Shifting sands should pay for Heemskirk

Difficult circumstances in recent years have required most resource companies to rationalise their project portfolios, prioritising those with the best chance of securing funding and delivering commercial success. Heemskirk certainly fits this profile. While the company pursued several gold and tungsten projects in the years leading up to the GFC, its focus in recent years has been a suite of Canadian industrial mineral operating assets acquired in 2005 for approximately C$5.6m.

Recently the company has further refined its asset portfolio by agreeing to sell its Lethbridge energy products processing plant for C$12m, comprising C$8.44m in cash and C$3.56m in inventory to fund the redevelopment and commissioning of its flagship Moberly frack sand facility which the company’s feasibility study has modelled to have an NPV of C$65m. 

It is the development of this project that underpins Heemskirk as a compelling investment proposition, particularly in context of its current market capitalisation of just $12m. 

Fracking and Frack Sand 

For those uninitiated with the concept, fracking is the process of creating cracks in underground reservoir rock formations to facilitate the flow and recovery of hydrocarbons (gas) out of a well. This is done by pumping fluid, under pressure, into a reservoir to create fractures (small cracks) from which gas can be released. The process is a bit like shattering a windscreen.  To facilitate gas flows from the fractures, sand particles (frack sand) are pumped through them to help keep the fractures open and allow the gas to permeate to the surface.

Whilst fracking is often misunderstood and misrepresented in Australia, it is a far more accepted and commonplace practice in North America.  Fortunately for Heemskirk, its Moberly sands project is located in the Western Canadian Sedimentary Basin (WCSB) in British Columbia, smack-bang in the middle of one of North America’s biggest growth addresses for unconventional gas drilling.

Heemskirk freely admits that the increased – and fortuitous - prominence of its Moberly sands project has been due to the wide-scale adoption of horizontal drilling practices. While Moberly’s sand qualities were not suitable for the coarse sand requirements of vertical drilling, extensive lab testing revealed it was much more amenable for horizontal drilling, which requires a finer sand to assist hydrocarbon flows.   Essentially, drilling technology developments have worked in Heemskirk’s favour. Most simply visualised as “Esperance beach sand”, Moberly’s sand has tested as 99.97% pure silica with ideal measurements of purity, roundness, sphericity, size and hardness. This has allowed the company to boast  one of the highest quality frack sands on the market. 

Click to enlarge

Source: Skifergas

Management

The Board of Heemskirk appears very conscious of having a board and senior management team that best represents the company’s size, projects and financial position.  Over the course of the last financial year Melbourne head office costs have been reduced by approximately 17% as the company keeps a sharp eye on unnecessary expenditure as it heads into Moberly’s capital development. 

Heemskirk is ably led by managing director Peter Bird, one of the company’s founding directors who assumed his current position in December 2011. Peter is a resource professional and geologist with over 20 years of industry experience.  Peter brings a combination of operational and corporate experience and a strong understanding of global commodity and investment markets having worked in technical, management, investment and human resource positions at major companies such as Western Mining, Merrill Lynch Equities, Newmont Mining Corporation, Normandy Mining and Newcrest Mining Limited. 

Importantly for Heemskirk shareholders, Peter has been involved in taking several companies from early stage exploration right through the resource cycle to production, making him well qualified to guide Moberly through a relatively straightforward brownfields upgrade.  At the company’s recent AGM the incumbent non-executive chairman announced his resignation and the company is now searching for a replacement with the requisite skills and experience.

Moberly

The Moberly sands project has the benefit of being a brownfields deposit.  It has been mined for over 30 years with its sands being used to produce flint grade silica products such as glass, manufacturing feedstock and high grade cement products for the oil and gas industries.  As a brownfields project it has the benefit of much existing infrastructure and thus a moderately low capex build of C$26m, which include C$2m of contingencies. The company has recently demolished its old 1960s plant and is now gearing up for the construction of its modern-day replacement.  About C$1.5m needs to be spent upgrading the existing haul road with the balance to be spent on plant and equipment – crusher, washplant, screener, dryer, classification and storage capabilities and load-out facility.  As with all projects there is execution risk, but this is somewhat mitigated by the fact that Moberly is a relatively straightforward brownfield development project that is fully permitted and engineered.  The funding part of the equation is also well underway with the company in discussions with several industry players and debt providers for the relatively small funding requirement over and above the company’s own cash reserves.

