MANAGEMENT'S DISCUSSION AND ANALYSIS
The following is management's discussion and analysis ("MD&A") of Perpetual Energy Inc.'s ("Perpetual", the "Company" or the "Corporation") operating and financial results for the three and six months ended June 30, 2020 as well as information and estimates concerning the Corporation's future outlook based on currently available information. This discussion should be read in conjunction with the Corporation's unaudited condensed interim consolidated financial statements and accompanying notes for the three and six months ended June 30, 2020 as well as the audited consolidated financial statements and accompanying notes for the years ended December 31, 2019 and 2018. The MD&A should be read in conjunction with the Corporation's MD&A for the year ended December 31, 2019, as disclosure which is unchanged from the December 31, 2019 MD&A has not been duplicated herein. The Corporation's consolidated financial statements are prepared in accordance with Canadian generally accepted accounting principles ("GAAP") which require publicly accountable enterprises to prepare their financial statements using International Financial Reporting Standards ("IFRS"). Readers are referred to the advisories for additional information regarding forecasts, assumptions and other forward-looking information contained in the "Forward Looking Information and Statements" section of this MD&A. The date of this MD&A is July 31, 2020.
NATURE OF BUSINESS: Perpetual is an oil and natural gas exploration, production and marketing company headquartered in Calgary, Alberta. Perpetual owns a diversified asset portfolio, including liquids-rich natural gas assets in the deep basin of west central Alberta, heavy oil and shallow natural gas in eastern Alberta and undeveloped oil sands leases in northern Alberta. Additional information on Perpetual, including the most recently filed Annual Information Form ("AIF"), can be accessed at www.sedar.com or from the Corporation's website at www.perpetualenergyinc.com.
ADVISORIES
NON-GAAPMEASURES: The terms "adjusted funds flow", "adjusted funds flow per share", "adjusted funds flow per boe", "available liquidity", "cash costs", "gas over bitumen revenue, net of payments", "net working capital deficiency", "net debt", "net bank debt", "net debt to adjusted funds flow ratio", "operating netback", "realized revenue", and "enterprise value" used in this MD&A are not recognized under GAAP. Management believes that in addition to net income (loss) and net cash flows from (used in) operating activities as defined by GAAP, these terms are useful supplemental measures to evaluate performance. Users are cautioned however that these measures should not be construed as an alternative to net income (loss) or net cash flows from (used in) operating activities determined in accordance with GAAP as an indication of Perpetual's performance and may not be comparable with the calculation of similar measurements by other entities.
Adjusted funds flow: Adjusted funds flow is calculated based on cash flows from (used in) operating activities, excluding changes in non- cash working capital and expenditures on decommissioning obligations since Perpetual believes the timing of collection, payment or incurrence of these items is variable. Expenditures on decommissioning obligations may vary from period to period depending on capital programs and the maturity of the Company's operating areas. Expenditures on decommissioning obligations are managed through the capital budgeting process which considers available adjusted funds flow. The Company has added back non-cash oil and natural gas revenue in-kind, equal to retained East Edson royalty obligation payments taken in-kind, to present the equivalent amount of cash revenue generated. The Company has also deducted payments of the gas over bitumen royalty financing from adjusted funds flow to present these payments net of gas over bitumen royalty credits received. These payments are indexed to gas over bitumen royalty credits and are recorded as a reduction to the Corporation's gas over bitumen royalty financing obligation in accordance with IFRS. Additionally, the Company has excluded payments of restructuring costs associated with employee downsizing costs, which management considers to not be related to cash flow from operating activities. Management uses adjusted funds flow and adjusted funds flow per boe as key measures to assess the ability of the Company to generate the funds necessary to finance capital expenditures, expenditures on decommissioning obligations, and meet its financial obligations.
Adjusted funds flow per share is calculated using the same weighted average number of shares outstanding used in calculating net income (loss) per share. Adjusted funds flow is not intended to represent net cash flows from (used in) operating activities calculated in accordance with IFRS.
Adjusted funds flow per boe is calculated as adjusted funds flow divided by total production sold in the period.
