Vermilion Energy Inc. Q2 FY2022 Earnings Call

Good morning. My name is Samara, and I will be your conference operator today. I would like to welcome everyone to the Vermilion Energy Q2 Conference Call. Thank you. Mr. Dion Hatcher, you may begin your conference.

Thank you, Samara. Well, good morning, ladies and gentlemen. Thank you for joining us. I'm Dion Hatcher, President of Vermilion Energy. With me today are Lars Glemser, Vice President and CFO; Darcy Kerwin, Vice President International and HSE; Bryce Kremnica, Vice President North America; Jenson Tan, Vice President of Business Development; and Kyle Preston, Vice President of Investor Relations. We'll be referencing a PowerPoint presentation to discuss our Q2 2022 results and our return of capital framework we announced this morning. The presentation can be found on our website under Invest with Us and Events and Presentations. Please refer to our advisories and forward-looking statements at the end of the presentation, as it describes forward looking information, non-GAAP measures, and oil and gas terms used today. It also outlines the risk factors and assumptions relevant to this discussion. As shown on Slide 2, we delivered another quarter with record fund flows of $453 million and record free cash flow of $340 million, which is over $2 a share. That's up 16% and 12% respectively from the previous quarter. The increase was mainly driven by strong commodity prices as global oil and North American gas prices strengthened during the quarter. European gas prices remained strong in Q2 and were relatively consistent with the prior quarter, with TTF in excess of CAD38 per mmbtu. Over the past several months, European gas forward prices have nearly doubled, which bodes well for Vermilion. I will review the fundamental drivers for this later in my presentation. Production during Q2 averaged 84,868 boe/d, down slightly from the previous quarter, mainly due to planned and unplanned downtime. A key notable event during the quarter was the closing of the Leucrotta acquisition on May 31. We have successfully integrated the Leucrotta assets and assembled the Mica asset team, which is now focused on completing a six-well pad that was drilled in Q2. We are excited to have these high-quality assets in our portfolio and look forward to scaling up our development. The Leucrotta acquisition was mostly funded by free cash flow generated in the quarter. As a result, net debt increased only slightly in Q2 to $1.6 billion; however, our net debt to fund flow ratio decreased to 1.1x due to increasing fund flows from operations. We remain on track to achieve our next debt target of $1.2 billion by the end of 2022. With this clear line of sight, we are pleased to outline our return of capital framework. Before I get into the details of our return of capital framework, Slide 3 reviews some of the key strategic objectives we accomplished over the last two years, which will position Vermilion to deliver very strong returns over the long term. These objectives were part of the strategic plan we developed during the 2020 downturn. Our number one financial priority was to reduce debt and strengthen the balance sheet. We have reduced debt by approximately $1 billion relative to Q2 2020 by the end of this year while also funding over $1 billion of strategic acquisitions without issuing any equity. We increased our international weighting and European gas exposure through the Corrib acquisition, which we expect to close in Q4 this year. Our international assets now represent over a third of our production base and contribute approximately two-thirds of our fund flow and free cash flow. This international diversification differentiates Vermilion from our peers. We reinstated a base dividend in Q1 of this year, and today we're excited to announce a 33% increase in our Q3 quarterly dividend to $0.08 per share. The dividend is very resilient at less than 3% of our fund flows and leaves ample room for increases over time. We completed the Leucrotta acquisition in Q2, significantly increasing the depth and quality of our North American inventory, which will further enhance our free cash flow profile and underpin our long-term return of capital. And finally, we said that we would increase our return of capital when we achieve the line of sight to our $1.2 billion mid-cycle debt target. With less than two quarters remaining in 2022 and a robust outlook for 2023, let me now review the return of capital framework on Slide 4. Vermilion has a long history of returning capital to its shareholders. In the past, this has been primarily through base dividends, which we've delivered over $40 a share. Going forward, base dividends will remain a key component of our return of capital framework; however, we want to ensure the base dividend is resilient over the long term through the commodity cycles while allowing for