Clean balance sheets, cash flow visibility and trading liquidity in oily stocks are the cornerstones of investment success in junior E&Ps, according to Oil and Gas Analyst Tim Murray of Desjardins Securities. In this exclusive interview with The Energy Report, Murray lays out his risk/reward proposition for his very favorite names.
The Energy Report: Tim, what is your investment thesis right now?
Tim Murray: It hasn’t changed since the last time we talked. We are biased towards oil plays. But we will look at selective natural gas players and we prefer the lowest-cost producers as well as the companies with a larger production base.
TER: Are you currently telling investors that they need to be patient?
TM: Yes. Most of the small/micro cap stories have seen a dramatic drop in share price over the last year; however, WTI (West Texas Intermediate) is hovering around $100/barrel (/bbl), and oil companies should be able to generate strong cash flow at these levels. The market has gone quieter on the smaller-cap companies as investors traditionally flock to larger, more liquid names in times of uncertainty. Once we see more general stability in the global market place we expect money to once again flow back into small/micro cap names.
TER: So, how does a micro-cap company get out of a hole like this? If its market cap has been knocked down so dramatically that the stock becomes hard for mutual funds to own, what must happen to get out of that situation?
TM: It usually comes down to market sentiment changing. Money managers will eventually start looking at the small caps again because those companies offer significant potential gains in a portfolio. You don’t buy small caps or micro caps for 20% returns; you buy them for 80% or 90% returns. Small cap names may currently be light in many portfolios, however we believe market participants will return to these names once general global market stability is demonstrated. The other option is to become an active acquirer in order to grow in size, however this can be a challenging goal for many small caps that have depressed valuations, unless you can purchase another small cap in the same situation.
TER: Do institutional E&P investors tend to think in terms of value, or are they looking for growth names?
TM: I think most institutional E&P investors are still looking for growth prospects. However, many of the small cap names are trading cheaply on a cash flow basis, so these growth stories can also be viewed as value plays. Most institutions are choosing companies with better balance sheets that don’t have to go to the market to raise money to move their drill programs forward. Companies that can show good visible organic growth from cash flow for the next two to three years seem to attract more attention. Institutions also seem to be most interested in liquid stocks.
TER: Gasoline prices in some regions have declined to the sub-$3/gal range, and this is right in front of a big holiday. Are we looking at continued weakness now in commodity oil?
TM: I don’t think so. We do like the commodity and prefer it to natural gas right now. As for natural gas, we are bearish in the short/medium term, and I don’t see any meaningful near-term catalyst to change that. We don’t see $50/bbl oil in the near term and we are thinking that anywhere between the $80–100/bbl bandwidth is a realistic range for WTI to trade over the next 12 months.
TER: What catalysts are needed to turn energy stocks around?
TM: Well, some equities have done well this year, and so it’s hard to paint a broad stroke across the board. We believe once general market stability has returned that market participants will return to the small/micro cap space. Looking more to a company-specific level, management teams that continue to deliver results will see stock prices that outperform their peers.
TER: When could we see some upward movement?
TM: There is lots of news flow operationally for the names I cover in January and February, so positive drilling results should help push individual stocks higher. On the commodity front it’s really hard to project what’s going to unfold in the next month and we prefer to look out over the next 12 months and believe a realistic trading level is between $80–100.
TER: What names are you talking to investors about today?
TM: The ones I’m talking about the most have strong management teams, good balance sheets, liquidity and visible cash-flow growth. My favorite name is Whitecap Resources Inc. (WCP:TSX.V), which has all those characteristics. Whitecap is run by Grant Fagerheim, who has led several other successful junior oil and gas companies. We believe Whitecap has a top-tier management team. This is the biggest company that I follow in terms of production and reserves, and it also has the best liquidity. It has a visible light oil growth profile for the next several years, offers a top-tier cash netback and a low relative corporate decline, which we believe positions them very well. We also like that Grant has traditionally been an active M&A player, which we think leads itself well to the current environment as we have mentioned previously many small/micro caps trade fairly cheap.
TER: What’s the story here? Is it about the Pembina Cardium and Valhalla Montney?
TM: Yes, and it is acquiring Compass Petroleum (CPO:TSX.V), which will give the company another core area targeting the Viking in the Dodsland region of Saskatchewan. So, it now has a fourth core oil area.
TER: Your target price was $11. Have you upped that?
TM: Yes, it’s $12.25 now.