The following table reconciles net cash flows from (used in) operating activities to adjusted funds flow:
Three months ended June 30, | Six months ended June 30, | |||
($ thousands, except per share and per boe amounts) | 2020 | 2019 | 2020 | 2019 |
Net cash flows from (used in) operating activities | (2,777) | 4,295 | (5,891) | 13,587 |
Change in non-cash working capital | (1,383) | (716) | (2,318) | (3,557) |
Decommissioning obligations settled | 3 | 360 | 177 | 666 |
Oil and natural gas revenue in-kind | 650 | - | 650 | - |
Payments of gas over bitumen royalty financing | (152) | (290) | (356) | (685) |
Payments of restructuring costs | 331 | - | 809 | - |
Adjusted funds flow | (3,328) | 3,649 | (6,929) | 10,011 |
Adjusted funds flow per share | (0.05) | 0.06 | (0.11) | 0.17 |
Adjusted funds flow per boe | (9.99) | 4.28 | (6.84) | 5.64 |
Available Liquidity: Available Liquidity is defined as Perpetual's reserve-based credit facility (the "Credit Facility") borrowing limit (the "Borrowing Limit"), less borrowings and letters of credit issued under the Credit Facility. Management uses available liquidity to assess the ability of the Company to finance capital expenditures and expenditures on decommissioning obligations, and to meet its financial obligations.
Cash costs: Cash costs are comprised of royalties, production and operating, transportation, general and administrative, and cash finance expense. Cash costs per boe is calculated by dividing cash costs by total production sold in the period. Management believes that cash costs assist management and investors in assessing Perpetual's efficiency and overall cost structure.
PERPETUAL ENERGY INC. | Q2 2020 | Page 1 |
Three months ended June 30, | Six months ended June 30, | |||
($ thousands, except per boe amounts) | 2020 | 2019 | 2020 | 2019 |
Royalties | 794 | 2,464 | 3,177 | 5,640 |
Production and operating | 1,834 | 4,911 | 6,002 | 10,231 |
Transportation | 782 | 1,635 | 2,052 | 3,166 |
General and administrative | 1,995 | 3,177 | 4,220 | 6,648 |
Cash finance expense | 1,902 | 2,250 | 4,472 | 4,560 |
Cash costs | 7,307 | 14,437 | 19,923 | 30,245 |
Cash costs per boe | 21.93 | 16.93 | 19.65 | 17.05 |
Realized revenue: Realized revenue is the sum of realized natural gas revenue, realized oil revenue and realized natural gas liquids ("NGL") revenue which includes realized gains (losses) on financial natural gas, crude oil, NGL, and foreign exchange contracts. Realized revenue is used by management to calculate the Corporation's net realized commodity prices, taking into account the monthly settlements of financial crude oil and natural gas forward sales, collars, basis differentials, and forward foreign exchange sales. These contracts are put in place to protect Perpetual's adjusted funds flow from potential volatility in commodity prices and foreign exchange rates. Any related realized gains or losses are considered part of the Corporation's realized price.
Gas over bitumen revenue, net of payments: Gas over bitumen revenue, net of payments, includes gas over bitumen royalty credits less payments of the gas over bitumen royalty financing. This is used by management to calculate the Corporation's net realized gas over bitumen revenue to reflect the substantive monetization of the future gas over bitumen royalty credits.
Operating netback: Operating netback is calculated by deducting royalties, production and operating expenses, and transportation costs from realized revenue. Operating netback is also calculated on a per boe basis using production sold for the period. Operating netback on a per boe basis can vary significantly for each of the Company's operating areas. Perpetual considers operating netback to be an important performance measure as it demonstrates its profitability relative to current commodity prices.
Net working capital deficiency: Net working capital deficiency includes total current assets and current liabilities excluding short-term derivative assets and liabilities related to the Corporation's risk management activities, Tourmaline Oil Corp. ("TOU") share investment, TOU share margin demand loan, revolving bank debt, term loan, current portion of royalty obligations, current portion of lease liabilities, and current portion of provisions.
Net bank debt, net debt, and net debt to adjusted funds flow ratio: Net bank debt is measured as current and long-term revolving bank debt including net working capital deficiency. Net debt includes the carrying value of net bank debt, the principal amount of the term loan, the principal amount of the TOU share margin demand loan and the principal amount of senior notes, reduced for the mark-to-market value of the TOU share investment. Net debt, net bank debt, and net debt to adjusted funds flow ratios are used by management to assess the Corporation's overall debt position and borrowing capacity. Net debt to adjusted funds flow ratios are calculated on a trailing twelve-month basis.
Enterprise value: Enterprise value is equal to net debt plus the market value of issued equity, and is used by management to analyze leverage.
VOLUME CONVERSIONS: Barrel of oil equivalent ("boe") may be misleading, particularly if used in isolation. In accordance with National Instrument 51-101 ("NI 51-101"), a conversion ratio for natural gas of 6 Mcf:1 bbl has been used, which is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead. In addition, utilizing a conversion on a 6 Mcf:1 bbl basis may be misleading as an indicator of value as the value ratio between natural gas and crude oil, based on the current prices of natural gas and crude oil, differ significantly from the energy equivalency of 6 Mcf:1 bbl.