consistent increases over time where it has not placed a burden on our business or the balance sheet. With this philosophy in mind, we plan to limit the annual base dividend outlay to approximately 10% of our mid-cycle fund flows. For reference, this would equate to approximately $100 million based on the current asset base but could increase if our asset base grows or if we see a fundamental shift in our mid-cycle commodity price assumptions. In conjunction with our Q2 release, we announced a 33% increase to our Q3 quarterly dividend to $0.08 per share Canadian. This equates to an annual dividend of $0.32 Canadian per share, or approximately $53 million based on the current number of shares outstanding. At this dividend per share level, we have the capacity to increase the base dividend, and we look forward to providing consistent increases over time. With our debt approaching target levels, we will pivot from allocating free cash flow for debt reduction to the return of capital. Maintaining a strong balance sheet is a core principle at Vermilion, and we will remain focused on that going forward. We plan to enhance our return of capital to shareholders while continuing to reduce debt to a target of $850 million by the end of 2023, implying approximately another $350 million of further debt reduction beyond our year-end 2022 target. It also implies we will be undrawn on our $1.6 billion credit facility, leaving just our term U.S. notes outstanding. The amount of free cash available for return of capital will increase as debt levels decrease based on the illustrative grid outlined on Slide 4. The grid is not intended to be prescriptive quarter to quarter but will be used as a tool to guide near-term return of capital allocation decisions while considering other capital requirements such as further debt reduction, asset retirement obligations, and acquisitions. As you can see from this grid and the near-term debt targets I discussed, a significant portion of our future free cash will be available to return to shareholders. Based on a return of capital allocation grid, recent commodity strip, and internal estimates, we anticipate returning up to 25% of free cash flow in the second half of 2022, and up to 50% to 75% of free cash flow in 2023 while achieving our debt targets. Our goal is to return capital in the most beneficial method to shareholders. We will consider various options to return capital, including share buybacks through the normal course issuer bid, regular and special dividends, and a potential substantial issuer bid. Based on our review of numerous data points, we will initially allocate the vast majority of this capital return to share buybacks. Given the structural improvements in our business, combined with the strong fundamental outlook for global commodities, we believe Vermilion is very well positioned to generate significant free cash flow in the years ahead. However, we do not believe this value proposition is accurately reflected in our share price today, and therefore we view share buybacks as the most compelling use of free cash flow that will benefit long-term shareholders. In early July, we announced the approval of our normal course issuer bid for the purchase of up to 16 million common shares, representing approximately 10% of Vermilion's public float. To date, we have repurchased 1.25 million common shares for $35 million. As we reduce our share count, this will also enhance our ability to increase the base dividend while adhering to our annual dollar limit of 10% of mid-cycle fund flows. We look forward to providing continued updates on our return of capital initiatives through the second half of this year and into 2023 as we carefully weigh capital allocation decisions against various uses of excess free cash flow, with a view of acting in the long-term interest of our shareholders. Slide 5 is from an Investor Relations presentation where we provide an updated financial outlook for 2022 based on the actuals to date and our estimates for the balance of the year using the current commodity strip. As you can see, on a pro forma basis including the full year impact from the Corrib acquisition, we are forecasting pro forma fund flows of $2.4 billion and free cash flow of $1.8 billion, or approximately $11 per share. We also show our year-end debt target of $1.2 billion, which incorporates returning upwards of 25% of free cash flow in the second half of this year. We have not yet provided any formal guidance for 2023, but if you assume production to sell flat at our exit rate forecast of 95,000 boe/d to 100,000 boe/d and you honor the backwardation in the commodity price forward strips, we are looking to generate similar amounts of free cash flow in 2023, which is consistent with analyst estimates. As outlined on Slide 6, looking at our cumulative free cash flow over a three-year period from 2022 through 