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Overview
High Arctic is a highly illiquid, nanocap stock, operating in a developing country, and connected to a volatile commodity. While this becomes an automatic pass for many, to me it screams opportunity. At the highest level, the investment thesis for High Arctic is laid out by Clay Williams, CEO of NOV. He loves to say that "it takes a while for prosperity to trickle down the oilfield food chain." The company is a lessor and operator of liquefied natural gas (LNG) rigs in Papua New Guinea (PNG), making it the poster child of this old oil adage. This presents investors with an opportunity to place a true "Heads I win; Tails I don't lose much" bet.
History
Historically, High Arctic has had three lines of business: well-servicing in Canada and the US, leasing out and operating of LNG rigs in PNG, and with a nod to operating leverage, adjacent services and products for rent with all other lines of business. After some pandemic-induced reflection, management decided to divest the significant majority of the non-PNG assets. What is left is a small snubbing business in the US, a 49% joint venture operating an oilfield in Canada, 42% of the private company it sold its Canadian well-servicing business to, and of course its PNG assets.
PNG
Papua New Guinea is a small island off the coast of Australia. Producing LNG in the country allows it to export it to Asia, which has very little natural LNG. Therefore, these countries turn into importers, keeping the LNG prices structurally higher than in the US. On top of this, "higher for longer" seems to be the case when it comes to LNG prices across the globe.
The country is still a developing nation with very little infrastructure. This requires both special expertise, equipment, and relationships, all of which High Arctic has. Because of this, High Arctic currently has no competitors operating in PNG. If the exploration and production (E&P) companies want to drill in PNG in the near future it will be through High Arctic.
Also of note is the politics involved. PNG's government struck deals to drill more than one field and considers these LNG projects to be of high importance. This means that there will be drilling in PNG. It is a matter of when, not if (of course barring something existential, like a pandemic).
Rigs
The final important piece of the puzzle is understanding the rig situation. High Arctic operates five rigs in PNG. Rigs 103 and 104 are owned by Santos (fka Oil Search). Rig 103 went back into service in the middle of 2022. Despite that, all of the other rigs have not been in operation. This alone has been enough to return the company to being cash flow positive. And this is not even where the real money is made. Because Santos owns Rigs 103 and 104 High Arctic does not make the money from leasing out the rig(s). This brings us to the crux of the thesis: High Arctic's owned rigs. High Arctic owns rigs 115 and 116, which are heli-portable, as well as workover rig 102. Putting these rigs on contract is when the cash really starts to flow in.
Capital Expenditure
Despite the rigs not being in service for a considerable amount of time, management has kept them in great condition. Because of this they expect capital expenditures to be minimal, as this is the majority of their capital expenditures. Management expects to spend $4-8M between the two heli-potable rigs. This would be a very small investment compared to the cash these rigs would then generate in a very quick period of time.
Valuation and Catalyst
Over the last couple of years, High Arctic has been burning cash and sitting on a flat stock price, while most involved in the oil industry have seen record profits and stock prices. With a market cap of $61M, the company is trading at less than 1.8 times its net cash. This is the setup for huge returns if, or when, the FIDs come in as expected.
Currently, Rig 103 is on contract, and the company also expects Final Investment Decisions (FIDs) on rig 104 as well as one of the owned heli-portable rigs. While they said this with higher LNG prices, High Arctic's management believes they can generate more cash than at the peak of the last cycle, which was $42M in free cash flow. For reference, just hitting that number would be about 61% of its current market cap.
Given the nature of the company, I believe it should be valued conservatively on its replacement cost. The company has an extremely clean balance sheet, making it a good, and again conservative, proxy for the company's replacement value. The current value of $2.37 a share is 100.1% higher than the current price. It is also worth noting that as the last energy investment cycle started to ramp up, High Arctic traded mostly in a range of about 1.2-1.4 times book value for several years. 1.2 times book would result in 140.7% upside to $2.84 per share.
Risks and Rebuttals
Size and/or liquidity
Size and liquidity are important to understand when analyzing or investing in the company, but there is no way around it, other than of course not buying.
