By The Energy Report, on February 22nd, 2012
 Tom MacNeill doesn’t have to go far to find the most unique early-stage energy companies to invest in. The President and CEO of Saskatchewan-based investment firm 49 North Resources, MacNeill is bullish on his own backyard, and says of the province’s resources, “You name it, we’ve got it.” In this exclusive interview with The Energy Report, he explains why Saskatchewan resource plays trump their Alberta or Ontario counterparts.
The Energy Report: Even some of the most successful small-cap resource investors were schooled in 2011. What did you learn from last year’s ups and downs?
Tom MacNeill: We were definitely reminded of the nature of resource investments. Liquidity absolutely vanished in 2008, but by the time it reappeared in 2009 and 2010, investors had decided they wanted to keep their hands on their cash. Oil entered and exited 2011 at roughly the same price, but at times it had been much higher and much lower. That spooked investors. It became evident that most of the investors who were still comfortable with equity investments preferred dividend paying structures. It’s been a very edgy time.
We were reminded that investors were walking on thin ice. The companies that stepped up and started increasing distributions from their oil and gas production were well served. Those that did not, were not. There’s been a bifurcation in the market. The entire capped energy index is down relative to most of the broader indexes for the simple reason that investors were withdrawing money from the sector even though one barrel (bbl) of oil was about $100 throughout the year.
TER: Will the legacy of 2011 be the split between those companies that brought in dividends and those that didn’t?
TM: It’s one of the legacies. A lot of companies die in the aftermath of an event like the 2008 downturn. However, not enough undeserving companies died off because they had just completed financings and had millions of dollars in their treasuries that enabled them to weather the storm. We didn’t have enough of a rout.
Going into 2011, there were still a bunch of these Johnny-come-latelies and investors got wise. They started to watch the burn rate and what management was doing. It was a wakeup call. It was a really bad year in ‘08, it was OK in ‘09 and ‘10, and then ‘11 leveled as investors became objective. I believe that investors are more objective this year than they have been in five years.
TER: Your company doesn’t just invest in resource companies, it also instills management teams and brings in consultants with specific expertise. It’s an investor and a partner.
TM: We’ve had to be a little bit of everything within 49 North. We act as in-house management for developing companies. We provide seed capital and later-stage capital. We’ve got 25-plus of the best geoscientists in Saskatchewan on staff in one of our subsidiary companies, Northrim Exploration Ltd. That enterprise works with most of the senior players working in the province developing potash, oil and gas, and other sedimentary resources and is moving into hard rock mining consultation. We also have substantial connections within the junior resource capital market and investment banking community worldwide.
We had to develop it that way for the simple reason that we had no capital market in Saskatchewan. Where government used to hold business back, it is now very supportive. The resource business is now wide open. It’s a tremendous opportunity for us, and anybody who wants to invest in the province, because it’s like Alberta was in the ’40s and ’50s.
TER: Saskatchewan certainly shares some of the same commodities with Alberta.
TM: We view ourselves as much better off than Alberta from a geological perspective. The Western Canadian Sedimentary Basin overlays almost all of Alberta, meaning there’s really no hard rock mining with the exception of some coal mining and some other assets in the Rockies. Alberta is very much an “energy only” resource province.
Saskatchewan is the opposite. The sedimentary basin covers the southern half, but the northern half is exposed Precambrian shield. We’ve got all of the mining prospectivity and assets that you would find in Ontario and other hard rock jurisdictions, plus all of the oil and gas that you find in Alberta, and a sea of potash and other natural resources. You name it, we’ve got it. The neatest part is that it’s mostly still in the ground. There are 27 active mines in the province, but we should have a multiple of that given our resource base.
TER: How long do you think it will take you to get to that point?
TM: We have just begun, but it is moving fast. There is $15 billion (B) worth of capital committed already to expansion in the potash industry, not including capital commitments from BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), which is moving into the final feasibility stage of its 8 million tons (Mt) per annum potash mine at Jansen Lake. When mining is combined with our exponential growth in energy development I expect that $15B will double or triple in the next 5-10 years.
One new gold mine just came on-stream this past year. There are three others that are prospective in the Greenstone Belt in northern Saskatchewan. There’s a potential rare earth elements deposit that’s near development. In the next 10 years, at least 10–20 mining operations should reach feasibility in the province.
TER: One commodity that Saskatchewan is well known for is uranium. The Athabasca Basin is one of the richest areas for uranium in the world. In a 2010 interview with The Gold Report, you told us that you had mostly purged uranium from 49 North Resources’ portfolio and wouldn’t get back in until it was “time.” Is it time yet?
TM: The comments I made were based on a couple of observations. There was a physical price spike in 2006 due to uranium speculators. It created a parabolic price chart, so we knew that the price of uranium was going to come off. When that happens, all of the junior explorers get crucified. We took that time to exit our positions.
We’ve been diligently watching the uranium price chart and energy complex in general and view this year as the time to be taking positions. Uranium stocks have been beaten up. That’s the time when we get involved in projects and we’re actively pursuing more than what we have on the books right now.
We’ve got a significant investment in Unity Energy Corp. (UTY:CVE), which is an early-stage explorer in the same area as Hathor Exploration Ltd.’s (HAT:TSX.V) RoughRider deposit and the area were Fission Energy Corp. (FIS:TSX.V; FSSIF:OTCQX) is exploring. Also we have been accumulating a large position in Eagle Plains Resources. They have substantial landholdings in the Athabasca basin in Saskatchewan and recently announced a high-grade uranium discovery on their property near the Rabbit and Cigar lake mines.
TER: Tell us about Unity.
TM: It’s in the early stages of a promising exploration program having done the geophysical work necessary to advance their package of properties. We hold approximately 12% of Unity. Given that initial results have been very encouraging, we will likely be expanding our exposure shortly.
TER: What’s the earliest that Unity would have a resource estimate?
TM: They are at a very early stage in the exploration cycle so the earliest would likely be at least 2-3 years. Investors need to realize uranium exploration takes time, is expensive and if you want good science you can’t rush the process. This is a long-term investment, as all uranium exploration plays are.
TER: What macroeconomic trends are going to continue to drive energy commodities?
TM: Oil acts a lot like gold in that it’s a good parking lot for rampant money printing in the U.S. One thing that can quell inflation in the short term is a high oil price since it slops up many of the newly printed dollar bills in an asset that is used almost immediatly. This seems counter-intuitive, but it takes time for the inflationary effect of high oil prices to bleed into higher asset prices. So in the short term, it actually helps the money printers because all over the world, oil is traded in U.S. currency, thus distributing the new liquidity worldwide. The U.S. is the only country with this advantage, which creates some ironic economic activity that investors should pay attention to. As long as the U.S. keeps printing money, there’s going to be a high oil price. If the liquidity being added actually creates economic development, there will be rampant inflation. Usually that’s a tap that can’t be turned off, which could lead to much higher oil and gold prices. We view the coming five-year period as very interesting and probably very lucrative for resource investors, especially in gold and energy.
TER: What energy commodities are you most bullish on this year?
TM: We’re focusing on heavy oil and coal (for conversion to crude oil), but our backyard is unique. There are 20–40 billion barrels (Bbbl) of heavy oil in place in west central Saskatchewan. There are also staggering quantities of light oil as well in Saskatchewan, but I’m not as interested in that. Everyone knows about the Bakken shale and other tight light oil plays now being developed using modern multi-staged fracturing but very few follow heavy oil development.
My interest is tied to the recycle ratio, which is the net profit/bbl divided by acquisition and development costs/bbl. The ratio for light oil in Saskatchewan averages somewhere around two, meaning if a company puts $1 million (M) into acquiring and developing an average well, it will get $2M out of it. But heavy oil in Saskatchewan can have a recycle ratio as high as five.
That’s not true of everywhere in the world. We have two heavy oil upgraders in Saskatchewan that have been consistently adding capacity so we’ve got a real blessing here in that we can develop our heavy oil fields and achieve higher netbacks than elsewhere because of that very unique refining capacity in our backyard.
TER: What are some of the companies benefiting from that?
TM: Most of the companies that are developing these heavy oil assets that are in production are very large already and beyond our scope, such as Canadian Natural Resources LTD. (CNQ;TSX) and Baytex Energy Corp. (BTE.UN:TSX). We’re sponsoring private companies in this space. However, Baytex is coming up with ingeneous ways to drill multiple lateral wells from one drill pad and get enormous production out of thin-formation, heavy oil projects. They also pay a pretty decent dividend yield as well. That’s the kind of story we’re looking for, but we’re looking for it at a very early stage when a company has a prospective heavy oil development field and is investing its first $1–5M in the project.
TER: Are any of your private oil plays expected to go public?
TM: Probably. Allstar Energy Ltd., in west central Saskatchewan, is a light oil producer that is converting into a heavy oil producer as well. We’ve actually taken that one in-house and made it a subsidiary company. Had the capital markets been a little bit more buoyant over the last nine months, we might have entertained taking that company public sometime last year. At some point, given it’s growth potential, its capital needs will outstrip our ability to supply it and we’ll have to take the training wheels off and take it public. That could be in 2012 or 2013 depending on how development goes.
We also sponsor Admiralty Oil Ltd., a very early-stage light oil development in southeastern Saskatchewan. It will probably go public if it has some success this year.
TER: You said you are bullish on coal. What are some of your holdings in that space?
TM: There are two that we really like, which are both developing coal-to-liquid technology. We view coal as just another long carbon chain that can be converted into a shorter carbon chain to make heavy crude. These two enterprises are going about it in different ways.
NuCoal, a private company in southern Saskatchewan, will use full gasification to convert coal into transportation fuels at the mine site. It’s a multibillion-dollar project. The company has control of one of the largest coal resources in the world and it could possibly go public sometime in the next 12–18 months.
Westcore Energy Ltd. (WTR:TSX.V), which we have an approximate 25% stake in, has a significant thermal coal resource that it’s developing on the Saskatchewan-Manitoba border. It is working with Quantex Energy in Calgary, which has a proprietary technology developed at the University of West Virginia. Quantex tested some of Westcore’s coal and determined that it’s perfectly adequate for converting into heavy or light crude depending on the extent of processing.
Westcore is currently starting its winter drilling exploration program. It already has at least seven defined targets that have hit intersections as thick as 100 meters (m) of coal, which is absolutely enormous. It’s conservative to estimate that those intersections average 50Mt/coal, which could mean that the company has at least 300Mt/coal in one small area. That’s world class. It appears it will cost about $40-50/bbl of oil for the conversion technology. It will probably cost approximately $200M to build an initial 10,000 bbl/day conversion facility. Given that the process appears to convert coal to heavy crude at a ratio of 3-4 bbl crude from each ton of coal, there’s an almost endless potential supply of heavy crude oil for the refiners in Saskatchewan. Now that is an exciting energy story.
TER: It does sound exciting. Is the process by which they turn coal into heavy oil similar to what’s happening in the oil sands where they steam the bitumen to separate the oil from the sand and gravel?
TM: That’s a liberating technique using steam to get the bitumen. Then the bitumen is processed through hydrocracking, which involves heating up the bitumen under pressure with catalysts to separate it by strata into various elements. The lights float to the top of the column and the heavy stuff stays at the bottom, leaving five or six different strata. These synthetic crude products are then piped to refineries for further processing. The NuCoal project is similar to that in that it uses similar full-scale gasification technology but with the intention of the plant refining all the way to the transportation fuel level right on site.