 The Metrics

The Moberly project has a JORC compliant resource of 32mt with a yield of 64%, equating to mineable reserves of over 20mt.  Heemskirk expects to commence production at an annual rate of 300kt which equates to a mine live of nearly 70 years.  The true resource base is considered much larger than the JORC print so the project is not limited by size.  In its feasibility study, Heemskirk  modelled production tonnage of 300kt pa over a 20-year mine life at a real discount rate of 7.5%, which yielded after-tax cashflows of approximately C$180m over that period for an NPV of C$65m. The project is seen as having a post-tax IRR of 32% and a relatively short payback period of less than 3 years.  With frack sands prices relatively stable in the C$180-C$200/t range, after operating costs and freight, EBITDA margins are expected to conservatively range between C$40 –C$50/t equating to an annual EBITDA  of C$12m-C$15m on  a 300kt pa basis.  The company’s strategy is to start small but volumes could easily be expanded to 600kt pa and beyond.

Project advantages

Whilst offering up robust financial metrics the Moberly sands project also benefits from a number of natural advantages that add to the investment proposition: 

• Quality of product: as previously mentioned with a 99.97% pure silica sand Heemskirk considers itself to have one of the highest quality products on the market.  This ensures its place in the queue as a ‘first preference’ sand if the market were to weaken and customers were to scale back orders.  Over the last two years the company has supplied test batches to potential customers (well operators) and has now attained ‘preferred supplier’ status. This will help ensure its product can be used as soon as the new plant is built and commissioned.
• Freight differentials: As much of the frack used in Canada is assumed to be supplied out of the US Moberly’s geographic location in the WCSB ensures it has a natural freight advantage over US supplied sands.

 Market Dynamics

The North American market (where horizontal drilling is most prevalent) accounts for approximately 85% of global frack sand demand.  The combined Canadian and US markets currently consume an estimated 30mt-32mt pa, with approximately 2mt-2.5mt used in Canada. These tonnage levels have increased significantly over the last five years with industry forecasts for demand to grow at least 20% pa over the next 3-4 year period.

With the US moving away from Middle East oil dependence it is increasingly looking to its massive undeveloped gas reserves as an alternative fuel source. US gas prices currently sit in the US$3-US$4 range. While the US would like to benefit from Canada’s gas production, the current spate of developments in the western Canada are increasingly being designated for export to Asia where prices are a much higher in the $US10-US$12 range.   It is these higher prices that underpin the rapid expansion of Canada’s gas market, most notably the development of the Kitimat export facilities.  The growing Asian demand for gas supply is expected to warrant continued drilling, and by extension, frack sand demand.

Summary

With a current market capitalisation of c.$12m Heemskirk currently trades at a small discount to its cash backing, holding cash and liquid investments of approximately $13m.  This discount will swell materially with the Lethbridge sales proceeds set to deliver another $8m into the company’s coffers.  However, shares are likely to continue to trade at a discount to cash backing as the majority of these funds have been designated to the Moberly development.  With the project fully permitted and engineered it is only the finalisation of funding that needs to be concluded before the company can immediately commence construction.

With first ground expected to be broken early in the second half of 2014 and a relatively short construction timeframe of 9-12 months, investors should not have to wait long before they begin to see some sort of valuation uplift.  With the project modelled conservatively to yield an NPV of C$65m and generate EBITDA in the range of C$12m-$C15m, it is easy to foresee a future share price re-rating and valuation for Heemskirk of several times that of its current $12m market capitalisation.