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Summary Birchcliff enjoys an ultra-low production cost for its natural gas, thanks in part to processing the majority at its own processing plant. I’m curious to see Birchcliff’s plan for 2016 as, despite the $120M price tag, it would make sense to expand the gas processing plant. The IRR is positive and will be 22% at a 10% higher gas price, so technically and theoretically Birchcliff should be going ahead with the expansion plans. But everything will depend on the company’s plans to achieve production growth, and I think Birchcliff will have to choose between the gas plant and a higher gross production rate. It’s pretty obvious the vast majority of the oil and gas producers are bleeding in the current price environment. That’s particularly true for Birchcliff Energy ( OTCPK:BIREF ) where the majority of the annual production consists of natural gas, which has been hit pretty hard. In fact, the gas price in North America has even dropped to less than $2. BIR data by YCharts Birchcliff is a Canadian company and I think it would be a better idea to trade the shares through the facilities of the Toronto Stock Exchange, where Birchchliff is listed on the main board with BIR as its ticker symbol . The average daily volume is much better in Canada as approximately 660,000 shares are changing hands on a daily basis for a daily dollar volume of $2M. El Nino Is Hurting the Company’s Top and Bottom Lines Let’s start with the good news: Birchcliff Energy was able to keep its production rate stable at a total of 38,400 barrels of oil-equivalent per day. As I said, the vast majority of this comes from natural gas sales and the revenue from natural gas was approximately 3.25 times higher than the revenue generated from selling the attributable oil output. As the average production rate in the same quarter of last year was just over 34,000 boe/day and as the average in the first nine months of the current financial year was approximately 38,400 barrels per day, Birchcliff has done a pretty good job at keeping its production rates pretty consistent despite the worsening climate on the oil and gas front. (click to enlarge) Source: Financial statements. The total revenue in the third quarter of the financial year was almost C$79M ($57M) , which is more than 25% lower compared to the same quarter last year, so the higher output didn’t compensate for the lower oil and gas prices. The operating costs also increased a bit, due to increased marketing and transportation expenses. Nonetheless, Birchcliff was able to write black numbers on its bottom line, and the company generated a net profit of C$4.8M ($3.65M) in the third quarter of 2015. Keep in mind that Birchcliff hasn’t hedged any of its gas and oil production, so “what you see is what you get.” The revenue has not been boosted by one-time events, such as the gain on derivative instruments. Source: Financial statements. The operating cash flow on an adjusted basis was C$44.3M ($32M), which is pretty good considering the circumstances and the shortfall to cover the capital expenditures. The investing part of the working capital position was limited to just C$20M ($14.5M). This could be better, but it could also have been a lot worse. This is where Birchcliff’s low-cost gas production at Montney comes in handy. Will Birchcliff Generate a Sufficient Amount of Cash Flow to Cover Its 2016 Capital Expenditures? My main test for Birchcliff will be in seeing what the company is planning to do next year. The original plan called for another 10%-12% production increase to 42,000-45,000 barrels of oil-equivalent per day, but I can imagine the company is currently developing a revised capital plan that will forego any production expansion while waiting for a higher gas price. This might probably be the smartest decision because even though the production costs at Montney are quite low, it might not be sufficient to cover the additional capital expenditures to indeed break even on the cash flow front. Source: Company presentation. It’s encouraging to see that even in the current gas price environment, the annualized operating cash flow will be roughly C$160M ($116M) and Birchcliff will have to try to keep the capital expenditures limited to approximately this level. Fortunately, the Canadian Dollar continued to weaken. This basically means that the lower natural gas price expressed in USD is partly compensated by the weaker CAD, which is also the currency Birchcliff is reporting its financial statements in. (click to enlarge) Fortunately, Birchcliff Energy still has ample access to liquidity as its bank has confirmed and increased an existing credit facility. Birchcliff can still draw approximately US$120M from this credit facility, and that should be sufficient to cover the capital shortfalls for the next two to three years. The Preferred Shares Could Be a Solution to Raise More Cash No company likes to issue new shares at the bottom of a cycle, but Birchcliff has an attractive Plan B. Birchcliff has two series of preferred shares in the market, and both the A-series and C-series have 2 million outstanding shares. The A-shares have a fixed 8% yield (payable quarterly) and are currently trading at 70% of par (and can be reset in 2017 based on the five-year yield on Canadian government bonds with a mark-up of 6.83%). The C-series have a fixed 7% yield . Both preferred share issues are perpetual, so Birchcliff can decide whether or not it wants to retire these preferred shares in the future. Should Birchcliff double the preferred share issue, it could raise C$70M ($50M) in a heartbeat, further reducing the pressure on its balance sheet. This could cover almost two years of capex funding shortfall. The additional cost of raising this C$70M? Just C$7.5M ($5.5M) per year. That’s not cheap, but it would provide an easy way to fund the ongoing activities. Once Birchcliff’s cash flows increase, the company can easily repurchase the preferred shares. Investment Thesis Birchcliff Energy is definitely hoping for a harsh winter to see a boost in the average gas price. The cash flow situation remains under control, but I think I would prefer the additional layer of safety and purchase the preferred shares. Yes, the upside is a bit more limited, but the series-C preferred share now yields almost 9%. That excludes any potential capital gains if Birchcliff decides to repurchase the preferred shares at par value sometime in the future. It will be very interesting to see what kind of capital investment plan Birchcliff has been preparing for 2016, and what it will do with the PCS gas plant, which was expected to see its throughput increase by 30% by the end of 2016. I think holding off on the expansion is the wisest decision, considering the IRR is just 22% at an AECO gas price of $2.5/GJ (currently at $2.25) and the initial capex is budgeted at US$120M. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.