Fishing for value is no easy task in a stormy economy, but investors can still come up with a profitable catch. Oil and gas analyst Nav Malik of Octagon Capital uses due diligence to identify select value plays with great growth potential. In this exclusive interview with The Energy Report, Malik discusses three cream-of-the-crop picks and a hot new play in the United Kingdom’s North Sea.
The Energy Report: Nav, what is your current investment thesis?
Nav Malik: Given the commodity price environment, we prefer oil and light-oil plays at the moment. The economics are much more favorable. We also like liquids-rich gas plays, which serve to boost project economics. Given natural gas prices, we’re not as favorable on dry gas plays at this point.
TER: You would think of the liquids as icing on the cake?
NM: Absolutely. Projects have better economics via more favorable pricing in the liquids. With dry gas around $3.50/thousand cubic feet (Mcf), it’s not as economic to drill purely for gas, but when you add a liquids component to it, that serves to boost the overall production revenue stream.
TER: What do you look for in small exploration and production (E&P) companies?
NM: For both explorers and producers, the first thing we look at is the management team. We look at management’s track record, how familiar they are with the assets and what their plans are for the assets going forward. That’s certainly a key part of it. For producing companies, we also look at growth potential, and that could be a function of the number of potential drilling locations and inventory that they can exploit. We look at the potential to boost operational efficiencies to lower operating costs. For developers, we look at the quality of the resource base, how much it has been derisked and what steps management has taken to derisk the project.
TER: When you’re looking at developers, does it make you more comfortable when you are able to see other producers in the vicinity?
NM: Yes, absolutely. That certainly is a key component of derisking, whether there’s some well control in the area surrounding a company. That is helpful and gives us more confidence.
TER: Are there certain channel checks that you perform?
NM: We talk to the energy services providers. Their relative level of optimism helps to put the puzzle together. We also look at available industry statistics, such as license data and land sale activity. There is a lot of information available in the oil and gas space, particularly in Western Canada, which helps us gain an understanding of how the future is going to unfold. We also talk with industry associations like the Canadian Association of Petroleum Producers (CAPP), and we attend conferences. There are all sorts of indicators that keep us in tune with industry sentiment regarding future plans.
TER: Do the service providers have pricing power?
NM: They do. It’s a very active drilling period at the moment and considering the extended spring breakup that we had earlier this year; the latter half of the year has been a very busy time for service providers. Most of them are guiding for continued strong activity right through into next spring and the next breakup period. Their capital expenditure (capex) budgets have been growth-oriented and higher than last year’s spending. That’s what we saw with Precision Drilling Corp. (PD:TSX) very recently, as well as several other smaller service providers. That general theme has been playing out even in this uncertain economic environment, and the feeling is still positive when it comes to drilling intentions.
TER: Can you be bullish on small E&Ps if commodity prices are in a trading range?
NM: Yes, absolutely. Many of the small E&Ps offer good growth potential. It comes down to their land base and drilling inventory. You can certainly see production and cash flow growth in a flat commodity price environment based on how active and how successful companies are at executing their drill programs. If a junior company has a solid inventory of potential targets and is able to execute on those, we do see production growth.
TER: Do you see investors flow funds in small E&Ps in a flat oil commodity market?
NM: Yes, and I think there are companies that offer good value and growth potential in this market. Those are the types of companies that investors should look for. Even if you assume commodity prices are going to be relatively flat, there is tremendous potential still remaining, and new technology is opening up further potential. Hydraulic multistage fracturing (fracking) and horizontal drilling have really opened up potential in many resource plays that were previously thought to be near the end of their lives. They’ve now been rejuvenated with the improved technology.
TER: Can investors make money in this environment?
NM: There are opportunities to profit. The economic environment is still uncertain, so if we saw a significant downdraft in economic growth followed by a corresponding decline in commodity prices, that would certainly be a risk for an investor. But we’re assuming relatively flat commodity prices going forward. We think the $90–110/barrel (bbl) for WTI (West Texas Intermediate) level is a very positive environment in which investors are able to make money. Opportunities are there as long as the economy doesn’t decline significantly.
TER: What is your forecast for oil and for gas?
NM: We forecast WTI at $90/bbl in 2012. For gas, we’re looking for about $3.50–3.75/Mcf for NYMEX.