SECOND QUARTER 2020 HIGHLIGHTS
On April 1, 2020, the Company sold a 50% working interest in its East Edson property in West Central Alberta to a third-party (the "Purchaser") for consideration including a cash payment of $35 million and the carried interest funding of the drill, complete and tie-in costs for an eight-well drilling program (the "East Edson Transaction"). A minimum of two horizontal wells targeting development of the Wilrich formation are required to be drilled, completed and tied-in during the third quarter of 2020. The Purchaser is required to complete the eight-well horizontal drilling program by April 1, 2022. The cash proceeds from the East Edson Transaction were used to repay bank debt. The eight-well development capital carry at East Edson is anticipated to restore gross production levels to more fully utilize the existing processing capacity, improve operating netbacks given the largely fixed operating cost base, and result in improved capital spending efficiency.
In response to the significant decline in global oil prices which began in late-March, all capital investment for the second quarter of 2020 was deferred, resulting in nominal exploration and development capital spending. Expenditures on decommissioning obligations were also reduced, enabled by the Alberta Energy Regulator's ("AER") cancellation of area-based closure expenditure requirements for 2020.
Second quarter production averaged 3,662 boe/d, down 61% from 9,370 boe/d in the comparative period of 2019, due primarily to the temporary suspension of heavy oil production in response to low oil prices, and the sale of a 50% working interest in the East Edson property in West Central Alberta, effective April 1, 2020. Compared to the first quarter of 2020, production declined by 51% or 3,817 boe/d. The closing of the East Edson Transaction on April 1, 2020, combined with natural declines at East Edson of 6%, reduced West Central production by 3,062 boe/d or 80% of the total production decline from the first quarter. The shut-in of Eastern Alberta heavy oil production due to low oil prices contributed the remaining 755 boe/d decrease. As Western Canadian Select prices improved materially from their April lows, the Company began reactivating certain low-cost heavy oil production in mid-May 2020, and has continued to ramp up production as oil prices recover. By mid-July, Perpetual had restarted all heavy oil production with the exception of approximately 250 bbl/d of higher cost production in certain pools at Mannville.
Realized revenue was $13.15/boe in the second quarter of 2020, 38% lower than the comparative period of 2019 ($21.26/boe). The decrease was due largely to the 88% decrease in Perpetual's realized natural gas price to $0.28/Mcf, combined with a 66% decline in realized NGL prices. Compared to the prior year period, lower realized natural gas prices were the result of $1.6 million in realized hedging losses on AECO-NYMEX
PERPETUAL ENERGY INC. | Q2 2020 | Page 2 |
basis differential contracts, as NYMEX prices weakened relative to AECO prices during the quarter. In the third quarter of 2019, the Company's 40,000 MMBtu/d market diversification contract was monetized for the period of December 2019 to October 2020 and did not impact second quarter 2020 revenue, but added $0.84/Mcf in the second quarter of 2019 on the relative strength of daily index prices at the five downstream markets compared to the AECO Daily Index. Realized gains on financial oil hedging contracts of $2.3 million or $44.32/bbl (Q2 2019 - realized loss of $1.2 million or $11.30/bbl) were recorded during the quarter, contributing to the second quarter realized oil price of $67.56/bbl.
Cash costs were down 49% to $7.3 million (Q2 2019 - $14.4 million), but up 30% on a unit-of-production basis to $21.93/boe (Q2 2019 - $16.93/boe) due to the impact of a 61% decrease in production. Cash costs decreased by $7.1 million from the prior year period and $5.3 million from the first quarter of 2020 due to the temporary shut-in of heavy oil production from late-March to mid-May, the closing of the East Edson Transaction on April 1, 2020, the reduction in employee compensation and work hours to 80% effective April 15, 2020, and payments received from the Canada Emergency Wage Subsidy ("CEWS") program. Managing through the COVID-19 pandemic saw Perpetual's corporate staff working remotely in the second quarter before transitioning back to a hybrid office protocol in late June. Field employees have continued to work on site, following strict social distancing and other health and safety measures.
The net loss for the second quarter of 2020 was $8.8 million ($0.15/share), compared to a net loss of $36.3 million ($0.60/share) in the comparative period of 2019. The decrease in net loss from the prior year period was due primarily to an impairment charge of $22.6 million and the $6.6 million decrease in the fair value of the TOU share investment recognized during the second quarter of 2019.
Cash flow used in operating activities in the second quarter of 2020 was $2.8 million ($0.05/share), down $7.1 million from the prior year period (Q2 2019 - cash flow from operating activities of $4.3 million and $0.07/share) due to the combined impact of the 38% decrease in realized revenue per boe and the 61% decrease in production caused by heavy oil shut-ins and the sale of East Edson production.
