Nov 09, 2008  Wow, thanks for your helpful post, it just clears it all. I have already read every title of this forum (engineering software) and none gives reference to this software, plus I have (before posting) searched (using that awesome facility for lazy people like me) using the keywords STARS and CMG (separately) having no results each.

Reservoir simulation is an area of reservoir engineering in which computer models are used to predict the flow of fluids (typically, oil, water, and gas) through porous media.

Under the model in the broad scientific sense of the word, they understand a real or mentally created structure that reproduces or reflects the object being studied. The name of the model comes from the Latin word modulus, which means “measure, pattern”. Modeling is one of the main methods of knowledge of nature and society. It is widely used in technology and is an important step in the implementation of scientific and technological progress.

The creation of models of oil fields and the implementation of calculations of field development on their basis is one of the main areas of activity of engineers and oil researchers.

On the basis of geological and physical information about the properties of an oil, gas or gas condensate field, consideration of the capabilities of the systems and technologies for its development create quantitative ideas about the development of the field as a whole. A system of interrelated quantitative ideas about the development of a field is a model of its development, which consists of a reservoir model and a model of a field development process.

The investment project is a system of quantitative ideas about its geological and physical properties, used in the calculations of field development. The field of deposits and deposits is a system of quantitative ideas about the process of extracting oil and gas from the subsoil. Generally speaking, any combination of reservoir models and development process can be used in an oil field development model, as long as this combination most accurately reflects reservoir properties and processes. At the same time, the choice of a particular reservoir model may entail taking into account any additional features of the process model and vice versa.

Cmg Computer Modeling Group

The reservoir model should, of course, be distinguished from its design scheme, which takes into account only the geometric shape of the reservoir. For example, a reservoir model may be a stratified heterogeneous reservoir. In the design scheme, the reservoir with the same model of it can be represented as a reservoir of a circular shape, a rectilinear reservoir, etc.

Layer models and processes for extracting oil and gas from them are always clothed in a mathematical form, i.e. characterized by certain mathematical relationships.

The main task of the engineer engaged in the calculation of the development of an oil field is to draw up a calculation model based on individual concepts derived from a geological-geophysical study of the field, as well as hydrodynamic studies of wells.

Modern computer and computational achievements make it possible to take into account the properties of the layers and the processes occurring in them when calculating the development of deposits with considerable detail.

The possibilities of geological, geophysical and hydrodynamic cognition of development objects are continuously expanding. Yet these possibilities are far from endless. Therefore, there is always a need to build and use such a field development model in which the degree of knowledge of the object and the design requirements would be adequate

Fundamentals[edit]

Traditional finite difference simulators dominate both theoretical and practical work in reservoir simulation. Conventional FD simulation is underpinned by three physical concepts: conservation of mass, isothermal fluid phase behavior, and the Darcy approximation of fluid flow through porous media. Thermal simulators (most commonly used for heavy crude oil applications) add conservation of energy to this list, allowing temperatures to change within the reservoir.

Numerical techniques and approaches that are common in modern simulators:

• Most modern FD simulation programs allow for construction of 3-D representations for use in either full-field or single-well models. 2-D approximations are also used in various conceptual models, such as cross-sections and 2-D radial grid models.
• Theoretically, finite difference models permit discretization of the reservoir using both structured and more complex unstructured grids to accurately represent the geometry of the reservoir. Local grid refinements (a finer grid embedded inside of a coarse grid) are also a feature provided by many simulators to more accurately represent the near wellbore multi-phase flow effects. This 'refined meshing' near wellbores is extremely important when analyzing issues such as water and gas coning in reservoirs. Other types of simulators include finite element and streamline.
• Representation of faults and their transmissibilities are advanced features provided in many simulators. In these models, inter-cell flow transmissibilities must be computed for non-adjacent layers outside of conventional neighbor-to-neighbor connections.
• Natural fracture simulation (known as dual-porosity and dual-permeability) is an advanced feature which model hydrocarbons in tight matrix blocks. Flow occurs from the tight matrix blocks to the more permeable fracture networks that surround the blocks, and to the wells.
• A black-oil simulator does not consider changes in composition of the hydrocarbons as the field is produced, beyond the solution or evolution of dissolved gas in oil, or vaporisation or dropout of condensate from gas.
• A compositional reservoir simulator calculates the PVT properties of oil and gas phases once they have been fitted to an equation of state (EOS), as a mixture of components. The simulator then uses the fitted EOS equation to dynamically track the movement of both phases and components in field. This is accomplished at increased cost in setup time, compute time, and computer memory.

