Source Energy Services Ltd

TSX:SHLE

Earnings Call Transcript

[Operator]

Thank you for standing by. This is the conference operator. Welcome to the Source Energy Services Third Quarter 2022 Results Conference Call. [Operator Instructions] The conference is being recorded. [Operator Instructions] I would now like to turn the conference over to Scott Melbourn, CEO. Mr. Melbourn, please proceed.

[Scott Melbourn, executive]

Thank you, operator. Good morning, and welcome to Source Energy Services Third Quarter 2022 Conference Call. My name is Scott Melbourn. I'm the CEO of Source. I'm joined today by Derren Newell, our CFO. Today, I'll cover the formal part of the call, and Derren and I will be available to answer any questions you may have.

Before I get started, I would like to refer everyone to the financial statements and the MD&A that was posted to SEDAR and the company's website last night and remind you of the advisory on forward-looking information found in our MD&A and press release.

On this call, Source's numbers are in Canadian dollars and metric tonnes, and we will refer to adjusted gross margin and adjusted EBITDA, which are non-IFRS measures as described in our MD&A. Except for the items just mentioned, our financial information is prepared in accordance with IFRS.

For the third quarter of 2022, we recorded 753,000 tonnes of sand sales which is slightly lower than anticipated due to the delayed completion programs in Northeast BC as ongoing permitting issues were prevalent throughout the quarter and weaker summer AECO pricing due to pipeline maintenance.

Total volumes for the quarter were higher than the first quarter of 2022; however, slightly lower than the sales volume realized in the second quarter of 2022. We recorded 84,000 tonnes of mine gate sales, which was slightly lower in the quarter as there were less outlets available for use in the U.S. for certain [indiscernible].

Compared to the third quarter of 2021, while total sales volumes were flat, revenues increased by 23% due to improved pricing. In the third quarter of 2022, we realized adjusted EBITDA of $16.3 million, excluding the $9.7 million realized on the settlement of outstanding foreign exchange contracts.

The $16.3 million of operational EBITDA is an increase of 44% from the third quarter of 2021 and a 10% increase from the second quarter of 2022 despite lower volumes. We reported net income of $5.9 million for the third quarter of 2022.

Sand revenue for the third quarter was $97.2 million, an increase of 22% over the third quarter of 2021. Compared to the third quarter last year, the increase in sand revenue was due to a 28% increase in average realized sand price excluding the impact of mine gate sales.

Strong activity levels from noncontracted customers during the quarter as well as pricing improvements with contracted customers created the improved pricing and gross margin realized during the quarter. Wellsite revenue was $21.7 million for the third quarter, an increase of 24% or $4.2 million compared to the third quarter of 2021. Despite lower volumes, wellsite revenue, revenue was higher due to the impact of longer hauls and terminals to the wellsite and improved pricing.

Total trucked volumes during the quarter were impacted by customer delays and the permitting issues in BC. Compared to the same period last year, Sahara-related revenue increased 53% on a quarter-over-quarter basis. And Sahara units were 87% utilized, a 52% increase in days utilized across the 9-unit fleet.

During the quarter, we added 2 new customers for our Sahara units. We continue to see strong interest in Sahara units from both Canada and the U.S.

Cost of sales in the third quarter were impacted by higher cost for transportation and freight due to increased fuel prices, a tighter trucking market and the increased cost of third-party sand purchases. These costs, along with higher labor costs and no Canadian Emergency Wage Subsidy, or CEWS receipts, were partially offset by Source's continued focus on streamlining production.

The weaker Canadian dollar on our U.S.-denominated costs increased costs by $3.51 per tonne compared to the same period as last year. Offsetting this increase at the adjusted EBITDA line was the gains realized on settling the foreign exchange contracts previously entered into to help manage the foreign currency exposure in the third quarter of 2022.

Excluding gross margin and mine gate sales, adjusted gross margin per tonne was $30.27, which was favorably impacted by improved pricing. Compared to the third quarter last year, adjusted gross margin for the third quarter of 2022 did not benefit from a stronger Canadian dollar, certain production credits or proceeds from the CEWS programs.

