montneyinitiation 04-16-14 gmp mc

Aaron Swanson, CFA R. Jason Konzuk, CA, CFA [email protected] [email protected] (403) 543-3563 (403) 543-3587 April 16, 2014

Prepared by GMP Securities L.P. See important disclosures on the last page of this report

Launching coverage on 5 Montney producers

Source: Company reports, geoSCOUT, GMP

Delphi Bigstone

AdvantageGlacier

StormUmbach

Alberta B.C.

Painted PonyBlair/Townsend/Cypress

DonnycreekKakwa/Wapiti

2015E Valuation2015E Production Risked NAV EV/DACF EV/Prod'n Total D/CF

Company (boe/d) (% Gas) ($/sh) (P/NAV) (x) ($/boe/d) (x)Advantage Oil & Gas 27,134 97% $8.51 0.7x 6.9x $52,123 1.7xDelphi Energy 12,116 69% $6.53 0.5x 7.1x $53,885 1.6xDonnycreek Energy 3,726 48% $4.37 0.5x 3.1x $37,988 0.5xPainted Pony Petroleum 18,363 85% $17.65 0.6x 9.9x $72,671 1.9xStorm Resources 8,526 80% $8.42 0.6x 10.3x $79,754 1.1x

A Montney Crüe

Report synopsis: The Montney gas resource play, which expands across northwestern Alberta into northeastern B.C., continues to see an increase in drilling activity, an improvement in type curves and a resulting step change in economics. Within this report, we look at five small to mid-cap Montney producers with the assets, upside and valuations, which justify our bullish stance on this play. Why Montney matters • Horizontal wells in the Montney continue to

dominate gas targeted drilling in Western Canada.

• Completions continue to improve resulting in a step change in well economics.

Advantage Oil & Gas (BUY, $8.00 TP) • Upper and lower Montney provide an inventory

of low risk development while the middle Montney has the potential to double inventory.

• Three-year development plan should grow production at a 21% CAGR.

Delphi Energy (BUY, $4.25 TP) • Some of the most economic Montney gas wells

in Western Canada. • Debt levels have peaked, the company is

undergoing significant transformation. Donnycreek Energy (BUY, $3.00 TP) • Small cap, cheap way to play the Montney at

Kakwa in Alberta. • Expanding resource upside with Upper Montney

wells. Painted Pony Petroleum (BUY, $14.75 TP) • 7 TCFe of discovered gas in place across

northeastern B.C. acreage. • Well positioned to be either an LNG supplier or

take-out candidate. Storm Resources (BUY, $6.75 TP) • Top tier management team leads 4th iteration. • Company is entering significant growth phase

and looking to further consolidate the Umbach area of northeast B.C.

Aaron Swanson, CFA R. Jason Konzuk, CA, CFA [email protected] [email protected] (403) 543-3563 (403) 543-3587

WHY THE MONTNEY MATTERS Spanning an area of roughly 150,000 km2 from west central Alberta into northeastern B.C., the Montney formation is currently the most dominant gas play in Western Canada. Early production from the Montney dates back to the 1950’s, but focused drilling did not pick up until 2005 when producers began using horizontal wells to target Montney siltstones and tight sandstones. From a geological standpoint, the formation thickens from the eastern and northeastern erosional edge towards the west-southwest where the formation is up to 300 meters thick with three distinct intervals (lower, middle, upper). Vertical depths range from 500m – 4,500m. It is important to understand that the Montney is not one play but many plays targeting various rock types from siltstone to very fine-grained sandstone to relatively high permeability Coquina shell beds. The Montney formation was deposited over 10 million years in an arid climate similar to modern west coast Africa. It was deposited over many settings from offshore turbidite to distal and proximal shoreface environments, which is reflected in the numerous rock types and complexity of the reservoir. Generally speaking, as depth (and reservoir thickness) increases to the southwest, reservoir pressure increases and oil and liquid content decreases. Location of Montney Rock Types

Source: National Energy Board (NEB) – Montney report published November 6, 2013


Alberta Montney cross-section – thickens and deepens to the southwest

Source: ERCB/AGS Open File Report 2012-06 (October 2012), GMP

Based on a somewhat dated ultimate recovery potential study released on the Montney in 2012, between B.C. and Alberta, there is nearly 450 TCF of marketable gas from the Montney, enough to meet over 100 years of current Canadian gas demand. When we factor in the associated NGL’s and oil, based on the expected case, there is nearly 80 billion barrels of equivalent marketable resource from the formation, making the Montney one of the largest hydrocarbon deposits in the world.

