Energy Investment Is an International Adventure: Darrell Bishop

Darrell Bishop Looking for outsized returns? Then broaden your horizons, suggests National Bank Financial Analyst Darrell Bishop, who focuses on regions where property acquisition is cheaper and oil sells at the Brent premium. In this exclusive interview with The Energy Report, Bishop whisks us around from Western Europe’s North Sea, to behind the former Iron Curtain in Albania, to developing energy plays in New Zealand. Learn how to navigate the risks of the space and what makes a far-from-home smallcap worth it all.

The Energy Report: You make the case that investors should take a look at small-cap international energy companies. Why?

Darrell Bishop: The main attraction is exposure to high-impact exploration targets. In the international space, a small-cap producer can prove up material reserves with a single well. This compares favorably with the junior space in North America, which has transitioned to an unconventional resource play based primarily on multi-stage hydraulic fracturing technology. The North American juniors are in a lower-risk and lower-reward environment. International companies are inherently more risky, so the potential for higher returns needs to justify that risk.

TER: How do domestic and international projects differ for small energy companies? Is technology a differentiator?

DB: Land acquisition costs in North America can be a huge barrier to entry for junior companies. We see a willingness for teams experienced in North American geology and technology to seek out opportunities in international jurisdictions where they can apply that expertise in a less-competitive setting. The junior international explorers tend to be the first movers in discovering emerging global plays. These projects can generate major shareholder value for investors. That’s why I think investors should look overseas when evaluating smaller energy companies to add to a portfolio.

TER: What geographies do you think are geologically and socially prospective for international energy development?

DB: There are many factors that investors have to look at in the international space. It comes down to a balance between geology, the fiscal and geopolitical climate in the country and the investor risk tolerance. The majority of the world’s reserves are located in less-stable regions. Negative regional headlines can impact the share price of companies that operate anywhere within that region—even if it is in a different country. Much of the time, news will affect share prices for companies totally unaffected by regional political developments. A recent example is Chinook Energy Inc. (CKE:TSX.V), which has operations in Tunisia—the epicenter of the Arab Spring uprising. Despite not experiencing a day of operational downtime through the unrest, the stock traded at a discount to its international peers. With that said, there are a few jurisdictions worth mentioning, although not without risk. Kurdistan and parts of Africa continue to attract investor attention based on recent exploration success, the potential for large reserves and production growth and increased interest from the majors.

On the other hand, once-popular regions in Argentina and Colombia have cooled. Argentina has tremendous shale potential, but investor interest has dried up following the government’s expropriation of Yacimientos Petrolíferos Fiscales (YPF:NYSE). In Colombia, which was once the poster child of international success stories, the risk appetite has fallen off as many of the lower-risk exploration targets have now been identified. That’s forcing companies to step out into more expensive and riskier frontier regions that show a lower chance of exploration success. Production from small international projects can decline steeply, so companies need to be successful with the drill bit in order to backfill potential production shortfall.

TER: You cover some offshore companies in the North Sea. How do smaller international energy companies fit into that market? What’s their niche?

DB: The North Sea has been in production for decades. The consensus is that most of the major fields have already been discovered. At this stage, the focus is shifting to increasing recovery from legacy fields and developing the remaining smaller fields. There are government incentive programs to partially offset the high taxes that are seen in the North Sea. That encourages smaller field development and opens up opportunities for small companies like Iona Energy Inc. (INA:TSX.V). These discoveries are too small for most of the majors to care about (because the majors need scale and large reserves), but smaller companies can build a business out of only a few discoveries.

We cover Iona Energy, which is a pure play on the North Sea. It’s focused on growing production from undeveloped discoveries that were too small for the majors. The majors ignored these deposits because they were not material additions to their reserves. However, for a smaller company, these reserves are potentially very material.

Iona trades at some of the cheapest metrics in our international space. Investors will have to be patient with a stock like this, as the major operational catalyst for the story is the first oil from its Orlando field. That’s currently not scheduled until mid-2013. Although it’s primarily an execution story, many investors have been burned in the North Sea and are cautious. That’s because North Sea projects tend to take longer and cost more than originally planned. With Brent prices now north of $110/barrel (bbl), industry activity and costs are likely to increase in the coming years. Short-term investors won’t pay for development projects that are a year out, but long-term investors may have a good risk-reward opportunity at these levels.

TER: International energy companies generally sell their production at the international price, which is currently at a large premium to U.S. domestic pricing. Will international energy pricing remain robust?

DB: Our thesis is that domestic West Texas Intermediate (WTI) will continue to trade at a discount to the international (Brent) pricing in the near term. That likely won’t change until more domestic production can get waterborne.

TER: What metrics do you use to evaluate smaller international energy companies?