Cmgl

The simulation model computes the saturation change of three phases (oil, water and gas)and pressure of each phase in each cell at each time step. As a result of declining pressure as in a reservoir depletion study, gas will be liberated from the oil. If pressures increase as a result of water or gas injection, the gas is re-dissolved into the oil phase.

A simulation project of a developed field, usually requires 'history matching' where historical field production and pressures are compared to calculated values.It was realised at an early stage that this was essentially an optimisation process, corresponding to Maximum Likelihood. As such, it can be automated, and there are multiple commercial and software packages designed to accomplish just that. The model's parameters are adjusted until a reasonable match is achieved on a field basis and usually for all wells. Commonly, producing water cuts or water-oil ratios and gas-oil ratios are matched.

Other engineering approaches[edit]

Without FD models, recovery estimates and oil rates can also be calculated using numerous analytical techniques which include material balance equations (including Havlena–Odeh and Tarner method), fractional flow curve methods (such as the Buckley–Leverett one-dimensional displacement method, the Deitz method for inclined structures, or coning models), and sweep efficiency estimation techniques for water floods and decline curve analysis. These methods were developed and used prior to traditional or 'conventional' simulations tools as computationally inexpensive models based on simple homogeneous reservoir description. Analytical methods generally cannot capture all the details of the given reservoir or process, but are typically numerically fast and at times, sufficiently reliable. In modern reservoir engineering, they are generally used as screening or preliminary evaluation tools. Analytical methods are especially suitable for potential assets evaluation when the data are limited and the time is critical, or for broad studies as a pre-screening tool if a large number of processes and / or technologies are to be evaluated. The analytical methods are often developed and promoted in the academia or in-house, however commercial packages also exist.

Software[edit]

Many programs are available for reservoir simulation. The most well known (in alphabetical order) are:

Open source:

• BOAST – Black Oil Applied Simulation Tool (Boast) simulator is a free software package for reservoir simulation available from the U.S. Department of Energy.^[1] Boast is an IMPES numerical simulator (finite-difference implicit pressure-explicit saturation) which finds the pressure distribution for a given time step first then calculates the saturation distribution for the same time step isothermal. The last release was in 1986 but it remains as a good simulator for educational purposes.
• MRST – The MATLAB Reservoir Simulation Toolbox (MRST) is developed by SINTEF Applied Mathematics as a MATLAB® toolbox. The toolbox consists of two main parts: a core offering basic functionality and single and two-phase solvers, and a set of add-on modules offering more advanced models, viewers and solvers. MRST is mainly intended as a toolbox for rapid prototyping and demonstration of new simulation methods and modeling concepts on unstructured grids. Despite this, many of the tools are quite efficient and can be applied to surprisingly large and complex models.^[2]
• OPM – The Open Porous Media (OPM) initiative provides a set of open-source tools centered on the simulation of flow and transport of fluids in porous media.^[3]

Commercial:

