Looking for outsized returns? Then broaden your horizons, suggests National Bank Financial Analyst Darrell Bishop, who focuses on regions where property acquisition is cheaper and oil sells at the Brent premium. In this exclusive interview with The Energy Report, Bishop whisks us around from Western Europe’s North Sea, to behind the former Iron Curtain in Albania, to developing energy plays in New Zealand. Learn how to navigate the risks of the space and what makes a far-from-home smallcap worth it all.
The Energy Report: You make the case that investors should take a look at small-cap international energy companies. Why?
Darrell Bishop: The main attraction is exposure to high-impact exploration targets. In the international space, a small-cap producer can prove up material reserves with a single well. This compares favorably with the junior space in North America, which has transitioned to an unconventional resource play based primarily on multi-stage hydraulic fracturing technology. The North American juniors are in a lower-risk and lower-reward environment. International companies are inherently more risky, so the potential for higher returns needs to justify that risk.
TER: How do domestic and international projects differ for small energy companies? Is technology a differentiator?
DB: Land acquisition costs in North America can be a huge barrier to entry for junior companies. We see a willingness for teams experienced in North American geology and technology to seek out opportunities in international jurisdictions where they can apply that expertise in a less-competitive setting. The junior international explorers tend to be the first movers in discovering emerging global plays. These projects can generate major shareholder value for investors. That’s why I think investors should look overseas when evaluating smaller energy companies to add to a portfolio.
TER: What geographies do you think are geologically and socially prospective for international energy development?
DB: There are many factors that investors have to look at in the international space. It comes down to a balance between geology, the fiscal and geopolitical climate in the country and the investor risk tolerance. The majority of the world’s reserves are located in less-stable regions. Negative regional headlines can impact the share price of companies that operate anywhere within that region—even if it is in a different country. Much of the time, news will affect share prices for companies totally unaffected by regional political developments. A recent example is Chinook Energy Inc. (CKE:TSX.V), which has operations in Tunisia—the epicenter of the Arab Spring uprising. Despite not experiencing a day of operational downtime through the unrest, the stock traded at a discount to its international peers. With that said, there are a few jurisdictions worth mentioning, although not without risk. Kurdistan and parts of Africa continue to attract investor attention based on recent exploration success, the potential for large reserves and production growth and increased interest from the majors.
On the other hand, once-popular regions in Argentina and Colombia have cooled. Argentina has tremendous shale potential, but investor interest has dried up following the government’s expropriation of Yacimientos Petrolíferos Fiscales (YPF:NYSE). In Colombia, which was once the poster child of international success stories, the risk appetite has fallen off as many of the lower-risk exploration targets have now been identified. That’s forcing companies to step out into more expensive and riskier frontier regions that show a lower chance of exploration success. Production from small international projects can decline steeply, so companies need to be successful with the drill bit in order to backfill potential production shortfall.
TER: You cover some offshore companies in the North Sea. How do smaller international energy companies fit into that market? What’s their niche?
DB: The North Sea has been in production for decades. The consensus is that most of the major fields have already been discovered. At this stage, the focus is shifting to increasing recovery from legacy fields and developing the remaining smaller fields. There are government incentive programs to partially offset the high taxes that are seen in the North Sea. That encourages smaller field development and opens up opportunities for small companies like Iona Energy Inc. (INA:TSX.V). These discoveries are too small for most of the majors to care about (because the majors need scale and large reserves), but smaller companies can build a business out of only a few discoveries.
We cover Iona Energy, which is a pure play on the North Sea. It’s focused on growing production from undeveloped discoveries that were too small for the majors. The majors ignored these deposits because they were not material additions to their reserves. However, for a smaller company, these reserves are potentially very material.
Iona trades at some of the cheapest metrics in our international space. Investors will have to be patient with a stock like this, as the major operational catalyst for the story is the first oil from its Orlando field. That’s currently not scheduled until mid-2013. Although it’s primarily an execution story, many investors have been burned in the North Sea and are cautious. That’s because North Sea projects tend to take longer and cost more than originally planned. With Brent prices now north of $110/barrel (bbl), industry activity and costs are likely to increase in the coming years. Short-term investors won’t pay for development projects that are a year out, but long-term investors may have a good risk-reward opportunity at these levels.
TER: International energy companies generally sell their production at the international price, which is currently at a large premium to U.S. domestic pricing. Will international energy pricing remain robust?
DB: Our thesis is that domestic West Texas Intermediate (WTI) will continue to trade at a discount to the international (Brent) pricing in the near term. That likely won’t change until more domestic production can get waterborne.
TER: What metrics do you use to evaluate smaller international energy companies?
DB: You have to be pretty selective when you’re playing the international space because of the jurisdictional risk. Typical smaller international energy companies are exploration focused. Frontier exploration success is less than 20%. To flip that around, you have a greater than 80% chance of failure on your exploration target. The current market is not paying much for exploration upside. For this reason, we tend to favor companies that have a balance of development opportunities (for cash flow) and exploration upside as a bonus. To evaluate production, look at cash flow metrics. To evaluate exploration prospects, look at the risk basis. Next, you break it down to a present value based on the number of barrels in the ground and the cost of extracting that. Management also is very important—they need a track record of success and in-country connections. A lot of times for junior companies in international jurisdictions, it’s who you know that matters most to help navigate the regulatory approval process rather than who you are. One last point: the international space, especially for small companies, is operational catalyst driven. Investors should watch for drilling events that may drive value.
TER: One of the jurisdictions you follow is unusual —Albania. Can you explain the investment thesis and the current opportunities?
