The recent surge in oil prices has renewed investor interest in the small-cap oil and gas E&P sector. One company that stands out for all the right reasons is Canadian domiciled small-cap, Whitecap Resources (SPGYF.PK). Since 2009 the company has unlocked considerable value for investors through a range of acquisitions as well as development and exploration projects. This has seen its share price surge in value to be up by almost 53% over the last year alone.

However, it is clear that the market has yet to fully recognize the true value of Whitecap and there is still considerable upside potential of over 30% for investors. This along with Whitecap's dividend growth strategy makes it a particularly appealing deep-value investment in the oil and gas E&P sector.

Investment case summary

Despite the surge in Whitecap's share price over the last year, the company continues to offer investors considerable potential upside of over 30%. This is because the market has yet to fully factor in the value of Whitecap's existing assets and recent acquisitions.

There are also a range of catalysts that are set to drive the company's share price higher and unlock further value for investors. The key catalyst is Whitecap's ability to continue growing higher margin light oil production in an environment where crude prices are now over $100 per barrel. Other catalysts include:

1. its ability to continue growing its proved and probable reserves through its well development program;
2. improved cost control which is seeing its netback per barrel grow;
3. the low decline rates of its assets; and
4. all of its operations are located in the relatively low risk jurisdiction of Canada.

When all of these factors are considered in combination with a net-asset-valuation (NAV) indicating Whitecap's indicative fair value per share is more than 35% higher than its current market price, it is clear there is considerable upside potential for investors.

Company profile

Whitecap is engaged in the acquisition, development, optimization, and production of crude oil and natural gas in western Canada. Along with its U.S. OTC ADR it also has a significantly more liquid listing on Canada's Toronto stock exchange as WCP.TO.

The company is focused on acquiring under-valued assets that are sustainable, with growth value and then developing and optimizing those assets to derive the maximum benefit possible. It is also focused on expanding and developing its core operations in order to expand its recoverable resource base. All of the company's assets and operations are located in Canada in the provinces of Alberta and Saskatchewan as the chart below illustrates.

Source: Whitecap Resources Corporate Profile.

Whitecap has a large light oil drilling program and a stable asset base, the majority of which is composed of light oil, giving it a pricing advantage over the majority of its Canadian peers that operate in western Canada. This is because it is not reliant upon Canadian heavy oil and bitumen assets for its production. Typically heavy oil and bitumen assets have higher development costs and the oil produced sells at a significant discount of up to 30% against the price of West Texas Intermediate.

Over the last four years Whitecap has been able to grow its proved and probable reserves at an exponential rate. The company now has 61 MMBOE of proved reserves (1P) and 88 MMBOE of proved and probable reserves (2P) as the chart below illustrates.

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Source data: Whitecap Resources Reserves Report 2009 to 2013.

Since 2009 Whitecap's reserves have a phenomenal compound annual growth rate of (CAGR) of just over 76% for its 2P reserves and 115% for its 1P reserves. This rate of growth is significantly higher than many of its small to mid-cap E&P peers and certainly bodes well for continuous strong growth in reserves.

This solid growth in reserves also saw Whitecap have a phenomenal reserves replacement rate for its 2P reserves of 1,054%, which is also higher than many of its equivalent size peers. This essentially highlights that Whitecap's proved and probable reserves are growing at a significantly faster rate than production is able to deplete them, indicating that despite continuing to grow production Whitecap's 2P reserves and therefore its NAV can only continue to grow. More importantly 69% of Whitecap's 2P reserves are composed of oil and non-gas-liquids (NGLs), of which a significant portion is higher value light oil.

The volume of Whitecap's proved and probable reserves also compares favorably to many of the company's peers, as shown by the chart below being higher than similarly sized Canadian peers Gran Tierra Energy (GTE) and Petrominerales (PMGLF.PK).

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Source data: Whitecap, Gran Tierra, Petrominerales, Whiting and Stone Energy Reserve Reports and 2Q13 Financial Filings.

But its reserves are lower than U.S. domiciled small-cap Stone Energy (SGY) and mid-cap Whiting Petroleum (WLL). However, in the case of Stone Energy a larger portion of its proved and probable reserves are lower margin and less profitable natural gas, with natural gas making up 51% of its reserves and oil and NGLs the remaining 49%.

All of which indicates, that Whitecap has had considerable success building its reserves to what are particularly sustainable and profitable levels. But while there is considerable evidence to indicate that Whitecap can continue to build its reserves at such an exponential rate, past performance is no guarantee of future performance.

