Given the hype accompanying the surge in natural gas output from the Marcellus shale in Pennsylvania, Canada’s own vast gas fields get lost in the shuffle.

That’s understandable: production has been declining as numerous legacy vertical wells gradually deplete, and drilling is down a lot as capital has headed for greener pastures, namely the pursuit of — until recently at least — more lucrative crude oil prospects.


Source: Canadian Gas Association

So there is no breathless reporting on a boom dramatically altering a nation’s energy prospects. The wells themselves are less prolific initially than those in the Marcellus, so don’t look as attractive based on first-year rates of return. And because Western Canada has for so long profitably produced gas from vertical wells, there has been less of a rush to adopt the horizontal drilling and hydraulic fracturing technologies.

But there’s a producer up there in Alberta that’s applying the newest techniques to the Deep Basin niche play it has been exploiting for more than a decade, and knows as well as anyone. And it’s doing so over stacked tight gas layers of sandstone that are already generating Marcellus-like returns, thanks to dramatic cost improvements that would make any US producer green with envy.

Source: Peyto presentation

That would be Peyto Exploration and Development (TSX: PEY, OTC: PEYUF). One or two of our readers have been asking us about this company for a year or more, and we owe you a sincere thank you for piquing our interest. What we’ve discovered over the ensuing months is perhaps the most efficient North American energy producer of them all, one that from the CEO on down to the rig operator displays a fanatical devotion to acting as owners would, in the shareholders’ best interest.

For all that, the $5 billion Toronto-listed company simply doesn’t get much attention: on this week’s conference call only a single analyst, from a boutique US research firm, bothered asking any questions.

Perhaps it’s because CEO Darren Gee, an 46-year-old industry veteran with more than two decades of experience in Alberta prospecting, already shares so much in a monthly blog, including the prior month’s Peyto production data as well as valuable industry and business insights.

In any case, Peyto remains significantly underappreciated given its screaming value proposition. Over the first nine months of 2014, the company booked C$627 million in revenue and converted that into C$449 million in cash flow from operations, an eye-opening and mouthwatering 72% conversion rate. Most of its peers are below 50%. Hyper-efficient lowest-cost Marcellus producer Cabot Oil & Gas (NYSE: COG) is at 61% this year.

Source: Peyto presentation

Peyto accomplishes this by picking off the most economical drilling prospects on its leased acreage and nearby land acquired in government auctions, and by owning its own midstream infrastructure, including nine gas processing plants, which means its zealous cost controls keep paying dividends at every step of the process up until the point at which the processed gas is delivered into the nearby TransCanada mainline.

For example, it uses natural gas to power its power plants, drilling rigs and vehicles saving big on fuel and electricity costs. It builds its own gathering lines and recycles its fracking chemicals.

The gas extracted is sweet rather than sour, so does not need to be scrubbed of excess hydrogen sulfide. It’s also rich in liquids and heat content, typically earning the company a 35% premium over the benchmark Alberta gas price for its production.

Alberta prices have typically been close to the US Henry Hub benchmark traded on the NYMEX, though with gas storage levels in the province unusually low and a cold winter forecast, they could yet surprise to the upside.

The spread between the industry’s lowest finding, development and production costs and some of its strongest realized prices has powered the company’s whopping 34% average annual return on equity over the last 15 years. 

Source: Peyto presentation

In keeping with its dedication to shareholder returns, Peyto increased its dividend by 25% in May and by another 10% effective in November, to 11 cents monthly (Canadian, as are all the financials pertaining to Peyto in this story.) That works out to a relatively generous 3.7% annualized dividend at the current share price.

Nifty as that is, dividends have recently consumed only a little more than a quarter of the funds from operations. The rest has been invested in a growing capital spending program largely financed out of current cash flow. That’s left an unleveraged balance sheet, one that should keep getting stronger as recent investments produce typically strong returns.

For example, after increasing production 31% year-over-year during the first nine months of 2014, Peyto plans to exit 2015 with a daily output conservatively projected at 15% above the year-end rate for 2014. Yet the capital budget for 2015 has been forecast for $700 million to $750 million, up modestly from $690 million this year. As usual, it should be overwhelmingly financed from cash flow.

And while Deep Basin wells are initially less productive than those in the Marcellus, the lower permeability of the formation also ensures a gentler decline rate. And that means the ultimate productivity of Peyto’s wells is understated by the year-to-year growth rate and the returns will look even better should natural gas appreciate over the longer term. The wells are also significantly cheaper than those in the Marcellus.

Peyto provides unusually granular data on its estimated full-cycle rates of return by well and geologic play, and the average of 27% makes one wish the company would step up its drilling. (Full cycle rates of return include the cost of land and infrastructure.)

Source: Peyto presentation

In fact, the company deliberately takes a counter-cyclical approach, drilling more when gas is cheap and industry costs low, and less when they rise and competitors begin chasing returns and pushing up costs.

So far, the company’s conservative, shareholder-friendly approach has delivered sparkling returns, and there’s every reason to expect these to continue. Should gas prices rise significantly, as they might, Peyto would likely pull back on drilling and become a cash return machine until the cycle turned once more. By valuing a company with Peyto’s unusually high cash conversion rate, modest decline curve and 10-15 years of cheap, geographically concentrated and highly predictable drilling inventory at roughly 10 times cash flow, the market is not giving it the valuation it deserves.

We can ignore this long-term winner no longer. Though drillers of this size would normally go into our Aggressive or Growth portfolio, Peyto’s prudence and willingness to return cash to shareholders make it suitable for the Conservative Portfolio, which is adding it as of today. Buy PEY.TO below $43 (Canadian) or PEYUF below $38.