2024, assuming flat production from our existing asset base and applying the forward pricing, we expect Vermilion to generate over $5 billion of free cash flow over this time, represented by the blue bars. This amount of free cash flow is equal to our current market capitalization. The gray bars show the cumulative free cash flow we currently plan to allocate to debt reduction. As you can see, the majority of the free cash flow was allocated to debt reduction in 2022, including funding over $1 billion of acquisitions, whereas in 2023 and 2024, we will pivot, and the majority of the free cash flow will be available for the return of capital to shareholders now that we have a much stronger balance sheet. As I mentioned in my earlier remarks, the fundamentals for European gas are very strong. Slide 7 shows historical pricing of European gas and Asian LNG, which have traded in a similar band since 2015 compared to the Canadian benchmark price of April. The blue bars represent the average premium that Vermilion receives on its total gas sales relative to April; this premium was approximately $6 mmcf in 2021 and is forecast to be approximately $19 in 2022. We also show the forward pricing for the balance of 2022 and 2023, which has increased significantly from historical levels. The second half of 2022 TTF is $75 per mmbtu, and 2023 is now over CAD70 per mmbtu. For every dollar increase in European gas prices, this adds an incremental $37 million of fund flows to Vermilion on an annual on-hedged basis. Our hearts, thoughts, and prayers are with the Ukrainian people, and our hope is that a negotiated settlement can be achieved quickly. The tragic events in Ukraine are undoubtedly contributing to the price increase; however, the underlying fundamental drivers for high European gas prices were in place prior to the invasion. The chart on Slide 8 shows the 2023 and 2024 forward price for TTF and how much it has increased since the beginning of the year. The calendar year 2023 TTF price has increased from under $20 at the beginning of the year to over $60 today. This will have a significant impact on Vermilion’s funds flows in 2023, and we have been adding more European hedges in recent weeks. We believe the structural drivers will be supportive for European gas prices for many years to come. Europe consumes approximately 45 Bcf/d to 50 Bcf/d of natural gas, with approximately 40% of that being supplied from Russia in 2021. With recent events, the EU is now trying to significantly reduce its dependence on Russian gas. The EU recognizes natural gas as a transition fuel, which will help facilitate the permitting and development of domestic supplies as countries increase the use of natural gas for power generation. Examples of this transition include Germany shutting down nuclear and accelerating a phase-out of coal from 2038 to 2030, and Ireland committing to build nine gas-fired power generators by 2024. With the domestic supply in Europe continuing to decline, the only viable option to replace Russian gas is to increase LNG imports, but there is limited new LNG supply coming to market prior to 2025 and 2026. These new projects require significant long-term contracts and capital. So, in order to attract LNG to Europe, buyers need to compete with Asia, which is driving European gas prices even higher. Short-term, we expect Asian LNG demand to increase as they look to build inventories before this winter; more importantly, mid to long-term Asian demand for LNG is forecasted to significantly increase. As I mentioned, we are starting to layer in more 2023 European gas hedges to lock in some of our fund flows at these higher prices. As shown on Slide 9, since our last update, we have increased our 2023 Euro gas hedge position from 32% to 45%. Those recent hedges were executed primarily with wide collars, with an average floor of about $40 and a ceiling of about $70. Through the higher gas prices, we may further increase our 2023 Euro gas hedge position to 60% to lock in even more fund flows. At the corporate level, given our low debt levels and current outlook, we intend to keep our total hedge percentage at the lower end of our target range of 25% to 50%, which will leave us exposed to sustain higher oil prices. Going back to our Q2 results, we have provided a brief summary of our operational highlights on Slides 10 and 11. The most notable activity in our international operations in Q2 was our offshore drilling program in Australia. This program was scheduled to start early in the second quarter but was delayed approximately one month due to unexpected maintenance and repairs on a third-party contracted rig. During routine inspection prior to moving the rig to our location, the operator identified some maintenance requirements and had to mobilize the rig to Singapore for repairs. We commenced drilling late in the second quarter, and drilling