The Westcore/Quantex route involves using a low-temperature direct liquefaction process. It adds some proprietary chemicals to the coal once it’s emulsified and converts it into heavy crude. The beauty is that the process does not leave much of a greenhouse gas footprint at the mine/processing site because most of the carbon dioxide and other problematic gases that would be emitted stay in the heavy crude and go to the refinery. The exciting part about low temperature conversion is its scale-ability with initial capital cost of probably one tenth that of full-scale gasification.
Both companies have viable approaches; they are simply on opposite ends of the development spectrum. One has low capital cost with smaller initial production while the other has large capital requirements at startup and therefore large initial output. At these energy prices we believe both approaches will be robustly economic.
TER: Once it’s converted it goes to the refineries. Where does the oil go from there?
TM: It is channeled into the North American distribution system running from northern Alberta into a hub center near Chicago. It goes directly into the pipeline system that bisects Saskatchewan diagonally. That’s the beauty. We’re infrastructure laden because we’re in between the consumptive market in the eastern U.S. and the production of western Canadian oil sands and conventional producers in the Western Canadian Sedimentary Basin.
TER: Do you have some parting thoughts on the energy space?
TM: I’m curious to see what prices are going to do. We’re comfortable that the price of uranium has bottomed and that it’s likely a very long-term bottom. We got our feet wet last year in some of the early-stage investments we’ve made. We’re going a lot harder this year and repatriating capital back into projects that we like. There are lots of good opportunities out there within companies that have done poorly in this twitchy market but have good projects.
The energy space should be an exciting one. If the governments keep adding liquidity, the resulting competitive devaluation of currencies will be inflationary and good for commodity prices. Or perhaps the world is going to get a little bit better—also good for commodity prices. It’s a bit of a win-win situation over the next five years if investors are patient.
Investors have to make sure that they stick to certain criteria. Look at management first, not the project, because the best project in the world can be screwed up by bad management. A marginal project can be made wonderful by good management.
TER: Thanks, Tom.
Read more of Tom MacNeill’s gold investing ideas.
Tom MacNeill is the founder, president and chief executive officer of 49 North Resources Inc., a Canadian resource investment company headquartered in Saskatchewan. As the first entity of its kind in the province’s history, 49 North is a pioneer in what is rapidly becoming one of the world’s most renowned resource jurisdictions. A graduate of the University of Saskatchewan (economics/geology), MacNeill is also a certified general accountant and holds a chartered financial analyst designation. MacNeill’s extensive knowledge of Canadian capital markets has been gained through experience as a management accountant within the mining industry, investment advisor with a major Canadian brokerage firm and chief financial officer of a Canadian trust corporation. He is a well-respected member of the resource industry and part of a worldwide network of exploration professionals and resource developers which enables him to source and structure projects.
By The Energy Report, on February 8th, 2012
 Despite depressed natural gas prices, investors in master limited partnerships (MLPs) leveraged to natural gas liquids can expect both excellent income and share price appreciation, says Credit Suisse Senior Analyst Yves Siegel. In this exclusive interview with The Energy Report, Siegel discusses his favorite MLPs and their winning formula for double-digit returns.
The Energy Report: Yves, what can investors expect out of MLPs between now and the end of 2013?
Yves Siegel: Steady as she goes. The yields for our group now are around 6%, and we expect distribution growth to be about 7%. If Fed Chairman Ben Bernanke is true to his word, we’ll continue to expect an environment of low interest rates for the next two years. So if you combine the yield and the distribution growth, we think investors could see low double-digit returns.
TER: How do distributions grow?
YS: When contracts roll over on terminal assets, they typically roll over at higher rates because they’re competing with new facilities. In order for companies to get a return on their facilities, they need a certain price. Storage at Cushing, Oklahoma, for example, is relatively expensive to build. When contracts roll over for those existing storage assets, typically those rates can move up to the prevailing rate for new construction. Distribution growth results not only from contract rollover but largely from new builds and investments that come online, either through greenfield projects or through acquisitions. The MLPs as a group have been able to grow distributions by investing capital in excess of the cost of capital. That’s been a winning formula for quite some time.
TER: Do you see real estate partnership investors shifting their attention to energy MLPs?
YS: I would suggest that retail investors who are searching for yield and invested in real estate investment trusts (REITs) are now looking at MLPs. I would also include investors who have historically invested in utilities. I think MLPs have been around long enough now that investors are feeling more comfortable with investing in the security.
TER: Returns on your MLPs coverage universe have been excellent in recent months, some experiencing double-digital total returns. With more demand and buying, do you expect yields to grow in addition to distributions?
YS: No; I think yields will compress. The current average yield is around 6%. I wouldn’t be surprised to see that reduced to 5.5%, the rationale being that stock prices move higher once the market sees healthy returns. Demand for income-oriented securities remains pretty robust. In a low interest rate environment, people continue to look for places where they can safely park cash as opposed to keeping it under their mattresses. I expect a combination of increased distributions and continued higher stock prices. The result would probably be net-net compressed yields.
TER: Do you expect to see initial public offerings (IPOs) for these types of MLPs this year?
YS: Yes, I expect to see new MLPs come to the market.
TER: Everything you’ve covered suggests good health in this sector. What is your investment thesis right now?
YS: The themes have been threefold: One, invest in MLPs that are well situated to participate in burgeoning shale plays, because as producers pursue these plays, they need the infrastructure to support further production.
Two, we think natural gas liquids (NGL) fundamentals are strong and will remain strong for the foreseeable future because NGL prices correlate with crude oil prices. NGLs are a byproduct of a natural gas production, and current low prices for natural gas are part of the cost of producing NGL. But crude oil prices are high, and that determines the revenue stream NGLs will produce. This all speaks to a very favorable margin opportunity. We would suggest that MLPs that have exposure to NGL fundamentals should continue to do well.
Three, we like this notion that MLPs can buy assets from their sponsors at attractive valuations that enable them to grow distributions. These dropdown stories will continue to perform well over the next couple years.
TER: Are extraction products from natural gas the most profitable part of natural gas production?
YS: Yes. As we speak, natural gas prices have fallen below $2.50/thousand cubic feet (Mcf). Natural gas is very depressed, but what’s keeping the economics favorable is the fact that some of these plays, such as the Marcellus shale play, produce NGLs along with the gas. The NGLs triple the actual realization on the commodity because of the liquids content. So that is a very, very powerful thematic right now.
TER: What are your preferred standards for MLP growth and income?
YS: Our approach focuses more on total return. Simplistically, an investor can buy a stock that’s yielding 8% but has 3–4% distribution growth, and he or she would probably have an 11–12% return. Conversely, an investor could buy a stock that’s yielding 5% and is growing 7–8%, and wind up with a 12–13% total return. Balancing total return with calibrated risk is the right approach. Don’t try to capture total return and take undue risk. Overall, the market pays for growth.
MLPs with more growth typically have much lower yields, so it’s not inconsistent for us to recommend Western Gas Partners, L.P. (WES:NYSE), for example, which is yielding below 5% but which we think will have double-digit distribution growth over the next couple of years. At the same time, we could recommend Boardwalk Pipeline Partners, L.P. (BWP:NYSE), which is yielding around 8% and is going to have much more modest distribution growth of 3–4%.
TER: Let’s segue into your top MLP picks.
YS: Well, what we like about Boardwalk Pipeline Partners is that it has a very steady revenue stream tied to its interstate pipelines. With new management in place, we think 2011 was perhaps an inflection point for the company to try to focus more on growth. It has done so by buying storage assets from Enterprise Products Partners, L.P. (EPD:NYSE) and signing a gathering agreement with Southwestern Energy Co. (SWN:NYSE) in the Marcellus. We think there is an opportunity to accelerate the growth in distributions if management is successful. If management falls short of that goal, I think investors would still be happy with the safety of the yield.
The other company that’s within that interstate pipeline business model is El Paso Pipeline Partners, L.P. (EPB:NYSE). That stock came under a little pressure when Kinder Morgan Energy Partners, L.P. (KMP:NYSE) announced that it was buying El Paso Corporation (EP:NYSE) last year. I think El Paso Pipeline Partners was unduly punished because investors felt the distribution growth would slow. It is going to slow, because instead of having all of El Paso’s pipeline assets migrate into the MLP, now some of those assets will be migrating into Kinder Morgan. It’s almost a truism that the growth at El Paso Pipeline Partners is not going to be as robust because those pipelines will be moving into a different entity. However, we still think El Paso Pipeline Partners will be able to grow its distributions at 9%, and in fact, Kinder suggested as much. So we think a 5.5% yield and 9% distribution growth over the next couple of years is a good formula for success and a good formula for total return potential.
When you think about the other theme we spoke about, the strength of the NGLs, Targa Resources Partners, L.P. (NGLS:NYSE) fits into that. We like Targa because of the investment opportunities, the integrated model it’s pursuing within its midstream business and its very good management team.
We also like DCP Midstream Partners, L.P. (DPM:NYSE), which is another NGL story, but it’s also a dropdown story. There is the MLP, DCP Midstream Partners, and its sponsor, DCP Midstream LLC (DPM:NYSE), which is 50% owned by Spectra Energy Corp. (SE:NYSE) and 50% owned by ConocoPhillips (COP:NYSE). DCP Midstream Partners will continue to see assets migrate to it from DCP Midstream, helping to finance its growth while it pursues its own organic growth.
Then, within the dropdown stories and also in the midstream space, it’s hard not to mention Chesapeake Midstream Partners, L.P. (CHKM:NYSE) and Western Gas Partners, which I mentioned earlier. Both of these MLPs are owned by exploration and production (E&P) companies—Chesapeake Energy Corp. (CHK:NYSE) for Chesapeake and Anadarko Petroleum Corp. (APC:NYSE) for Western. The upstream parents are investing millions of dollars on building infrastructure to connect their wells, and the MLPs are helping to finance that via the dropdown. In the case of Western, it is having some good organic growth in the DJ Basin on top of what it can expect to acquire from its parent. We think Western and Chesapeake give investors nice, double-digit growth.
For investors who are looking for more safety, or simply more mature MLPs, Enterprise Products Partners LP probably represents the best in class, being the largest MLP and having a vast footprint within the U.S. spanning NGL, crude oil and refined petroleum products. It covers the whole spectrum, and it has an excellent management team. It has an excellent balance sheet and a great formula for 5% steady distribution growth as far as the eye can see. Enterprise is a real core holding and one that we would like to have in any MLP portfolio.
TER: Over the past 52 weeks Enterprise is up 15%, and it’s up 2% over the past four weeks. With a $43B market cap, what are its growth prospects?
YS: Well, it is investing $3–4B annually in organic growth projects. Let’s not forget that it will cost billions of dollars to build U.S. energy infrastructure that supports shale play development. We think that a majority of that spending is being done by MLPs and Enterprise is a good case in point. That runway is probably pretty long, meaning infrastructure spending should last several years. That bodes well for the MLPs that are investing the capital and should be generating returns that support distribution growth.
It’s not only the size of the company that matters, but the ability to execute projects efficiently and cost effectively, using existing assets in some cases that provide leverage. For example, Enterprise will be using some of its existing pipeline and its right-of-way in order to realize its planned ethane line, stretching from the Marcellus to the Gulf Coast. The joint venture crude pipeline that it is doing with Enbridge Energy Partners, L.P. (EEP:NYSE) from Cushing to the Gulf Coast makes use of an existing pipeline there. It is reversing the Seaway pipeline at an extremely reasonable cost, which speaks to your point that there are not many companies out there that have the infrastructure or the entrepreneurial spirit to go after these projects.
TER: Are there any other companies that exhibit this entrepreneurial spirit?