Despite Whitecap's strong reserve growth it does not appear as cheap as some of its peers, trading with an enterprise-value of 36 times its 1P reserves and 25 times its 2P reserves, as shown by the chart below.

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Source data: Whitecap, Gran Tierra, Petrominerales, Whiting and Stone Energy Financial Filings 2Q13, Yahoo Finance and Fidelity.

Overall these ratios indicate that Whitecap while under-valued is not as cheap as peers such as Whiting and Stone Energy. But on the basis of these measures it is far cheaper than Canadian peers Gran Tierra and Petrominerales.

Delivers a strong financial performance in a tough operating environment

A pleasing aspect of Whitecap is that the company has been able to deliver a consistently strong financial performance despite the gyrations in the price of crude caused by production disruptions and ongoing conflict in the Middle-East. Despite declining oil prices Whitecap has delivered five consecutive quarters of revenue growth as the chart below illustrates.

Source data: Whitecap 2Q12 to 2Q13 Financial Filings.

As the chart illustrates despite second quarter 2013 revenue remaining relatively flat QoQ it has grown by 25% YoY to $87 million on the back of significant production growth. The company has also been able to boost its bottom-line for the same period by 300% QoQ although it has fallen by 20% YoY to be $20 million.

Whitecap's management also continues to maintain a firm control of costs. Despite total expenses increasing by 8% QoQ and 12% YoY to $61.5 million, the company's ratio of cost of goods sold (COGS) to revenue fell by 1% QoQ and 3% YoY. This is because the key driver of increased expenses was the company's increased production, and as the COGS to revenue ratio illustrates, costs continued to fall in proportion to total revenue generated.

Whitecap's COGS to revenue ratio is also particularly low for a junior oil and gas E&P company and is well below the industry average for a similar sized company. All of which bodes particularly well for Whitecap to be able to maintain its margins and continue to grow profitability.

This becomes evident when Whitecap's strong EBITDA growth over the last five consecutive quarters it taken into account. Second quarter 2013 EBITDA was up by 3% QoQ and 68% YoY giving the company a solid adjusted EBITDA margin of 30% and an unadjusted EBITDA margin of 73%. This as the chart below indicates is one of the highest EBITDA margins among its peers and can be attributed to management's disciplined approach to costs along with generating strong cash flow.

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Source data: Whitecap, Gran Tierra, Petrominerales, Whiting and Stone Energy Financial Filings 2Q12 to 2Q13.

This solid EBITDA margin makes Whitecap a particularly compelling investment. It indicates that management's focus on cost control and asset development is having a significant and positive impact on its profitability, despite fluctuations in the company's bottom line.

Despite low debt and solid cash flow the balance sheet is of some concern

Whitecap's overall balance sheet position is solid, particularly when it's low debt to equity ratio of just under 0.4 and net assets of $1.03 billion are taken into account. However, there are some apparent weaknesses, particularly when the low amount of cash on hand totaling $18,000 and low operating cash flow to debt ratio of 0.5 are taken into account.

For investors these are of some concern and highlight that the company needs to focus on boosting its cash flow along with its cash on hand. But it should also be emphasized that Whitecap typically relies upon cash flow and its credit facilities to fund its liquidity requirements. At the end of the second quarter 2013 the company had $143 million in unutilized credit available to fund any working capital deficiencies.

However, despite these deficiencies Whitecap's risk metrics compare favorably with many of its junior oil and gas E&P peers that operate in North America such as Whiting and Stone Energy as the chart below illustrates.

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It is also not experiencing the short-term liquidity issues that have affected the performance of Canadian peer Petrominerales, which have made that company a take-over target. Recently Canadian mid-cap oil and gas E&P play, Pacific Rubiales made an offer to buy Petrominerales for $909 million.

Production continues to grow boosting profitability

The key factor driving Whitecap's solid performance is the company's ability to grow production over the last five consecutive quarters. As the chart below illustrates second quarter 2013 production grew by 2% QoQ and 32% YoY.

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Source data: Whitecap 2Q12 to 2Q13 Financial Filings.

The increase in production can be primarily attributed to the acquisitions that Whitecap completed in 2012 including the purchase of Invicta Energy Corp. and a number of west central Saskatchewan properties in the second quarter of 2013. In addition to which, the company's successful drilling and completion programs has also boosted production and helped to offset natural declines.

