Canacol Energy Ltd. (CNE-T) C$3.26 Clarinete Blows 21 mmcf/d on First Test

Target price: $6.50 (12 month)

Event Canacol Energy (CNE-T) late yesterday announced that a first test in the Clarinete-1 gas discovery well on the VIM-5 block in northern Colombia has yielded a final stabilized rate of 20.6 mmcf/d (15.5 mmcf/d net to Canacol's expected 75% interest) with no water.

Impact: POSITIVE.

• This flow rate is roughly in line with our expectations based on indications of significant net pay and porosity on logs, which explains why we're not changing any of our assumptions or our target.
• However, we nonetheless view the market's initial positive reaction (up over 10% in early trading) as appropriate, due to the confirmation of productivity that the test provides.
• Depending on results from a second uphole test of a separate potential pay zone that Canacol expects to conduct imminently, it appears Clarinete-1 has productivity potential that is well above that of Canacol's previous successful gas wells in the area.
• Crucially, Clarinete-1 could provide a substantial portion of the well productivity required to meet Canacol's contractual obligations to start delivering 83 mmcf/d in late 2015 (up from current sales volumes of 20 mmcf/d). This would allow Canacol to defer some development drilling on the Esperanza block until cash flows have increased in calendar 2016 and beyond, reducing the near-term capital expenditures required to meet contractual sales obligations.
• Canacol is currently negotiating a new take or pay gas sales contract associated with the Clarinete discovery and expects to provide details "in the near future". For reference, Canacol in September announced a 5-year sales contract at US$8/mcf (escalating further over the five years) for the nearby Palmer discovery on the Esperanza block. That contract was announced only 15 days after the Palmer discovery test results were announced.

TD Investment Conclusion We like Canacol’s long-life reserves and resources with limited exposure to global oil prices in Colombia gas and Ecuador oil assets. These assets now account for over 90% of our Fully-risked NAVPS. We also like management’s track record of value creation since 2011 through business-development initiatives and follow-up execution of drilling. We expect Canacol to continue growing its asset base in Colombia and other countries in Latin America (including potentially in Mexico). We expect generally positive exploration drilling results to continue; yet, Canacol is currently trading at a discount to the average of its closest peers on all relevant key metrics. We believe Canacol's growing gas resource base in the Lower Magdalena Basin is increasingly likely to make it a take-out target, and that Canacol’s exposure to shale resource potential in Colombia, and partnership with three majors (ExxonMobil, Shell, and ConocoPhillips), positions it to attract investment for long-term shale potential when interest in the play re-awakens.

Details & Outlook Background: The company previously announced on December 19 that (through acquisition and farm-down) it had acquired a 75% interest the VIM-5 block and made a potentially significant gas discovery with the Clarinete-1 exploration well. Reserves addition potential: With a pre-drill third party best estimate resource assessed at 405 bcf net to Canacol's 75% interest in the block, the Clarinete discovery holds potential to significantly increase Canacol's most recent 2P gas reserves of 113 bcf (that represented 47% of the company's total 2P oil and gas reserves excluding service contract volumes), all of which are located on the adjacent Esperanza block. In the short term, we don't expect Canacol to book proved reserves or conclude a sales contract for more than a fraction of the pre-drill prospective resource estimate at Clarinete (since a single well test is not enough to have certainty on volumes for such a large structure). Near-term catalysts: We nonetheless see potential for a second test and conclusion of a gas sales contract at attractive pricing to provide positive follow-on catalysts over coming weeks, as these logical next steps should give the market increased comfort that Canacol can produce and sell gas to produce substantial future cash flows. We continue to cautiously assume Canacol will achieve average realized prices of $6.40/mcf for volumes produced from Clarinete, and would likely be forced to increase that assumption if Canacol announces a sales contract with something closer to the most recent contract ($8/mcf).

Justification of Target Price Our target price is based on an unchanged combination of 0.85x Base NAVPS and 0.70x Risked Upside to Base NAVPS, which is slightly below the average multiples we use for Canacol’s closest comparables, mainly due to some longer-life and higher-risk assets in Canacol's portfolio. We currently use a range of 0.15x–0.90x in terms of our multiples of Risked Upside for our coverage of International E&Ps. Key Risks to Target Price Key risks associated with our target price include business risks of the company and industry, including but not limited to: loss of key employees; drilling success; volatile commodity prices; operating costs; capital cost overruns; product supply and demand; financing/access to capital; government regulations; legislation; unexpected changes in contract/fiscal terms; asset expropriation; royalties; taxes; exchange rates; interest rates; and environment and weather concerns. The key near-term risks specific to Canacol are:

• A significant portion of our valuation is based on exploration potential.
• Higher-than-average security risk, in particular in the Caguan Basin.
• Higher-than-average geo-political risk.