YS: ONEOK Partners, L.P. (OKS:NYSE) has an excellent management team, and it is also a play on the burgeoning NGL market. I would also mention Magellan Midstream Partners, L.P. (MMP:NYSE), which is focused on crude and refined products pipelines.
TER: Both of those companies have had tremendous runs recently; ONEOK is up 39% over the past 52 weeks, while Magellan is up 21% or so.
YS: Both of those stocks have good growth characteristics and excellent management teams, but investors might want to wait for a better entry point before buying. They’ve certainly had really terrific runs.
Sunoco Logistics Partners, L.P. (SXL:NYSE) is also doing its bit to take advantage of getting ethane out of the Marcellus. It is also helping to de-bottleneck the amount of crude oil that’s trapped at Cushing by moving crude production from the Permian Basin down to the Gulf Coast instead of north to Cushing. I put it in the same sort of category, as it has a good management team, strong balance sheet and very good growth prospects. All those good things are reflected in the stock price, so a better entry point might be worth waiting for.
TER: Sunoco Logistics has pulled back a bit over the past four weeks, but not much.
YS: I’d just like to stress the fact that the companies in the MLP class are very transparent because of cash flow. It’s a very good pass-through structure for getting cash back to shareholders in a tax-efficient manner.
TER: If you had to pick one of these MLPs as a very favorite, what would it be? Or should investors choose a basket of MLPs?
YS: My thought is that investors are best served by diversifying within a basket of MLPs. I don’t think MLPs are mispriced securities, so you’re not necessarily going to have outsized returns, nor do I think investors who are looking at the bond and stock markets could really expect outsized returns. For the equity market, if investors could see a 6–8% type of total return, they should be pretty happy.
TER: Yves, we haven’t seen any large gains in the price of crude over the past six months, and we have certainly seen the price of gas depressed. If energy commodities began to strengthen, what kind of an effect would that have on these MLPs?
YS: It would affect different sectors in different ways. With the gathering and processing companies, most of the contracts are for a percentage of proceeds. The MLPs do a pretty good job of hedging their commodity risk out one to three years. But in a strong NGL- and crude oil-pricing environment, net-net they would benefit. Low natural gas prices are positive for gas processing margins. However, some intrastate pipelines would see diminished volumes if drilling slows down in dry gas areas. If crude and gasoline prices were to get too high and gasoline prices get too high, refined petroleum product pipelines might experience some negative pushback because of declining volumes in their pipelines.
TER: Thank you for sharing your knowledge and time today.
YS: You bet. Thank you.
Yves Siegel joined the Credit Suisse Energy Research Team in June 2009 to cover the MLP and natural gas pipeline sectors. Immediately prior to joining Credit Suisse, Siegel was a senior portfolio manager at a New York hedge fund focused on MLPs. Prior to his buyside experience, Siegel had established a leading sellside MLP franchise, having spent more than 10 years at Wachovia Securities after prior sellside engagements at Smith Barney and Lehman Brothers. He has received both a BA and an MBA from New York University and is a CFA charterholder.
By The Energy Report, on February 3rd, 2012
With the winter warmer and drier than previous years, natural gas companies are suffering from depressed prices. However, Raymond James Analyst Luc Mageau identifies liquids-rich companies that can create profits with or without a natural gas price rally. In this exclusive interview with The Energy Report, Mageau explains how to use well payout rates to evaluate a company’s longer-term cash flow.
The Energy Report: With Brent Crude trading at about US$110 per barrel (bbl) and natural gas futures trading at 10-year lows, are you leaning more heavily toward oily names than you did in 2011?
Luc Mageau: Absolutely. In fact, although gas prices have been reduced to around the $2.50 level, it still seems like the picture could get worse before it gets better. Current natural gas storage is at ~3.5 trillion cubic feet (Tcf); that’s a full 0.4 Tcf fuller than an average winter. The reason we have such a glut of gas is the winter has not been co-operating. Basically, we rely on winter to post the bulk of the withdrawals throughout any given year—in the last few years, we have truly been relying on a cold winter to bail us out of the storage glut and we’ve been lucky. On average we normally see ~150-200 billion cubic feet (Bcf) of gas withdrawn per week. With the warm weather we’ve been getting, our average withdrawals from storage have been closer to 80-100 Bcf during the 2011/2012 winter season—that translates to a lot of excess gas. Making matters worse, the weather is not expected to get colder. This means we could be in store for several more weeks of warmer-than-average winter, and given we only have a handful of weeks left in the official “withdrawal season,” we’re running out of time to get back to normal storage.
Historically, when weather fails to bail us out of the glut we have seen production shut-ins to curtail the problem. This time, I think we could be in a slightly different boat—and we can blame the price of oil for that. You see, over the last several years, low natural gas prices have forced gas producers to derive cash flow from other sources. One major source has been incremental extraction of natural gas liquids (NGLs). NGLs are heavier hydrocarbons that are produced in conjunction with natural gas. These products typically trade closer to the oil price. Given the wide discrepancy of oil:gas pricing, NGLs can account for a good chunk of the effective price a gas producer receives. What this means is that even when gas prices are below $2.50, the NGL component now being realized from produced gas is allowing a lot of gas that would have historically been shut in to remain marginally economic, and as such, still on production. So we are seeing less shut-in production than historically, and even if we were to begin shutting in production now we would need nearly 6 Bcf/d to be shut-in for the bulk of 2012 just to get back to normal storage levels—a situation that seems unlikely.
The bottom line is that we continue to expect gas prices will stay depressed and oil prices to continue to thrive and as a result, oil stocks should continue to outperform in general.
TER: Should investors stay away from the gas-heavy names or simply gas-heavy names with liquids-poor content?
LM: Some companies are certainly offering good value today and just because gas prices are low right now doesn’t mean that there are no investable ideas. This being said, dry gas companies (i.e. those with liquids infused plays below 20 bbl/MMcf) are really having their cash flows squeezed right now. Netbacks for companies in this camp have been compressed to mid-single digits and even keeping production levels flat without adding a significant amount of debt is hard. On the other hand, companies with liquids rich gas plays that generate 50 bbl/MMcf or more can boost the realized price of their gas by $4.00/mcf. In fact, given the price of liquids, these companies were already generating in excess of 80% of cash flow from the liquids anyway, so the price of gas does not make that much of an impact on the overall value of the company. So if you are looking for gas exposure, it would probably be safer to look at companies that have exposure to these types of plays. In our coverage universe, Crocotta Energy Inc. (CTA:TSX) is probably the best positioned in this camp.
TER: Let’s talk some more about your coverage universe. Crocotta Energy relies heavily on its liquids-rich assets. Please tell us about how one of those assets, Edson Bluesky, is insulating Crocotta from low gas prices.
LM: Crocotta has been working this asset up for the bulk of 2011 and it has been having very good success. In all it holds ~36,000 acres of land here and the key play so far has been the Bluesky formation. The reason that this play is exciting is because it truly is liquids rich—getting anywhere from 50-100 bbl/MMcf of NGLs. What this means is that even though Crocotta is a gas-weighted producer, at $2.00/mcf gas prices the company can generate netbacks in the mid-$20/barrel oil equivalent (boe) range (compared to low- to mid-single digits for most gas companies). The wells typically cost ~$5.8M, so they are expensive, but considering the amount of wells already drilled on the land base, they are low risk and generate an NPV of over $4M even at $2.00/mcf gas (compared to drier gas wells that would be posting closer to $0-1M NPVs). So the company is still making plenty of money even at these gas prices and it still offers the option on gas prices for the future.
TER: Crocotta exited 2011 with production of about 6,500 boe/day, well ahead of both the company’s exit guidance range and your expectation of about 6,000 boe/day. In fact, those fourth-quarter results brought Crocotta’s 2011 average production up to 3,725 boe/day. What sort of production are you expecting in 2012? And will that be enough to reach your 12-month target of $4.75?
LM: Our numbers have the company exiting 2012 north of 8,000 boe/d—one-third of that production is expected to be oil and liquids. The growth is primarily expected to come from Bluesky liquids rich wells, but we’ve also built in some wells for the company’s Cardium lands at Edson. Late in 2011 the company announced its first Cardium well in the Edson area had an initial production rate of 1,000 boe/d (60% oil). This was previously a formation that we were not anticipating much growth from so there is a significant opportunity for the company to build an oil-weighted portfolio of wells if it can show that this is repeatable—and based on what we’ve seen, we think that’s possible. So our $4.75 target price is premised on the production profile through 2012 and 2013. In fact, for 2013, even at $2.00/mcf gas the company could post cash flow of $0.90/share so it is currently trading at just 3.8x, lower than its gas-weighted peers.
TER: You cover Cequence Energy Ltd. (CQE:TSX), which recently conducted some tests on several new wells at Simonette, Alberta, which is part of the Montney Shale play. One new well tested at 4.8 MMcf/d and 216 bbl/day of condensate over 15 days, which would correspond to a liquids yield of about 45 bbl/MMcf. That means that these wells would be economic even at $2.50 natural gas. What’s your outlook for Cequence given these testing results versus lower than expected oil-equivalent production in 2011?
LM: We believe the recent Montney well results continue to prove that the Simonette area is highly prospective for natural gas production growth. This combined with the additional take-away capacity from the pending Alliance Pipeline connection adds comfort that growth will continue through 2012. You are certainly correct; at 45 bbl/MMcf the company’s Montney wells continue to be economic at $2.50/mcf gas. The unfortunate take-away, however, is that the payout ratios on these wells are expected to be approaching three years. This means that it essentially takes three years for the company to re-coup the money it put into the ground to drill the well, and for a junior company, this makes sustained growth at current prices difficult.
TER: Cequence says that once it connects to the Alliance Pipeline and the Aux Sables liquids extraction facility, which is slated to happen in April 2012, its operating netbacks from Simonette production would reach $30.31/boe. Do those numbers line up with yours and, if so, do you expect that to significantly move the share price?
LM: It all comes down to your view of natural gas prices. We are currently forecasting $3.25/mcf gas for 2012—which sounds more bullish than it actually is. Based on that, we have netbacks in the $18/boe range. If current prices were used instead, i.e. $2.25/mcf gas, netbacks would go to $10/boe.
TER: What’s your 12-month target on Cequence?
LM: We are at $3.50—but again that is premised on $3.25/mcf gas for 2012.
TER: A smaller name that you cover is Renegade Petroleum Ltd. (RPL:TSX.V). Renegade exited 2011 with higher-than-expected average production of 3,625 boe/day, which resulted in year over year growth of 73%. Renegade has set its 2012 production guidance at between 4,000 and 4,200 boe/day and that should result in another year of significant growth. Please tell our readers about why you believe Renegade will reach its production guidance and why you raised your 12-month target to $5.00.
LM: Renegade certainly did have a great year in 2011. After it rolled up its JV partner in the Viking (Petro Uno), it went to work post-breakup and its production growth number definitely reflects that. For 2012 we expect the company is going to put a bit more emphasis on southeast Saskatchewan, though, and we had previously been a bit more conservative on our view of the potential there. We were previously forecasting another break-up season similar to what we saw in 2011—wet and prolonged. But the very unseasonably warm summer, combined with the almost nil snow accumulation in the region is making things look much better than originally expected. Now anything can change—especially the weather—but with a slightly longer drilling season than originally expected, we were able to bring up our production estimate a bit to an average of 4,070 boe/d for 2012, about the midpoint of guidance. With our oil price deck at $100 WTI for 2012, our cash flow estimates and target followed suit.