• Schlumberger INTERSECT^[4]
• Schlumberger ECLIPSE – Originally developed by ECL (Exploration Consultants Limited) and currently owned, developed, marketed and maintained by SIS (formerly known as GeoQuest), a division of Schlumberger. The name ECLIPSE originally was an acronym for 'ECL´s Implicit Program for Simulation Engineering'. Simulators include black oil, compositional, thermal finite-volume, and streamline simulation. Add-on options include local grid refinements, coalbed methane, gas field operations, advanced wells, reservoir coupling, and surface networks.^[5]
• ECHELON, by Stone Ridge Technology: a fully implicit simulator, the only full GPU accelerated reservoir simulator for black-oil formulations.^[6]
• ESTD Co. RETINA Simulation – RETINA Simulation is a Black-Oil and Compositional reservoir simulation software fully developed in Engineering Support and Technology Development Company (ESTD). ^[7]
• CMG Suite (IMEX, GEM and STARS) – Computer Modelling Group currently offers three simulators: a black oil simulator, called IMEX, a compositional / unconventional simulator called GEM and a thermal and advanced processes simulator called STARS.^[8]
• Sensor, by Coats Engineering, is a black oil and compositional reservoir simulator developed beginning in the 1990s by Dr. Keith H. Coats, founder of the commercial reservoir simulation industry (Intercomp Resource and Development, 1968). Sensor is the last of many reservoir simulators developed by Dr. Coats.
• XXSim is an EOS based general purpose compositional reservoir simulator with fully implicit formulation. It allows any components to appear and stay in any fluid phases (aqueous, oilec and vapour ).It can be simplified to the conventional or traditional black oil, compositional and thermal modules. It also can be expanded to fully EOS based thermal simulator.^[9]
• Tempest MORE is a reservoir simulator offering black oil, compositional and thermal options.^[10]
• ExcSim, a fully implicit 3-phase 2D modified black oil reservoir simulator for the Microsoft Excel platform ^[11]
• Landmark Nexus – Nexus is an oil and gas reservoir simulator originally developed as 'Falcon' by Amoco, Los Alamos National Laboratory and Cray Research. It is currently owned, developed, marketed and maintained by Landmark Graphics, a product service line of Halliburton. Nexus will gradually replace VIP, or Desktop VIP, Landmark's earlier generation of simulator.^{[citation needed]}
• Rock Flow Dynamics tNavigator supports black oil, compositional and thermal compositional simulations for workstations and High Performance Computing clusters ^[12]
• Plano Research Corporation FlowSim is a fully implicit 3-phase, 3-D, black oil and compositional finite difference reservoir simulator with LGRs, dual porosity dual permeability, and parallel capabilities.^[13]
• GrailQuest's ReservoirGrail employs a patented approach called Time Dynamic Volumetric Balancing ^[14] to simulate reservoirs during primary and secondary recovery.^[15]
• Gemini Solutions Merlin is a fully implicit 3-Phase finite difference reservoir simulator originally developed at the Texaco research department and currently used by the Bureau of Ocean Energy Management and Bureau of Safety and Environmental Enforcement to calculate Worst Case Discharge rates and burst/collapse pressures on casing shoes and blowout preventers.^[16][17]
• Under Palm Trees' DeepSim is a fully implicit, 3-phase, compositional finite difference reservoir simulator for the Android phone and tablet platform. ^[18][19]
• TTA/PetroStudies offers a full-fledged black oil simulator, Exodus, with assisted history matching module (Revelations) that can vary porosity/permeability/structure/netpay/initial pressure/saturations/contact depths to match wells' observed rates/cumulatives/pressures.^[20] Revelations runs multiple cases on shared network computers. Exotherm offers thermal simulation of SAGD, CSS with discretized wellbore flow up to surface.

Application[edit]

Reservoir simulation is ultimately used for forecasting future oil production, decision making, and reservoir management. The state of the art framework for reservoir management is closed-loop field development (CLFD) optimization which utilizes reservoir simulation (together with geostatistics, data assimilation, and selection of representative models) for optimal reservoir operations.

See also[edit]

References[edit]

• Aziz, K. and Settari, A., Petroleum Reservoir Simulation, 1979, Applied Science Publishers.
• Ertekin, T, Abou-Kassem, J.H. and G.R. King, Basic Applied Reservoir Simulation, SPE Textbook Vol 10, 2001.
• Fanchi, J., Principles of Applied Reservoir Simulation, 3rd Edition, Elsevier GPP, 2006.
• Mattax, C.C. and Dalton, R. L, Reservoir Simulation, SPE Monograph Volume 13, 1990.
• Holstein, E. (Editor), Petroleum Engineering Handbook, Volume V(b), Chapt 17, Reservoir Engineering, 2007.
• Warner, H. (Editor), Petroleum Engineering Handbook, Volume VI, Chapter 6, Coalbed Methane, 2007.
• Carlson, M., Practical Reservoir Simulation, 2006, PennWell Corporation.
• R. E. Ewing, The Mathematics of Reservoir Simulation