The company has also forecast an impressive growth in production over 2013 and 2014, as illustrated by the chart below, which based on the company's historical performance, appears achievable.

Source: Whitecap Investor Presentation September 2013.

Whitecap has estimated that annual production for 2013 will grow by 37% YoY and in 2014 by 17% YoY. Such a significant growth in annual production will significantly boost Whitecap's cash flows and bottom line. This will allow it to continue funding both its dividend payments and capital expenditure for its development program, as well as strengthen its balance sheet.

Whitecap's average realized price per barrel of oil continues to grow

A further pleasing aspect of Whitecap is that it has been able to consistently increase the average realized price per barrel of oil received over the last five consecutive quarters. For the second quarter 2013 its average realized price per barrel grew by almost 2% QoQ and 14% YoY to $64.42 as shown by the chart below.

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Source data: Whitecap 2Q12 to 2Q13 Financial Filings.

This significant increase in average realized price per barrel can be primarily attributed to the decreasing price differential between Canadian light sweet crude and West Texas Intermediate. For the second quarter 2013 the discount fell by 63% YoY to $3.67 primarily because of supply disruptions in Canada during the quarter.

With oil prices now spiking to over $100 per barrel Whitecap's average realized price per barrel is expected to increase. This in conjunction with the company's ability to increase production at this time bodes well for its bottom line. However, Whitecap's average realized price per barrel of oil is low in comparison to many of its peers as the chart below illustrates. This can be attributed to the price for light sweet Canadian crude being discounted against the price of West Texas Intermediate more heavily than other forms of crude.

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Source data: Whitecap, Gran Tierra, Petrominerales, Whiting and Stone Energy Financial Filings 2Q12 to 2Q13.

Companies such as Petrominerales and Gran Tierra receive higher average realized prices per barrel of crude than Whitecap because they are producing higher quality Colombian crude. Whiting also produces a higher quality crude that receives a higher benchmark price than light sweet Canadian crude.

But as highlighted earlier Whitecap's Canadian light sweet crude is not as heavily discounted as Canadian heavy oil or bitumen. This does not leave it exposed to the same price risks and volatility as those companies that have a significant portion of their production made up by Canadian heavy oil and Bitumen, such as Husky Energy (HUSKF.PK), Suncor (SU), Imperial Oil (IMO) and Canadian Natural Resources (CNQ).

Netback per barrel has grown considerably over the last year

Despite declining for the last three consecutive quarters, Whitecap continues to report a solid netback per barrel for the second quarter 2013 of $44.16. This as the chart below shows is an almost 1% decrease QoQ but a significant increase of 18% YoY.

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Source data: Whitecap 2Q12 to 2Q13 Financial Filings.

The QoQ decline in the company's netback per barrel can be primarily attributed to an increase in transportation costs caused by wet weather in Alberta and Saskatchewan affecting road bans and increased wait times at sales terminals. However, the substantial increase in Whitecap's netback per barrel YoY can be primarily attributed to reduced operating costs per barrel of oil produced and higher average realized price per barrel.

It is also expected that Whitecap's netback per barrel will continue to increase. This is because of higher crude prices, the falling price differential between Canadian light sweet crude and West Texas Intermediate and lower operating costs per BOE. But infrastructure issues particularly the lack of pipeline capacity in Canada combined with increased pipeline disruptions and the growing costs of rail transportation will continue to affect the netbacks received by Canadian oil producers such as Whitecap.

Whitecap's netback per barrel is relatively high in comparison to other North American based oil and gas producers. But it is significantly lower than those Canadian companies operating in South America, such as Gran Tierra and Petrominerales as illustrated by the chart below.

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Source data: Whitecap, Gran Tierra, Petrominerales, Whiting and Stone Energy Financial Filings 2Q12 to 2Q13.

Whitecap's high netback in comparison to other North American based oil and gas producers as well as its continued growth bodes well for Whitecap to continue increasing margins and profitability, thus unlocking increased value for investors. It also compares favorably to those companies operating in South America, because Canada is a far more stable and lower risk jurisdiction than Colombia, Brazil or Argentina.

Whitecap's development and asset acquisition program continues to add value

An important aspect of Whitecap's operations is the company's development program, which is focused on optimizing production and the value of its assets. This program is not only focused on building production but also reducing decline rates and boosting netbacks, as the chart below illustrates, thus making Whitecap a more profitable operator.

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Source: Whitecap Investor Presentation September 2013.