TER: Things don’t look quite so rosy for Open Range Energy Corp. (ONR:TSX). Most of Open Range’s production base is from natural gas and its production is slated to contract in 2012. Nonetheless, you still have a C$2.00 target on that name. Tell us about that one.
LM: Open Range is coming off of a stellar year in 2011. It successfully launched the spin-out of its Poseidon division, which continues to be a strong performer. However, with that division gone, the bulk of the company’s opportunities are in dry gas, meaning NGLs under 20 bbl/MMcf. The company also has ~$50M of debt on a $75M line and is planning six gross wells for this year. So facing the current commodity price environment, the company is really in cash-conservation mode and as a result has forecasted production to shrink through this year—a stark contrast to the massive growth it was leading investors to believe for most of 2011 (its presentation projected a 2012 exit rate of ~10,000 boe/d). Now the assets that the company has are actually quite good—as far as gas assets go. The company has primarily one consolidated land block in the deep basin, an area that characteristically has large gas reserves and low operating costs, but it also has very low liquids yields so the netbacks are at $2.25/mcf gas. Our $2.00 target is premised on a $3.25/mcf gas price and to be fair, for gas investors looking at options on the commodity, Open Range is certainly a good candidate, however we believe gas markets will remain weak for some time, likely putting more near-term pressure on the name—we’ve had the company rated market perform since the spin-out, which really reflects our neutral-to-negative outlook on natural gas prices.
TER: And, finally, Strategic Oil & Gas Ltd. (SOG:TSX), which completed a $40M equity financing in December to give the junior a total of C$42 million in the bank. How is Strategic planning to use that cash?
LM: Strategic has two core light oil assets; the Maxhamish Chinkeh sand horizontal play in northeast BC, where Legacy is the operator, and its Steen River lands in northern Alberta. At Steen River, the company is the operator and has a 100% working interest in 70,000 net acres, so it has a lot of flexibility to accelerate the program here as well as a significant amount of running room for future drilling. There are at least three different oil-prone zones being targeted at Steen, so this is where we see the company getting the leverage for growing production in 2012. With that in mind, the company has provided a $60M capital program for 2012 that focuses on Steen. It has two rigs running there now, and plans to drill 20 (17 net) wells in 2012. Although the focus is still on the high-impact vertical Keg River wells, which get initial production rates of about 200 bbl/d for $1.5M, the company is also going to continue to advance its more “resource-style” horizontal play in the Sulphur point formation, and test out some new zones and play concepts in the area. Given that this program is pretty front-end weighted (there are nine wells planned for Q112), we think the company could use its balance sheet to expand this program through the back half of the year if it continues to achieve results like it has been.
TER: Despite the equity dilution in December, over the course of 2012 you expect Strategic’s share price to almost double to C$1.50. How is that going to happen?
LM: Strategic spent a lot of time on its Steen River assets in 2011. A lot of this was laying the technical foundation on which to build a strong portfolio of oil drill prospects. It successfully tested the horizontal Sulphur Point oil play, and it built out and de-risked its Keg River locations. With its balance sheet now all cashed up, we see 2012 really as a year where it focuses on aggressive drilling at Steen River. Since these wells can get IP rates of 100—200 bbl/d of oil and the capital costs of drilling them are low, it is able to really step on the accelerator pedal quickly. So we think that both cash flow and production will grow substantially through the year and into 2013. Right now we have it spending its guidance of $60M in 2012 and exiting the year with production of ~3,000 boe/d, a pretty strong growth profile when you compare it to 2011 exit production of 1,880 boe/d.
TER: Do you have some parting wisdom to impart to investors looking to enter this space for the first time in 2012?
LM: We are still constructive on oil prices, and with our view on NGL pricing and yields, we remain very cautious on the outlook for gas prices, so obviously we would overweight oil-focused names. That said, there are gas-weighted names that have currently good liquids yields with the ability to weather low gas prices and reallocate capital away from dry gas. Crocotta Energy is an exceptional example of this—the company is getting a liquids yield of 50-80 bbl/MMcf, which means that not only can it weather low natural gas prices, the bulk of cash flow is already coming from the liquids so the wells are very economic even at gas prices with a $1-handle. Second, we would certainly look to invest in companies that have the financial resources (balance sheet and cash flow) to fund an oil- or liquids-focused drilling program in order to take advantage of current oil prices. To put this in perspective—a typical oil well will pay-out in ~1.5 years, which means that all the money a producer puts in the ground they get back in 1.5 years—everything else after that is profit. Gas wells on the flip side can have pay-outs longer than three years. For a junior company, the ability to recycle cash by putting it in the ground, getting it out and repeating the process is paramount—particularly given that the amount they have is very limited. So to that end, junior companies with high oil weightings that we especially like include companies like Renegade Petroleum, Strategic, and Twin Butte Energy for their growth profiles and valuation. However, the top pick in our space right now is Twin Butte Energy, which recently closed the acquisition of Emerge. It pays a healthy dividend of 7%, has the potential to outperform its guidance, and has a very conservative payout ratio for 2012 if light-heavy differentials and oil prices remain within reason of current levels.
TER: Thanks for sharing your insights with us.
LM: My pleasure.
Luc Mageau joined Raymond James in March 2006. He is responsible for covering junior and intermediate oil and gas producers. Prior to joining the firm, Luc was employed as a commercial lender at a major bank and as a research analyst at a U.S.-based equity research firm. He has a bachelor of commerce degree from the University of Alberta (2001) and holds the CFA designation.
By The Energy Report, on February 1st, 2012
 Powers Energy Investor Editor Bill Powers doesn’t shy away from microcaps; he embraces them. In this exclusive interview with The Energy Report, he explains why triple-digit oil is here to stay and how the best-positioned companies will be sitting pretty when natural gas prices rise—as will investors who time the rebound right.
The Energy Report: Is it fair to say that you are a value investor?
Bill Powers: Absolutely. I’m very much a value investor focused on fundamentals and finding companies that can grow reserves, production and cash flow without taking on too much debt and/or diluting shares. Those are the companies that can have very strong long-term outperformance. That is my theme, and I think it is really powerful right now. The companies I’ve identified do not currently reflect future prices that their stocks will be receiving.
TER: Clean balance sheets, steady cash flow and a depressed market price: would that sum it up?
BP: Yes. The Canadian junior market has changed in the last 10 years markedly. It’s matured greatly. Many companies have proven management teams and very good cash flow but are trading below their net asset value.
TER: Do you try to stay away from micro-cap stocks?
BP: Absolutely not; I very much embrace micro-cap stocks. As a newsletter writer, my commentary is largely directed at investors who want information on companies that are below Wall Street or Bay Street’s radar screen. I try to find the company that I feel is best positioned in a certain play and that have the chance for the best share price appreciation. Usually, it’s not the large-cap producers who have acreage in the play.
TER: How do you define a micro-cap?
BP: I consider a micro-cap as $250 million (M) on down.
TER: You recently wrote in the Powers Energy Investor that foreign investors are paying too much for joint venture (JV) agreements with large North American companies. If foreign companies are overpaying, why is that depressing the price of gas?
BP: I’ll give an example: Chesapeake Energy Corp. (CHK:NYSE) made a deal with Total Energy Services (TOT:TSX) to farm out its Utica shale acreage in Ohio. To put this into perspective, there have only been a handful of wells drilled in Ohio into the Utica shale, primarily within one county. This is a speculative play and I am very skeptical of how productive the Utica shale could really be.
That being said, the way these deals are structured is that Total, the foreign company in this case, pays $600M up front to Chesapeake, which will be drilling wells funded completely by Total. So between now and the end of 2014, it will be spending $1.5B on drilling. There are other companies that have done similar deals totaling maybe $20B from largely foreign companies farming into U.S. acreage. This is important because the foreign company will fund drilling for usually two years irrespective of gas price, and when companies drill with somebody else’s money, they are not sensitive to the fact that gas right now is under $2.50/thousand cubic feet (Mcf). It’s a good deal for the American companies, but it’s usually a very, very poor deal for the foreign firms.
TER: Classic economic theory says that if you keep producing like this and prices get very low, people will quit producing. Then, eventually, prices will go back up. When does that happen?
BP: I think it’s going to be happening fairly soon. Right now we have a glut of gas. Part of this is due to Haynesville and Marcellus operators’ drilling acreage to keep leases from expiring. The rig count is really starting to fall, especially in the Haynesville, which is producing 6 billion cubic feet (Bcf)/day right now and is the largest-producing field in the U.S. But that rate has already flattened out, and production will probably start to fall as rigs continue to get dropped. These are very high-decline wells. Texas production is beginning to decrease because the Eagle Ford is not offsetting production declines elsewhere in Texas. Gulf of Mexico production continues to go down. Basically, with gas under $3/Mcf, virtually every field in North America is uneconomic, and we will see a big slowdown in drilling. Very few companies have attractive hedges in place because we’ve had low gas prices for a couple of years. We will see a rebound in gas prices, and it will be quite violent. The challenge is finding the right timing of it. It is not so much a function of when the economics make sense as it is about when other people’s money runs out. We’re seeing that happen right now.
TER: Have we reached the point of maximum pessimism yet?
BP: That’s hard to say. I do think there is a lot of pessimism, but that doesn’t mean a reversal is imminent. I do think that at some time in 2012 we will see that reverse itself, and when that happens we will see gas prices increase substantially.
TER: It sounds like you are playing a very bullish scenario for natural gas. One of the first things I noted in your model portfolio from your Powers Energy Investor is that you have significant personal exposure to natural gas.
BP: Yes, absolutely. From an investor’s standpoint, being a contrarian is easy when your stocks are going up or when your ideas are being recognized by other market participants. What I’m doing in my newsletter is finding gas producers that have been beaten bloody by the marketplace but are low-cost producers that will make it to the other side to see the rebound in gas prices. I’ve identified about five companies that are leaders in certain plays or that have very good leverage to what I think are some of the best North American unconventional resource plays. Those are all places that will continue to produce into the future because they have the better acreage that will become economic once gas prices go back to $4/Mcf. Right now, you’re getting a lot of upside for free because the marketplace doesn’t believe that gas prices will eventually rebound.
TER: Could you talk about those companies you just referenced?
BP: Sure. One of the companies is Ultra Petroleum Corp. (UPL:NYSE), which is a slightly bigger company than I usually cover. It is very active in Wyoming on the Pinedale Anticline, and it’s also very active in the Marcellus. It is a very low-cost producer. This company was a penny stock about a decade ago.
Another I really like, a smaller company, is Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX). It has a great project in the Montney in Canada. It is an extremely well-run company that I think is doing very good work up there.
There are other companies that offer a lot of value and have seen their share prices decline, such as Fairborne Energy Ltd. (FEL:TSX) in the Willrich. It’s a very exciting play in Alberta’s Deep Basin.
This is just a preview of companies that I think have good acreage and that are very leveraged to rising gas prices.
TER: Those were three of your five favored gas companies. What were the other two?
BP: One is Quicksilver Resources Inc. (KWK:NYSE). It’s a U.S.-based company that has a fair amount of debt on its balance sheet. However, for a small-cap company, it has fantastic acreage in the Horn River Basin, where it is very early stage, but this may turn out to be the best shale gas play in North America. Time will tell. This company has been around for more than 50 years, and it has a very good management team. It has been a leader in a number of shale plays. It had the Antrim shale in Michigan and the Barnett shale in Texas. It was one of the early players in those plays.
The other one I like is a bigger company that continues to produce very good results, and that is Southwestern Energy Co. (SWN:NYSE) in the Fayetteville shale as well as in the Marcellus. The company has a dominant acreage position in the Fayetteville and has really been able to grow its production quickly in the Marcellus. It is a very well-run company by Steve Mueller.