TER: What companies do you currently like?
NM: Equal Energy Ltd. (EQU:TSX; EQU:NYSE) is one of the names that we like. This is a company that has about 9,500 barrels a day (bpd) of production. It’s in the liquids-rich Hunton play in Oklahoma. It also has an asset base in the Cardium and in the Viking in Canada. So it’s in some light oil-focused plays in Canada and a liquids-rich gas play in Oklahoma. The economics are very favorable, and it’s been executing very well on its plays.
It just recently sold some noncore assets and applied the proceeds to its debt. It also has potential upside from an area in Oklahoma where it has about 20 sections in the Mississippian formation, which has become a highly attractive light-oil play in the U.S. A lot of the major companies in the U.S. are drilling here, including SandRidge Energy Inc. (SD:NYSE), which has been very active in this play.
TER: Will Equal develop its Mississippian play in 2012?
NM: Yes, I think we’ll see some cash flow from Equal’s land base in the Mississippian next year. I think it’s looking for potential partners to keep its own capital costs low.
TER: Equal decreased its guidance down for 2012. You had expected it to produce 11,600 barrels oil equivalent per day (boepd) in 2012, but the company is now projecting 9,400–9,800 boepd with a lower percentage of oil as well. What are the issues that resulted in these revised expectations?
NM: Part of it was that it sold off some non-core assets recently, which lowered its production numbers. We also find management to be very conservative, which is a good thing. They want to ensure that they are putting out achievable numbers in the investment community, erring on the side of caution. Finally, the company is not including potential development of the Mississippian in its cash flow and production guidance. Thus, there is certainly more upside there.
TER: So, the Mississippian could be a key catalyst for upside?
NM: Yes, absolutely. However, the market isn’t giving Equal much credit for the potential growth its acreage suggests. I think once it announces development plans there, or when it has partnered with somebody in the area to develop that play, that should really be a catalyst for the stock to move higher. The current share price level does not reflect this value.
TER: Is paying down debt the best use of proceeds from Equal’s asset sale?
NM: For Equal Energy specifically, it is the best use of proceeds. Its debt level was more than 2.5x its debt-adjusted cash flow number. That’s on the higher end of the scale for most companies in the energy space. I would say around 1–1.5x is the level most energy companies probably strive to remain below. So its debt is slightly higher than the industry average, and I think for that reason, using these proceeds to bring down its debt was really prudent on management’s part.
TER: Because of Equal’s lowered production forecast, you reduced your target price from $11.20 to $9, which still represents an 80% implied return.
NM: Yes, exactly. It’s still trading at a relatively attractive valuation. On an enterprise value (EV) to debt-adjusted cash flow basis, it’s trading at less than 4.5x, which is at the lower end of the range. Most companies in the energy space are trading around the 4–6x multiple. It’s at the lower end of the range, so valuation is attractive. Even our $9 target price represents solid upside from current levels.
TER: Equal sounds like a classic value play.
NM: Absolutely. It’s a good value play with an attractive valuation, a strong set of assets and a very strong management team as well. I think it’s doing all the right things. As it continues to execute, it should be reflected in its valuation going forward. So it’s a good time to step into the stock, and I think you could certainly see the stock price get closer to our target price over the next year or so.
TER: If Equal is producing on its Mississippian play a year from now, would you consider this company a legitimate growth story?
NM: I think there is growth potential out of the Mississippian. Plus, it has a number of locations available to drill in all of its plays, in the Cardium, the Viking and in the Hunton formation. So there certainly is solid growth potential there. I think we will see that down the road.
TER: What else do you like?
NM: I also like Spartan Oil Corp. (STO:TSX), which is a junior company primarily focused on the Cardium play in Alberta. What we like here is that it’s an emerging growth story. By the end of this year, it should be producing about 1,500 bpd. It has a very contiguous land base and is very low risk in the sense that there’s a lot of historical production from its specific area of the Cardium in East Pembina. It is basically exploiting horizontal drilling and multistage fracking to further increase production from its land base. So we’re looking at production doubling from current levels by the end of next year. Spartan recently increased its guidance for 2011 from about 1,050 bpd to likely hitting 1,500 bpd by the beginning of 2012. It’s been getting good results from the wells it has been drilling, and I think we’ll see that continue. The other thing I like about Spartan is that it has been reducing its capital costs on well drilling. Originally, the company was expecting to spend about $3.3 million/well in the Cardium. The company reduced that figure to about $2.5M/well, and it will likely go even lower than that. I think it’s commendable to management on how they’ve been able to reduce capital costs.
