drilled and effectively connected four wells during the first half of the year, but output is flat versus fourth quarter of 2020.

So did you shut some wells during the second quarter or something else is at play? So that's the first question.

Yes. The drilling program has been impacted by various delays.

The most recent one being the very long national strike here. So we've seen also some COVID-related delays with respect to quarantines and whatnot.

So the drilling program has been rolling out at a slower pace, but we're still anticipating to drill up to 12 wells this year.

Okay. Thank you.

And then you mentioned that the July output was around 190 Mcf per day. This is due to the increase uptake from a particular client or sector or this is an increase of market share by lowering prices in the spot market?

We are seeing a bit of tightness in supply, primarily from Ecopetrol, and we're seeing an uptake in thermoelectric power generation as well. So certainly through the latter half of July and now into the first week of August, we're seeing very high interruptible sales at very good pricing, wellhead prices.

Wellhead pricing for the interruptibles for the past three weeks has been above $5 in MMBtu. So we're seeing very robust demand at the moment and very high interruptible pricing, and we expect that situation to continue through the remainder of this quarter.

Okay. And just a final one.

Regarding the Tesorito contract, is this still expected for the first quarter of 2022 and the uptake is full take-or-pay?

Yes. The project should come online in February or March of next year.

Construction is rolling out according to schedule. It was somewhat delayed as well by the national strike in May, slightly delayed, but everything is running very well there.

And yes, we will be supplying all of the gas to that facility. That project, a 200-megawatt project, has the capability of consuming up to 40 million cubic feet per day of gas.

And that’s take or pay.

It's similar to the majority of our contracts.

Okay. Thank you very much and congratulations on the results.

Great. Thank you.

Hi. Thank you for the call.

I have two questions. First, Charle just say that maybe you are seeing strong prices in Colombia.

And I'm just wondering if this is going to be like the scenario for the second half of 2021? Or if you see like any specific dates when you see a significant recovery in natural gas prices in the country?

That's my first question. The second question is Ecopetrol wants to have more exposure to gas businesses.

So I'm just wondering if you may know like how this can affect like the view in the long term for Canacol. Or how would be the strategy of Ecopetrol, like trying to get a more market share on this business in Colombia?

That's my second question. And the last question is more about the gas trading revenues.

You have presented for the first quarter and the second quarter. And I'm just wondering if you can comment about it.

And if we are going to see this trading revenue recurring, I mean, for the second half of 2021 and going forward? Or if you can comment about this?

Thank you.

Yes. With respect to the first question, as I mentioned a little earlier, through July, interruptible spot prices increased significantly.

As I mentioned, we're now selling spots above about $5 to $5.15 into the spot market currently. And that's a reflection of both the high demand, particularly on the part of the thermoelectric power plants as well as tight supply.

And you have to keep in mind that we are the only company that has actually been drilling gas wells for the past year. Ecopetrol, which is the biggest producer of gas in Colombia, has not drilled a single gas well in the past two years.

That obviously has a significant impact on supply. So we, of course, have invested considerably in continuing to drill.

We've brought a lot of new production on stream precisely to backfill Ecopetrol's decline. And as a result, there was the lack of drilling on Ecopetrol's part.

We are now enjoying full-swing demand basically based on our the production potential that we've invested in. Secondly, I guess, remaining on the theme of Ecopetrol, yes, they have announced very large plans to increase natural gas production, of course.

They have to appear to be environmentally friendly like anyone else. However, keep in mind that their gas fields are very mature.

They're almost completely drilled up. There's no drilling to be done.

As a matter of fact, in the Guajira on the coast is fully drilled. They are planning to drill in the Piedemonte, in the Cusiana-Cupiagua field.

Those plants have been delayed now for two years. They were meant to start drilling there in 2019.

Here, we are in 2021, and they have yet to start drilling there. So that's a potential.

It's a new supply of gas from new wells in the [indiscernible] market. But that, of course, is the interior market of Colombia, which we do not currently sell in to.

And of course, Ecopetrol is very focused on the offshore. There's been several indications of gas in the offshore, a very deep water, however, 2,000 meters of water.

Those discoveries need to be appraised. They need some more drilling off there to offshore to figure out how big or how small these discoveries are to see if they can commercialize them.

However, given the water depth of 2,000 meters, these would be the deepest non-associated gas fields in the world, basically. No non-associated gas deals are in deeper water than these ones.

So that represents, obviously, a significant challenge to commercialization. I have to mention a very long time line to commercialize of eight to 10 years.

And with respect to the third question about gas trade, I'll let Jason answer that question.

Sure. Thanks, Charle.

So just to refresh everyone's memory, we buy approximately $6.4 million of gas a quarter and sell about $6.4 million of gas a quarter, i.e., we don't produce it. Each and every quarter as that is a fixed contract on both the buy side and the sell side.

We make about $25,000 or $30,000 a quarter. So it's something that our gas team can easily handle.

It's through an existing customer of ours. It helps keep our finger on the pulse of the market.

But that particular contract is – it's a one-year contract and it is at the end of 2021. I have no color whether or not the offtaker will want that renewed at the end of that.

But just to stress, we do not speculate in gas trading. This is locked in and a fixed price number coming in and a fixed price number going out that all ends at the end of this year currently.