So those are just some companies that I try to find. Each is unique. Each of them has different catalysts that will help its share prices more than double once gas prices start to move up. I think these stocks could go up three- or four-fold from here without any problem.
TER: Ok, you love natural gas. What about oil?
BP: I’m very bullish on oil. I think there are some very good factors that will keep the price of oil over $100/barrel (bbl) almost irrespective of how the economy does. With the natural declines from the Gulf of Mexico and the North Sea as well as Venezuela and Mexico, a lot of countries are struggling to keep up production. I think the U.S. has been able to increase its production materially over the last five or six years due to breakthroughs in technology, but that does not change the long-term trajectory of oil production in the U.S. We will see declines from California and the Gulf of Mexico, and we will see further production declines in Alaska, which will largely offset some of the very exciting production growth in unconventional plays, such as the Bakken in North Dakota or the Permian Basin in Texas. I do think triple-digit oil prices are here to stay, and I think we could see $150/bbl before too long, especially if there is a disruption in the Middle East. I think the leverage available to investors with small-cap companies is really mindboggling when you look at what oil prices mean to these companies.
TER: What oil-based companies are we looking at?
BP: Arsenal Energy Inc. (AEI:TSX), a very exciting play in the Bakken. It also has acreage in the Willrich and a very good management team. It is growing its production, and it just did an acquisition that grew its production to around 4 thousand barrels (Mbbl)/day. It has a very strong future as far as production growth that’s high net back, high cash flow and reasonable balance sheets. That’s one company that I am very high on. It has a market cap of only about $109M. It is one of my favorites.
As far as other companies that have great leverage that will go up, I’m becoming very keen on oil sands companies. I think companies like Connacher Oil & Gas (CLL:TSX) are going to rebound and continue to rebound. PetroBakken Energy Ltd. (PBN:TSX), Petrobank Energy & Resources Ltd. (PBG:TSX) and Petrominerales Ltd. (PMG:TSE) are all very oil-weighted companies that will be able to really ramp up cash flow in 2012 as oil prices maintain the $100-level.
Then we do see some U.S.-based companies like SM Energy Co. (SM:NYSE) in the Eagle Ford. This is along my theme of trying to find companies with the best leverage to a certain play. I think SM Energy has the best acreage in the Eagle Ford.
A couple of companies are involved in secondary oil recovery are Evolution Petroleum Corporation (EPM:NYSE) and Denbury Resources Inc. (DNR:NYSE). I think both of those companies are very well-leveraged to oil prices.
So those are some ideas that I think will provide shareholders great returns in the next two years.
TER: Speaking of oil sands, the Obama Administration nixed, at least temporarily, the Keystone XL Pipeline from Canada down to the Gulf Coast. Are the concerns valid? Aside from the developer TransCanada Corp. (TRP:TSX), who does this hurt?
BP: I think this really hurts American consumers. I don’t believe the concerns over the environmental aspects of the XL Pipeline were valid whatsoever. I think this was almost entirely a political maneuver. Right now, the U.S. still imports a substantial amount of production from overseas, and I don’t think some of these overseas suppliers are nearly as reliable as Canada. We import a lot from countries such as Venezuela and Mexico, which are struggling to maintain their production levels and are increasing internal consumption. So I think it is unlikely we will see material imports from either of those countries 10 years from now. Given the growth profiles of many Canadian oil sands producers such as Imperial Oil (IMO:TSX; IMO:NYSE.A) and Cenovus Energy Inc. (CVE:TSX; CVE:NYSE), I think we will see material growth in the Canadian oil sands from about 1.2 million barrels (MMbbl)/day to maybe 4 MMbbl by 2022, obviously depending on permitting issues and the price of oil. I think the Keystone would have been a very good supply. Eventually, I think the Canadians will get fed up and build a pipeline to Port Rupert and send the oil sands production to Asia if the U.S. cannot find some solution to get the XL Pipeline moving forward.
TER: The differential in price for what Asians are paying could pay for shipping that oil to Asia.
BP: Yes, absolutely. And one of the things we’re seeing in Asia is that some of the biggest producers such as Indonesia are seeing flat to declining production. And China has really struggled to keep its production flat. There have been some very good offshore finds in Malaysia and Vietnam that will replace some of the declines from places like Indonesia, but on an overall basis, those are not keeping up with the growing regional demand. Numerous Asian countries, especially China, would love to tap into the Canadian oil sands. A pipeline will get built. It’s just a matter of whether it leads to the U.S. or to the west coast of Canada.
TER: You have reviewed Energy XXI (EXXI:NASDAQ) recently.
BP: It’s not in my model portfolio right now, but I was very impressed that it has been able to grow production and that the company has a material oil weighting. It has a very good mix of exploration prospects as well as development prospects. Right now, the market has really turned its back on the Gulf of Mexico producers such as Energy XXI, and it is trading at lower valuations than its onshore peers, but it is able to generate material cash flow. In the case of Energy XXI’s balance sheet, I think some investors were a little scared off by its debt levels, which I see as very manageable given the cash flows it will be receiving over the next two years and its significant material reserves that it can borrow against. I think Energy XXI has a pretty bright future. I’m going to continue to monitor the company and see how it continues to execute over the next six months or so. It has a very good mix of high-impact exploration and lower-risk development.
TER: Bill, you are writing a book now?
BP: I’m currently working on a book that looks at shale gas and what I consider to be the myth of a 100-year supply. While there is a significant amount of shale gas that will be recovered in the next decade, it is nowhere close to a 100-year supply. Shale gas is not the game changer that a lot of people think it is.
TER: What thought would you leave us with?
BP: I think the perceived risks in energy investing have been somewhat overblown given where oil prices are. The space is very volatile, but for investors who can take a longer-term approach and who can identify companies that are well-run and that have legitimate projects, there are fantastic returns available. The energy sector has been out of favor, but the fundamentals are very strong. I think investors who can position themselves in gas-weighted firms ahead of the coming rebound will be richly rewarded, but there are also fantastic returns in oil-weighted companies that will benefit mightily from triple-digit oil prices.
TER: Bill, I’ve enjoyed speaking with you.
BP: Thank you for having me.
Bill Powers is the editor of Powers Energy Investor and previously the editor of the Canadian Energy Viewpoint and US Energy Investor. He is a former money manager and has been an active investor for over 25 years. Powers has devoted the last 15 years to studying and analyzing the energy sector, driven by his desire to uncover unrecognized trends in the industry and identify outstanding opportunities for retail and institutional investors.
By Christopher Briem, on January 24th, 2012
My inner energy futures trader is mesmerized by what is happening in the natural gas markets of late. If you do not wake up at night wondering if natural gas will flip from contango to backwardation then I will make it simple.. the price of natural gas is plummeting faster than anyone predicted.
A little over 3 years ago, right around when a lot of folks were signing a lot of their Marcellus Shale leases, the benchmark price for natural gas peaked at over $14 per million British thermal units. The benchmark is for the gas at the Henry Hub pricing point. As of Friday that price had dropped to around $2.34. So for now a decline of 80+% from it’s recent peak, but nobody seems to know where the trend ends. Some describe it as a 10 year low in natural gas prices, but that is in nominal prices. Adjusted for inflation I wonder what prices would be described as? I only know what I read, and it seems to me that industry folks, or at least the traders, are beginning to contemplate a near term future where there isn’t enough storage capacity to hold the gas being produced. Then what?
Remember the glow of steel mills along the rivers? There may be a new glow forming across the Pennsylvania countryside.
But it means more than the potential artificial twilight that may be on the horizon. Most landowners signed leases with upfront hand money as a bonus to entice signing development rights to one of the drillers out there, but also with guarantees of royalties against future production usually around 12.5% as per state law setting the minimum royalty payments, though many may have negotiated higher shares.
But not all minimums are a minimum. Some may remember that the drillers won a court case against landowners that the royalty payment was only due on the price NET of a cost to get gas to market. How much that isI do not know, but if there are any folks out there in receipt of royalities it would be of interest (at least to me). The only number in the record I see is from this old blog post which says Range Resources is deducting 72 cents or 80 cents, mer MMBtu, for dry and wet gas respectively.
So just for sake of argument, assume the selling price for gas is the benchmark price. Yes, some may be getting more, but hold the thought and lets assume a dry gas example for moment. If you net out 80 cents from the peak and current prices it works out to $13.28 back in 2008 and $1.62 on Friday, it then works out to a royalty decline of over 88%.
Seems to me there are some latent stories out there of individual landowners seeing their royalty checks dropping precipitously? Though I have no idea what the time lag is between production and check which may have a lot to do with it. The biggest drops in gas prices have been very recent, and certainly to recent to have been reflected in checks yet.
The bigger question is just where the stability returns to the market. Are current price levels enough. Some industry folks say clearly yes and that profit can be made even as low as $2.50, likely because of the other ‘wet’ products in the gas here. But we are not even at that level right now.
By The Energy Report, on January 20th, 2012
 With oil reserves less and less accessible to western majors, producer stocks can carry significant geopolitical risk. In this exclusive interview with The Energy Report, First Asset Investment Management Inc. Senior Vice President John Stephenson explains why service-oriented companies are smart selections for risk-averse energy investors. No matter what happens in the oil and gas business, the companies doing the drilling have solid prospects in this market environment.
The Energy Report: 2011 was a pretty exciting year with oil prices all over the map, largely fueled by the European debt crisis. What do you expect are going to be the hot topics affecting energy commodities in 2012?
John Stephenson: The spread between Brent and West Texas Intermediate (WTI) prices, which was a big story in 2011, will continue to play a role. I expect a lot of talk about how WTI has once again resumed its place as the global benchmark. Another big topic, as it always is, will be the continuing geopolitics of oil, be it a possible Arab spring in Saudi Arabia or Iran’s nuclear program and how that impacts the world. In terms of possible black swan events, the Environmental Protection Agency (EPA) or other regulators could limit horizontal drilling and fracking. However, that could be very positive in the short run for natural gas prices.
TER: What caused the big spread between the WTI and the Brent prices?
JS: Everyone used to look at WTI as the main global benchmark for crude oil prices, and Brent historically traded at a slight discount. Then, over time, Brent started trading at a premium to WTI. What people have to understand is that these benchmark contracts specify grade and location. The delivery location of the WTI crude contact is Cushing, Oklahoma. Because it’s landlocked, you can’t get crude in from the Gulf region, which actually traded in line with Brent. There also wasn’t enough pipeline capacity to get the large inventories of crude that had built up in Cushing out to other global markets. So it really was an infrastructure issue that caused the price spread. Now, various companies have gotten together and proposed pipeline alternatives that would alleviate this glut of oil at Cushing. Therefore, you’ve seen the spread go from $25 to about $11.40, where it is today.
TER: Your management company, First Asset Investment Management Inc., manages a variety of different commodity-focused funds. What is your 2012 energy outlook?
JS: Our outlook is very supportive and positive for oil. One of the interesting things about oil is that despite the dire headlines, mainly out of Europe, oil has held in as well as it has. In fact, it’s been hitting eight-month highs recently. Why is that? Partly because demand is so strong. We saw record demand globally in August and near-record demand in October and November and continuing strong demand despite the fact that Europe appears to be dipping into recession and growth is potentially slowing a little in Asia. This is why I’m very positive on this and expect to see oil go higher.
Natural gas, on the other hand, is very weak. It’s sub-$3/million cubic feet (MMcf) right now, and I think it will continue to be weak. Historically the period between December and March is when natural gas trades at a premium to its summer prices. This is actually the first winter I can recall seeing it trading at a discount.