DB: You have to be pretty selective when you’re playing the international space because of the jurisdictional risk. Typical smaller international energy companies are exploration focused. Frontier exploration success is less than 20%. To flip that around, you have a greater than 80% chance of failure on your exploration target. The current market is not paying much for exploration upside. For this reason, we tend to favor companies that have a balance of development opportunities (for cash flow) and exploration upside as a bonus. To evaluate production, look at cash flow metrics. To evaluate exploration prospects, look at the risk basis. Next, you break it down to a present value based on the number of barrels in the ground and the cost of extracting that. Management also is very important—they need a track record of success and in-country connections. A lot of times for junior companies in international jurisdictions, it’s who you know that matters most to help navigate the regulatory approval process rather than who you are. One last point: the international space, especially for small companies, is operational catalyst driven. Investors should watch for drilling events that may drive value.

TER: One of the jurisdictions you follow is unusual —Albania. Can you explain the investment thesis and the current opportunities?

DB: We cover three companies in Albania. The first two are primarily focused on increasing oil recovery from legacy fields—Bankers Petroleum Ltd. (BNK:TSX) and Stream Oil and Gas Ltd. (SKO:TSX.V). Bankers is not a small company; it has a market cap of approximately $800 million (M). The third company we cover in Albania is an early-stage explorer called Petromanas Energy Inc. (PMI:TSX.V). It is an interesting story for many reasons. Earlier this year, Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) farmed in for a 50% interest in two of its blocks, which, combined with cash on hand, basically funds exploration plans through 2013.

TER: Are these offshore explorations?

DB: No, these are all onshore. Shell is interested in these blocks because of similarities to the Val d’Agri and Tempa Rossa fields located across the Adriatic Sea in Italy. One of those fields is currently producing 90 thousand barrels a day (Mbblpd) from fewer than 30 wells. Shell and Petromanas are currently drilling their first exploration well in Albania. That well cost $30M and is carried almost entirely by Shell. The well is a re-drill of an existing discovery that flowed oil to surface about 10 years ago, but the rate was limited due in part to a series of operational issues and poor decisions. Well results are expected by year-end. If successful, we see this as a potential company maker for Petromanas. Additionally, Petromanas has two other wells it is planning to spud before year-end, which means there are several potential drilling catalysts on the horizon.

TER: How about the political and social issues in Albania? For most investors, it must be an unknown.

DB: For the most part, it is unknown to most investors. Albania, up until about 20 years ago, was a Communist society. It’s been in transition to democracy for the better part of the last decade. There are social and environmental issues in Albania. However, the government is pushing to turn things around and be more investment friendly. The country is applying for European Union status, which is a vote of confidence in foreign investment in the country. While the country is still in transition mode and has challenges, the big picture is positive over the longer term.

TER: Is the geology in Albania somewhat complicated compared to North America?

DB: The risks there are primarily a function of geology. To date, exploration and production activity in Albania has focused on shallow formations (less than 2,000 meters) that produce heavy oil. Petromanas is targeting much deeper, more complex sub-thrust structures. There has been limited exploration on these formations to date. With advances in three-dimensional technology and deep drilling, plus experience in geologically similar Italy, the companies feel like they have a better understanding of how to create exploration success in that geography.

TER: Is the major trend for the small-cap international energy sector the application of new exploration and development technologies?

DB: There are a couple of major trends in the industry. The single biggest factor is technology. In most international jurisdictions, expertise and the rate of technology adoption greatly lags that of North America. We see adoption of seismic, drilling and completion technologies that were pioneered and perfected here in North America as the catalyst to advance the industry internationally. In the international jurisdictions, the use of these technologies is just beginning to grow. These technologies have been key to discovering new areas for exploration and production that were not considered prospective or economic until now. One example is the worldwide emergence of onshore unconventional shale plays. Another example is the advance of deepwater exploration technology that is unlocking huge exploration potential in places like Angola, Namibia and Brazil.

The second trend driving the sector is commodity prices. In most international jurisdictions, oil is priced relative to Brent, which as we discussed is at a healthy premium to North American oil. A similar pricing structure is in place for natural gas, which can fetch three to five times more internationally than in North America. This is a significant motivator for international companies, as the potential return justifies riskier exploration targets.

TER: Another underexplored location with complicated geology you cover is New Zealand. Can you give us an overview of the energy investment situation there?

DB: New Zealand has received increasing attention from oil and gas companies because they’re seeking out new regions to explore globally. New Zealand offers a bit of a unique opportunity in our international space. It is underexplored, but also benefits from a politically stable climate with fiscal terms that encourage investment. There are multiple sedimentary basins with known or potential hydrocarbons—both onshore and deep-water offshore. There have been multiple discoveries, even hydrocarbon seeps to surface, which demonstrate an active petroleum system in many of these basins. Currently, all of New Zealand’s oil and gas production comes from the Taranaki Basin on the west side of the North Island. Because of the tectonic setting, the geology is favorable for structural petroleum traps. However, exploration is complicated because of the lack of structural repeatability of these formations. Advances in technology, mainly seismic and drilling, have enabled companies to better focus their exploration efforts. While current production is on the west side of the island, the east coast is where things get interesting. There is tremendous exploration potential in some of the shale reservoirs, which are yet to be tested and estimated to contain billions of barrels of undiscovered resource.