The company also has a solid drilling inventory as the chart below illustrates giving it 10 plus years of development drilling locations, boding well for the company to maintain its replacement rate.

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Source: Whitecap Investor Presentation September 2013.

This program along with the planned drilling and well development activities through 2013 should allow Whitecap to meet its production target estimates all of which will significantly contribute to boosting Whitecap's bottom line and boost the value of its assets. They will also boost the sustainability of Whitecap's production by increasing reserves and maintaining its impressive reserves replacement rate thus boosting the production life of its 2P reserves.

A key plank in Whitecap's development strategy is the acquisition of value accretive assets with solid development potential and synergies with its existing assets. In April 2013 Whitecap closed the acquisition of Invicta Energy Corp. for $60.2 million, which saw the company acquire additional production of 500 BOEPD and 2P reserves of 3 MMBOE. This gives the transaction the attractive valuation metrics as set out in the table below.

The company also completed the acquisition of a Viking light oil asset under water flood in the second quarter of 2013 for $110 million. The acquisition adds 900 BOEPD - of which 95% is light oil - of high netback, operated production, which has a low base decline of 20 percent. Whitecap has estimated that by 2014 production will more than double from 550 BOEPD to 1,200 BOEPD.

Both of these acquisitions bode well for Whitecap to not only boost reserves and production but also its cash flow and ultimately bottom line. It is also clear that at this time the market has yet to forecast the accretive value of these acquisitions into Whitecap's share price as the NAV highlights.

The outlook for crude despite improving remains uncertain

The outlook for crude continues to remain mixed and while it has fallen by 7% from its August 2013 high, it continues to be at over $100 per barrel for both WTI and Brent. At the time of writing WTI futures contracts due in November are trading at just over $100 while Brent contracts are at almost $108.

Furthermore, it is forecast by the U.S. Energy Information Administration (EIA) that the average price per barrel for WTI in 2013 will be $98 and in 2014 it will be $96, while for Brent it is $108 for 2013 and $102 in 2014. These estimates are far more positive than the outlook for the prices of crude that the EIA released earlier in 2013, with both being around 16% higher than they were in April this year.

It is also expected that the ongoing geo-political tensions and conflict in the Middle-East will continue to create supply outages. These in conjunction with growing demand for crude from rapidly expanding emerging economies will see demand continue to grow pushing the price of crude higher over the long term. All of this certainly bodes well for the performance of junior oil and gas E&P companies and sees many including Whitecap trading with share prices lower than their NAV. Accordingly, the revised outlook and forecast crude prices have been factored into the NAV for Whitecap.

Like the majority of oil producers Whitecap has implemented a strategy to manage or hedge commodity risk through a series of hedges using derivative contracts with price collars. These collars as the chart below illustrates, are based on the price of WTI and establish a minimum price of $90 per barrel.

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Source: Whitecap 2Q13 MD&A.

This hedging strategy allows Whitecap to maintain a given level of cash flow, allowing it to continue funding key capital projects including exploration and development projects, as well as its dividend payments.

Shareholder remuneration is impressive

An appealing aspect of Whitecap is that unlike many other junior oil and gas E&P companies it commenced paying a regular monthly dividend of five cents Canadian in January 2013. This gives the company an annual dividend of 60 cents Canadian per share and an impressive yield of just over 5% at the time of writing.

However, while the dividend is quite appealing it is unclear at this time just how sustainable the dividend payment will be, with the company having an estimated future payout ratio of 97%. This is even more concerning when the low amount of cash on hand is considered. But the dividend does provide investors with a healthy reward for waiting for Whitecap's true value to be recognized by the market.

Foreign investors in Canadian companies also need to be aware that withholding tax of 25% is payable on dividends. But this can be reduced depending on the nationality of the investor, and whether there is a tax treaty in place between Canada and the country in which the investor is domiciled.

However, in the case of U.S. investors, the tax treaty between Canada and the U.S. reduces this withholding tax to 15%. In addition, there is no withholding tax payable for dividends paid to an approved pension or retirement plan, provided they are generally exempt from tax in the country of residence.

Determining Whitecap's indicative fair value

Whitecap's share price has performed strongly over the last year, but there is still considerable upside potential to be realized for investors particularly with the recent surge in crude prices. But on the basis of its valuation ratios - particularly its price per flowing barrel of $132,988 and enterprise value of 11 times EBITDA - it appears somewhat expensive in comparison to its peers as the chart illustrates.