Other references

1. ^'Department of Energy'. Retrieved 3 March 2014.
2. ^'MRST Homepage'. Retrieved 3 March 2014.
3. ^'Open Porous Media Initiative'. Retrieved 3 March 2014.
4. ^'INTERSECT Homepage'.
5. ^'ECLIPSE Homepage'.
6. ^http://stoneridgetechnology.com/echelon/
7. ^'RETINA Homepage'.
8. ^'CMG Homepage'. Retrieved 28 October 2016.
9. ^'XXSim Homepage'.
10. ^'CMG Homepage'. Retrieved 3 March 2014.
11. ^'ExcSim'. Retrieved 24 April 2015.
12. ^'RFD Homepage'. Retrieved 7 March 2014.
13. ^'FlowSim'.
14. ^'ReservoirGrail Software Page'. Retrieved 13 January 2016.
15. ^'ReservoirGrail Homepage'. Retrieved 13 January 2016.
16. ^'Appendix E – Reservoir Modeling Team 2010; Reservoir Modeling Report'(PDF). Retrieved 19 April 2016.
17. ^'BSEE Procurement Business Opportunities'(PDF). Retrieved 19 April 2016.
18. ^'DeepSim - Android Apps on Google Play'. play.google.com. Retrieved 2017-08-13.
19. ^'DeepSim – Powerful reservoir simulation with an intuitive interface'. deepsim.stupendous.org. Retrieved 2017-08-13.
20. ^'PetroStudies Consultants Inc. – Index page'. www.petrostudies.com. Retrieved 2017-09-27.

External links[edit]

• * Software for reservoir simulation

Computer Modelling Group (OTC:CMDXF) is a software company based in Calgary, Canada. The company has one primary product, which is the CMG Simulation Suite. This software is used to model oil and gas reservoirs deep underground to determine the most effective way of developing them. The software is highly complex and deeply technical, requiring domain expertise in mathematics, physics, reservoir engineering and computer science, which provides a barrier to entry. It is also highly mission critical to oil and gas producers, which means it is one of the last things they will cut from their budgets, because even though the software is expensive, it is cheaper than doing a suboptimal job developing your reservoir. Finally, I would note that the company trades in Canadian dollars and all values in this report are in that currency unless otherwise noted. For USD denominated investors, the recent improvement in the CAD should make some of their revenue streams more valuable going forward. The company also trades on the Toronto Stock Exchange under the symbol CMG.

Competitive Characteristics

While I write about all sorts of companies (focusing on undervalued Microcaps) this product is one that I have a somewhat deeper level of understanding. Prior to becoming a full-time investor and financial analyst, I analyzed projects at an oil and gas company as a reservoir engineer. During that time, I became proficient in using the CMG software suite, so I have a customer perspective as well.

Reservoir simulation software is very complicated. Essentially, the software is solving an equation of state (I believe they use a modified Peng-Robinson) which is just an equation to determine the temperature and pressure at any given point. They do this by numerically solving linear equations. But since the size of an oil or gas reservoir can be large, and the properties vary across the reservoir, you have to solve it using a very big matrix with lots of points. So their numerical solver is also very complicated. I asked them once (as a customer, not an investor) to explain it, and they said it was proprietary, never published even academically. As an example, I considered applying for a role at CMG a few years ago supporting this software, and one of the jobs they had was for a member of the software development team. The minimum requirements were dual PhDs in computer science plus either math or physics.

This isn't something that a pair of bro-grammers with some Snapchat (SNAP) stock option money are going to be able to dislodge. I believe these barriers to entry are likely to result in strong results going forward. Nonetheless, they do have competition, in two ways.

The biggest name in the market is Schlumberger (SLB), which sells a rival reservoir simulator called Eclipse. However, Schlumberger is potentially a less focused rival, as they are a huge company and sell mostly oilfield services as opposed to software. I believe this leaves room for CMG to potentially convert some of their customers over time, as they are 100% focused on the simulation market. CMG is widely regarded in the industry to have a superior product for unconventional reservoirs, especially thermal projects and chemical EOR, while Schlumberger's product is dominant in more conventional black oil fields, which includes most large offshore plays. Unconventional plays are where the industry is going, and because they are more complex they are also generally more simulation intensive. Thus, there are industry tailwinds, as demand is moving towards their areas of speciality. This quote from a reservoir engineer in the field is a great case in point.