operations are progressing, although the delay resulted in some deferred production and increased costs. We expect to finish drilling in early September and will start the wells shortly thereafter. It was a relatively quiet quarter in Europe as the team focused their efforts on preparing for our second half 2022 drilling campaign, which will include two wells in the Netherlands, three wells in Hungary, and two wells in Croatia. Subsequent to the quarter, a forest fire near our Cazaux field in southern France resulted in approximately 1,500 bbl/d of production being temporarily shut-in. Our staff in France worked closely with emergency responders to ensure the safety and security of our employees, contractors, and installations, ensuring there were no HSE incidents. We are in the process of making necessary repairs and bringing this production back online; however, this will have an impact on our France production in the second half of 2022. It was a relatively quiet quarter in Canada, as drilling and completion activities in West Central Alberta and Southeast Saskatchewan were limited during the second quarter due to spring breakup. Following the announcement of the Leucrotta acquisition in late March, we assembled our Mica asset team and focused on integrating the assets and working closely with the Leucrotta team in drilling the first six-well Montney pad. Drilling was successfully completed during the second quarter, and the team is now focused on completion activities that are progressing as planned. In the U.S., we drilled four of our planned six operated Turner wells and completed two wells during the second quarter. One well was brought on production during the second quarter, while the remaining wells will be completed and brought on production during the third quarter. Overall results to date are in line with expectations. Subsequent to the quarter, we successfully executed drilling and completion activities on three two-mile laterals, which are significantly more economic than the one-mile laterals. Moving to Slide 12, our Q3 2022 capital program is well underway, and in Europe, we will start our drilling campaign later this month and continue through the fourth quarter. As mentioned, the forest fire in Cazaux field in Southern France resulted in approximately 1,500 barrels a day of production being temporarily shut-in, and we expect to have most of it back online by the end of the year. Looking at our Q3 production forecast, we will benefit from a full quarter contribution from the Leucrotta acquisition and new production from the U.S., Southeast Saskatchewan drilling programs, partially offset by the Australia drilling program delay and fire-related downtime in France. Taking all this into account, we expect Q3 production to be in line with Q2. As a result of the forest fire-related downtime in France, offshore drilling delays in Australia, combined with inflationary pressure, we are increasing our 2022 capital budget by $50 million to $550 million. We are maintaining our annual production guidance of 86,000 to 88,000, excluding the Corrib acquisition volumes. We plan to update our production guidance once we have greater certainty on the timing of the Corrib close, which we expect to occur in Q4. Our exit rate forecast of 95,000 boe/d to 100,000 boe/d, including Corrib acquisition bonds, remains unchanged. Before we open it up for Q&A, I want to make some closing remarks on our upcoming leadership changes. As we announced earlier this year, Vermilion’s Executive Chairman and Co-founder, Lorenzo Donadeo, will be retiring from the company effective September 1. Lorenzo was instrumental in creating what Vermilion is today along with creating significant value for our shareholders during his tenure. On behalf of the whole organization, I would like to thank Lorenzo for his leadership and guidance of the company over the past 27 years. He will be greatly missed by everyone at Vermilion. But if anyone deserves a long, happy, and fulfilling retirement, it is Lorenzo. We wish you all the best and look forward to providing regular quarterly updates as a meaningful shareholder of Vermilion for many years to come. As previously announced, Mr. Bob Michaleski will assume the role of Independent Chairman upon Lorenzo's departure. Bob has 41 years of experience and oversaw Pembina’s pipeline transformation from merely an Alberta-based oil company into one of North America's leading integrated energy transition service companies. He served as the President and CEO of Pembina for 13 years. He joined the Vermilion Board in 2016 and was appointed as Chair of the Audit Committee in 2020. Vermilion’s executive committee structure will continue, and I will lead the role of Chief Executive Officer along with all the existing members. Well, that concludes my prepared remarks. Well, with that, we'd like to open it up for questions.