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Its price to operating cash flow per share of eight times also makes it appear expensive, but with an enterprise value of 36 times 1P reserves and 25 times 2P reserves it appears that the market has unfairly valued its assets.

All of which indicates, that while these ratios provide investors with a useful picture of whether Whitecap is undervalued particularly in comparison to its peers they do not provide a comprehensive picture. In order to do this, I have determined Whitecap's indicative fair-value per share using a net-asset-valuation (NAV) methodology.

In order to do this I have determined the present value of Whitecap's after-tax cash flows generated by its net proved and probable reserves, which is then divided by the number of common shares outstanding. When applying this methodology and calculating Whitecap's indicative fair-value per share I have used the following assumptions:

1. I have taken Whitecap's 2P reserves of 87.5 MMBOE and discounted the difference between its 1P reserves of 60.9 MMBOE by 50%, so as to represent the accepted likelihood of those probable reserves becoming proven reserves.
2. I have discounted the future value of the company's cash-flows derived from those reserves by 10%, to determine their present value.
3. I have assumed an average basket price per barrel of oil of $90, representing the outlook for oil.
4. I have factored in a minimum royalty rate of 12%, which represents the average royalty rate paid by Whitecap.
5. I have conducted the valuation over a 10-year period.
6. I have calculated the present value of debt and asset retirement obligations using a 2.5% growth rate (representing the long-term GDP growth rate) over the valuation period. This factors in the likelihood that both debt and asset retirement obligations will continue to grow as the company expands.
7. Despite the particularly positive exploration and development outlook I have not factored in any increase in reserves from those operations or future discoveries, because of the uncertainty that surrounds oil exploration.

After applying these assumptions and factoring in each of the catalysts discussed, I have calculated an indicative fair value for Whitecap of $15.89 per share, as displayed in the chart below.

At the time of writing Whitecap is trading at around $11.43, indicating that the company's shares are currently unfairly valued by the market by 39%. As such there is potential upside of 39% for investors, making Whitecap a deep-value opportunity for the patient investor who is seeking dividend income and strong growth potential. This becomes even more apparent when the conservative valuation methodology and substantial margin of safety is considered.

Risk factors

Unlike many of its peers - such as Gran Tierra and Petrominerales - which operate in high risk jurisdictions such as the Middle-East and Latin America, all of Whitecap's operations are located in the relatively low risk jurisdiction of Canada. This effectively means that the company is not exposed to risk such as:

1. Currency risk, with the currencies of emerging economies being far more volatile than developed economies.
2. Production disruptions and loss of assets caused by terrorist attacks, civil conflict or other forms of civil disobedience.
3. Canada's legal system is stable and transparent thus reducing the risks associated with licensing, royalties disputes and taxation disputes.
4. The threat of expropriation of assets.

But like all junior oil and gas E&P companies Whitecap is still exposed to a variety of risks including:

1. Regulatory changes with growing concern in Canada over the environmental damage caused by oil production, though this is predominantly focused on the oil sands industry.
2. Infrastructure constraints with pipeline capacity in Canada having reached capacity leading to supply bottlenecks, which is making companies such as Whitecap more reliant on higher cost rail and road transportation.
3. Environmental risk, particularly environmental damage caused by accidents and spillages that lead to costly litigation, regulatory fines and damages. Whitecap mitigates this risk by carrying a range of liability and pollution insurances.
4. Commodity price risk, with the price of crude having fluctuated wildly over the last year leading to uncertainty over its future direction. But Whitecap as discussed earlier mitigates this risk through a range of hedging activities.

As discussed Whitecap has a range of strategies in place to mitigate its risks and these are further mitigated by its strong acquisition, exploration and development program, which thus far has guaranteed the sustainability of its oil and gas production.

Bottom line

Whitecap is a particularly promising junior oil and gas E&P company with a solid asset base, growing production and strong asset development and optimization program. It is also somewhat unique among its peers for paying a dividend with a yield of 5%, which is higher than the dividend yields of many oil majors. It is also clear that the market has yet to fully price in the value of Whitecap's assets in particular the additional boost that its recent 2013 acquisitions have given it.

As a result, particularly in light of the improved outlook for the price of crude, Whitecap now offers investors upside potential of 39%, making it a deep-value investment opportunity for the long-term investors. Furthermore, those investors will be rewarded by the company's handsome dividend yield as it continues to unlock value for the shareholder.