Upstream Exploration: Cash Flow Explodes (OTCMKTS: CDDRF)


Imaginima/E+ via Getty Images

Headwater Exploration (OTCPK: CDDRF) (HWX: TSX) has picked the right time to develop a profitable heavy oil discovery. Additionally, management has kept the balance sheet debt-free to minimize any potential concerns during an industry downturn. But until that downturn occurs, there is very profitable oil to be produced and management is determined to produce as much as possible.

(Canadian dollars unless otherwise specified)

Summary of key operating ratios

Financial and operational highlights

Headwater Exploration, Third Quarter 2020, Earnings Press Release

This major project startup is doing much better than average as profits turned positive before there was a full year of significant production from the main project. Backing up the income statement is a very pink adjusted cash flow amount. The latest cash flow exceeded the annual rate of 100 million Canadian dollars.

This success of the project so far has prompted management to increase the capital budget to keep 2 rigs in operation during the important winter months (before the Canadian spring break-up imposes downtime) .

There has been talk of a surplus of oil production from the first quarter of 2022, which would cause inventories to build up. This could certainly happen if supply grew faster than demand. Again, the current recovery was completely underestimated from the start. This underestimation has resulted in bottlenecks and supply shortages that will eventually be resolved.

In the meantime, the current price environment is very favorable for the further development of this heavy oil deposit. Even if OPEC and EIA are correct on long-term pricing, forecasts will still allow for a comfortable profit margin. The market is obviously going to be very wary of any predicted “soft landing” for prices after the last decade. So, investors will have to decide for themselves whether betting on this soft landing or something better is worth the risk.

A description of possible positive outcomes

First exploration success

Headwater Exploration January 2022, Corporate Presentation

One of the things the market is probably not pricing in the current future is the company’s ability to potentially expand more square footage. Most of the company’s forecasts have only used production from the central area for future forecasts. So there is no growth after a few years as this core area matures.

On the other hand, the company has a lot of area to develop for probably decades to come. As technology advances, mature areas are regularly revitalized with new drilling and well completion techniques. Secondary recovery also tends to improve over time. So the chances of the company running out of opportunities (at least in my lifetime) are probably slim to none. Nonetheless, Mr. Market, as usual, only looks at the company’s current forecast. So there is a lot of upside potential which is very reasonable without a lot of risk as many neighbors reduce the risk of additional acreage.

Now, it’s true that one of the exploration wells ran into easy-to-fix technical issues (as the oil was actually above what management thought it should be). But sometimes the market seems to focus on results without the reason for those results. This type of decision-making will enable a change in value in the stock price when the results match management’s expectations.

In the meantime, the payment indicated above allows very easy hedging to ensure a satisfactory minimum return. The debt-free balance sheet will allow management to halt production (and possibly live off the value of the hedges at this point) until the market bottoms out and begins a recovery. Recent industry cycles have been rapid because unconventional businesses can adapt quickly to changing market selling prices. This rapid adjustment is expected to continue well into the future.

In addition, management has planned an oil processing plant that will connect to an oil pipeline and will allow a significant drop in transportation costs. The projected C$4/barrel drop in transportation costs will significantly increase cash flow. Management now has a joint venture gas processing facility which will also reduce long-term costs (as well as carbon dioxide emissions).

This management manages the rapid growth of the company very well. This progress reflects the experience of a team whose members have built and sold businesses before this one. This greatly reduces the risk of the current situation.

The working capital balance of approximately C$64 million provides considerable protection against a decline in the current share price, as does the debt-free balance sheet. This management relies on operating leverage to deliver superior results to shareholders. So far, this strategy seems to be working extremely well.

Projection of the future for the central area

Development prospects for the core of the capital

Headwater Exploration January 2022, Corporate Presentation

What is not yet on investors’ radar is the ability of some of the unexplored acreage to materially increase the production projection shown above. So far, this projection is based on a small area. But the “Exploration” results show possibilities of adding materials to the production shown above.

Now it is very likely that the best area was developed first. But there’s no reason in the world that the rest of that acreage shouldn’t produce satisfactory yields. It won’t take much more viable acreage to bring production to 50,000 BOED. Indeed, at current market prices, the cash flow would be there to develop the other areas fairly quickly because the return on investment remains less than one year. This allows very fast cash generation with which to expand production.

This company has a relatively low production compared to the potential of the area. The quality of neighboring operators suggests that there are many more areas to be developed. Additionally, everyone in the region is looking at other intervals of this stacked game for future business development. So there are a lot of probable and possible future developments.


This stock has been on a sharp rise since the current management took over from the previous management. But there seems to be a lot more potential in the future. The acreage holdings of promising acreage are quite large for a company of this size. The success of a few exploration wells seems to promise much more growth for fiscal 2022 than management currently expects.

In any case, a large part of the area indicated above is “in play”. Unconventional business is far more predictable than conventional business has ever been. As a result, dry exploration wells are rare because the presence of oil can be largely determined in advance. Instead, much of the time is spent optimizing oil production for maximum profits.

In terms of the upside and risk of the business, this company has found a relatively predictable goldmine that will be subject to industry pricing and selling conditions. The balance sheet will make it easy for that business to know if the industry is slowing down while maximizing cash flow during better times. Investors could do much worse than this company.


About Author

Comments are closed.