DB: We cover three companies in Albania. The first two are primarily focused on increasing oil recovery from legacy fields—Bankers Petroleum Ltd. (BNK:TSX) and Stream Oil and Gas Ltd. (SKO:TSX.V). Bankers is not a small company; it has a market cap of approximately $800 million (M). The third company we cover in Albania is an early-stage explorer called Petromanas Energy Inc. (PMI:TSX.V). It is an interesting story for many reasons. Earlier this year, Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) farmed in for a 50% interest in two of its blocks, which, combined with cash on hand, basically funds exploration plans through 2013.
TER: Are these offshore explorations?
DB: No, these are all onshore. Shell is interested in these blocks because of similarities to the Val d’Agri and Tempa Rossa fields located across the Adriatic Sea in Italy. One of those fields is currently producing 90 thousand barrels a day (Mbblpd) from fewer than 30 wells. Shell and Petromanas are currently drilling their first exploration well in Albania. That well cost $30M and is carried almost entirely by Shell. The well is a re-drill of an existing discovery that flowed oil to surface about 10 years ago, but the rate was limited due in part to a series of operational issues and poor decisions. Well results are expected by year-end. If successful, we see this as a potential company maker for Petromanas. Additionally, Petromanas has two other wells it is planning to spud before year-end, which means there are several potential drilling catalysts on the horizon.
TER: How about the political and social issues in Albania? For most investors, it must be an unknown.
DB: For the most part, it is unknown to most investors. Albania, up until about 20 years ago, was a Communist society. It’s been in transition to democracy for the better part of the last decade. There are social and environmental issues in Albania. However, the government is pushing to turn things around and be more investment friendly. The country is applying for European Union status, which is a vote of confidence in foreign investment in the country. While the country is still in transition mode and has challenges, the big picture is positive over the longer term.
TER: Is the geology in Albania somewhat complicated compared to North America?
DB: The risks there are primarily a function of geology. To date, exploration and production activity in Albania has focused on shallow formations (less than 2,000 meters) that produce heavy oil. Petromanas is targeting much deeper, more complex sub-thrust structures. There has been limited exploration on these formations to date. With advances in three-dimensional technology and deep drilling, plus experience in geologically similar Italy, the companies feel like they have a better understanding of how to create exploration success in that geography.
TER: Is the major trend for the small-cap international energy sector the application of new exploration and development technologies?
DB: There are a couple of major trends in the industry. The single biggest factor is technology. In most international jurisdictions, expertise and the rate of technology adoption greatly lags that of North America. We see adoption of seismic, drilling and completion technologies that were pioneered and perfected here in North America as the catalyst to advance the industry internationally. In the international jurisdictions, the use of these technologies is just beginning to grow. These technologies have been key to discovering new areas for exploration and production that were not considered prospective or economic until now. One example is the worldwide emergence of onshore unconventional shale plays. Another example is the advance of deepwater exploration technology that is unlocking huge exploration potential in places like Angola, Namibia and Brazil.
The second trend driving the sector is commodity prices. In most international jurisdictions, oil is priced relative to Brent, which as we discussed is at a healthy premium to North American oil. A similar pricing structure is in place for natural gas, which can fetch three to five times more internationally than in North America. This is a significant motivator for international companies, as the potential return justifies riskier exploration targets.
TER: Another underexplored location with complicated geology you cover is New Zealand. Can you give us an overview of the energy investment situation there?
DB: New Zealand has received increasing attention from oil and gas companies because they’re seeking out new regions to explore globally. New Zealand offers a bit of a unique opportunity in our international space. It is underexplored, but also benefits from a politically stable climate with fiscal terms that encourage investment. There are multiple sedimentary basins with known or potential hydrocarbons—both onshore and deep-water offshore. There have been multiple discoveries, even hydrocarbon seeps to surface, which demonstrate an active petroleum system in many of these basins. Currently, all of New Zealand’s oil and gas production comes from the Taranaki Basin on the west side of the North Island. Because of the tectonic setting, the geology is favorable for structural petroleum traps. However, exploration is complicated because of the lack of structural repeatability of these formations. Advances in technology, mainly seismic and drilling, have enabled companies to better focus their exploration efforts. While current production is on the west side of the island, the east coast is where things get interesting. There is tremendous exploration potential in some of the shale reservoirs, which are yet to be tested and estimated to contain billions of barrels of undiscovered resource.
TER: So New Zealand is a frontier—which companies are there now? Are both juniors and larger companies there?
DB: Shell has been a major player in the country for some time, but we’ve also seen some heavyweight companies recently step in, such as Petrobras (PBR:NYSE; PETR3:BOVESPA), Anadarko Petroleum Corp. (APC:NYSE), Apache Corp. (APA:NYSE) and Exxon Mobil Corp. (XOM:NYSE). But there are also a couple of junior, Canadian-listed companies with a presence. Tag Oil Ltd. (TAO:TSX.V) is one we recently initiated coverage on. New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX) is another Canada-listed junior in the area.
TER: Tag has an interesting past—and investors have done well with it. It’s not a smallcap anymore. Is there upside to the stock? What events are you looking for?
DB: I agree, the stock has had a good run the last couple of years, and that’s mainly on the back of success with the drill bit. Two of Tags fields transitioned from discovery to production, but we still see upside from here. The current valuation is supported by shallow conventional development at these two fields. Production is approximately 2,400 bblpd now and set to ramp up to between 5–6 Mbblpd between November and March. That’s entirely from 14 drilled wells that are behind pipe-awaiting infrastructure expansion. It has less than 10% of its production permits explored to date. We see Tag in the early stages of unlocking the potential of these assets from a conventional perspective.
Besides these assets, Tag has three high-impact, liquids-rich prospects that are drill ready. Two of these prospects, Cardiff and Hellfire, are slated to be drilled within the next six months and could add material value to the company. The real game-changer for Tag could come from a carried call option that it has on an unconventional resource in the east coast. Apache farmed in and is carrying Tag for the first $100M in exploration capex to test unconventional shales in the East Coast Basin. If the partners can prove moveble hydrocarbons with an upcoming four-well program, it’s likely going to be all systems go for Tag. On the regulatory front, there are still public concerns over hydraulic fracturing. That’s a hot topic with industry and the government. Tag has been working to dispel the myths associated with hydraulic fracturing. There is a parliamentary report due in November. That could be an important factor in unconventional operations going forward.