Adjusted funds flow in the second quarter of 2020 was negative $3.3 million ($0.05/share), down $7.0 million (191%) from the prior year period of $3.6 million ($0.06/share) due primarily to lower cash flow from operating activities. Compared to the first quarter of 2020, adjusted funds flow improved by $0.3 million, due to higher cash flows from operating activities.
FUTURE OPERATIONS
Perpetual has a first lien, reserve-based credit facility (the "Credit Facility"). On December 24, 2019, Perpetual's syndicate of lenders completed their semi-annual borrowing base redetermination, reducing the Credit Facility borrowing limit (the "Borrowing Limit") from $55 million to $45 million effective January 22, 2020.
In January 2020, the Company sold its remaining 1,000,000 TOU shares for net cash proceeds of $14.3 million (the "TOU Share Proceeds"). Net proceeds were used to repay the outstanding TOU share margin demand loan of $0.1 million, with the balance used to repay a portion of the Credit Facility. On April 1, 2020, the Company sold a 50% working interest in its East Edson property in West Central Alberta to a third party purchaser for consideration including a cash payment of $35 million and the carried interest funding of the drill, complete and tie-in costs for an eight well drilling program (the "East Edson Transaction"). Net proceeds were used to repay a portion of the Credit Facility. Effective April 1, 2020, Perpetual's syndicate of Credit Facility lenders completed their borrowing base redetermination, incorporating the impact of the East Edson Transaction. The Borrowing Limit was reduced from $45 million to $20 million. The Credit Facility will continue to revolve until the next scheduled borrowing base redetermination on July 31, 2020. The July 31, 2020 redetermination date has been extended to August 10, 2020 to provide the lenders additional time to complete their review. If not extended, the Credit Facility will cease to revolve, and all outstanding advances will be repayable on November 30, 2020. The further extension of the Credit Facility repayment term is dependent on the Company's ability to repay or extend the term of the $45 million second lien term loan (the "Term Loan") that matures and requires repayment on March 14, 2021. The Company also has $33.6 million of unsecured senior notes that mature on January 23, 2022. Although the TOU Share Proceeds and the East Edson Transaction cash consideration have reduced the Company's revolving bank debt borrowed under its Credit Facility, the Company remains dependent on the support of its lenders to the Credit Facility which has a current maturity of November 30, 2020, in addition to the $45 million Term Loan maturing March 14, 2021.
During the six months ended June 30, 2020, cash flows used in operations were $5.9 million which contributed to a working capital deficiency of $8.9 million as at June 30, 2020. Perpetual continues to forecast a use of cash in operations for the next twelve-month period and potentially beyond. The Company will require additional financing to fund the working capital deficiency and future operations, and to refinance the upcoming Credit Facility and term loan maturities as the available liquidity and operating cash flows are not anticipated to be sufficient. Perpetual is considering options including the sale or monetization of additional assets, the extension of existing debt maturity dates, or alternative financing.
Due to the facts and circumstances detailed above, coupled with considerable economic instability and uncertainty in the oil and gas industry which negatively impacts operating cash flows and lender and investor sentiment, there remains considerable risk around the Company's ability to address its liquidity shortfalls and upcoming maturities. In addition, there continues to be some uncertainty regarding the Sequoia Litigation which may restrict the Company's ability to manage its capital structure. As a result, there is material uncertainty surrounding the Company's ability to continue as a going concern that creates significant doubt as to the ability of the Company to meets its obligations as they come due. Therefore, the Company may be unable to realize its assets and discharge its liabilities in the normal course of business.
Perpetual's financial statements have been prepared in accordance with generally accepted accounting principles applicable to a going concern, which assumes that the Corporation will be able to realize its assets and discharge its liabilities in the normal course of business. These financial statements do not reflect adjustments that would be necessary if the going concern assumption were not appropriate. If the going concern basis were not appropriate for these financial statements, then adjustments would be necessary in the carrying value of the assets and liabilities, the reported revenues and expenses, and the balance sheet classifications used. These adjustments could be material.
