Eric Nuttall: Maximizing Oil and Gas Investments
Source:The Energy Report 05/20/2010
"If you want to talk about the Gulf and the oil leak in terms of investment, I think it's creating some pretty interesting investment opportunities," says Eric Nuttall, portfolio manager of Sprott Asset Management's Energy Fund. The straight-shooting Nuttall never fails to opine or shine as he explains why onshore oil plays are solid investments and talks oil and gas juniors, shales and prices in this exclusive interview with The Energy Report.
The Energy Report: How do you see the European Union's sovereign bailout of Greece affecting the oil price?
Eric Nuttall: It relates to the overall psychology about global and European economic growth. We've seen the price of oil have unbelievable volatility on different headlines. A few weeks ago when Goldman Sachs was being investigated for fraud, oil took a tumble. It is largely being driven by traders looking for an excuse to buy or sell, depending on whatever headline they read that day. It's difficult now to appreciate the effect the bailout of Greece is going to have on European and global oil demand. I think that it's more of a knee-jerk reaction than an actual shift in fundamental demand or supply.
TER: The oil price is up a few dollars since we first heard about British Petroleum (NYSE:BP; LSE:BP)'s accident in the Gulf of Mexico, which is likely to delay further offshore exploration there. How do you see this incident influencing the oil price?
EN: As it stands, I think it has had almost no fundamental impact, and there's a few reasons for that. One, the route of oil imports into Louisiana has not been impacted because the slick is too far east. As long as there are no disruptions in actual imports of crude oil, there really should be minimal impact on pricing.
TER: And over the long term?
EN: Were there to be a permanent ban on offshore drilling, that would obviously have an impact given the Gulf accounts for a meaningful percentage of overall U.S. oil production. However, with the long lead time to projects, be it three to five years to first oil or first gas, a short-term ban on drilling is not going to have an impact on longer-term supplies. I really don't see it having a large impact in either the short term or long term.
TER: What about the environmental implications?
EN: I think that it's too early to accurately say, though there is obviously a bias in the media to over-sensationalize at times. There are suspicions that 5,000 barrels of oil per day are leaking into the Gulf. I've read that over 2,000 barrels per day naturally leak from subsurface cracks in the seabed. Longer term, I think the impact is not going to be as significant as some people are predicting.
TER: Has the oil spill created investment opportunities?
EN: I think it has created some pretty interesting investment opportunities, one being British Petroleum. I started buying it the last Friday in April. It's turned into a sin stock, along with the tobacco companies. We've seen an erosion of over $21 billion in market cap, which I find just astounding. I put pen to paper in terms of what the maximum exposure could be, and my maximum cost scenario amounted to around $10 billion. That's less than half the market cap erosion. In the meantime, the price of oil is doing quite well. You can buy a company, with a PE at seven, yielding about 7% annually, and it's obviously out of favor.
TER: How much BP did you buy?
EN: I made it about a 2% weighting for the overall energy fund, thinking that it looks like a pretty easy 10% trade over an undefined time period, but I don't expect it to be a long-term holding. You get paid 7% per annum in the meantime.
TER: Why didn't the oil spill decrease all oil company stocks? Why just BP?
EN: There's no reason that it should have. There is some thought that for offshore drilling companies, it's going to become more expensive because of increased insurance costs; and secondly, there is likely going to be a need for more safety equipment such as a second blowout preventer, or maybe more servicing of the equipment. So higher cost, lower margins. Some companies that would actually benefit should a long-term offshore drilling ban be enacted would be the onshore oil producers. The Bakken names have been very, very strong. In addition, the Canadian oil sands become increasingly attractive, given that the Gulf of Mexico is one of the few areas of tremendous prospectivity. If reason goes out the window and there is a medium- to long-term ban on offshore drilling in the Gulf, then the only remaining large source of oil is either the Bakken or the Canadian oil sands.
TER: There's not much fundamental support for oil in the $80 range. Some experts believe the trading of oil derivatives is largely responsible for pushing the price to that level. What's really going on?
EN: I would agree that a price in the high $80s is probably not justified. The most important number to look at now is OPEC's capacity and compliance on production rates. We have seen a significant deterioration in OPEC compliance relative to what their production quotas are. I think we've had six months now of abiding to 50% overall compliance, and they're sitting on 5-6 million barrels a day spare capacity. They've publicly stated—at least Saudi Arabia has—that they find a price in the $70s or $80s to be "fantastic." The largest holder of spare capacity in the world is telling you that the high $70s and $80s is its price point. That tells me that in the medium to long term, that will probably be the going price until a global economic recovery is able to soak up a majority of OPEC's spare capacity.