The bottom line is that we continue to like the stock at these levels. Tag has a very strong balance sheet, and we see the valuation as being underpinned by significant near-term production given those already-drilled wells. There is additional upside potential from a busy “catalyst-rich” operational calendar over the next 12 months.
TER: What does the New Zealand energy market look like in terms of import/export and pricing?
DB: With respect to oil, New Zealand is a net importer of oil. Current production in the country is approximately 50 Mbblpd. Demand in the country is approximately 150 Mbblpd. With respect to pricing, oil is priced relative to Asian Tapis pricing, which is comparable to Brent. With respect to gas, the situation is similar to North America in that New Zealand natural gas is a landlocked product. Current production is approximately 400 million cubic feet a day (MMcfpd). Pricing is generally between $4–5/Mcf, which is a healthy premium to what North American producers receive.
TER: If New Zealand natural gas production increases dramatically, what happens to the price? It is a small domestic market.
DB: That has been some of the pushback for the story of gas production in New Zealand. Offsetting the small domestic market is the fact that the major gas fields that are in the country have been in steady decline over the last few years. There is talk that demand for gas will increase over the coming years, in part due to the expansion of the Methanex plant in the Taranaki Basin. If existing production drops and there is an increase in demand, then new production can be easily absorbed by the market.
TER: Are there any final thoughts you want to leave with investors who are contemplating how to get into the smaller overseas energy explorers and producers?
DB: Investors need to be selective when they’re playing the international space. There are unique risks in each jurisdiction. Look for stocks that balance development and exploration. The current market does not pay much for exploration, but that may be an opportunity for longer-term investors. Keep an eye on operational catalysts and favor companies with strong management teams.
TER: Thanks a lot for talking with us.
DB: I appreciate the opportunity.
Darrell Bishop is a Research Analyst with National Bank Financial (NBF) covering international oil and gas E&P companies. Based in Calgary, Bishop joined NBF in late 2011 after working as a senior research associate at Macquarie Capital Markets where he focused on international oil and gas E&Ps. Prior to Macquarie, Bishop had 10 years of industry experience with CorrOcean Aberdeen, Petro-Canada East Coast and Devon Canada where he worked in various roles including asset optimization, production engineering and corporate development. Bishop holds a Master of Business Administration from the University of Calgary and a Bachelor of Mechanical Engineering with a specialization in oil and gas from Memorial University. Bishop is a Professional Engineer with the Association of Professional Engineers and Geoscientists of Alberta (APEGGA).
Smaller Canadian-based companies are exploring and producing in countries all over the globe, in areas that may present even greater returns in the coming years. Frederick Kozak, oil and gas research analyst at Canaccord Genuity, draws on nearly 30 years of experience in the field to focus on investment opportunities in locations ranging from New Zealand to Colombia and Egypt. In this exclusive interview with The Energy Report, he discusses hospitable jurisdictions (it’s not what you think) and which companies are flourishing in them.
The Energy Report: It seems the oil market has defied the expectations of all of those who were predicting $5/gallon ($5/gal) gasoline this summer. What happened to the $130/barrel ($130/bbl) oil that people were talking about?
Frederick Kozak: When oil gets into triple digits, $100+, $110, $120/bbl, it really starts impacting the North American economy, particularly the U.S. As gas approaches $5/gal, people start cutting back, which impacts worldwide demand. Combined with issues in Europe, China and other world political and economic events, the markets get nervous. The price of oil has turned around to reflect, perhaps, a less rosy economy for the next 12–18 months. The number of contracts that are traded on a daily basis on the NYMEX certainly outnumber real physical daily oil production by a larger multiple. Any way the wind blows influences the paper trade and it’s not blowing in their favor right now.
TER: What are your oil price expectations for the foreseeable future?
FK: Our long-term view is for $100/bbl Brent with West Texas Intermediate (WTI) at around $92.50/bbl through at least next year. That translates to $100/bbl Brent with a permanent differential reflective of the increasing demand from undeveloped parts of the world. Over the last 10 years, the Chinese have doubled their per capita consumption of crude. There’s still a huge amount of consumption growth potential there. So, is $40/bbl oil ever feasible again? Certainly on a spike down, but the latest numbers out of the oil sands show that $65/bbl is the break-even number. That might be the floor. However it trades, it’s probably going to be higher than that.
TER: How do the prospects look for oil exploration and production companies (E&Ps)?
FK: North America has seen a wonderful resurgence in oil production due to newer technologies. The shales and tight oil sands that were previously uneconomic at $30, $40 or $50/bbl are exceptionally economic now. Canadian oil production has also increased. Roughly 75% of the world’s crude oil reserves are in the hands of national oil companies, some of which are not friendly to the Western world. That really limits where people can go. My analysis indicated that one of the best places in the last five years for oil exploration has been in South America, in Colombia.
TER: You cover a pretty broad range of companies. Most of these are Canadian companies looking in a lot of places outside of Canada. What are your criteria for companies you want to cover?
FK: I mentioned Colombia, but there are other countries I’m covering, including New Zealand as well as Egypt. I like countries with favorable business climates that are friendly to Western business practices, good fiscal terms and the ability to take money in and out of the country without onerous currency controls.
TER: Besides Colombia, several countries in South America are getting a lot of attention from oil explorers. What is the big appeal?