And we'll take our first question from Menno Hulshof with TD Securities. Please go ahead.

Yeah. Thanks. Thanks, and good morning, everyone. I'll start with a question on Corrib. If we assume that it does close, what is your best guess in terms of the purchase price net of accrued free cash flow? We've run some numbers on this end, and in our estimate is very low, but any thoughts here would be helpful.

Thanks, Menno. I'm going to pass it over to Lars to address that one.

Yeah, good morning, Menno. I think you're thinking about it the right way in terms of cash to close at December 31st of this year from a modeling perspective. And then obviously full access to the cash flows in 2023. I think the number that is good to use for year-end this year would be a purchase price of CAD100 million to CAD150 million Canadian, if it were to close at the end of 2022. And that would be inclusive of the contingent payment that is in the money for 2023, which was $25 million. So I think that's the best way to model it and a good way in terms of how you're thinking about it.

Thanks, Lars. Regarding acquisitions, you've previously mentioned that smaller European gas packages might become available. While I understand there are restrictions on what you can disclose, could you provide a general overview of the criteria that need to be met before pursuing another European package? Additionally, do you believe these opportunities can compete with buybacks at the current share price?

Well, thanks Menno. I’ll pass it back to Lars to address what we're thinking about that relative to our return of capital framework.

Thanks, Dion. I’d like to revisit the return of capital strategy. Our focus is on the $11 per share of free cash flow we’re generating. Dion mentioned $1.8 billion of free cash flow in 2022 on a pro forma basis, which is a reasonable estimate for 2023. The return of capital framework will guide our capital allocation with flexibility, primarily through share buybacks for now. Regarding acquisitions in North America, we don't anticipate anything significant as we’ve largely addressed inventory. Future moves will likely be smaller, aimed at enhancing our current presence. In Europe, we’ve had success with acquisitions, and while these will compete for capital alongside shareholder returns, we’ll seek deep value opportunities there as we progress. We’ve previously discussed potential prospects in markets like the Netherlands, but any action taken will need to compete with our commitment to returning capital.

I'll take our next question from Greg Pardy with RBC Capital Markets.

Thanks for the update, Dion and Lorenzo. Wishing you all the best as you approach your retirement. I have a modeling question: what kind of consolidated book tax rates should we expect? Lars, could you clarify that tax question? Is it still around 11% or 12% pre-tax?

Yeah, so I think for 2022, and I'll sort of correlate these tax rates to the pro forma numbers. So we're referencing $2.4 billion of cash flow for 2022. In the context of that, 10% to 11% is still a good way to think about it, Greg. For 2023, I would say that rate has gone up in the context of current strip pricing. I would sort of peg it at 13% to 15% for full-year 2023.

What about book, sort of like 30% odd or so just as a book tax rate?

Sorry, could you repeat that, Greg?

Yeah, just your book tax rate. What would you sort of be thinking? I know you're giving me the cash taxes, but just as a book tax rate?

Yeah. So I think a good way to think about it is in the 30% range.

In relation to Menno's question, with Europe now reevaluating gas as a transition fuel, are policymakers or governments approaching you as one of the established developers in Europe to promote the growth of domestic supply rather than depending solely on imports?

Thanks, Greg. I'll take this one. Looking back over the last several quarters, I believe Europe is facing an energy crisis. Policymakers have prioritized their approach, starting with LNG, which is significant but requires longer timelines. There have been discussions around offshore developments, which brings us to your question about onshore activities. We are actively engaging in both the Netherlands and Germany, specifically examining what Vermilion, as a long-standing operator in these regions, can contribute with increased activity. We focus on what we can control, so we have added technical staff in both the Netherlands and Germany to prepare for higher levels of activity. I must note that timelines are longer in Europe, meaning it takes more time to move from discussions to actions and drilling. However, it’s encouraging and somewhat expected to see increased activity due to the current situation and the need for more domestic supply from responsible producers like Vermilion.