Montney unconventional potential in B.C. and Alberta (as of 2012)

Source: National Energy Board (NEB) – Montney report published November 6, 2013

Low Expected High Low Expected HighNatural gas (tcf) 3,197 4,274 5,405 316 449 645NGL's (mmbbls) 87,360 126,931 176,783 1,540 2,308 3,344Oil (mmbbls) 80,949 141,469 227,221 452 1,125 2,430Barrel Equivalent (mmboe) 701,142 980,733 1,304,837 54,659 78,266 113,274

In Place MarketableHydrocarbon


Follow the money – Montney drilling continues to attract majority of gas directed investment dollars In terms of producer capital allocation, the Montney formation is seeing by far the most capital allocation of all the natural gas resource plays in Western Canada. Assuming an average well cost of $6 million, we estimate 2013 saw over $4 billion in producer capital. From a pure licensing perspective, we estimate 2013 saw over 1,000 Montney gas wells licensed across Western Canada, nearly ten-times the amount of the next closest formation. In fact, licensing activity in the Montney was greater than the next nine formations combined. As a result of the increased drilling activity in the formation, we have witnessed a corresponding exponential increase in production from the formation. In the production exhibits below, we highlight hydrocarbon production exclusively from the Montney horizontal well bores. It is interesting to see how free condensate volumes have increased more recently, which we believe reflects the fact producer dollars are focused on the areas providing the highest liquids content.

2013 Western Canadian gas licensing activity – Montney dominates

Source: geoSCOUT, GMP

Montney horizontal production history


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WHAT’S DRIVING THE ACTIVITY? We see a number of factors behind the Montney formation’s dominance in Western Canada’s gas drilling game. It is our belief that much of the success surrounding the Montney relates to, like most things, time and money. Producers have had nearly a decade of active horizontal drilling in the formation to establish areas that work and those that don’t. Billions have been spent through the learning process to establish what we have today - more concentrated areas of activity and some of the most robust well economics in Western Canada. Key areas have been de-risked as producers are now focusing on improving type curves and well economics through various changes in drilling and completion techniques. Given where we see the Montney in the “play life cycle” we feel this is an opportune time to get exposure as an investor. Factors driving Montney development 1) Zeroing in on areas that work – Activity is more focused on areas with higher liquids content

In the exhibit below (left) we show a chronological map of Montney horizontal licensing activity across B.C. and Alberta (this includes both oil and gas wells). What is clearly evident is how the play has become concentrated in a handful of areas as opposed to the early days when drilling activity was much more dispersed. The figure on the right hand side displays free condensate yields from Montney horizontal gas locations (we omitted the oil wells to provide a better indication of true free liquids yields), with the point being there is a clear correlation between licensing activity and liquids yields in the formation.

Montney oil and gas licensing activity –more concentrated Montney gas producers and free condensate yields (IP60)


2014201320122011201020092008pre-2008

> 100 bbl/mmcf50-100 bbl/mmcf30-50 bbl/mmcf20-30 bbl/mmcf10-20 bbl/mmcf< 10 bbl/mmcf


2) Economics are undergoing a major transformation Now that producers have de-risked the most prospective Montney areas, the focus has shifted to improving the type curves and economics. Generally speaking, a number of producers are moving to a ball-drop completion technique, which has not only reduced completion costs, it has resulted in a material improvement to production type curves and ultimately economics. In the table below we display the impacts of four different Montney plays where the producers have recently shifted to a new completion method. The new completions are significantly increasing production rates, which is transferring to an improvement in well economics, with the average payout cut by more than half. Delphi’s Montney wells at Bigstone have undergone the most significant transformation as the old wells (gelled oil fracs) were marginally profitable and took over 4 years to pay out, compared to the new wells (hybrid slickwater fracs), which are massively economic, with an estimated payout of 6 months.