TER: So New Zealand is a frontier—which companies are there now? Are both juniors and larger companies there?

DB: Shell has been a major player in the country for some time, but we’ve also seen some heavyweight companies recently step in, such as Petrobras (PBR:NYSE; PETR3:BOVESPA), Anadarko Petroleum Corp. (APC:NYSE), Apache Corp. (APA:NYSE) and Exxon Mobil Corp. (XOM:NYSE). But there are also a couple of junior, Canadian-listed companies with a presence. Tag Oil Ltd. (TAO:TSX.V) is one we recently initiated coverage on. New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX) is another Canada-listed junior in the area.

TER: Tag has an interesting past—and investors have done well with it. It’s not a smallcap anymore. Is there upside to the stock? What events are you looking for?

DB: I agree, the stock has had a good run the last couple of years, and that’s mainly on the back of success with the drill bit. Two of Tags fields transitioned from discovery to production, but we still see upside from here. The current valuation is supported by shallow conventional development at these two fields. Production is approximately 2,400 bblpd now and set to ramp up to between 5–6 Mbblpd between November and March. That’s entirely from 14 drilled wells that are behind pipe-awaiting infrastructure expansion. It has less than 10% of its production permits explored to date. We see Tag in the early stages of unlocking the potential of these assets from a conventional perspective.

Besides these assets, Tag has three high-impact, liquids-rich prospects that are drill ready. Two of these prospects, Cardiff and Hellfire, are slated to be drilled within the next six months and could add material value to the company. The real game-changer for Tag could come from a carried call option that it has on an unconventional resource in the east coast. Apache farmed in and is carrying Tag for the first $100M in exploration capex to test unconventional shales in the East Coast Basin. If the partners can prove moveble hydrocarbons with an upcoming four-well program, it’s likely going to be all systems go for Tag. On the regulatory front, there are still public concerns over hydraulic fracturing. That’s a hot topic with industry and the government. Tag has been working to dispel the myths associated with hydraulic fracturing. There is a parliamentary report due in November. That could be an important factor in unconventional operations going forward.

The bottom line is that we continue to like the stock at these levels. Tag has a very strong balance sheet, and we see the valuation as being underpinned by significant near-term production given those already-drilled wells. There is additional upside potential from a busy “catalyst-rich” operational calendar over the next 12 months.

TER: What does the New Zealand energy market look like in terms of import/export and pricing?

DB: With respect to oil, New Zealand is a net importer of oil. Current production in the country is approximately 50 Mbblpd. Demand in the country is approximately 150 Mbblpd. With respect to pricing, oil is priced relative to Asian Tapis pricing, which is comparable to Brent. With respect to gas, the situation is similar to North America in that New Zealand natural gas is a landlocked product. Current production is approximately 400 million cubic feet a day (MMcfpd). Pricing is generally between $4–5/Mcf, which is a healthy premium to what North American producers receive.

TER: If New Zealand natural gas production increases dramatically, what happens to the price? It is a small domestic market.

DB: That has been some of the pushback for the story of gas production in New Zealand. Offsetting the small domestic market is the fact that the major gas fields that are in the country have been in steady decline over the last few years. There is talk that demand for gas will increase over the coming years, in part due to the expansion of the Methanex plant in the Taranaki Basin. If existing production drops and there is an increase in demand, then new production can be easily absorbed by the market.

TER: Are there any final thoughts you want to leave with investors who are contemplating how to get into the smaller overseas energy explorers and producers?

DB: Investors need to be selective when they’re playing the international space. There are unique risks in each jurisdiction. Look for stocks that balance development and exploration. The current market does not pay much for exploration, but that may be an opportunity for longer-term investors. Keep an eye on operational catalysts and favor companies with strong management teams.

TER: Thanks a lot for talking with us.

DB: I appreciate the opportunity.

Darrell Bishop is a Research Analyst with National Bank Financial (NBF) covering international oil and gas E&P companies. Based in Calgary, Bishop joined NBF in late 2011 after working as a senior research associate at Macquarie Capital Markets where he focused on international oil and gas E&Ps. Prior to Macquarie, Bishop had 10 years of industry experience with CorrOcean Aberdeen, Petro-Canada East Coast and Devon Canada where he worked in various roles including asset optimization, production engineering and corporate development. Bishop holds a Master of Business Administration from the University of Calgary and a Bachelor of Mechanical Engineering with a specialization in oil and gas from Memorial University. Bishop is a Professional Engineer with the Association of Professional Engineers and Geoscientists of Alberta (APEGGA).

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