TER: That represents 40% upside potential from here.
TM: Yes, and the upside may seem light for a small cap, however it carries considerably less risk than some of the other companies I cover. For instance, I have a target of $1.25 on Torquay Oil Corp. (TOC.A:TSX.V; TOC.B:TSX.V), which would be a much greater return, but there’s a lot more inherent risk in a Torquay then there is with Whitecap. So, on a risk/return basis, Whitecap is currently my top pick.
TER: You took Torquay down from a $2- to a $1.25-target, which is still better than a 200% implied return from current levels. What’s your investment thesis on the company?
TM: A larger portion of my $1.25 target hinges on the company’s key core property at Lake Alma. The company is basically trading at my base net asset value (NAV), which is essentially all the company’s other properties. Torquay has discovered oil at Lake Alma; however, it has not been extracted economically to date. Torquay’s management team believes they do have a viable play and that they can extract the oil economically. However, Torquay is not big enough in size to fund a meaningful drilling program from cash flow, and the company is going to have to go to the market to raise money if they would like to get aggressive again with Lake Alma. The large drop in share price and its marginal success at Lake Alma over the last 18 months could make raising money challenging. That’s why on paper it looks like a no-brainer to invest in because of the huge potential return, but there’s a lot of risk associated with the company from a market perspective (raising capital) and exploration risk at Lake Alma. If Torquay can’t succeed at Lake Alma, then I would have to remove the Lake Alma upside of approximately $0.75/share.
TER: Who is currently buying the stock? Is it the hedge fund community?
TM: Since November and December, Torquay has had relatively huge trading volume. Some investors picked it up in the $0.25–0.30 range because they thought it was so cheap that they couldn’t go wrong as it was trading below its base NAV. So they basically got exposure to Lake Alma for free. It’s hard to say who’s playing in this story right now. Some hedge funds may be looking to add this classic high-risk/high-reward play to their portfolios.
TER: What other companies do you like?
TM: It is not my top pick, but one of my other favorite names is Spartan Oil Corp. (STO:TSX). I think of it as a mini lookalike of Whitecap, however smaller in size. Spartan’s core property is located at East Pembina targeting the Cardium formation. Management is very familiar with the Cardium as its predecessor company showed terrific growth drilling the Cardium horizontally. The key asset for Spartan is the Keystone unit #2, which is a legacy oil pool that has been drilled vertically. Spartan believes it can substantially increase the recovery factors through the application of horizontal drilling. The #2 unit has never had a horizontal well drilled into the pool and Spartan has drilled three to date, and we’re waiting on results from these wells. Spartan also has a couple of exploratory plays in Saskatchewan, which is the torque in this story. Further positive drilling results could lead to another core area. We also would like to point out that the balance sheet is very strong and Spartan could announce a very aggressive 2012 capital program.
TER: This is the best-behaved stock in your universe. It’s had its head above water for an entire year.
TER: Is your target still $4.75?
TM: My target is higher than that. It’s $5.25 now. Whitecap and Spartan are my two favorite names right now. I like both their balance sheets. I believe Whitecap can show organic growth in the 20% neighborhood from cash flow over the next several years, and Spartan should be able to demonstrate similar numbers over the next 12–18 months because its balance sheet is very strong.
TER: Tim, you follow Strategic Oil & Gas Ltd. (SOG:TSX). I saw that it had recently negotiated a $40M bought-equity deal. When a company can avoid the risk of going to the market by selling its equity directly to the investment banks, it sounds like a very positive development.
TM: I definitely agree with that as Strategic will have a very strong balance sheet entering 2012, which will allow it to have an aggressive 2012 drilling program. Strategic has two oil plays that are both very early stage and quite high risk. We can see growth prospects for the next 12–18 months if either one of the oil plays is deemed commercial. On a comparable basis, Strategic’s assets are much higher risk than Whitecap’s or Spartan’s. This stock could perform very well with good drilling results or very poorly with bad drilling results.
TER: I enjoyed speaking with you very much. Thank you.
TM: Cheers. Thank you.
Tim Murray joined Desjardins Securities in July 2011. Prior to this, he was an oil and gas analyst for almost six years at several investment boutiques covering junior and mid-cap companies. He also spent over a year at AltaGas Income Trust performing risk and credit analysis on natural gas and power assets for the company’s midstream business and served as an investment advisor for three years. Tim was awarded the CFA designation in 2003.