TER: How long will that take?
EN: I think that could take several years. In the meantime, an $80 oil price is as high as we go for the short term.
TER: Among your Energy Fund's bigger holdings is Bankers Petroleum Ltd. (TSX:BNK), which is up to $9 now from about $1.70 a year ago. What are things you look for when you seek investment opportunities in oil companies like Bankers?
EN: We look for companies that have a very meaningful resource upside that is not currently being recognized by the market. In addition, we look for companies that are well funded, preferably have production, and are stewarded by good management teams.
TER: That sounds like Bankers.
EN: Bankers is a perfect example. We got involved in the company a few years ago. I had been following the asset, which is the largest onshore oil field in Europe and was discovered by the Russians in 1929. A new management team parachuted in and we had known the new CEO Abdel (Abby) Badwi and his technical team from a previous company that we had done extraordinarily well with called Rally Energy.
TER: Is that when you got involved?
EN: The day that Abby joined Bankers we offered, and they accepted, a $50 million financing. Bankers have used those funds to increase production, but much more importantly, it was able to delineate the field. Since our initial investment, the field has grown from about 2.2 billion barrels to over 5 billion barrels of oil in place. And they have used Canadian drilling technologies—pumping and horizontal drilling—to meaningfully increase the production profile of a typical well. They've been having wells come on at over 150 barrels a day on a horizontal basis, which is just phenomenal. It really increases the net present value of the company because you accelerate production. The company is producing over 8,000 barrels a day and has a visible window to grow to over 30,000 over the next several years.
TER: Is it a takeover target?
EN: There are very few assets like this that have the strategic nature of both being onshore and also being of a material enough size to attract the attention of a large state oil company. We think Bankers is likely to be taken over in the next, I would say, two years, most likely at a 50% to 100% premium from where it's trading today. I think that when Abby and his team are ready to part with it and move on, it should generate quite a bit of interest.
TER: You also hold a lot of Corridor Resources Inc. (TSX:CDH), which has exploded from about $2 this time last year to around $6.30. Tell us about it.
EN: Corridor has a lot of the same attributes as Bankers. It had a large land base in New Brunswick, which is not a province that is typically associated with hydrocarbon production. We saw quite a bit of running room in their McCully Gas Field. In addition, we thought that they had very significant onshore shale gas potential, as well as a huge offshore exploration prospect that could contain up to 1 billion barrels of oil. Corridor owns 100% of that prospect and we're hoping that they will be able to drill it later this year.
Since our investment, they've increased production at McCully and, most importantly, a very significant a shale gas producer called Apache Corporation (NYSE:APA) agreed to evaluate the commercial potential of natural gas in the Frederick Brook shale formation. Having such a premium quality shale gas producer come to New Brunswick really validated the resource potential.
TER: How is that working out?
EN: Corridor has drilled a few wells into it, had promising test results, and so now Apache is carrying them for $25MM, on an earn-in basis, which will take them through proof of concept. At that point, Corridor could have over 50 TCF (trillion cubic feet of natural gas) net to the company. That's a huge, huge potential resource and that's something I look for. We weren't paying for it at the time. It always makes me uncomfortable when you're expected to have to pay for exploration success. I much prefer to buy companies that are cheap with existing production; you get the resource upside for free, because exploration doesn't always work.
TER: Is that an investment philosophy?
EN: I tell my sales force I never want to come into the office and be afraid that I am going to have a name down 80% because they dusted one individual well. It's a tough way to get rich. I much prefer buying companies with existing production where you get the exploration as a free option as opposed to the exploration upside being the only thesis to the investment.
TER: What are some other juniors you have your eye on?
EN: One name that's done very well for us is Rock Energy Inc. (TSX:RE). It's a conventional producer of heavy oil in the Lloydminster area of Alberta, Canada; it's trading about four times cash flow on existing production, but at the same time, they're testing a natural gas play in the Elmworth area of Alberta. It's surrounded by the likes of Encana Corporporation (TSX:ECA), ConocoPhillips (NYSE:COP), and Daylight Energy Ltd. (TSX:DAY.UN;DAY) (formerly Daylight Resources Trust), all of which are well-regarded companies. These companies have either successfully tested or have existing production from two zones, which Rock is targeting, which are the Montney and the Nikanassin zones. They have had a successful Montney test rate. They should have a good Nikanassin test rate over the next couple of quarters. If 10% of their acreage works in one of those two zones, then it could triple their reserves. So they have a highly significant exploration program; but at the same time, it's trading at four times cash flow and existing production—so your downside is largely protected.