TER: Weak natural gas prices are a result of increased shale gas production through fracking, which has created a significant oversupply in the last year or so. Is this going to continue, do you think?
JS: Yes, the U.S. has 200–250 years of reserves of shale gas at current production rates. I don’t see any reason at all for it to change unless, of course, the EPA or someone else were to rule that fracking was detrimental to the environment and there was a moratorium placed on drilling. That could be a black swan event and could change things. If things continue the way they are, there’s no doubt that prices will stay low. Now, clearly, there is some opportunity to export this, but that means building a liquefaction terminal, probably on the Gulf Coast or some other part of the country where people are willing to have a liquefaction facility. That would turn natural gas into a liquid to be transported to Asia or potentially to Europe, where the prices are much higher than they are in North America.
TER: So even though we may have hit peak oil, we certainly haven’t hit peak gas.
JS: No, I don’t think we’ve hit peak gas. Four years ago, the talk was that we were running out. They were going to build terminals on the Gulf Coast to take liquefied natural gas from Trinidad and other places, gasify it and put it in the U.S. pipeline system and supply the northeast in particular with natural gas. Now we’re finding we have so much of this stuff in various shale deposits that we have the potential to become a huge energy exporter. Hopefully that will be the case, but for now we don’t have the infrastructure in place to make that happen.
TER: In some respects it’s a happy turn of events compared to previous supply concerns.
JS: Not if you’re a producer of natural gas, but if you’re a producer of oil, it’s great. If you’re a consumer of electricity, then it’s great.
TER: As far as your portfolio selections and your outlook for this year, you’re clearly leaning much more toward oil and gas liquids. What other factors do you think are going to be affecting prices this year and into the future?
JS: What impacts prices for commodities is supply and demand. I think you’re going to see that demand continues to grow. The reality of why we’ve hit record world demand is not because consumers in the U.S. are doing so much driving. It’s rather because consumers in Asia are doing so much driving. China is now the number-one car market in the world. Who would have thought? If you look at total energy consumption, including coal and other sources, China has overtaken the U.S as the number-one consumer of energy in the world. That trend will continue and put upward pressure on oil prices over time.
The other theme that I think is important for investors to understand is that most of the majors have had real trouble finding replacement reserves to keep producing at the same level. Most of the industry has run from one country to another, where they’ve been kicked out. When Lee Raymond was running Exxon, he ran over to Russia, then to Nigeria, then Venezuela. The settlement that Venezuela was willing to offer Exxon for its assets was a pittance. This is typical of what we’re starting to see around the world. It’s very hard for most of the majors to find new reserves and to continue to produce at the same levels because most of the world that has energy is not open or friendly to the West. This creates a huge problem for these companies.
Given that backdrop, investors need to find companies with reserves in geopolitically stable locations, or where companies are not in the business of generating the reserves; they’re in the business of helping oil companies produce those reserves. That leads you to the service sector, which I think is a lower-risk area. Investors can stay in North America and invest in companies they know and understand without worrying about geopolitics.
TER: What are some of the names that you like in the service sector?
JS: I think if Saudi Aramco, the largest oil company in the world, is going to do a job and it’s going to produce a new field, it will call in Halliburton Co. (HAL:NYSE) or Schlumberger Ltd. (SLB:NYSE). It’s not going to call in Exxon Mobil Corp. (XOM:NYSE). It doesn’t need Exxon’s expertise or capital. But it does need Halliburton’s or Schlumberger’s expertise. These global majors are going to do well on the service side. In the last 25–30 years, the industry has gone from positive bullish cycles to bearish cycles. The people who had the expertise in down-hole seismic techniques, who understood how to operate drill bits at various angles and how to cement and case wells and all of these other things became outsourced to the service industry. The true oil business expertise is in the service industry; that’s why I see it as a sound investment.
TER: So if I may make a mining metaphor, it’s the guys that supply the shovels to the miners that are going to make the money, not necessarily the miners.
JS: Absolutely. It’s the California Gold Rush all over again, except it’s the global energy rush, and you want to be in the picks and shovels business, not necessarily in the prospecting business laying claims. If you’re a Western company and you’re laying claims, chances are you’re laying claims in some part of the world that doesn’t want you there and that may kick you out down the road. Then what do you have?
TER: What are some other companies in your portfolio holdings that you particularly like at this point?
JS: One area to look at is the smaller energy service companies, like Calfrac Well Services Ltd. (CFW:TSX) and Trican Well Service Ltd. (TCW:TSX). Again, there is an increasing amount of drilling that’s happening, even on the gas side. It’s just happening with these new horizontal drilling and fracking techniques. These are the guys who supply this equipment. That’s very strong.
I also think you want to look at the oil companies that don’t have problems with reserves and short reserve life, including some of the Canadian oil sands producers. I would recommend Suncor Energy Inc. (SU:TSX; SU:NYSE) and Canadian Natural Resources (CNQ:NYSE; CNQ:TSX). These stocks are cheap. They’re trading as if oil were $55 or $60/barrel (bbl) when it’s over $100/bbl. These low valuations offer a great opportunity.
TER: Looking at your portfolio in your First Asset Energy and Resource fund back at the end of last quarter, Sept. 30, you were about 78% in cash. Was that a strategic decision? Have you changed that cash into equities at this point?
JS: No. We were very defensive at that time, and I think the reason was pretty simple: Europe was blowing up and when any major economic zone is blowing up, I don’t think you want to be in commodities or commodity producers. Now we’re seeing that the market has stabilized, and you’re going see growth going forward. Valuations certainly never got ahead of themselves in either individual stocks or in any energy sector, so I expect valuations to move higher at this point.
We’re no longer at that same cash level. Our position at that time reflected an overall nervousness about the world. When you have these dominant issues, you need to take your money off the table, which we did. Ultimately, the trade was to the downside, and we preserved value by doing that. I’m very proud that we were able to raise so much cash and be truly defensive at a time when the market was dropping quite substantially.
TER: Are there any of your other attractive portfolio holdings that you’d like to discuss at this point?
JS: I think in terms of other commodity themes that are working well, certainly Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) would be a great name—that’s on the copper side; it is the largest pure copper producer out there. On a similar vein with a little bit better growth and a little bit more sensitivity to the market—meaning it will move a little more dramatically than the market itself—would be First Quantum Minerals Ltd. (FM:TSX). That’s another name that I think does very well.
We haven’t talked a lot about the agricultural names. If we’re talking about the broad resource base, it’s been a tough time in the agricultural space, particularly for the fertilizer companies. But I continue to think Potash Corp. (POT:TSX; POT:NYSE) looks attractive, especially at this level. Agrium Inc. (AGU:NYSE; AGU:TSX) looks attractive at this level. It’s a little more defensive than Potash. The Mosaic Company (MOS:NYSE) has struggled. I would probably recommend CF Industries Holdings Inc. (CF:NYSE) over Mosaic. Those are the areas that I would look to.
Also, in terms of other oil and gas producers, Canyon Services Group Inc. (FRC:TSX) does well. Transocean Ltd. (RIG:NYSE; RIGN:SIX), a big supplier of offshore platforms, will do well in this environment. Even Baker Hughes Inc. (BHI:NYSE) is transitioning its fleet to more horizontal drilling from straight vertical drilling. Those are all names that we have held and will continue to hold in the future and expect to do well.
TER: To sum things up as far as the energy outlook for 2012, what would you like to tell us?
JS: I would say that energy remains the most important of all the commodities. It will be the most important in 2012 and likely in 2020. Even though we’re over 100 years into the energy era, we are still very much dependent on oil. While it may seem expensive when we’re filling up at the pump or when we look at the futures prices, it’s still cheaper than orange juice on a volumetric basis. There is no substitute for oil, at least no good substitute. There is no technology right now that is commercially viable enough that could change the industry in the way that horizontal drilling and fracking changed the natural gas world. So I think you’re going to see oil prices move considerably higher.
Demand no longer is being driven by America; it’s being driven by Asia and predominantly by China. That trend will continue. In many parts of the world where demand is growing the fastest, namely the Middle East as well as some parts of South America and Asia, fuel prices are subsidized. In an environment where gasoline prices are subsidized, the consumer isn’t feeling the full impact that we feel here in North America. So for those reasons, I think we’ll see oil prices move higher, stay higher and exit 2012 at least $130/bbl. Natural gas prices, on the other hand, will remain range-bound in the $2.50–3, maybe $4, range. It’s very hard to see a successful investment strategy for investors there, other than with the service companies that are going to be the beneficiaries from all of that drilling.
TER: I think that pretty well sums it up. We appreciate your thoughts and input today.
JS: My pleasure.
John Stephenson is a senior vice president and portfolio manager with First Asset Investment Management Inc., where he is responsible for a wide range of equity mandates with a particular focus on energy and resource investing. He has been recognized by Brendan Wood International (BWI) as one of Canada’s 50 best portfolio managers for the past three years. He is the author of The Little Book of Commodity Investing (John Wiley & Sons, 2010), which has been translated into five languages and Shell Shocked: How Canadians Can Invest After the Collapse (John Wiley & Sons, 2009), and writes a free bi-weekly investment newsletter, Money Focus, which reaches a global audience of more than 125,000 (www.reportonmoney.com).
Stephenson is regularly quoted by Bloomberg News, Reuters, The Associated Press, The Wall Street Journal and The Globe and Mail and is a frequent guest on Bloomberg TV, CNBC, CNN, Fox Business and Canada’s Business News Network (BNN), Sun TV and the CBC. He is frequently the keynote speaker at investment conferences throughout North America. Stephenson holds a degree in mechanical engineering from the University of Waterloo, an MBA from INSEAD, as well as the Chartered Financial Analyst (CFA) and Financial Risk Manager (FRM) designations. He lives in Toronto.
By The Energy Report, on January 4th, 2012
 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.
By The Energy Report, on December 28th, 2011
 According to Jim Letourneau, author of the Big Picture Speculator, oil and gas aren’t going away any time soon. Indeed, new technologies offer the industry and investors profitable opportunities. Read more about why Letourneau considers shale gas, shale oil and enhanced oil recovery “game changers” in this exclusive Energy Report interview.
The Energy Report: Jim, in a nutshell what is the big picture in the oil and gas space right now?
Jim Letourneau: Despite a big renewable trend, oil and gas are still critical to world energy markets. We will need both for the foreseeable future, at least the next decade.
TER: You recently wrote about fear paralyzing the market. What effect is fear having on you as a newsletter writer?
JL: When people are scared, they want dividends, U.S. dollars and precious metals. No matter how interesting or exciting the company is, in a really strong bear market it will not matter unless the assets are productive today. People will look at a mine that is in production and has cash flow. A project that involves lots of drilling to build out a deposit is a tougher sell.
Most newsletter writers, myself included, do not like talking about companies whose stocks do not appreciate. Fewer people want to be invested in the stock market because they don’t see why they should be. However, even that can be an opportunity. When people are fearful, sometimes the market can turn and have a really nice run. If we do not have new lows over the next couple of months and the trend changes, we would hypothetically be able to enjoy that for quite some time.
TER: Some oil and gas companies are boosting dividends in an effort to get attention in the market. Do you expect that to continue?
JL: That is a way of showing off, of saying “Look, we are so comfortable with our business model that we can afford to pay out dividends.” If there is a bull market in dividend-paying stocks, there also could be a time when that popularity will end. It could be just a passing phase.
TER: But it does provide a bit of flexibility: A company can increase or decrease its dividend. It is one of the cards a company can play if it has a lot of free cash flow.