Source: Simulation Industry Study

I picked this quote because I think it is balanced. Both sets of software have places where they would be the better choice. I just happen to think that CMGs advantages are in a segment that is growing, which puts them in a position to take market share.

As far as I know, there are no official market share studies, but this is list from a company that supplies post-processing services of the most popular simulators they support.

Source: Kraken Post Processing

CMG might never overtake Schlumberger as the number one simulation company in the industry, but they do have advantages, as seen in the conclusion slide from the previous study. I believe their cost and niche advantages should allow them to continue grow earnings coming out of the oil price downturn.

Source: Simulation Industry Study

The second competitor to the CMG Suite is internal software developed in-house at oil companies. This is relatively common among very large oil companies (you can see some in the list above), as in house software that is better than commercial packages has the potential to become a significant competitive advantage, as well as removing the expense of licence fees. However, I believe the market is turning away from in-house software for a couple of reasons. The first is that the engineers employed at oil companies tend to be Reservoir/Mechanical/Chemical types, and there isn't a depth of software skill there. Plus, developing software takes your best reservoir engineers away from working on reservoirs and puts them in a development role, which isn't a core competency. While licences for CMG and Eclipse are very expensive, developing in-house software is inevitably more expensive, and comes with costs in adjacent areas (training, support, etc.) that can otherwise be included in a licencing package for commercial software, and shared industry wide. In a soft oil price environment, a duplicative internal software package is a potentially attractive source of savings.

Sharing the cost of developing advanced software across the industry makes sense, and even the super-majors that have historically done it themselves are moving towards shared development (see the section on Shell below). The logical way for the majors to do that is to convert their engineers from in house software to commercial packages. This, combined with significant growth on the independent side of the industry, where the extreme cost of developing new high-end software isn't likely to fly, means that the market for commercial reservoir simulation software is likely to grow faster than oil and gas capital spending as a whole, as some spending that was previously simulated in-house moves to commercial packages. The cost and complexity advantage to commercial software over in-house software packages functions as a barrier to entry from oil and gas companies insourcing the simulation function.

Given that they have what I believe are competitive advantages against all of their major competition, I believe they will continue to expand their market share in the coming years. In the last few years, revenue has been declining, but I don't believe that is symptomatic of a loss in market share, rather I believe it is a macro factor, in that the market for essentially all oil and gas suppliers has been shrinking.

Macro Environment

That being said, I don't believe CMG's revenues are under significant additional threat from the oil and gas price downturn, as much of their non-recurring revenue has already melted away.

The company has three revenue sources: Annuity/Maintenance Licences, Perpetual Licences, and Professional Services. Perpetual licences are one time fees paid for the use of a specific version of the software. Companies with perpetual licences have the option (which most take) of paying an additional maintenance fee that includes access to new upgrades as they come out.

Annuity customers don't pay anything upfront, but do pay a yearly fee for use of the software (subscription basis). The annuity and maintenance payments are both recurring type revenue, and they make up the vast majority of the revenue, 87% in the most recent quarter.

These revenue sources are more sticky than one-off licence sales for a few reasons. The first is they are ongoing contracts, so they benefit from inertia. To sell a new perpetual license, someone has to choose to buy it. To continue selling their recurring revenue, all that has to happen is nobody decides to cancel an existing commitment. Plus, if anyone considers cancelling a maintenance contract, there are strong sunk cost arguments against it, as the high up-front payments were already made, so keeping the latest version at a lessor cost is relatively economic.

Given the depth of the downturn, it seems reasonable to assume that most producers who were going to cancel their recurring payments have done so, as most have been through multiple layers of cost cuts. This logic also applies to loss of licenses through staff reductions, as it is likely that most staff reductions have happened by this point.