FK: Let’s start at the bottom end of the spectrum with Venezuela, which has huge natural resources of heavy oil in the Orinoco belt and a government that is extremely unfavorable to Western interests. As a result, Petróleos de Venezuela S.A. (PDVSA), the national oil company, was once producing in excess of 3 MMb/d. About 10 years ago, Hugo Chavez started firing the competent oil and gas people and started replacing them with ones you might call political appointees. As a result, the country’s oil production has gone down. The government also nationalized a number of projects and took away the commercial viability of foreign oil and gas companies to do business there. As long as he and people of his ideology are running that country, as rich as it is in resources, it’s not a place you can do business.
Argentina now appears to be turning in that direction with the nationalization of Repsol-YPF S.A. (REPYY:OTCPK). I cover three small oil and gas companies in Argentina, and I downgraded my outlook for them. As rich as the country is in natural resources, the current government is still influenced by the policies of Peron and is doing some very odd things. Although it’s not a stay-away-from country, it’s much less attractive and that is reflected in the share prices of other public companies involved there.
At the other extreme is Colombia, where I first got involved in 2007. My catalyst at that point was the second election of President Uribe. In many South American countries, you get one president who makes a bunch of changes and then he’s gone after one term. Being around for a second term basically allowed Uribe to institutionalize the first four years of changes. That’s when I thought it was the time to be investing in Colombia.
For many years, people thought about Colombia in terms of Miami Vice and the Colombian drug cartels and missed the fact that the country had been at civil war for nearly 50 years. It has great oil and gas potential with a number of very significant oil discoveries, including Cano Limon, Cusiana-Cupiagua and others. Most of the country was unexplorable because of the problems with the various guerilla groups.
Once Uribe started getting that under control, it became attractive from a security perspective. Also, he recognized that the Ecopetrol contracts of the 1990s had become so onerous that nobody was investing there, so he had the Colombian fiscal regime completely revamped for new exploration blocks. As a result, Colombia has gone from 525 Mb/d in mid-2007 to nearly 1 MMb/d today. That’s nothing short of remarkable given that the government is also looking at potentially 1.5 MMb/d total production in the next five years.
That’s one of the reasons the oil and gas community has focused on it. Many of the oil and gas companies involved in Colombia are Canadian-listed or with Canadian senior management teams. We’re entrepreneurs and we’re all over the world, exploring for oil and gas. Surprisingly, you can count the number of public American oil and gas companies operating in Colombia on one hand. There have been and are a lot more private enterprises still operating in Colombia that are U.S. based, but surprisingly few public ones.
TER: How about Brazil?
FK: Brazil has huge offshore potential. I’m less of a fan of Brazil, and I put it somewhere in the middle of the list because I’m wondering which direction it’s going to head. Brazil dwarfs the rest of the South American economies and is less inclined to have foreign capital come in. There are foreign oil and gas companies operating there, but it has not opened up like Colombia. Because it has so much work to do in the offshore sector, there is some discussion as to whether or not Petrobras (PBR:NYSE; PETR3:BOVESPA) will open onshore production to foreign capital exploitation. I have been watching with great interest what HRT Participacoes em Petroleo SA (HRTPY:OTCBB) has been doing up in the Solimoes Basin. It’s a Brazilian company that went public in Brazil with a number of North American private shareholders.
TER: So what’s higher on your list?
FK: I would rank Peru after Colombia, ahead of Brazil.
TER: Even though there are potential political problems there?
FK: I think that perception has yet to be established. The president has well-documented past socialist leanings but he has kept a number of the key pro-business advisers and government ministers, even civil service people in those positions under a previously more business-oriented government. We are seeing examples out of Peru where things are working just fine.
Gran Tierra Energy Inc. (GTE:NYSE; GTE:TSX) has a working interest in Block 95 in the Marañon basin, which was assigned to it without any timing issues or onerous changes to its oil and gas contract terms. Similarly, Pacific Rubiales Energy Corp. (PRE:TSX; PREC:BVC) is going into Peru now, on a joint venture deal with BPZ Energy Inc. (BPZ:NYSE). While that deal has just been announced and hasn’t proceeded through the regulatory process, indications are there shouldn’t be any issues related to that.
Peru has a very robust mining industry and there have been a bunch of changes to that. It does have a very robust natural gas industry, but on the crude oil side, it is very under explored. Peru appears to be a very good business environment for oil and gas companies. Some people have compared it to Colombia 10 years ago.
Pacific Rubiales remains my top pick and has been for a couple of years. When I first met the management team in Bogota in 2007, they presented the plan for the Rubiales oil field. I’ve seen many business plans come and go and not work out. That is why I’m usually skeptical. My technical background and experience in oil and gas engineering indicated that Pacific Rubiales’ plan could work. Of all of the companies I’ve ever looked at in my career as an analyst, going back more than a decade, this is the only company with a management team that has delivered exactly what it said it would five years ago, virtually on time and on budget from an oil field that is probably going to exceed production expectations as the year progresses.
It has a very strategic thinking team that ran Petróleos de Venezuela S.A. back in the good old days. It also has an enviable inventory of exploration lands in Colombia, and it has been very good or very lucky in finding heavy oil, which it continues to do best.
The joint venture in Peru with BPZ Energy is another very logical example of taking advantage of great technical expertise it gained in Lake Maracaibo in Venezuela, that’s similar to the shallow, offshore water off northern Peru where BPZ’s assets are. I very much like what Pacific Rubiales is doing and can see how 100 Mboe/d today, in five years could be developed into 170 Mboe/d.
TER: What else do you like in that area?
FK: In Colombia, I like Petrominerales Ltd.’s (PMG:TSX) exploration inventory. The company struggled for the last half of 2011 with its exploration program in the Colombian foothills, but over the last couple of months, it seems to be having success. We just need the news on the testing of its more recent wells in the Corcel trend to see if it’s back on track. I like its exploration inventory in the Colombian foothills, where it just finished drilling on a potential high-impact well called Bromelia. It will be testing that over the next two to three months to see if it’s made an interesting discovery there.
TER: You also cover New Zealand, which is an area most people don’t associate with oil and gas production.