Impact of new completion techniques on well performance and economics

Source: geoSCOUT, company reports, GMP 3) Montney is seen as the leading formation for LNG feedstock

To date, the National Energy Board has received eleven applications for west coast LNG export licenses, for a total capacity of 21.2 bcf/d. Of the eleven, eight have been approved, with combined export capacity of 15.1 bcf/d, while the remaining four, which are still in the regulatory process, could add an incremental 5.1 bcf/d. While many of the project proponents already possess the upstream assets required for their facilities, four projects with a combined capacity of 4.0 Bcf/d (Woodfibre LNG Export Pte. Ltd., Jordan cove LNG L.P., Triton LNG L.P., and Kitsault Energy Ltd) lack the dedicated resources to supply their LNG projects, hinting these companies will be in the market for supply.

LNG export license applications

Source: National Energy Board, GMP

Old New % change Old New % change Old New % change Old New % changeWell Perfromance

IP 30 (mcf/d) 4,689 5,581 19% 4,381 7,024 60% 2,678 4,244 58% 3,176 5,147 62%Liquids yield (bbl/mmcf) 73 108 48% 14 14 0% 35 36 3% 0 0 N/A

EconomicsBT NPV (10) ($mm) $1.6 $16.6 956% $4.5 $9.7 116% $3.0 $5.9 100% $3.1 $4.0 28%

Well Payout (months) 53 6 -89% 38 14 -63% 32 15 -53% 43 23 -47%

AAV- GlacierDEE - Bigstone PPY - Townsend SRX- Umbach

Project Company/Ownership Export License Capacity (BCF/D)KM LNG Operating General Partnership Apache/Chevron Approved 1.3BC LNG Export Co-operative LLC Haisla Nation/LNG Partners LLC Approved 0.2LNG Canada Development Inc Shell/PetroChina/Mitsubishi Corp/Korea Gas Corp Approved 3.2Pacific Northwest LNG Ltd Petronas - Progress/JAPEX/PetroluemBRUNEI Approved 2.6WCC LNG Ltd Imperial Oil Resources Ltd/ExxonMobil Canada Ltd Approved 3.9Prince Rupert LNG Exports Ltd British Gas Group (BG) Approved 2.8Woodfibre LNG Export Pte. Ltd. Pacific Oil & Gas Ltd Approved 0.3Jordan Cove LNG L.P. Veresen Inc Approved 0.8Triton LNG L.P. Altagas Pacific Partnership/Indemiitsu Kosan Co Ltd Under Review 0.3Kitsault Energy Ltd. Kitsault Energy Ltd. Under Review 2.6Aurora Liquefied Natural Gas Ltd. CNOOC/INPEX Gas BC Ltd Under Review 3.2

21.2


ADDING FIVE NAMES TO OUR MONTNEY PORTFOLIO In addition to the seven producers with material Montney gas exposure currently under coverage (ARX, BIR, CR, CQE, NVA, POU, RTK), we are increasing our Montney coverage portfolio to include an additional five names, each operating within a distinct area along the greater Montney fairway. The new names include: Advantage Oil and Gas, (AAV-T), Delphi Energy (DEE-T), Donnycreek Energy (DCK-V), Painted Pony Petroleum (PPY-T) and Storm Resources (SRX-V). We see the addition of these five names as key to rounding out our Montney gas coverage list and believe each name carries a unique characteristic, appealing to a wide breadth of investor demand. As we established early in this report, the roughly 150,000 km2 of Montney prospective land extending from west central Alberta to northeastern B.C. is extremely diverse and offers a number of different play types. We do not believe it is accurate to group all Montney producers in one basket, as economics are varied and producers are in different stages of the de-risk to exploitation lifecycle. There is no question surrounding the momentum of Montney producers year-to-date, with the group returning an average of 33%.