The oil price situation has deeply hurt the sales of perpetual licenses. Sales are down well over 50%, with $5.5M of perpetual licences sold in the trailing twelve-month [TTM] period, from a peak of $13.4M in their fiscal year that ended in 2015. These sales are actually starting to recover, with the most recent quarter approximately double the same quarter a year ago. Thus, green shoots are starting to appear in the perpetual licence business, and it is the most exposed to oil prices, so it seems to me that the macro situation is looking up, even at current oil prices. If oil prices improved, the company could see significant extra revenue with immaterial additional costs.

The chart below shows the companies three revenue streams. As you can see, the annuity/maintenance line has been very stable throughout the downturn, while perpetual sales declined. Those sales are starting to come back, which provides the potential for upside to the earnings.

Source: Author Created from Public Data

Investments for the Future

The company is in a complicated business, and they continue to spend money on research and development to improve their products. They expense this money as they spend it as opposed to capitalising it. This is the more conservative treatment, because it penalises current earnings for research that will provide long term benefits.

For example, the company has an agreement with Shell (NYSE:RDS.A) (NYSE:RDS.B) to develop a new reservoir simulator. Shell is paying roughly half the development costs, and will get free perpetual licenses, while CMG pays the other half and can market the product to others. The company has estimated $8.3M of costs related to this simulator in fiscal 2018 along with $4.0M in reimbursements from Shell. This is pretty clearly an investment for the future, as they aren't actually selling the software yet, its still in development. This provides the company two optionality paths: they have a new product to sell when development is finished, or if the oil and gas industry doesn't recover, you can eventually expect an earnings improvement of $4.3M per year when the project is cancelled. For a company with TTM earnings of $22.4M, that is a potentially significant uplift. Presumably management believes the new product is worth the investment (and their record is pretty good on those decisions) so once it reaches maturity there could be a significant sales uplift as well.

It is worth noting that Shell is willing to pay half of the costs of the simulator, and will not share in the revenues from any of the customers. Plus, this product is incremental to their existing product portfolio, as it integrating production and geomechanical engineering disciplines, which is a separate set of workflows than their existing simulation portfolio. This will make their product portfolio more complete, as geomechanical simulation was in my opinion their biggest weakness. The completion of this project should allow them to take even more market share over time.

Valuation

That $22.4M of annual earnings is an exceptionally valuable stream of income, in my opinion. It includes essentially all the capital spending necessary to run the business (and they just finished a new headquarters, so I would expect capex to drop even further) and includes significant investments into the future. I am not going to adjust it for depreciation, because I believe much of their depreciation is economic (they have significant investments in computers, for example). I will adjust that for the amount I believe they are spending on true growth capex into new products, which I mentioned above I think is at least $4.3M per year. Thus, I will use adjusted earnings of $26.7M. I will of course discuss the risks to these earnings below, but I believe growth is more likely than a decline in earnings.

According to the Stern School of Business, the average trailing P/E for application software companies is 133 times earnings. I would have to turn in my value investor card if I valued anything at that multiple, but I do believe this is an exceptional business deserving of an above market multiple. With the S&P at roughly 25X earnings, I think 30X earnings is an appropriate metric here.

There is a precedent for high multiple businesses in this sector, especially those that are information services businesses. Core Laboratories (CLB), for example, is in an adjacent business, providing analysis services, and trades for over 50X earnings. Of course, CLB has 11% net income margins, and a 47% return on equity as well as a 13% return on assets, so financially it is still a very strong business, even during an oil downturn. Then again, CMG has 32% net income margins, 23% return on assets, and a 37% return on equity. Those figures are at least comparable, so even discounting CMG for size supports my supposition that a 30X multiple is reasonable, and doesn't require comparing the company to any of its high-margin enterprise software peers.

That values the business at $801M. This business is of exceptional quality, it is capital light with sticky revenues and a number of market competitive advantages, and will see significant growth if oil prices come back. The company also has $67M of cash and no debt. Adding that to the earnings value provides a sum of the parts valuation of $868M, which suggests a value of $10.90 CAD per share, or 15% in excess of their current $9.50 CAD stock price.