FK: I have followed New Zealand’s oil and gas industry for more than 10 years. It has to import the majority of its crude oil because only one-third of its domestic consumption comes from within in the country.
I cover a company called New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX), whose president was the president of the very first company I wrote a research report on as an analyst when I first started. Fortunately, for me, he was successful. Otherwise, I might not be here today. So, when I look at oil and gas companies, regardless of where they are, I always look at the people first. As president, he’s successfully run a number of public and then private oil and gas companies in the last 10 to 15 years. I know that the company management, with him at the helm plus its technical people on the ground in New Zealand, is quite viable.
The company has an enviable position in the Taranaki Basin in New Zealand, the only currently producing basin in the country. I like its land base. I rank it up there with the best of the companies that are operating in New Zealand right now. It has been lucky on its first two wells. It’s producing around 1,000 boe/d, but those wells are limited until it ties in its gas production. It has great conventional exploration potential, and like its next-door neighbor, Tag Oil Ltd. (TAO:TSX.V), which I do not cover, it has a very large land base on the east coast of New Zealand’s North Island, which is potentially oil-shale prone. That could become a very interesting catalyst for both of the companies in the future. Right now, I’m more interested in what New Zealand Energy is doing on its conventional stuff.
TER: What do you see for upside on its stock?
FK: My target price is $4.50, but it’s a highly risked target price based on its exploration inventory. The company has over 20 exploration locations that it could be drilling in the next 18–24 months. Where could the stock go? I have an official target and another number in my mind that might be a double of that. It’s going to depend on its exploration success in the basin in a very underexplored mostly 100% working interest land base. I’ve looked in detail at all the prospects and I have to say it is extremely impressive. Time will tell.
TER: Another couple of areas that haven’t had much publicity or visibility are Egypt and Yemen. You cover a company that’s pretty active in those two countries. What’s going on there?
FK: TransGlobe Energy Corp. (TGL:TSX; TGA:NASDAQ) is one of my favorite names right now. I’ve followed the company for 12 years, so I am extremely familiar with it and its management. I just came back from Egypt where the company ran an analyst trip field trip to update everybody on its properties and operations. Yemen is where TransGlobe got started. TransGlobe situated itself right beside Nexen Inc.’s (NXY:TSX; NXY:NYSE) producing Masilla field in eastern Yemen. It was directly offsetting that with a small amount of production net to it, and then on the western side of the country, right beside existing infrastructure and existing oil and gas. That production net to them, if it was all onstream, which it’s not right now because of pipeline disruptions due to the tribal issues that are ongoing in Yemen, would be about 2,500 bbl/d. The company’s total production today is 17 Mbbl/d roughly. So it’s become much less material to it. At some point in time, it’s going to divest itself of Yemen, but not at this point and, certainly, not when production is shut in. When it’s producing, it spins off really good cash flow. So that’s valuable for it to finance other activities.
TransGlobe got into Egypt about four years ago when it acquired a 2,800 bbl/d field that had been undercapitalized for a number of years, doubling that field’s production to about 6,000 bbl/d over time. It has also made a very significant discovery in a formation that nobody had paid any attention to, which appears to be pervasive throughout the land. Its current production is all on the Gulf of Suez within 10–20 kilometers (km) of the ocean and a very short distance to get the oil to port for export. This has been the focus of its operations, growing that production to about 17 Mbbl/d today.
Egypt just had a bid round, which closed at the end of March. The successful bidders should be announced sometime this summer. The company has bid on all the lands around its current production, which if successful, will really set it up for a lot of future exploration and production potential. Its management team has been very conservative in running the business and it presented its roadmap to 40 Mbbl/d to the analyst and investor community in the trip to Egypt. The company’s current assets are probably good enough to get it to 30 Mbbl/d. With success in the upcoming bid rounds, it’s not a far cry to get to 40 Mbbl/d.
The bid round was mostly focused in the Gulf of Suez region, but the company also acquired a number of blocks in the western desert of Egypt, which is where the big companies are operating—Apache Corp. (APA:NYSE) et al. TransGlobe has two discoveries that are going to be brought onstream—one in the middle of this year and one at the end of the year. And it’s about to spud a very material exploration well in a block that it’s just acquiring that is a 200 MMbbl prospect size. If that’s successful, it changes the game for it all over again. I like TransGlobe because of the management, the prospect inventory and the production potential. I can’t say enough good things about the company and its potential. The stock had been an absolute champ this year since mid-December, until it put out a really good first quarter and the market decided that it didn’t like the company anymore and sold the stock off. I think it’s a very attractive company at this valuation.
TER: Are there any other attractive opportunities that you’d like to talk about?
FK: One company that is an interesting one from an exploration perspective is also operating in South America, but it’s offshore. That’s CGX Energy Inc. (OYL:TSX.V), which I cover and have a $1.85 target price on. It just drilled a dry hole offshore Guyana that cost it $71M. It drilled that 100%. It also partners with Tullow Oil Plc (TLW:LSE) and Repsol in an adjacent block on a well that’s costing $160M, of which it has 25%. It could be one well away from either being a hero or not. CGX has been around for a long time, but it’s drilling in a basin where very few wells have been drilled. Tullow and Repsol are known explorationists, particularly Tullow, which has had great success around the world, offshore in this very same play type. Tullow just drilled a successful well off French Guiana. Now, it’s moved into offshore Guyana in a similar basin with the same play type. Everybody has their fingers crossed, and if this well doesn’t work for CGX, the share price is probably going to be reflective of very expensive wallpaper.
TER: That’s a pretty expensive bet, isn’t it? Even 25% of a $160M well is a lot of money.
FK: Yes, it is.
TER: But on the other hand, the upside is that if it hits, the payback can be pretty quick.
FK: Exactly right.
TER: Based upon what you’re expecting for the oil markets in the coming months and years, what investment strategies would you suggest for playing this market?