TER: Spartan’s relative strength has been extremely high. It’s up 27% over the last six months and up 14% over the past month. It’s really a mirror image of many of its peers that have gone the other direction. Is it a legitimate growth story?
NM: Absolutely. I think it’s one of the best junior names in the industry at the moment based on the land base and potential for growth alone. It’s just a matter of getting the resource out of the ground. The company’s growth trajectory should continue to accelerate, given those characteristics.
TER: I guess this is a case that proves investors can make money in this kind of market.
NM: Exactly. Spartan Oil is a great example of a very solid, growth-oriented, junior oil and gas company.
TER: Any other promising value plays?
NM: Another company we like is Xcite Energy Ltd. (XEL:TSX.V). Xcite has a play in the United Kingdom’s North Sea called the Bentley Field, which it was awarded back in 2003. The field is located about 160km east of the Shetland Islands. It has derisked that field significantly by drilling some exploratory wells and some appraisal wells that have demonstrated commercial flow rates. Its most recent reserve report outlines about 28 million barrels (MMbbl) of proven and probable reserves, and it also has about 87 MMbbl of contingent resources that we think should be reclassified as reserves once the company actually starts developing the field and begins producing. There are about 115 MMbbl potentially recoverable from the Bentley Field, which we think is very valuable. Our target price of $5 is based on our net asset value (NAV) model for that field, and represents considerable upside compared with the current share price.
TER: Yes, an upside of about 250%.
NM: Given that Xcite is not producing at the moment, there is obviously a higher level of risk, but it offers a very compelling risk-reward opportunity, in our opinion. We expect solid production out of the Bentley Field, upwards of 40 thousand barrels per day (Mbblpd) in about Q414.
TER: That’s three years from now, which is a lifetime in the energy sector. But if this kind of production can be achieved, this is a multibillion-dollar market cap company.
NM: Just over a $1 billion is roughly where our valuation is on it currently.
TER: Shares of Xcite are down 74% from one year ago. Is this due to the play’s built-in risk, or is there something else that has caused such a brutal drop in its share price?
NM: In this case I think it’s more about the economic environment. Capital is required to execute on the Bentley Field development strategy. When the financial markets are uncertain, it may be more difficult to access or raise capital. That being said, Xcite actually does have enough capital available to begin the first step of the process. In my opinion, the company is not really constrained by any means, but some investors may feel that there is a high level of risk still involved. I think the other issue that may have brought the share price down slightly is that the company is awaiting Department of Energy and Climate Change (DECC) approval for its Bentley field development plan. Xcite recently revised those plans, which may have caused some uncertainty in the investment community. We think that it will receive DECC approval shortly, which should serve as a positive catalyst for the share price.
TER: Even though the company’s share price has been beaten down dramatically, it still has a $251M market cap, which means it could be owned by a lot of mutual funds. Sometimes a company’s market cap can drop so low that mutual funds can’t own them, but that’s not the case here.
NM: Absolutely. I think that speaks to the value of its asset in the Bentley Field, a very valuable resource. There are other large players in the North Sea, such as Statoil ASA (STO:NYSE: STL:OSLO) and Apache Corp. (APA:NYSE). There are a lot of companies in the North Sea that can appreciate the value in the Bentley Field. For those reasons, we also consider Xcite a potential takeout target down the road.
TER: This Bentley Field play is a huge and complex project.
NM: Yes, absolutely, but lots of potential, in our opinion.
TER: Many thanks to you, Nav.
NM: Thank you very much.
Nav Malik joined Octagon Capital Corporation in late 2010 as a research analyst covering the oil and gas sector. He has over 15 years of capital markets experience, primarily focused on companies in the energy, transportation and industrial/manufacturing industries. Mr. Malik was ranked as the number-one Business Trust Stock Picker in the 2009 StarMine Analyst Awards, and has also been highly ranked in other investment industry surveys. He has a Bachelor of Commerce degree from the University of Calgary and a Masters of Business Administration from the University of Western Ontario.