It is also worth noting that software companies are often valued on a price-to-sales basis, because many of them either lose money or make very little as they invest in growth. Stern data has a 4.2X P/S ratio for enterprise software businesses, whereas CMG trades at a P/S ratio of 10X, materially in excess of the sector average. Of course, ultimately sales are only valuable if they convert into earnings, and CMG's net margins are much, much better than the average of the companies that in the industry. Stern's software (system and application) segment has 11% net margins, and CMG has margins nearly three times as high at 32%. Essentially, I believe that CMG's sales are much more valuable than most of the other companies in the industry, for both qualitative and quantitative reasons. Quantitatively, CMG has been around for decades and earns great margins. Qualitatively, the company has sticky recurring revenue, and has a high quality product. It is also expanding its addressable market by investing into new products for new markets, and those investments are running through the income statement, so its margins are actually depressed from what they could be.

Given all that, I think a better-than-S&P but less than sector earnings multiple is a reasonable way to value it, which brings me to that $10.90 CAD price target. I also think there are a number of opportunities for this to appreciate well beyond that price, as there are a few potential catalysts here.

Catalysts

There are a few potential catalysts here, the biggest one of which is a potential takeover. Happily for investors, there are a number of potential buyers for CMG, making a takeover a credible catalyst. The company could be purchased by a large oil and gas service company for perceived synergy effects. Schlumberger made an acquisition to get the Eclipse software package, and one of their major competitors such as Halliburton (HAL) or Baker Hughes (NYSE:BHGE) could be potential suitors. Both are so large that CMG would be merely a tuck-in. It would also give them an opportunity to change the defaults in the software to their own completion equipment and service styles, which could potentially add market share for their other businesses. Halliburton already owns what I believe is the third place reservoir simulator, so CMG would allow them to consolidate to a strong second and compete with Schlumberger. Baker doesn't really compete in that business, so it would be a chance for them to broaden their offering.

There are also other potential strategic acquirers. Core Laboratories is in an adjacent business, and would have significant sales synergies. It also has highly valued stock (trailing P/E 50+) so a stock acquisition at a premium would be accretive for them.

There are also potential acquirers on the software side. As an example, Constellation Software (OTCPK:CNSWF) is a roll-up of software companies also based in Canada, also trading at a 50+ P/E. CMG would be more expensive than their average acquisition, but also would have better long term prospects.

Finally, there is also a possibility of a private firm. Private equity firms have been known to buy software companies with high switching costs, because they can significantly increase profits in the short term. As an example, Bain purchased MYOB (an Australian accounting software firm) and has been steadily raising prices ever since. A short term playbook would be potentially attractive at CMG, because they spend significantly on R&D which is expensed, and their customers are sticky. Thus, a more mercenary management could cut expenses and grow the top line (at 100% contribution) with price increases. While I suspect a strategic buyer would likely pay more than private equity, having them as a potential bidder is a benefit.

Competitive Advantages for Growth

CMG has a competitive advantage because of its history that I believe is not widely known. The company was born out of academic research conducted at the University of Calgary (and their new headquarters is at the U of C research park). When the company went public in the late 1990s, the majority of the stock was reserved for an entity called the Foundation CMG. If they still held it, that would be worth over $350M, although my understanding is they have sold the stock and built a diversified endowment, which probably means the balance is less, as CMG stock has performed very well. The mission of the foundation is to 'Promote and Fund University Research in Oil and Gas Reservoir Simulation with Industry Collaboration and Technology Transfer.' They are granting over $5M per year towards this goal, and are getting approximately $25M in matching funds from industry and government sources.

Now, imagine you are a professor who is receiving $1M per year in research support from Foundation CMG. Which reservoir simulator are you likely to use in your research, and recommend to your students? (Who are of course the next generation of reservoir engineers). I would suggest the ~900 graduate students who have received funding from the Foundation are likely to also be positively predisposed to the companies software. They are likely to be familiar with it, and have a positive outlook on the company. Now, not all or even most of these people will end up as decision makers at oil companies buying reservoir simulation software. But almost certainly some of them will, and the foundation has been ramping up its own grants and the matching funds it attracts in recent years, so I expect this factor to grow dramatically in the future. There are two factors there, the previous students are more likely to be in positions of power as time goes on, and the higher budget influences more people.