Montney producers – year to date share performance

Source: Bloomberg

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MONTNEY SCORECARD Breakdown of covered companies’ Montney plays

Source: geoSCOUT, Company reports, GMP Ranking Montney plays

Source: geoSCOUT, Company reports, GMP

AAV AAV AAV DEE DCK PPY SRX ARX BIR CR CQE NVA NVA POU POU

Montney Play / Area Glacier - Upper

Montney

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Kakwa - Middle

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Lower Montney

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Simonette Upper

MontneyBilbo South

Montney Bilbo North

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Karr / Gold Creek

Montney

Musereau / Kakwa

100 bbls/mmcf Montney

Well costs ($mm) $5.50 $6.60 $5.80 $9.20 $10.00 $7.20 $5.00 $5.25 $6.00 $4.70 $7.50 $9.00 $9.00 $8.00 $8.00NPV ($mm) $3.65 $4.56 $4.92 $13.73 $9.88 $6.59 $5.91 $5.65 $4.06 $3.91 $5.34 $9.51 $7.00 $5.37 $12.25PIR (ratio) 0.7x 0.7x 0.8x 1.5x 1.0x 0.9x 1.2x 1.1x 0.7x 0.8x 0.7x 1.1x 0.8x 0.7x 1.5xPayout (months) 26 26 24 9 19 22 15 10 32 11 28 14 21 23 8

IP (30) (boe/d) 858 704 704 1,090 855 893 860 767 597 906 921 1,270 1,318 1,083 1,333IP (30) liquids content (bbls/mmcf) 0 39 10 108 150 14 36 25 6 30 30 105 73 50 100IP (30) liquids content (% ) 0% 19% 6% 39% 47% 8% 18% 13% 3% 15% 15% 39% 30% 23% 38%EUR (mmboe) 0.82 0.78 0.90 1.23 0.88 1.21 0.88 1.04 0.90 0.90 0.98 0.89 0.93 0.74 0.91

denotes new coverage

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New names offer a taste for every palate All the companies covered in this report have primary assets producing natural gas out of the Montney formation, however, in many ways this is where the similarities both start and end. Of the five companies, 2014 production estimates range from over 20,000 boe/d, down to the 1,500 boe/d range and cover various stages of the company (and play) lifecycle. Additionally, production varies from 100% gas to a 50/50 mix of gas and NGLs Forecast production and gas weighting

Source: Company reports, GMP Securities

NEW NAMES…FROM 30,000FT Advantage Oil & Gas What we like: Well-delineated Montney resource, with 83 wells drilled in upper Montney and 21 wells

into the lower Montney. Recent middle Montney success offers potential to double resource on the play and add a

liquids component. Fully funded development plan should result in a 21% production CAGR over next three

years. Cautionary notes: Significant delineation of middle Montney remains, with only nine wells drilled to date into two of three potential layers. Delphi Energy What we like: New completion techniques appear to be a game changer with wells showing $16 million

NPV potential. Already up the learning curve – investors are now paying for execution and face less

reservoir risk. 2013 was a year for operational improvements, we see 2014 as the year Delphi

significantly improves its financial position. Cautionary notes: New corporate type curve appears to be reflective of some of the company’s best performing Bigstone Montney wells.

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Donnycreek Energy What we like: Appear to have a top quality land position in one of the most liquids-rich areas of the

Montney gas fairway. Majority of drilling activity has focused on the Middle Montney interval, while the most

recent well successfully tested the Upper Montney, resulting in a potential doubling of the company’s drilling inventory.

Has the largest contiguous land base in the Montney prospective Wapiti area. Early well results suggest there is much more work to be done here but, if successful, we believe this is the ticket to the company being acquired.

Cautionary notes: Small cap producer in a capital-intense play (wells cost upwards of $10 million), meaning until the company reaches a higher critical mass, access to capital will be important to play development.