FK: It’s been a challenging market, no question. Investors should be looking at oil companies as opposed to natural gas companies, in friendly jurisdictions. I have what I call the five Ps, and I alluded to three of them: first and foremost, people; secondly, exploration prospects; thirdly, production; a very important one is profitability; and lastly, the politics, and how well they’re politically connected.
You can trade Argentinean stocks, but I’m not a fan of actually owning them for a long term. Colombia, I would own long term. It has proven itself to be a very good environment for investment.
Similarly, Egypt is going through real political change. A lot of the things you see on the evening news and the headlines are just that, headline risk. Through the entire Arab Spring last year, TransGlobe did not lose a single day of production. It is being paid on time by the Egyptian government. Egypt relies on three things for its income. Two of those are tourism and oil and gas. So I wouldn’t hesitate, despite the headline risk and the fear, to invest in quality companies in Egypt, particularly TransGlobe.
TER: Thanks for joining us today and for some very interesting ideas.
Frederick Kozak joined Canaccord in early 2007 and has nearly 30 years of oil and gas industry experience in his role as an oil and gas research analyst at Canaccord Genuity. Kozak previously worked as a research analyst at a Canadian boutique investment firm, where he was ranked the #3 Stock Picker for Oil and Gas in Canada for 2005 in the annual StarMine Analyst Awards. Since being at Canaccord, he has added to that award with the #3 Earnings Estimator award for 2009 and the #2 Stock Picker for 2010 for Oil and Gas in Canada, as recognized by StarMine, as well as being recognized by Zack’s Investment Research as being #1 Stock Picker, North America E&P companies. Kozak started his career as a petroleum engineer and has also worked in the oil and gas industry in financial analysis and corporate planning. Kozak holds a Bachelor of Applied Science in geological engineering from the University of British Columbia and a Master of Business Administration from the Ivey School of Business at the University of Western Ontario. He is a registered professional engineer in the province of Alberta.
The ratchet theory suggests that government spending tends to ratchet up in times of crisis (wars, social upheavals, recessions) and then to remain at the new higher level. It has been put forward as an alternative to Wagner’s law (discussed in an earlier post).
In terms of the ratchet mechanism, the explanation for upward movement in government spending may appear straight forward, reflecting public demands for the government to ‘do something’ to help solve a problem. The process is not entirely mechanistic, however, because public demands for government action can vary depending on ideological factors e.g. changing perceptions about the role of government in helping people who are adversely affected by a recession and about the effectiveness of deficit spending. It is also possible for the upward movement to occur for opportunistic reasons e.g. politicians with an ideological leaning toward big government ‘never want a serious crisis to go to waste’.
A variety of reasons have been put forward to explain why public spending might remain at the new higher level after the end of the crisis. The most mechanistic explanation is status quo bias – the tendency of people to choose to maintain the status quo rather than to change a policy. For example, once tax rates have been increased to fund war time spending, status quo bias may favour retention of higher tax rates.
In addition, new programs created during a crisis may tend to develop a life of their own by creating interest groups with a vested interest in their continuation – including newly created bureaucracies that will fight to prevent themselves from being eliminated.
However, the ratchet theory does not provide a complete explanation of the growth of government. In his review of Robert Higgs’ book, ‘Crisis and Leviathan’, Gary Anderson notes that while most historians argue that the Civil War was the pre-eminent crisis in American history, ‘following this particular crisis, government sank like a stone relative to the growth of the private economy’.
Dick Durevall and Magnus Henrekson did not find strong support for the ratchet theory in their recent study of trends in size of government in the UK and Sweden from the beginning of industrialization until the present:
‘There is no consistent evidence of a ratchet effect in either country. There is some evidence of an asymmetric effect in both countries in the post-war period, but this is reversed in subsequent periods. Hence there is no clear evidence that government exploits recessions and crises to permanently shift the government spending ratio upwards’ (p. 22).
In New Zealand, government spending as a percentage of GDP seems to have fallen during WW2 as well as in the latter half of the 1950s and the 1990s. At the same time, as noted by Bryce Wilkinson, ‘the timing of the increases in the state’s share looks opportunistic’. Wilkinson suggests that growth in government spending reflects ‘changing ideas about the role of the state and the increasing power of vested spending interests’ (‘Restraining Leviathan’, 2004: Figure 5, p.41).
It is also difficult to see a consistent ratchet effect in the following chart for Australia showing estimates of government spending as a percentage of GDP over the period from 1939 to the present. The increase that occurred in the 1970s has not been reversed, but during the 1950s the Menzies government seems to have managed to defy the ratchet effect by reducing government spending to levels close to those in 1939.
I have never previously thought that I might one day have reason to praise the economic achievements of the Menzies government. It seemed to me that the Menzies government’s greatest claim to support free enterprise was to have removed war-time price control, rationing and import controls (more or less and belatedly). However, the efforts of this government in reducing the size of government during the 1950s deserve high praise.
Summing up, it seems to me, to be important not to downplay the role of ideology in influencing trends in government spending. During some periods there may be a tendency for government spending to ratchet up in response to crises. Changes in government spending may also be influenced by changes in the power of interest groups (for example as changes occur in the age structure of populations). In the end, however, ideas about the role of government matter a great deal.
Is New Zealand disadvantaged by economic geography to such an extent that it cannot hope to catch up to Australia’s average income levels, even with further improvements in institutions and policies? That is probably the most important question considered in the second report of the 2025 Taskforce that was released a few days ago.
The 2025 Taskforce was set up by the New Zealand government after the 2008 election to recommend how the gap between average incomes in Australia and New Zealand could be closed. Incomes of New Zealanders have generally risen less rapidly than those of Australians over the last 40 years, resulting in a gap between average incomes of around 35 percent in recent years. After the 2008 election, the NZ government committed to closing this income gap by 2025.