If these items were excluded from the third quarter of 2021, the third quarter of 2022 adjusted gross margin per tonne has increased by 55%. For the 3 months ending September 30, 2022, adjusted gross margin per tonne increased by 3% compared to the second quarter of 2022 due to higher prices.

For the third quarter of 2022, total operating and general and administrative expenses were consistent with the same period last year. Operating expenses had increased royalty costs as well as higher repairs and maintenance expense that were offset by lower variable incentive compensation expense compared to the same period last year.

For the third quarter of this year, G&A expense decreased by $100,000 from prior year due to lower professional fees and bad debt provision. Due to the mechanics of our new ABL facility and a change in currency of customer contracts, we wounded up our foreign exchange hedges during the third quarter of 2022 and recognized a foreign exchange gain of $9.7 million.

Of this gain, $3.3 million relates to normal course operation for the fourth quarter of 2022 and the remaining $6.4 million relates to contracts due to mature in 2023. In the quarter, Source also realized a $2.1 million FX related to activity in the third quarter of 2022 as part of its normal course operation, which was partially offset by FX losses from translating our U.S.-denominated working capital costs.

For 2023 and beyond, we are anticipating being in an naturally balanced FX position. However, we will continue to monitor our FX exposure and actively manage if required. Subsequent to the quarter end, on October 14, 2022, we closed a new revolving asset-backed senior credit facility with the syndicate comprised of FGI Worldwide and CIT Northbridge Credit. The new facility provides access to funding of USD 55 million or approximately CAD 75 million and provides Source with a lower cost of borrowing, less restricted covenants, which will allow Source to focus on generation of free cash flow and the reduction of debt. The details of our main facility are outlined in our MD&A.

Due to the fact that we closed in the ABL facility subsequent to quarter end, we are required to classify our debt as [ trend ] at September 30. When we closed our new facility on October 15 and made the outstanding interest payment with the noteholders, the debt reverted back to being reported as long term.

On September 30, the principal balance outstanding on our notes was $163.5 million, and the balance outstanding on our term loan was $10.5 million. Source had $3.3 million drawn under its ABL facility. The ABL facility was also being used to support $10.7 million lines of credit, leaving $30.5 million of available liquidity.

Net debt was $177.3 million, a reduction of $17.2 million. As business performance improves in 2023, with the rollover of long-term contracts, we will continue to focus on reducing debt levels and ensuring we have a capital structure that can withstand the peaks [indiscernible]

Source's capital expenditures for the third quarter were $4.5 million, an increase of $2.6 million compared to the same period last year. The increase in expenditures were primarily related to costs associated with maintenance activities at the Peace River facility and overburden the removal for mining operations.

Growth capital expenditures for the quarter were related to permitting additional items at the Peace River mining. As we look at the full year for 2022, we expect net capital expenditures to be approximately $10 million to $13 million, with the year-over-year increase driven by overburden expenditures in Wisconsin and Peace River maintenance capital. We are anticipating a similar capital program for next year with the largest component of the program focused on overburden removal.

Now as we look ahead, we anticipate the demand for oil and natural gas globally will remain strong. This operating environment is expected to result in drilling and completions programs in 2023 and beyond to remain robust.

With the increased activity levels across North America, the frac sand supply and demand fundamentals have been and are expected to remain tight for the foreseeable future. These fundamentals, coupled with Source's leading service offering and logistics capability, has translated into pricing gains for 2022, a trend that is expected to continue for the balance of the year and into next year of contract renewals.

We also expect that the impact of ongoing permitting issues in BC will be resolved and activity that has been postponed in the area will proceed. When the backlog of activity is coupled with already strong industry fundamentals, there is an expectation of a continuation of improved business performance for Source into 2023.

In the longer term, Source believes the increased demand for natural gas, driven by the conversion of coal-fired power generation facilities, increased natural gas pipeline export capabilities and LNG exports will drive incremental demand for Source's services in the WCSB.