High Arctic's asset base and debt profile make the chances of a permanent loss of capital very slim, even if you were to get trapped in the stock.
Potential of extended time before FID's
Its price being so depressed and the company's potential to quickly ramp up its free cash flow provide the possibility of strong absolute returns and internal rate of return (IRR), even if the FID decisions took several years.
Potential of projects being canceled
This is highly unlikely as it would be detrimental to the reputation of involved E&Ps (Santos, Exxon, and Total). These companies have made deals with the government of PNG. Backing out of deals like these has a negative effect when going to the negotiating table with another government.
If for some existential reason, these projects were canceled the company trades so far below its net asset value that the risk of permanent loss of capital becomes very small.
Potential of poor capital allocation
On this point management speaks for itself. The recent divestitures back up management’s promise to focus on the PNG business and return excess cash to shareholders.
Competition
Being a monopoly business in a, literal, commodity industry you would naturally think competitors would come in and drive down margins, but this is not the case with High Arctic's PNG business. This is best illustrated by the fact that the company has been doing business with Santos (PNG's longest-tenured operator) since 2007. High Arctic's relationships, expertise in PNG, and specialized heli-portable rigs make it highly unlikely they lose this business.
Management said they expect a new major entrant into the PNG market in the next two to three years. They actually welcome this. They believe that there is more than enough room for another player, and that more drilling will bring more infrastructure to the area, creating a positive feedback loop.
Commodity Price
Of course, LNG, as well as energy in general, can sometimes see major price swings. That said, these rigs are contracted out on multi-year leases. This naturally means that the E&P companies are looking through the short-term volatility, and instead to the longer-term expected price curve.
Though these things are truly impossible and can change quickly, the current expectation is "higher for longer." Additionally, even if prices were to come down, they are still structurally higher in Asia than in the US.
PNG/Political
While PNG does suffer from political instability, there has never been an issue with those involved in the LNG projects. On a macro level, the LNG projects are important to the PNG economy and therefore the government. Looking at it specifically from a High Arctic perspective, the company hires all of its operators locally in PNG.
Operational
Even those that have never looked at the energy industry in any real capacity are well aware of the safety issues that are associated with it. This is always something to keep in mind when making any investment in the industry, but you cannot get much safer on that front than High Arctic. In its most recent quarter, it hit the "safety milestones of 6 years and 3 million work hours recordable incident free."
Macro/systemic
Another inevitable risk when investing in the energy industry. It is impossible to predict and impossible to control these risks, but they are important to understand when making investments in the space. It is also worth keeping in mind that this same potential headwind could also be a tailwind.
Other Items of Note
In late February management reinitiated a monthly dividend (currently at a 4.7% yield) for the first time since before the pandemic. Though this is a just singular data point, conventional wisdom would say that they would not do this if they were not confident in the business.
Management has a strong history of buybacks, monthly dividends, and special dividends. The investor relations section of its website displays a chart of the cash returned to shareholders on the home page.
Though management has no intention of monetizing it, the company's 42% stake in its private well-servicing subsidiary alone is worth more than the current market cap. The deal was closed less than eight months ago for $90.95M, valuing High Arctic's 42% stake at $38.2M. Another important factor in reducing the risk of a permanent loss of capital, and/or catalyzing value realization.
High Arctic has about $42M in cash and less than $5.5M in debt and lease liabilities. Just one more way your downside is protected.
Summary
Simply put, High Arctic offers an asymmetric opportunity to the upside. If/when its rigs come on contract, then the business should inflect from money losing to gushing cash. If not, then you are sitting on an asset with a strong balance sheet, valued significantly below its replacement value, setting the stage for a catalyst to bring big gains. On top of this, a 5.5% dividend yield while you wait has never hurt either. For those that missed the oil run, this could be your shot at redemption.
"valuing High Arctic's 42% stake at $38.2M" - Are you talking about team snubbing ?
HWO's team snubbing is only $8 mil for the 42% ownership.
Nice write-up, enjoyed reading it.