Since the Taskforce presented its first report last year, Philip McCann – an economist with expertise in economic geography – has advanced the view that New Zealand’s geographical disadvantages prevent it from becoming a high productivity economy. McCann has implied that structural features that are advantageous in the current era of globalization differ so much from those exhibited by New Zealand that this economy could not reasonably be expected to have relatively high productivity. He suggests ‘this is true irrespective of the degree of flexibility in the domestic labour market, the degree of transparency in the local institutional environment, or the levels of cultural aspirations for success’ (‘Economic geography, globalisation, and New Zealand’s productivity paradox’, New Zealand Economic Papers, Dec. 2009: 299).
The particular aspect of geography that McCann considers to be most disadvantageous to New Zealand is its relative lack of agglomeration economies associated with large cities. These agglomeration economies arise from knowledge exchanges, better networking and coordination, a nursery role for new enterprises, improved labour market matching processes and greater competition.
McCann argues that agglomeration economies can explain the decline in New Zealand’s per capita incomes relative to Australia because of the way the world has changed. One strand of the argument has to do with the increasing importance of knowledge-intensive activities that can often be undertaken at lower cost where face to face contact is possible among the various participants. Another strand is that with closer economic integration between Australia and New Zealand the economy with relatively larger agglomeration economies, i.e. Australia, has become a relatively more attractive location for capital investment and employment of highly skilled workers.
McCann sums up: ‘ … although New Zealand underwent fundamental institutional reforms in the 1980s and 1990s, at exactly the same time as this was taking place the landscape of global economic geography was shifting in favour of other places. It may well be that the deregulatory reforms limited some of the most adverse aspects of these shifts, thereby minimising the productivity gap. Yet the point still remains that the world changed, and the world of the late 20th and early 21st centuries is very different from the world that provided New Zealand with almost a century and a half of productivity advantages’ (p. 300).
How does the Taskforce respond? The Taskforce acknowledges that both New Zealand and Australia have been disadvantaged by geography. It notes that according to recent OECD research the impact of greater distance to markets is equal to around 10 percent of GDP per capita for both countries. However, it judges the evidence in support of the view that New Zealand’s small population limits the potential to obtain agglomeration effects to be weak. In particular, Auckland’s position within the regional hierarchy of Australasian cities is not declining – the population of Auckland has been growing faster than the populations of Sydney and Melbourne. The Taskforce also points out that there is no evidence that New Zealand suffered an adverse shock from globalization during the 1980s; that migration from New Zealand to Australia is disproportionately of highly skilled workers as agglomeration theory implies; or that the relative performance of small countries has declined in the past 20 years.
The Taskforce concludes: ‘… modern growth theory provides stronger support for the importance of institutions and policy than it does for geography, especially in the deterministic interpretations of economic geography’ (p. 41).
Sitting in Australia, current concerns in public policy discussions about the emergence of a two-speed economy in this country make the agglomeration theory of relative decline in New Zealand’s economic performance seem rather odd. Rather than a concern that agglomerations centred on Sydney and Melbourne are leaving the rest of Australia behind, the main concern is that New South Wales and Victoria (along with other states) are being left behind as economic growth steams ahead in Western Australia and Queensland, as a result of rapid expansion of the minerals sector and related industries. There is also reason for concern that, over an extended period, the particularly poor performance of the New South Wales government has detracted from the substantial location advantages that Sydney should enjoy.
If we reject the idea that Australia’s alleged agglomeration advantages make it impossible for New Zealand to close the income gap, where does that leave us in terms of explaining New Zealand’s relatively poor economic performance? The Taskforce pours cold water – correctly in my view – on another geographical explanation, namely Australia’s good luck in having plentiful supplies of mineral resources to export to rapidly growing markets in China and India. It is only in the last few years movements in Australia’s terms of trade have been much more favourable than in New Zealand. Moreover, New Zealand also has substantial mineral and hydrocarbon resources.
I think that leaves us with having to explain New Zealand’s relatively poor economic performance in terms of policies that are less favourable to economic growth. That also poses a problem because the impression given by various international comparisons of institutions and policies is that since the mid-1990s there has not been much to choose in overall terms between the economic policy environments in New Zealand and Australia. It seems likely, however, that New Zealand has not performed so well in the areas that have mattered most from a growth perspective. For example, one major problem discussed by the Taskforce is the effect of relatively high levels of government spending in discouraging investment in export industries – via impacts on the real exchange rate as well as tax rates.
The Taskforce has expressed the view that closing the gap in average income levels by 2025 will require policies that are superior to those in Australia in their focus on growth. It seems to me that those who believe that New Zealand has geographical disadvantages should logically be strong supporters of that view (unless they reject the objective of closing the income gap). The greater the geographical disadvantage, the greater the policy superiority New Zealand will need in order to meet the objective of closing the income gap by 2025.
Some New Zealanders might say that this is a question that only an Australian could ask, but it seems to me to be a good way to raise the issue that I want to discuss. (I hope that when I look back on this in a few days time it will still seem like a good idea!)
The ratings that I am writing about are the ladder of life ratings from the Gallup World Poll – the top step of the ladder represents the best possible life and the bottom step represents the worst possible life. But I could be referring to any of a range of surveys that ask people to place a numerical rating on how happy they are or on how satisfied they are with their lives.
I do not intend to argue that New Zealanders have a peculiar propensity to over-rate their satisfaction with their lives. The issue I want to discuss is what it means when surveys show that New Zealanders are just as satisfied with their lives as people in the U.S. even though average incomes in NZ are only about two-thirds of the U.S. level. I propose to compare the impact of income differences and other factors on the survey measures of subjective well-being in order to enable readers to consider whether the impacts attributable to income differences provide an accurate measure of its impact on the quality of lives.