And we'll take our next question from Patrick O’Rourke with ATB Capital.

Congratulations to Lorenzo. Obviously a long and well-established career here at Vermilion, so we appreciate all your work. Guys, maybe just to build on Greg's question there, you talked about sort of the regulatory regime and timelines in Europe. As we get into the 2023 budgeting cycle and as you look at the portfolio, sort of what are the other hurdles to bringing on production in Europe? Where could you allocate capital to sort of capture this windfall gas price that we're seeing over there in sort of the quickest manner? Is it in the Netherlands? Is it in the CEE? What are sort of the infrastructure constraints? I don't think that you would have any in the Netherlands there.

Well, thanks, Patrick. I think, first of all, the acquisition with Corrib to bring on that 7,700 Boe/d is probably the most impactful thing that in hindsight was very well timed, and we're excited to close that at the end of this year. So again, that's 7,700 Boe/d there. From an organic point of view, we're focused on every boe to look for opportunities. I think in Germany, we do have a deep inventory of drilling prospects. Again, we've added resources back to look at some of the larger targets, which are a bit higher risk. That's something we're reviewing. CEE is an area once we get these permits in place like SA-10, we're able to follow through and drill wells within shorter timelines. And then Netherlands, we used to drill four to six Wells; we're drilling two in the second half of this year or so. Our view would be less work back to those higher levels of activity. I would say all jurisdictions. Netherlands does have the potential to increase activity, as does Germany. We drilled three wells earlier this year, and we're looking at what we might be able to do on the gas side in late 2023 and into 2024. So quite excited to be having those conversations. Again, our near-term focus is getting more staff in those areas to react once it aligns with the regulatory framework to put more capital into those business units.

Okay. Shifting to the return of capital framework, particularly regarding the dividend, you mentioned steady dividend increases. The calculations we have for today's dividend increase indicate it's below 4% of the 2023 pre-cash flow. Could you provide some guidance on what you mean by steady increases and also the frequency with which you plan to review the dividend going forward?

I'll pass that one to Lars to talk about our thoughts on the base dividend.

Thank you, Patrick. We have structured the base dividend to not exceed 10% of our cash flows at mid-cycle pricing. We want to maintain this discipline to ensure the base dividend remains strong. With today's increase, we need about $50 million to support the new dividend we announced. This amount gives us the opportunity to keep increasing it while still adhering to the 10% limit. Regarding how we will approach future increases, we aim for consistent growth over time. Additionally, with the capital return framework we introduced today, we have flexibility in how we return capital. While the base dividend will be one method, it won't account for most of the capital returned. We also have the option for share buybacks, variable dividends, and special dividends, and currently, we are inclined towards buybacks based on our analysis of capital allocation. This should clarify that the fixed base dividend is just one aspect of our total capital return strategy, and we want to ensure it remains steady even at lower prices than what we are currently experiencing.

We'll take our next question from Josef Schachter with Schachter Energy Research. Please go ahead.

Good morning, everyone. And thanks so much for taking my question. In Europe, we're seeing a lot of demand management, the UK talking about preparing for blackouts, Germany telling certain industries they may get cut back certain percentages of gas, assuming the Russians are aggressive in terms of cutting back. Is there anything going on the supply management side where they're asking you to hold back and put into storage near consuming areas gas to bring on later? Or if you have new wells coming on, bring them on close to the winter? Is there any supply management stuff going on that would impact Vermilion in Q3, Q4, and into Q1 of next year?

Hi, Josef. I'll take that one. The quick answer is no, we're selling all the gas that we're producing, and there are no discussions around us storing or restricting our production. With that, I think that we have no more questions. So I guess Samara, we would like to thank everyone again for participating in our Q2 conference call and look forward to future updates.

Thank you. And this concludes today's call. Thank you for your participation. You may now disconnect.