Delphi Energy Corp. (TSX:DEE) is also a name I like a lot for a one- to two-year investment. They have a great asset base in the Deep Basin of Alberta where they are targeting in 2010 over five new zones that have no meaningful reserve bookings. I see them having the potential to triple their production and quadruple their reserve base through a successful exploration program this year, which so far has been going extremely well. At the same time, they produce over 8,000 boe/d and trades at around six times enterprise value to cash flow, so it is not being valued at an egregious valuation.
TER: What about onshore oil juniors in places that are maybe not quite as stable as Canada but still relatively stable? Something like Tethys Petroleum Ltd. (TSX:TPL).
EN: Tethys has had some extraordinary well results in Kazakhstan; they're also in Tajikistan and Uzbekistan. The market is highly anticipating a follow-up well from their original well. Management thinks they could be sitting on a very material oil discovery in the hundreds of millions of barrels. The geographical location of their discovery is kind of in the no man's land in Kazakhstan in terms of where it was thought you would find oil; it was thought to be a much more gas-prone area of the country. They could have an incredible material oil discovery; there have been some very large numbers thrown around, like several hundred million barrels recoverable potential. If further drilling is successful, then the company should do quite well, even though it's been a big winner over the past year.
TER: You also own a lot of Questerre Energy Corporation (TSX:QEC).
EN: Questerre is in the Utica Shale, an emerging shale play in Quebec. Of the juniors, Questerre has the largest and highest-quality acreage swath in the play. The stock has been weak recently; Questerre did a financing at over $4 and now trades around $3. They have had some very encouraging test rates from a recent eight-stage horizontal well that rivals the Marcellus Shale, We think, given the passage of time, assuming that future horizontal wells confirm the first test rate, Questerre could be sitting on a four-to-five net TCF discovery, and on a market cap today of roughly $700 million with well over $160 million in the bank, it's a pretty good higher-risk investment. However, they have limited production, so your risk is a little higher than other names.
TER: Could you provide with an overview of natural gas exploration over the last 20 years?
EN: Until recently, the majority of natural gas was produced from conventional sandstone; these would be highly permeable, high-porosity reservoirs of consolidated sand. You typically drill a vertical well that requires no fracking, which is when you put pressure on the reservoir to induce artificial cracks to enhance the flow rates. Until the last 15 years, sandstone deposits were the predominant focus of the industry. As large discoveries became more rare, the industry started targeting unconventional zones. These include tight sands, a sandstone where natural permeability is low. If you drilled a vertical or horizontal well into one of those without fracking it, it would yield an uneconomic rate. Tight gas has been a focus for about the past 15 years as large discoveries have been made such as the Pinedale anticline in Wyoming.
After that, the industry went toward coal bed methane—coal seams saturated with gas that must be desorbed. CBM, too, had a large increase in production but is now in decline. After coal bed methane, the industry started going toward shale gas.
Shale has natural gas in the actual porosity of the reservoir and the natural fractures; however, it really needed better fracking technology to make most plays economic. The revolution was to drill a horizontal well using a very long lateral hole and then be able to place not one frack but up to 30 different fracks in an individual well bore. The Barnett Shale was really the first to take off commercially. That led then to the Marcellus Shale, Fayetteville Shale, and then most recently the Haynesville Shale, which is being touted as probably the most economic shale play. It straddles the border between Louisiana and Texas.
TER: How has finding natural gas in shales changed the industry?
EN: In Canada, going back a couple of years, the average well would come on at about a quarter of million a day in initial production. In the Haynesville Shale, it is not uncommon to drill a 15 million-a-day well—or 60 times the average initial production of a Canadian conventional vertical well. This is a huge change in average productivity, which has led to a very bloated natural gas storage situation in North America, which has led to low prices.
TER: Is it true that certain shale leases are artificially inflating supply?
EN: A lot of companies acquired acreage in these shale plays, predominantly the Haynesville Shale, and the terms of the leases require a company to drill and produce within about a three-year timeframe. For a lot of these companies the expiration window is fast approaching. Companies are being forced to drill and produce on this acreage, even though the economics may not be as stellar as they once thought they would be. That's leading to an artificial influx of natural gas.
TER: Where do you see prices going for the rest of 2010 and then maybe for the next three to four years?