Painted Pony Petroleum What we like: LNG upside: 7.0 tcfe of contingent resource and a clear line of sight to the West Coast. Type curves have seen a material improvement with the recent switch to ball-drop

completion technology. Operational momentum clearly in Painted Pony’s favour as the company recently

increased 2014 average production guidance by nearly 15% on the back of initial production rates from four new wells.

Cautionary notes: LNG projects and timelines are uncertain and 5-year growth plan may be scaled back if the company does not have required capital.

Storm Resources What we like: Proven management team with a history of value creation over the previous 3 iterations

of Storm. Potential to be a consolidator in the Umbach area; acquired Montney assets from Yoho

in January 2014. Conservative reserve bookings leave considerable unbooked upside – reserve bookings

are currently based on 8% of Storm’s Umbach land position. Cautionary notes: Well economics are driven by liquids yields, which exhibit significant variability. Good news is liquids rates are trending in the right direction.


HOW THEY STACK UP Within this section of the report, we compare the five new companies to their gas-weighted peers on four metrics: 1) Growth – Both production and cash flow per share 2) Operating measures – Cash flow netbacks and cost structure 3) Valuation – Cash flow, production and NAV-based 4) Balance sheet – Debt relative to cash flow and debt relative to production

Growth: Our comparative metrics for growth include production per share and cash flow per share. Our average projected production per share growth for the gas-weighted small to mid-cap names sits just over 20% (2014). Ignoring Donnycreek’s over threefold projected increase, amongst the new names, we are forecasting production per share to increase by an average of 25%, with Painted Pony leading the way. Given the continued improvements in Montney type curves, we foresee growth rates expanding from our current estimates. Given the recent increase in natural gas prices (when compared to 2013 levels) cash flow per share growth is much more pronounced. On average, we are forecasting the group’s cash flow to rise 80% in 2014, with our new names increasing by an average of 85%.

Comparative growth metrics – production and cash flow

Source: Company disclosures, GMP

Netbacks and cost structure: Low-cost structure and strong realised pricing help drive asset profitability. Therefore, it should come as no surprise those companies with a higher weighting to liquids and low-cost structure are forecast to have the strongest cash flow netbacks. The average forecast 2014 cash flow netback for the group is $23.15/boe, with our new names falling right in line. Given the relatively low finding costs in the Montney, we believe these producers will continue to deliver strong recycle ratios.

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Valuations: When comparing the relative valuations of the five companies with the larger peer group, we note that on average the Montney producers tend to trade at higher multiples. Painted Pony and Storm have of the three highest EV/DACF multiples in the group. The same can be said when looking at the valuation multiple from a production metric standpoint. Given the Monteny resource potential, operational momentum, and recent type curve improvements seen in the play, we do feel any sort of premium valuation multiple is justified. On average, our junior-intermediate gassy names trade at a 2014 EV/DACF multiple of 9.2x; this falls to 7.5x in 2015 on the back of a strong group growth profile. On average, our new Montney names trade at a slight premium in 2014 (9.8x), but given the better than average projected growth profiles, they trade at a slight discount in 2015 (7.4x).

Comparative valuation metrics


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What are you paying for from a NAV basis? From a standpoint of resource upside potential, our new Montney producers are trading at a premium to their Base NAV (outside of DCK, but we believe this discount is due to the recent results from their Wapiti Montney play), meaning the market is giving these names value for their unbooked upside. In terms of relative value to Risked NAV, Delphi appears most attractive as the stock is trading at a slight premium to its Base NAV, which only includes 21 non-producing East Bigstone locations (representing roughly 2.5 years of drilling activity), signifying the reserve report is not aggressive by any means.

Current share price relative to their NAVs


Balance sheet: Generally speaking, balance sheet strength amongst our gas-weighted juniors and intermediates is pretty healthy, thanks to strong first quarter pricing. On average, the group is carrying a trailing 2014 D/CF ratio of 1.2x, with our new names falling in line with this average. On a utilization basis, the new Montney names have drawn roughly 70% of their bank line, although we suspect lending lines will be expanded given the fact reserve reports have recently been updated.

Comparative balance sheet metrics


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