It is now possible to make fairly accurate comparisons of the impact of income and other factors on average ratings of subjective well-being at a national level. Recent research by John Helliwell, Christopher Barrington-Leigh, Anthony Harris and Haifang Huang has shown that a high proportion of differences in average life evaluations between countries can be explained statistically by differences in a relatively small number of variables reflecting social, institutional and economic circumstances of life (See Table 3, ‘International Evidence on the Social Context of Well-being’, Working paper 14720, NBER, 2009). The most important variables are income (log of per capita GDP), friends (the proportion of survey participants who have relatives or friends they can count on for help when they are in trouble), freedom (the proportion who satisfied with their freedom to choose what they do with their lives) and corruption ( responses to questions relating to whether corruption is widespread throughout government and business).
In the Figure below I have used these research results to show reasons why average survey measures of subjective well-being in several countries differ from the U.S. ratings.
The net differences from U.S. ratings are shown next to the label for each country. If you focus on New Zealand you can see that the perception of NZers that their country is relatively free of corruption outweighs the negative impact on survey responses of the fact that average incomes in NZ are substantially lower than the U.S. average.
If you consider that corruption is as big a problem in the U.S as, for example, in Greece, you might think that this provides an accurate depiction of the relative impacts of income differences and corruption on the quality of life in New Zealand and the U.S. However, when I look at the expert ratings of corruption levels in Transparency International’s corruption index, the U.S. doesn’t look too bad. The rating of the U.S. in this index (7.3) is lower than Denmark and NZ (both on 9.3) and Australia (8.7) but well above Italy (4.8) and Greece (4.7). (It is also interesting that Greeks do not perceive that their corruption problem to be any worse than that in he U.S. and that NZers do not perceive themselves to be as free of corruption as the Danes).
The point is that the influence of various factors on the survey ratings of quality of life depends on the way they are perceived. Americans are sensitive to corruption in their society and they don’t like it. The ratings are more like emotional responses than dispassionate evaluations. It seems to me that self-reports of how people feel about their lives tell us about their emotional state, which is an important influence on well-being but is not identical to it.
One way to test survey ratings is to ask ourselves to what extent we would be prepared to rely on them in making decisions affecting our own well-being. It seems to me that income may be more important to people when they make decisions affecting their our well-being than when they answer questionnaires about the quality of their lives. If you were in Europe contemplating a choice between moving your family to either the U.S. or NZ, would you consider the importance of differences in average income levels to be adequately reflected in survey ratings of the quality of life?
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How Small Is It?
New Zealand’s entire gross domestic product, the value of all goods and services produced within a year, was approximately $128.1 billion in 2007, around the same amount as the state of Iowa. The importation of one major piece of industrial machinery earlier this year required a comment in investment banks’ economic reports so as not to set the import-export seesaw tottering. Economic analysts regularly track “external migration” as workers flock to Australia, Canada and the United Kingdom for jobs, then flow back home when economic times pick up. When 29,000 jobs were lost in the first quarter of 2008, that was 1.3% of all the jobs in the nation, and it was enough to send the unemployment rate from 3.4% to 3.6%.
Services comprise the largest single sector of the economy and in 2006 made up 76% of employment. Agriculture, although only 7% of the total economic pie, heavily influences the rest, with industrial sectors including food processing such as milk and meat, wood and paper production from forestry and textiles from wool. It’s estimated that the recent drought’s effect on agriculture, and its attendant industrial sectors and hydroelectric production, was enough to knock a full percentage point from GDP growth in the first half of 2008.
Industrial production is kept discreet so that it doesn’t injure the other major industry—tourism—nor the burgeoning film sector. Crude oil, extracted offshore from the Tui oilfield, is loaded aboard tankers from the wellhead and immediately exported to overseas refineries rather than touching those pristine shores, while the government has funded an agency called Film New Zealand as a “one-stop shop” (their term) for producers of movies both major and minor to simplify the process from casting to special effects.
But much of this economy is based on trade, and exports influence fully 22% of New Zealand’s GDP, leaving the economy at the mercy of global whipsaws. Although soaring commodities prices, including milk, meat and crude oil, have bolstered trade-based cash flows for the past few years, imported refined gasoline costs have surged even higher, rising 12.8% in the first quarter alone and driving consumer inflation to income-crunching levels.
The Reserve Bank of New Zealand’s attempts to contain inflation have included raising the interbank (wholesale) interest rate to an eye-popping 8.25% and leaving it there for a solid year. However, this has made the New Zealand dollar a favorite for international investors dabbling in what’s called the carry trade, where funds are borrowed in a nation with a very low interest rate (such as Japan’s 0.5% or the 2.0% current in the United States) and invested in a nation with a high one. Although the investor risks currency fluctuations wiping out those gains, the practice has become so popular that New Zealand’s currency has been pushed to frantically high levels—making their goods more expensive overseas and reducing the volume and value of those all-important exports proportionally.
It doesn’t help that there’s a housing market “correction” underway there, too, matching those in the U.S. and UK although not as severe. With banks passing on those high interest charges to their clients, mortgage rates are variable and in double digits, sending home sales plunging by 42% since June 2007.
The official definition of a recession is two consecutive quarters of negative GDP growth. With first quarter 2008 GDP printing at −0.3% and the second quarter looking even worse, it’s likely that New Zealand will be the first industrialized nation in 2008 to meet this definition.
Economic analysts expect that the slowing growth will cool inflation and give the Reserve Bank a chance to lower those interest rates, leading to higher domestic growth over time and sending international investors elsewhere in their search of carry trade profits. As the New Zealand dollar weakens against other major currencies, their exports will become more affordable overseas and those discreet industries will become more competitive on the global marketplace.
Who knows, Peter Jackson’s next New Zealand movie, The Hobbit, scheduled to go into pre-production in 2009 and into shooting in 2010, may be enough to pull the entire nation out of the recession. And an end to the drought won’t hurt, either.