JL: Exactly. Some of the major gold producers are increasing their dividends. Everything else being equal, I would rather have a dividend from a gold producer than from a financial institution. Banks will tell you everything is great until the day before they collapse. If people are looking for dividend-paying stocks, at least gold mines or oil and gas companies have productive assets; they produce something of value. That’s where I would concentrate.
TER: That seems to be where the Chinese are concentrating. Sinopec just bought Daylight Energy Ltd. (DAY:TSX) for a little more than $10 a share, more than double the closing price the day before the bid. Do you think China will continue to turn its dollars into hard assets while dollars still have value?
JL: The short answer to your question is yes. China is making acquisitions all over the world every day of anything that is productive.
It tells you something about the state of the market that Canadian investors thought Daylight was worth less than $5/share and China waltzed in and paid $10 without any haggling at all. This was an opportunistic move by Sinopec.
Chinese companies have taken the clever strategy of going for lesser-tier companies. If they go for a bigger one, they will take a minority interest so it is not seen as a takeover.
TER: What did Daylight have that the Chinese wanted?
JL: Daylight has oil, natural gas and high-content natural gas liquids in a few different plays in western Canada. The Chinese are buying companies with the potential for productive assets.
I think China also has a very long-term horizon concerning its energy policies. The country is willing to invest in the long term over a broad portfolio of energy sources. The Chinese know that all the investments may not all work out, but they can afford to do it.
We are still building out the capacity to export natural gas from North America. If that happens, our low-price North American natural gas will be very attractive to China.
TER: At a recent investment conference in Montreal, you told the audience about three “game changers” in the oil and gas space: shale oil, shale gas and enhanced oil recovery (EOR). Can you please give our readers the nuts and bolts of your presentation?
JL: All three of those things involve new technologies that are squeezing more oil out of the ground than we ever thought possible.
In terms of shale oil, the best example is the Bakken in North Dakota and Saskatchewan, and possibly Montana and Southern Alberta. The Bakken really changed the oil and gas landscape in North America to the point of using trains to transport gas from North Dakota to Texas. And there are a lot of other source rocks that have the same characteristics and will be developed over time.
Shale gas was actually the first big game changer. Five years ago we were building natural gas import terminals because we thought we would run out of domestic natural gas. Today, North America has the cheapest natural gas in the world and we are building export terminals. It started in Texas, in the Barnett Shale. For every argument that says shale gas will not work, there are arguments that say it will. A lot of the technical problems that exist today will be solved in the not-too-distant future. That is one of the reasons I am not a huge believer in peak oil; yes, you can extrapolate present-day trends, but you cannot predict what human innovation will come up with to increase supply.
That leads to the third category, which is enhanced oil recovery. Big picture, roughly a third of the oil that has been discovered has been produced. Getting the next third out will take some innovation. There are a lot of interesting technologies in EOR that make it quite likely that the next third will be produced. Recovery factors can move up from 33% to 50% or 60%.
TER: I see your point on shale oil and EOR. But gas prices on the NYMEX are at record lows. Very few companies can make money at that level. The only shale-gas companies seeing an uptick in their share price deal with natural gas storage, and they are running out of places to put it. How can an investor make money in shale gas?
JL: There are two sides to the story. First, abundant, cheap shale gas is good for consumers of natural gas. Second, all commodity bull markets end.
Natural gas is not the best place to invest, but, it does point to the opportunities. The service companies that unlock the shale gas are doing fairly well. I suggest that people look not so much at the producing side but more on natural gas being used as transportation fuel. Some petrochemical industries and the steel industry will benefit from cheap natural gas. So, you have to be a little bit nimble.
TER: Could you give our readers a name or two in the shale-oil space?
JL: I really like Shoal Point Energy Ltd. (SHP:CNSX) because not too many people pay attention to the company. It discovered Green Point, an oil-in-shale play in Port au Port Bay in western Newfoundland. The Green Point shale can be over 2,000m thick, compared to the Bakken, which is typically 30m thick. The extra thickness really changes the amount of oil per section. Shoal Point has an oil-in-place number of at least 100 billion barrels, calculated from volumetrics. Production will be the challenge, but that is just too big a resource to ignore.
TER: The company also has the Ptarmigan oil-in-shale play in Newfoundland and the South Stoney Creek gas play in New Brunswick. How is Green Point progressing?
JL: There was a delay for further testing and Shoal Point had to wait for permits. Investors got a little discouraged because everybody wants results right away, and the share price languished.
Now, the company has the permits and will deepen the well and test it soon.
TER: In other Newfoundland oil projects, the provincial government has wanted a piece of the action. Does the government have a piece of this?
JL: I’m not sure. But, I cannot imagine Newfoundland not having a royalty interest because that is typically how we do things.
TER: Are there other shale oil plays?
JL: There are a lot in the Alberta Bakken, in Montana and southern Alberta, where that play has yet to really ignite and catch on fire. Companies are also looking in the Duvernay in Alberta. That is a deeper, Devonian shale that sourced a lot of the Leduc oil.
TER: Do you have any names in the shale gas space?
JL: Given that the price of that commodity keeps dropping, one way to play shale gas is through service companies. GasFrac Energy Services Inc. (GFS:TSX) has gotten a lot of attention for using gelled propane as the carrier fluid instead of water.
There has been a lot of concern about the use of water in fracking. Very few people realize that most oil and gas production in North America involves about 10% oil and 90% water.
People like GasFrac because it does not use water. But more importantly, in certain types of formations having a liquid hydrocarbon that changes to the gas phase when the pressure drops helps avoid the formation damage and other problems that can happen when you use a massive water-based frack.
TER: In terms of enhanced oil recovery, what names are you following?
JL: There are very few specific companies; usually it is an oil company with a project. One that I have been following for a long time, and worked for, is Wavefront Technology Solutions Inc. (WEE:TSX.V).
All versions of EOR involve injecting a fluid. It could be water, CO2, chemicals or nutrients. The more uniform and evenly distributed those fluids are, the better the process will work. Wavefront has patented an injection process that provides that uniform fluid distribution.
The company is not quite profitable yet, but the growth will come quickly from its Powerwave application for EOR.
TER: Wavefront now has a market cap of around $68 million (M). It would not take long for a major producer to get older assets to market if this technology works as well as you suggest.
JL: The biggest upside for oil companies using the technology is that they can increase their reserves without infill drilling. The oil industry does not just jump and try new technology; it likes to see some proof. Wavefront now has proof. The longest Powerwave installation is over four years old. It has numerous case studies that document how the technology works and how it makes money for the client. It has made the transition from an unproven technology to a proven technology. It is now a commercial technology with a lot of upside.
Wavefront is essentially a technology company that licenses its technology to oil companies. Wavefront will not have a lot of additional expense to sell 100 tools or 150 or 200. The scalability is exciting.
TER: If a major can apply that technology in its old basins, it would not take long to reach perhaps, $70M worth of oil.
JL: Definitely. Of course it depends on the size of its fields, but increasing ultimate production by 5-10% provides some big numbers. More and more people are seeing exactly that. Wavefront could become a takeover target. The company has roughly $24M in cash. It has a lot of staying power.
TER: Jim, what should investors be keen on in the oil and gas space in 2012?
JL: I would still look to oil and gas service companies with the right technology. Shale gas fracking companies are interesting plays to look at.
I would not be too excited about natural gas producers. Those producers who are moving toward liquid rich natural gas are a little more interesting.
Overall in the oil space, the only thing that would move oil prices any higher would be severe geopolitical tension. And I wouldn’t be shocked to see some unpleasant geopolitical tension in 2012. Economic news is creating tension all over the world. When that happens it’s usually pretty bullish for energy prices.
TER: Jim, thank you for your time and insights.
Jim Letourneau is a public speaker, geologist, corporate evangelist, and investor in emerging technologies and discoveries.
By Christopher Briem, on December 19th, 2011
Well, in Ohio there is certainly more debate over the economic impact of shale gas development. No, that isn’t right, there is debate here, but I can’t say I’ve seen a headline this blunt in Pennsylvania.
See the Cleveland Plain Dealer over the weekend: Shale gas will not create 200,000 Ohio jobs by 2015, Ohio State University says of industry. Not only that, but here is what it says about the jobs created in Pennsylvania:
“We estimate that Pennsylvania gained about 20,000 direct, indirect and induced jobs in the natural gas industry between 2004-2010, which is a far cry fewer than the over 100,000 jobs reported in industry-funded studies (and the 200,000 expected in Ohio by 2015),”
Hmm… I guess if I had to start to judge which numbers are closer to reality, I would first look at what backgrounds the various authors have in regional economics and employment research.
By The Energy Report, on December 16th, 2011
As developing countries increase their energy consumption, the oil and gas sector will continue to grow, powered by Canadian companies feeding global demand. In this exclusive interview with The Energy Report, President and Portfolio Manager Bill Bonner of Brickburn Asset Management in Alberta reveals several energy companies with maximum production and growth potential.
The Energy Report: Bill, your bottom-up firm makes its investment decisions based on individual company fundamentals, but do you have a sector bias?
Bill Bonner: Our focus is entirely Canadian energy, with one exception: We also manage private client assets and traditional portfolios. I have two partners who look after non-energy holdings in those portfolios, but our background has been as energy investors for 30 years, so that’s what we focus on. People allocate capital to us because of our energy expertise.
TER: Are you bullish on oil and gas as commodities?
BB: Over the near term, it’s hard to be bullish about the price of natural gas. Even if there were some abnormal weather events this winter, it’s unlikely we’re going to get a big bump in the price of natural gas. Over the medium to longer term, we can be quite bullish. The outlook for gas over the long term is spectacular, given it’s an environmentally friendly commodity. If you had a choice to burn coal or natural gas in your power plant, you probably should pick natural gas. That transition is happening.
There is one caveat. Natural gas liquids are a component of natural gas. Producers today are likely not looking for dry sweet gas—they’re looking for gas that has some liquids component. The heating value is higher, and companies can extract the liquids if the price is positive. So, while operators acknowledge the gloomy near-term outlook for gas, there are companies that want to focus on liquids-rich natural gas.
Oil is an entirely different scenario. Given the volatility of oil, prices are up. We are consuming more energy than ever, and that trend’s not going to decline. Yes, there will be some bumps along the road, the Eurozone issues for example, but the energy demand in Europe and North America is not the most important variable today. Emerging markets in developing countries are driving the demand higher, and that’s not going to change. The outlook for oil demand will continue to be positive in the short, medium and long terms.
TER: What is your oil forecast? Are you using current oil prices or higher oil prices in your models?
BB: The baseline we use is $80/barrel (bbl) for light sweet crude oil (West Texas Intermediate, WTI). There are many other lighter crude qualities that are more important than WTI, but it’s a benchmark that’s commonly used. Our near-term projected range is $80–100/bbl, and we’re at the upper end of that now. In the past six months, we’ve had two tests, and in the worst—Europe’s contagion—$80/bbl was the bottom, so we think that has established a bottom price. Not only that, the Organization of Petroleum Exporting Countries’ range last year in its World Oil Outlook was $75–85/bbl. This year’s report defines the trading range as $85–95/bbl, so we say $80/bbl is a pretty comfortable bottom level.
We’ll look at a business and ask, what happens if the oil price is $80/bbl? What happens to the cash flow and the capital spending program? If we’re comfortable that the company can still plow ahead even at that level, then we want to take a position. It’s possible to be seduced by the higher price at $100/bbl, but you have to recognize that in the short term, that is a windfall. However, one to two years out, the baseline might be $100/bbl. That’s the direction we’re going.