Source continues to see increased demand from customers that are primarily focused on the development of natural gas properties in the Montney, the Duvernay, and the Deep Basin. This trend is consistent with our view that natural gas will be an important transitional fuel that's critical for the success and a movement to a less carbon-intensive world.

In support of the move to a less carbon-intensive world, Source has begun focusing on exploring opportunities which transition from traditional fossil fuels to less carbon-intense energy solutions. As a pathway to diversifying our business and the participating in decarbonization of the economy, Source is advancing opportunities in our own operation as well as new service offerings at the wellsite and at our terminals.

Source continues to focus on increasing its involvement in logistics services for additional oilfield services and other industries to diversify our revenue stream and further utilize the Western Canadian terminals. Over the longer term, it's anticipated these opportunities will be a meaningful part of the Source's business.

Thank you for your time this morning. That concludes the formal portion of our call. We will now ask the operator to open the lines up for questions.

[Operator]

[Operator Instructions] The first question comes from John Gibson with BMO Capital Markets.

[John Gibson, analyst]

Apologies if I missed this. I was wondering if you could give us a sense of what percentage of your volumes were maybe under those previous contract regimes versus what you're expect them be in 2023?

[Scott Melbourn, executive]

Yes. Good morning, John. So I'll start off and Derren will dive in with additional details. I think for Q3, we were probably about 60% to 70% of our volumes were under the long-term contracts and 30% to 40% were on spot volumes for -- on some of our shorter-term contracts.

So looking forward, as those contracts roll off and we either renew or we don't renew some of those contracts, we expect to probably be for 2023 closer to a 50% under contract and probably 50% under spot [ covenants ].

[Derren Newell, executive]

This is Derren. Yes, I don't have anything to add.

[John Gibson, analyst]

And I guess, maybe could you talk about your expectations for average pricing now versus kind of when those contracts roll off?

[Scott Melbourn, executive]

Yes. And I think as we've indicated before, some of those contracts are well below what the market pricing or spot pricing is in now. So we expect a large pickup in pricing and in gross margin as we cycle into 2023, and we expect another step change in business performance for the company in 2023. So we're -- most of those contracts -- and actually all of those contracts will be renewed by the end of Q1 of 2023. So we're expecting much higher pricing at the end of 2022.

[John Gibson, analyst]

Great. Last 1 [indiscernible] I guess. But how are you seeing volume shape up in Q4? I mean I know there's typically a seasonal slowdown. Are you seeing that? And then also, what are you seeing for demand in Q1 of 2023?

[Scott Melbourn, executive]

Yes. I think you nailed it. We're seeing a seasonal slowdown in Q4. And so we expect the volumes, of course, are going to be slightly lower than Q3. And there's still an opportunity for the customers to pull capital into Q4 and the volumes to pick up a little bit. But nonetheless, we expect a regular seasonal slowdown to hit in Q4.

in Q1, we're seeing some pretty robust customer demand right now. And I think we are probably at a much higher level than what we saw in 2022 in Q1. However, a little caution: budgets haven't been finalized and programs haven't been finalized. And so early look, it looks pretty robust going into the beginning of 2023, but there's still some work to finalize the schedule.

[Operator]

The next question comes from Josef Schachter with SER.

[Josef Schachter, analyst]

Contract, as you mentioned, will renew in Q1. Is there the thought process of changing the timeline of how long contracts last so that if there's issues of a rail strike and prices that you have to push through or other cost pressures would be easier to pass through than waiting until the contract expires. How are you thinking? And what is the contract terms that you are now versus are you thinking of changing it to a shorter term?

[Scott Melbourn, executive]

Yes. Excellent question. I think as we are thinking about sort of the environment coming up in maybe in the next 3 years to 5 years, we continue to be very bullish on activity level in the Western Canadian sedimentary basin.

And so yes, that's really going to drive our thinking on the term of the contract as we renew. So as we sit today, we would probably wouldn't be looking at going any longer term than maybe 1 or 2 years. But that's always going to be dependent on the ultimate details of the contract we're entering into.