PERPETUAL ENERGY INC. | Q2 2020 | Page 3 |
SEQUOIA LITIGATION UPDATE
On January 13, 2020, the Court of Queen's Bench (the "Court") issued its written decision related to the Statement of Claim filed on August 3, 2018 against Perpetual and its President and Chief Executive Officer ("CEO") with respect to the Company's disposition of shallow gas assets in Eastern Alberta to an unrelated third party on October 1, 2016 (the "Sequoia Litigation"). The decision dismissed and struck all claims against the Company's CEO and all but one of the claims filed by PricewaterhouseCoopers Inc. LIT in its capacity as trustee in bankruptcy (the "Trustee") against Perpetual. The Court did not find that the test for summary dismissal relating to whether the transaction was an arm's length transfer for purposes of section 96(1) of the Bankruptcy and Insolvency Act (the "BIA") was met, on the balance of probabilities. Accordingly, the BIA claim was not dismissed or struck and only that part of the claim can continue against Perpetual. The Trustee filed a notice of appeal with the Court of Appeal of Alberta, challenging the entire decision, and Perpetual and its CEO filed a similar notice of appeal contesting the BIA claim portion of the decision. The appeal proceedings are scheduled to be heard in December 2020.
On September 24, 2019, Perpetual filed an application for security for costs of the appeal. On January 28, 2020, the Court of Appeal issued its decision with respect to Perpetual's security for costs application, requiring the Trustee to post security with the Court of Appeal in the amount of $0.2 million. Applications filed by the Trustee to appeal the security for costs decision and alter the reasons for the decision were dismissed at a hearing held on June 18, 2020. Costs of $0.1 million were awarded by the Court of Appeal in favor of Perpetual on July 21, 2020.
On February 25, 2020, Perpetual filed a second application to strike and summarily dismiss the BIA claim on the basis that there was no transfer at undervalue, and Sequoia was not insolvent at the time of the transaction nor caused to be insolvent by the transaction. Applications for security for costs for future litigation were also filed at that time. In July 2020, the Orphan Well Association ("OWA"), certain oil and gas companies, and six municipalities applied to intervene in the second BIA dismissal application proceedings. The OWA and certain oil and gas companies will be permitted to intervene in the proceedings which will take place on October 1st and 2nd, 2020.
Management expects that the Company is more likely than not to be completely successful in defending against the Sequoia Litigation such that no damages will be awarded against it, and therefore, no amounts have been accrued as a liability in Perpetual's financial statements.
OUTLOOK
Perpetual currently anticipates that five wells of the eight-well carried interest drilling program at the 50% owned East Edson property will be drilled in the second half of 2020, with two wells tied-in to production late in the third quarter followed by three wells commencing production early in the first quarter of 2021. While oil prices have recovered from their second quarter lows, capital expenditures for the remainder of 2020 in Eastern Alberta have been deferred, pending a sustained recovery of WTI oil prices to the US$45.00/bbl level.
With the reactivation of shut-in heavy oil production and the contribution from the first two carried interest wells at East Edson in late-September, production is forecast to increase in the third quarter to 4,500 to 4,700 boe/d (32% liquids). Fourth quarter production is anticipated to increase to 5,200 to 5,400 boe/d (28% liquids) with the full impact of the two East Edson wells. An additional 250 bbl/d of heavy oil production could be re-started if WTI oil prices increase above the US$45.00/bbl level.
Abandonment and reclamation expenditures will also remain suspended for the second half of the year, enabled by the AER's cancellation of area-based closure expenditure requirements for 2020. We are optimistic that funding from the Alberta Site Rehabilitation program may facilitate the advancement of abandonment and reclamation projects previously planned for 2020, with $0.3 million of applications approved to date.
Minimization of operating and corporate costs will remain a priority, as will ensuring employees remain safe and healthy amid the COVID-19 pandemic.
SECOND QUARTER FINANCIAL AND OPERATING RESULTS
Capital expenditures | ||||
Three months ended June 30, | Six months ended June 30, | |||
($ thousands) | 2020 | 2019 | 2020 | 2019 |
Exploration and development | 30 | 5,170 | 5,260 | 6,380 |
Corporate assets | (41) | 30 | (38) | 58 |
Capital expenditures | (11) | 5,200 | 5,222 | 6,438 |
Acquisitions | 89 | - | 89 | - |
Net proceeds on dispositions | (34,750) | - | (34,750) | - |
Total | (34,672) | 5,200 | (29,439) | 6,438 |
Exploration and development spending by area | ||||
Three months ended June 30, | Six months ended June 30, | |||
($ thousands) | 2020 | 2019 | 2020 | 2019 |
West Central | (200) | 445 | (67) | 1,113 |
Eastern Alberta | 230 | 4,725 | 5,327 | 5,267 |
Total | 30 | 5,170 | 5,260 | 6,380 |
PERPETUAL ENERGY INC. | Q2 2020 | Page 4 |
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Perpetual Energy Inc. published this content on 10 November 2020 and is solely responsible for the information contained therein. Distributed by Public, unedited and unaltered, on 10 November 2020 22:56:02 UTC