Gear Energy Ltd. announces first quarter 2020 operating results

MESSAGE TO SHAREHOLDERS

In January 2020, the West Texas Intermediate (“WTI”) benchmark index peaked at US$65 per barrel. Not long after, the COVID-19 pandemic began which impacted the global economy and significantly reduced world oil consumption. In addition, an oil price war erupted between Russia and Saudi Arabia who both began to flood the market with additional oil supply. As a result, oil prices plummeted by over US$100 with WTI hitting a low of negative US$37 per barrel in April. Since then, WTI prices have recovered somewhat to current levels around US$23 per barrel. With this modest recovery, the industry and investors appear to be cautiously optimistic that perhaps the worst is behind us. The response from the oil industry has been significant; Canadian and US drilling rig counts are now down by approximately 80 and 60 per cent from 2018 levels respectively and OPEC+ have concluded their price war with a commitment to cut approximately 8 million barrels per day of production through the second half of 2020. In addition to the supply responses, there have been some early encouraging signs on the demand front as well. For the first time since March, total US product supply (a key indicator of demand) has posted a positive change, global inventories appear to be peaking, and the media is full of headlines regarding a proposed global shift out of the current economic lock-downs. The recent data is certainly more encouraging than it has been for the last seven weeks.

The scale of recent volatility is certainly unprecedented. However, volatility in general is not something that is new to the industry. Just over a year ago the Canadian energy industry experienced a material shock to pricing with differentials being devastated by a localized supply-demand imbalance. During the fourth quarter of 2018, WCS heavy oil prices dropped to $19 per barrel and MSW light oil prices hit a low of $32.50 per barrel. Fortunately, through a combination of supply responses and increased demand, prices had essentially fully recovered by the second quarter of 2019 with those two benchmark prices increasing by 154 and 70 per cent, respectively. Over the same time period, Gear’s reported funds from operations increased by over 700 per cent from $2.1 million in the fourth quarter of 2018 to $17.1 million in the second quarter of 2019. History tells us that it is very difficult to predict the scale and timing of any potential price recovery. However, it is encouraging that eventually it has always recovered in the past.

As a result of the current weakness and uncertainty in the price of oil, starting in April Gear chose to shut-in the majority of its production and immediately pursue reductions to the variable costs of the business in an effort to maximize funds from operations. Protection of the corporate balance sheet remains the top priority. All capital investments were halted in early March 2020. In addition, Gear implemented a 20 per cent reduction in the salaries of all permanent employees and in the directors’ fees for its non-management directors, as well as an immediate and aggressive production storage and shut-in program. With approximately two-thirds of field operating costs being classified as variable, the current low commodity prices do not financially support production. By limiting field operations, Gear intends to eliminate the variable costs in order to maximize the impact of the forecasted gains on risk management contracts and the resulting funds from operations. Once certain price thresholds are met, production is expected to be restarted with minimal cost. Gear has regulated production levels before in times of low commodity price environments with negligible impact to its oil reservoirs.

QUARTERLY HIGHLIGHTS

• Funds from operations for the first quarter of 2020 was $6.3 million, a decrease of 54 per cent from the fourth quarter of 2019 as a result of significantly lower commodity prices. Realized prices fell from $47.97 per barrel in the fourth quarter to $31.24 per barrel in the first quarter.
• Realized hedging gains of $2.8 million or 45 per cent of the funds from operations. For the remainder of 2020, Gear has hedged 3,200 barrels per day using various swaps, collars, and three-way collar structures.
• Drilled nine successful gross (9 net) wells including; seven heavy oil wells consisting of four single lateral wells in Paradise Hill, two multi-lateral wells in Lindbergh, and one single leg lined well in Frenchman’s Butte, all in the Lloydminster area of Alberta; and two medium oil wells consisting of one multi-stage fractured well in Killam and one multi-lateral well in Provost, all in the east central area of Alberta. Two of the Paradise Hill wells remain uncompleted until oil prices recover.
• The new Sparky oil well in Provost is Gear’s first well into this medium oil area. The Provost well has produced at an average rate of approximately 150 barrels per day for the first 30 days of production, well above expectations. Wells in this area are typically drilled as multi-stage fractured wells whereas Gear’s well was successfully drilled as an unlined multi-lateral horizontal well at a much lower capital cost. Gear has accumulated a total of 8 sections of land in this area and intends to pursue follow-up drilling as soon as prices recover.
• Net loss of $110.2 million primarily as a result of non-cash impairment of $93.9 million on property, plant and equipment due to a material drop in commodity prices and the de-recognition of Gear’s $23.3 million deferred tax asset.
• Actual bank debt increased by $2.4 million from December 31, 2019 with Gear drawn $66.6 million on its $90.0 million credit facilities. Net debt increased by $10.5 million primarily as a result of capital and abandonment expenditures exceeding funds from operations for the quarter by $5.5 million and a non-cash impairment of oil inventory of $4.3 million as a result of the drop in oil price. First quarter net debt to quarterly annualized funds from operations was 3.2 times.
• The next semi-annual borrowing base review of Gear’s credit facilities is slated to be complete on or about May 31, 2020 with the current maturity date of the credit facilities on May 28, 2021. These credit facilities carry a single financial covenant. As at March 31, 2020, Gear was in compliance with this covenant.
• On April 17, 2020 the Government of Canada, through Export Development Canada and Business Development Bank of Canada, announced that it will make available financial liquidity support to Canada’s oil and gas sector in order to help companies ensure a degree of continuity of operations during this period of uncertainty. Eligible companies must have been financially viable prior to COVID-19. The programs also include other stipulations and restrictions. Gear is continuing to explore whether it will be eligible for the programs through active discussions with its lenders.