If we feel there is a advantageous contract for Source for 3 years, we may entertain a contract length of 3 years. In terms of the other items, I think over the years, we've become more and more efficient at structuring our contracts. So that then needs onetime items, whether it be rail related or whether it be other items that are out of the control of Source are pass-through and so are immediate pass-through versus having to break the contract or having to sort of bare cost to the length of the contract. And so we'll certainly be looking to make sure that we'll cover off and we're protected any contracts that we enter into.

[Josef Schachter, analyst]

Okay. One more from me. From what we've seen from the media, it looks like a couple of the unions in the rails are not accepting the buy and negotiate a deal. If there is a strike for even any length of time, do you have prepositioned inventories enough in Canada that you won't really be impacted in at least the Q4 or Q1 that a strike does take place?

[Scott Melbourn, executive]

Yes. We're watching closely to see. I think we are of the belief that if any strike does happen, it won't carry on for a long time, given the impact of the U.S. economy and actually the impact of North American economy. And so that's 1 thing that I think sets Source apart from others is our ability and our ability to store sand in basin and our ability to withstand sort of short-term outages.

We have approximately 200,000 tonnes of storage that -- throughout the basin that we can utilize. And we will make sure that it is as full as possible leading up to any sort of work stoppage or any rail outages that we may anticipate.

[Operator]

The next question comes from John [indiscernible] with Canaccord Genuity.

[Unknown Analyst]

Just wondering if you could share with us your thoughts at the field level in terms of profit intensity in the basin? And I guess with BC issuing licenses again, does that have a meaningful tailwind on the business here next year?

[Scott Melbourn, executive]

Yes. I'll start out and maybe Derren could dive in with anything I missed. The profit intensity, I think, is -- it's slowly continuing to trend up. I wouldn't -- it's nothing like what we saw maybe 5 or 6 years ago where we saw sort of step-changes in completion programs. But I still think we see a trend of increased profitability kind of across our customers sets and across the areas that we operate in.

And so I still see a continuation in the trend of more profit per well. And we certainly haven't seen many indications of a trend of less profitable levels. So I think that's trending favorably. In terms of the permits in Northeast BC, we're -- we absolutely think that creates a tailwind.

We also think there's just a backlog of activity that is going to happen, and it's going to happen in the early part of 2023, as our customers and some other E&P gets to areas that they haven't been able to get to in 2022. And so I think the landscape of additional permits -- just the macro backdrop is setting up nicely for Source in -- certainly in the beginning of 2023 and for the balance of 2023.

[Derren Newell, executive]

Right. [indiscernible] add, John. Don't forget the impact of LNG. Canada keeps [indiscernible] and we're excited about what that does for the basin, they keep creating stability over the next couple of years [indiscernible]

[Unknown Analyst]

Great. Great color. And as you think about potential demand growth. How are you positioned in terms of your mine operations and your rail lease cars in terms of maybe needing potentially higher volumes going forward?

[Scott Melbourn, executive]

Yes. I think we're feeling pretty comfortable in terms of our position of our ability to produce additional product and ship additional products. We also feel pretty comfortable about our position in Peace River. We spent sort of the balance of this 2022 being absolutely ready to produce a portion of the profit that will stand out.

And so given our ability to grow some production at the mine, given Peace River, we feel like we're in a comfortable position to be able to fulfill customer demand as it grows. I think we're going to be very careful about spending any additional money on growing any additional production capacity until we see that the market will bear it. We certainly don't want to repeat any oversupply situation, but we're cautiously optimistic that the demand will [ heir it ] within the next couple, 3 years, and we'll be looking at adding additional production.

[Operator]

[Operator Instructions] As there are no further questions, this concludes the question-and-answer session. I would like to turn the conference back over to Scott Melbourn for any closing remarks.

[Scott Melbourn, executive]

Thank you, everyone, for joining Source Energy's conference call. If you have any follow-on questions, as always, myself and Derren are available.

[Operator]

This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.