EN: I think for the next three years there's a cap of about $6 on natural gas. There is an unbelievable amount of supply that is highly economic at that price point. You have companies that are the largest in the industry such as Encana and Chesapeake Energy Corp. (NYSE:CHK), both sending out very aggressive growth forecasts. They're both growing by 50% over the next three to five years. So when you have the largest companies bringing on production at a time when natural gas pricing is in the $4-$5 range, it tells you that they view the marginal cost of supply to their portfolio as much less than historically. We used to think that we needed $7-$8 to grow natural gas profitably. That is no longer the case.
TER: What effect is hedging having?
EN: Much of industry in the U.S. is hedged, approximately 55%, at around $7; that's allowing companies to maintain a very active capital-expenditure program. This has led to a very over-supplied market, and my theory is that until the core areas of each of the shale plays are drilled up, which I think could take three to five years or longer, we're in a situation of a chronic oversupply. Four dollar natural gas is too low; I do not think $4 is sustainable, but at the same time, I do not think we need $7-$8 to bring on supply. I think a $5-$6 range, probably closer to $6 than $5, is probably what we should be expecting over the next three-odd years.
TER: Which one gets you more excited: the oil or the gas sector?
EN: It's a common question because a lot of people say oil is trading at $84 and gas is at $4, obviously you must be looking for oil companies and that's not necessarily the case. The valuations of oil companies now and the multiple that you have to pay is significantly higher than for natural gas companies. If we use a long-term natural gas price of $5, we can buy some natural gas companies at their proven net present value, which implies that you're getting the probable and possible reserves for free. Given the confidence in proven reserves, the risk/reward on that type of investment is extraordinarily low. I think as gas prices firm up from $5 over the next six months, those companies will be very good performers. Despite having the stigma of being natural gas producers, I think people are going to head to that area of the market over the next couple of months.
TER: Does that mean you're not looking at oil companies?
EN: There are some oil companies as well that are trading at very attractive valuations. It's not so much trying to target natural gas or oil; it's trying to be opportunistic in trying to find the most upside on a risk / reward basis.
TER: What's Eric Nuttall's tried-and-true method of playing the sector?
EN: Buy companies that trade at reasonable valuations on existing production but whom also have very meaningful reserve potential for which you don't have to pay. Make sure that their balance sheets are strong enough so that they can withstand a long period of low commodity prices so they won't be forced to liquidate assets. Invest in management teams that have proven themselves in the past, but make sure you're buying into good assets. You can have a good management team with a mediocre asset and they're still probably going to do okay. But if you have a good asset and a bad management team, you're probably not going to do terribly well. The quality of the asset is terribly important.
TER: That's all?
EN: One other thing. Try to recognize opportunities before others, and this just doesn't apply to the oil and gas sector, but it's something that we always try to do. Recognize opportunities before others; don't be afraid to be wrong; act quickly if you see a very exciting opportunity where the risk reward is very skewed; act quickly, act big.
TER: Is that what you did when you recently took a position in Massey Energy Co. (NYSE:MEE)?
EN: Massey is out of favor given that there was a significant mine explosion in April. The stock has fallen 30% or $1.2 billion. The ultimate cost of the monetary reimbursement for the families of the fallen miners is likely to reach $100 million. So you have about an 18-times decrease in market cap relative to ultimate exposure. You're buying a company at seven-times earnings. They have the largest net metallurgical coal reserve of any U.S. company. Met coal pricing has been extraordinarily strong due to strong steel demand worldwide. You need met coal to produce steel. You've got a market cap of $3.8 billion with some debt, so an enterprise of $4.5 billion and a coal reserve of almost three billion tons. It's not a bad value proposition. The memories from the tragic accident will pass with time and the stock should do quite well.
Eric Nuttall is a portfolio manager with Sprott Asset Management (SAM). He joined the firm in February 2003 as a research associate and was subsequently promoted to research analyst in 2005, associate portfolio manager in 2008, and then to portfolio manager in January 2010. Eric is co-manager of the Sprott Energy Fund along with Eric Sprott, and also co-manages the Sprott 2010 Flow-Through Limited Partnership with Allan Jacobs. In addition to his responsibilities for those two funds, Eric supports the rest of the Sprott portfolio management team with identifying top performing oil and gas investment opportunities. Further, Eric contributes towards internal macro energy forecasts, and his insight into emerging unconventional plays has been covered in several financial publications such as The Wall Street Journal, Asia and Barron's. Eric graduated with high honors from Carleton University with an Honors Bachelor of International Business.
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