TER: So is the recent WTI of $102/bbl a bit overbought?
BB: I wouldn’t necessarily say that. Does $2 make a difference if your top level is $100/bbl? I don’t think so, but at that level the market is pricing in a degree of optimism that we are comfortable with. If we saw $110/bbl, I wouldn’t feel as comfortable.
The feedback we get from producers is that they are hedging as soon as they see prices in excess of $100/bbl. That indicates industry is thinking cautiously, so perhaps we should be thinking the same way.
TER: Gasoline prices at the pump are down about $0.10/gallon (gal) over the past two weeks, but crude has been in a trading range over H211. If it remained in this range, would that be an extremely bullish scenario for oil producers?
BB: Yes, I think so. If the new baseline could become $100/bbl as opposed to $80/bbl as we believe it sits today, then we have to adjust our thinking. In the U.S., $4/gal seems to be a magical number. Above that, you get lots of chatter in the press about how horrible that is; below that, people seem to be accepting.
TER: As of June 30 in your Dominion Equity Growth Resource Fund, you were invested in oil and gas production 2:1 versus exploration, 62% versus 31%. Why are you weighted the way you are with a growth fund?
BB: The production stories are cheap, yet they have organic growth built into them. There are three names I really like; two are large, and one is small: Whitecap Resources Inc. (TSX.V:WCP) and Surge Energy (SGY:TSX.V) being the large ones and DeeThree Exploration Ltd. (DTX:TSX.V) being the small one.
If we want exploration exposure, we tend to focus on international stories as opposed to domestic stories. It’s more and more difficult to find a good exploration story in the Western Canadian Sedimentary Basin. Pre-production or small-production stories in places like Argentina and North Africa are quite exciting. Our investment view and portfolio weight is driven by the fact that we see the production stories are inexpensive.
TER: Surge is one of the larger of these that you like, with $602M market cap. What’s your story there?
BB: Surge is becoming quite oily. You can’t get away from natural gas with most of the producers in the basin here in western Canada, so if you want to play an oil story, you’re probably going to end up owning some gas too. Surge is about two-thirds oil and one-third natural gas.
The management is what really attracts us to the company, as we’ve been invested with the management team a couple of times prior to Surge.
Three of the company’s plays really jump out at us, all light oil plays. The opportunity on those, based on about a 10% recovery factor, is about 30 million barrels (MMbbl) of recoverable crude. When you apply secondary production technology (i.e., water flood), that number almost doubles. It’s not a matter of finding the hydrocarbons; they are there. It’s a matter of exploiting what you already have. And Surge has good operators who can take a challenging situation and figure out a way to improve recovery factors. Surge is also sitting on some big oil-in-place opportunities with just under 500 drilling locations. It expanded its capital expenditure budget from $120M to $160M to take advantage of its inventory of opportunity. The company has had no dry holes in 2011 so far—not a bad batting average.
TER: About a month ago, Surge revised its 2011 production rate up 73% over its exit production of 2010. The market is looking at that as history though. Does that have any bearing on 2012?
BB: Surge is going to continue to organically grow production, however it acquired an asset at Valhalla at the Peace River Arch area in Alberta, Canada, which is partly why production jumped.
As for internal organic growth, Surge has its top three plays well positioned. It’s just a matter of completing exploitation of these plays. We expect the company will exit this year at 7,000 barrels of oil equivalent (boe) and has the potential to double production in 18 to 24 months. That’s pretty good growth.
TER: What’s your investment thesis with Whitecap?
BB: We’ve also had some past experience with management at Whitecap, and it has built previous companies through an active acquisition strategy.
Whitecap has made three or four acquisitions that have all been accretive to shareholders, and now the company is roughly the same size as Surge. Interestingly, Whitecap is in some of the same areas that Surge is in, up in the Peace River Arch area. Whitecap and Surge have similar profiles in terms of production mix—two-thirds oil, one-third gas. That’s the production base; when you look at the revenue however, it’s more like 90% oil and 10% gas; that’s a reflection on how tough the gas business has become.
Whitecap is an aggressive hedger. It will hedge up to two-thirds of its production. We don’t have a problem with that because we just want to make sure the company executes on its budget.
Smaller producers used to be criticized for hedging, and the argument was that they were taking away upside from investors. That has changed. Now, financial analysts say hedging is fine if it achieves the objective, which is to meet the capital spending. We want to see production growth. Whitecap has been a good example of a company that does that. Its hedging experience has added 10–15% to its netbacks.
TER: Is that because there is a very high relative strength that’s up 28% over the past 12 weeks?
BB: Yes, the Whitecap story is partly management and partly execution, which is a reflection of management. The company is positioned to again double the production, and when you start to run through the metrics of the inventory, making some assumptions about how much it will take to finance the process, you can see an added $10–11/share. I look at the stock at $8.50/share, and I think it could potentially double from this point. This production story has growth.
TER: So Whitecap is going from a small-cap to a mid-cap producer.
BB: Yes. It’s a larger small-cap company at the moment, with 7–8 thousand barrels a day (Mbblpd). In Canadian terms, we would probably call this a mid cap at the current $750M enterprise value. Things are a little smaller in Canada in terms of definitions.
TER: It opens up the possibilities of being owned by larger mutual funds too.
BB: It certainly helps.
TER: DeeThree has had a bumpy ride over the past 12 weeks. It’s down 40%.
BB: This is more of an exploration story than a production story, although the company certainly has production. The leverage here, compared to either Surge or Whitecap, which have the potential to double, is that DeeThree has potential to quadruple.
TER: It’s a value play.
BB: It’s a matter of execution too. Again, this is a situation where we’ve been familiar with management and have made money with them in the past. When DeeThree first set out, it made a significant acquisition in southern Alberta that included all kinds of infrastructure, gathering systems, plants, etc. What the company didn’t realize at the time was underlying its lands is a play that is now emerging and catching everybody’s attention. It’s the Alberta Bakken. DeeThree has been able to farm out part of its massive land spread. There are 250–300 prospective sections on trend (a section is 640 acres). Recent land sales on trend have gone from $500/acre to $1,000/acre. That equates to a large “conceptual” value for DeeThree and it got us interested in the name.
Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE), Crescent Point Energy Corp. (CPG:TSX), Murphy Oil Corp. (MUR:NYSE), Nexen Inc. (NXY:TSX; NXY:NYSE), an independent called Legacy Oil & Gas Inc. (LEG:TSX) are all playing this trend in southern Alberta. If it works out, DeeThree’s farmout on 30% of its lands will have essentially confirmed the trend is present on its lands, which in our opinion sets it up to be an acquisition target.
In addition to the Alberta Bakken lands, DeeThree made an acquisition we thought was absolutely spectacular. It’s a light oil play in the Brazeau area of northwest Alberta. The Belly River formation is the producing horizon. The company acquired 42 sections of land that prospectively may have oil in place of 50 MMbbl per section. That represents an incredibly large resource number. However, because the oil formation is very tight, well completion success will be determined by successful multistage fracks. It is in its early stages, but DeeThree is getting results.
I think DeeThree can triple its production on Brazeau, in addition to its growth potential with its Alberta Bakken play. The company would emerge from roughly 3,000 boe to something closer to 10,000 boe and have that Alberta Bakken inventory still sitting there. There’s great leverage in the name, especially at $2.20/share.
TER: Why has DeeThree been so weak recently?
BB: It’s partly market cap, but there have also been confusing signals coming out of the Alberta Bakken play. There was some suspicion that Legacy, partnered with Bowood Energy Inc. (BWD:TSX), was going to abandon it. Crescent Point also suggested there might be some challenge with the play itself. That’s not surprising, but some of those negative comments affected DeeThree’s stock.
I’m looking back to when DeeThree bought the Brazeau property in Q111. That was a $125M acquisition, and the company issued a bunch of equity. The market hasn’t focused too much on what’s happening at Brazeau, though, and has just focused on Alberta Bakken.
TER: You’re clearly not averse to owning private equity in this fund. ET Energy Ltd. is your largest holding, representing nearly 22% of your Dominion Equity Resource Growth Fund net asset value as of June 30. Is that percentage holding?
BB: It’s increased slightly because the fund has shrunk in size, but it wasn’t our plan to have that large a weighting.
TER: How do you value a private equity in your portfolio?
BB: There’s the fantasy valuation, and then there’s the valuation that our auditors will accept. Under the new International Financial Reporting Standards rules, we have to value it based on what we really believe the value is, but we need reference points like third-party pricing events. We look at whether the company issues equity to outsiders or there’s trading activity in the stock, and even then we have to make a judgment call. For example, if a company has 66M shares outstanding and 100K shares trade at $3/share, is that really the value of the company? I would argue it’s not. In terms of our analysis, we’ll look at a variety of things, including third-party pricing events, but we’ll also pay attention to what the company is publishing and what the independent engineering data suggests. Then it’s a judgment call.
We have to be careful in that our fee revenue is based on the value of these portfolio components. We tend to err on the conservative side in terms of valuation because we never want to be accused of raising prices to get more fees.
With ET Energy, we’ve held our position for almost six years. We bought it at $1/share and have written the position up to $7/share over that time period. We had evidence that the stock traded well over our carrying value, but over that time, we also had the meltdown in 2008 and further trouble in 2010, hence we are comfortable with our current carrying value. We know the company is in the midst of a pre–initial public offering (IPO) financing round, and we’ll have to see how that looks and adjust the value accordingly. Our reference points make us very optimistic about the real value. The company’s execution of its business plan will be the convincing factor.
TER: Will that pre-IPO financing round be equity?
BB: Yes. The most recent financing round was a three-year note with warrants attached to it. Share purchase warrants were valued at $10/share. There’s some anti-dilution provision in that warrant, but there’s a reference point.
TER: Why do you love this company?
BB: We like the oil sands to start with, but also ET’s production technology is environmentally friendly. There’s no water used, and it’s very energy efficient. The capital costs to put it in place are a fraction of the alternatives. We also know the resource is well defined on the company’s land. It’s just a question of executing and unlocking the value. What’s given us real confidence is the fact that Total (TOT:NYSE), the French company, is now partnering with ET in its commercial development. Having a big brother like that by your side adds credibility to ET’s execution of its business plan.
TER: What is your exit strategy?
BB: The exit strategy is to wait and see how the public markets react. We believe ET will be public sometime in the next 12 months. That comes from management, but it’s subject to the markets, of course.
As far as other companies go, our ambition in the portfolio is to hold roughly 20 names. We like the exploration stories that are unfolding in Argentina. Madalena Ventures Inc. (MVN:TSX.V) and ArPetrol Ltd. (RPT:TSX.V) are companies that have land positions, production and growing opportunity in Argentina. Argentina looks like Alberta did 25 years ago. There’s been some political risk over the last 10 years, but a lot of that has been put aside. Argentina knows it has an energy deficit and the solution is to develop its many reserves.
TER: Thank you for your time and insights.
Bill Bonner is co-founder and president of Brickburn Asset Management, a Calgary-based investment counseling firm largely focused on the Canadian energy sector. He is directly responsible for managing energy investments in public market portfolios, private client portfolios and private equity pools. With over 30 years of energy capital markets experience, Bonner brings a perspective to Brickburn Asset Management that has been built on a solid foundation and in-depth knowledge of Canada’s energy sector. Prior to founding Brickburn Asset Management, he was a founding director of Network Capital, the predecessor to Brickburn. His career also included 14 years with Peters & Co. Limited, where he was a significant shareholder, member of the Executive Committee, and managing director of Institutional Sales and Trading.
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