Source: FoundationCMG.com

Business Catalyst

I mentioned earlier that the software works by solving a very large set of equations over and over again. That is significant from a catalyst point of view because of how the company sells licences. Each (costly) licence allows for running one instance of the companies software on one processor. However, because of the size of the equations it can take hours and hours to run a 3D model of a large field or to model a large number of years. With parallel processing, the software is able to split the set of equation in half (non technical explanation, but that's the effect) and one processor works on each half. The result isn't twice as fast modelling time, but it's close. A user can also use more than two processors for even faster run times. This is an important feature, because often time is money, and that is especially true given the iterative nature of reservoir modelling, where an engineer might try 50 or more scenarios to see which set of operating parameters and we'll placements generates the highest NPV from a given reservoir. It is also important because a company needs a license for every processor operating the software, not for every engineer. So a model running 4 processors requires the customer to have four cmg licences, even though the model may be run by only person.

That is a potential catalyst for additional licences, because it doesn't require employment growth for companies to consider adding more licences, more licenses can also be used to make their existing staff more productive.

There are three components to running a reservoir model: software, hardware, and a reservoir engineer to run it. Reservoir engineers are expensive, and buying new (even high end) computers is pretty cheap, and with cloud computing you can just rent them. So computing power is so cheap that it's almost never the bottleneck, and adding more engineers is so expensive you only want to do it if you're sure about your future needs, while adding more licenses can get you increased productivity from your existing staff, and software doesn't need benefits or an office.

In uncertain times when companies are trying to more with less, that makes more software a potentially attractive way for a producer to spend money, and is one reason I believe CMG will be able to grow their earnings even in a flat oil price environment.

Accounting Catalyst

Every once in awhile when you're reading the more arcane notes of a financial statement, something will jump out at you. That is why I always read the sections on changes in accounting treatments. In the case of CMG, they will be switching to IFRS 15 in their financials starting after April 2018. This means that their annuity revenue, which I mentioned above, will no longer be booked as revenue over the life of the contract as it is now. Instead, the revenue will be booked when the contract is signed. This has the potential to provide a significant one-time revenue bump when they switch standards, as I believe they will book all their future (already sold) annuity revenue at once. While this doesn't change the value of the business in any way, a big one-time earnings beat is a potential catalyst, as it will get analysts paying attention to the stock, and it will show up on screeners, etc. This accounting change won't affect the maintenance contracts on their perpetual sales, and they don't break out the annuity sales vs maintenance revenues, so its hard to determine how big this will be, but I expect it to be material given the combination is 80%+ of the companies revenues.

Risks

While I believe the company is a sound long term investment, any business has risks. CMG is based in Canada, and most of its expenses are in CAD, but some of its sales are in USD. The USD has depreciated against the CAD this year, which will hurt them going forward. Happily for the company, a major factor in the CAD exchange rate is the price of oil. So if the CAD continues to appreciate it is likely it will be because of higher oil prices, which would provide an offsetting benefit.

Another potential risk comes from Schlumberger. Their major competitor is much bigger than them, if they decided this business was more strategic they could hurt CMG by decreasing the price of their competing product. While I expect Schlumberger to remain a rational competitor, this is always something to consider.

Finally, the company is paying out a dividend that exceeds its earnings. This isn't a problem in the medium term, because its relatively close and they are effectively just returning their large cash pile to shareholders, which is sensible since they don't really need it. However, if they decided to cut the dividend, it is likely the stock would decline as yield based investors sell. Any such decline would likely be a buying opportunity, but that doesn't help with a position purchased in advance.

Conclusion

CMG is a software company that is likely to take market share and experience secular growth due to its significant competitive advantages. These factors have been overshadowed in recent years by the macro environment affecting its customers, which is why the stock is trading at a 15% discount to my estimation of its current value. There are a number of potential upsides to that value, from improved macro conditions to a takeover. Thus, on the balance, I believe CMG shares are attractive, and I have a long position in the company.

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Disclosure:I am/we are long CMDXF.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Short SNAP via puts

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