Base Stock Evaluation on $90 Oil
Source: George Mack of The Energy Report (5/26/11)
May 28th, 2011
Platform Advisors Founder Adam Michael searches the globe for oil and gas discovery stories with established cash flows that support share value in reasonably secure political environments. In this exclusive interview with The Energy Report, Adam reveals some names from his own portfolio holdings that he believes could generate considerable upside production growth to return significant multiples for investors, even if oil prices hover at $90/bbl for the next year.
Approach Resources Inc.
Canacol Energy Ltd.
DeeThree Exploration Ltd.
Murphy Oil Corp.
Newfield Exploration Company
Pacific Rubiales Energy Corp.
Rosetta Resources Inc.
TransGlobe Energy Corp.
The Energy Report: We've had a 10% correction in Brent crude since the end of April, and oil has been a bit weak as we're starting to see some real signs of improvement in the U.S. economy where it really counts—employment. What factors are putting downward pressure on oil?
Adam Michael: I think the biggest factor over the last year has been quantitative easing (QE), which has led to speculators entering into the crude futures market in proportions that I haven't seen before. For instance, the net long in crude oil futures by speculators is more than twice as high as it was back in 2008. This has gotten the attention of Congress, and recently we've seen the Chicago Mercantile Exchange, CME Group (NASDAQ:CME), begin to raise margin requirements for crude futures. I think the goal is to get some of the speculative money out of crude futures, and that's one of the reasons we've seen a decline over the last month.
TER: Sounds like a healthy thing that could dampen the potential for a bubble.
AM: I think so. Crude oil dropped $20 in a matter of a couple of weeks. That's a pretty sharp correction, but I think it was healthy because it helped wipe out some of the excess speculation. There could be some more downside to go but, historically, crude kind of tops out sometimes during the summer and maybe late June and early July. I don't see any reason why that wouldn't play out this year. We're still in a kind of historically strong period for crude oil. I'm not sure how much down side there is from here.
TER: In terms of oil price per barrel, is there a sweet spot where the macroeconomy can remain vigorous? What is the upside price-per-barrel limit on commodity oil?
AM: Well, I have read various opinions on this and I have to think that a good price for oil right now would be somewhere in that $90–$100/bbl range. That would allow the economy to keep taking steps and provide for improvement in global industrial production and gross domestic product (GDP) without choking off too much demand. So, I think $90–$100 is a great price for crude oil, and that is kind of a sweet spot. The kind of volatility we could see is $80–$120/bbl. I don't know how long it will remain there at those swing points. So, I think $90–100 is the right price.
TER: Do you have a forecast for oil?
AM: I don't really have a forecast, but for the longer term I use $90/bbl crude in my models and for my sensitivity analysis. I look at what kind of cash flow a company can generate with $100 or $80 oil. I think $90 is a good, safe number to use.
TER: Do you feel that $90 oil is a conservative enough estimate to build your models for the next 12 months? The next 24 months?
AM: Well, I think it is a good number through the end of 2011. As global demand continues to creep higher, eventually, we're going to soak up that spare capacity that OPEC has, and that's when things will get a little more interesting. That's probably a 2012 event, but then we're talking $110–$120/bbl oil. At some point, the price will get high enough that it will support some demand destruction—but we're not there yet.
TER: The U.S. just ran up against the federal debt ceiling of $14.3 trillion back on May 16, and the credit and equity markets really want that ceiling to be exceeded (at least temporarily). But it seems pretty obvious that something must be done to reduce debt to a lower percentage of GDP. What impact would this kind of austerity have on the economy? Will it strengthen the U.S. dollar? Will it hurt oil? Will it hurt energy companies?
AM: Obviously, the debt ceiling is a hot topic right now. I am guessing that Congress will probably negotiate with the president, and the negotiations might go all the way up to the deadline on August 2. I'm not sure how big of an effect it's going to have, and one of the reasons is that there seems to be a shortage of bonds because investors are having a tough time finding yield. So, there's a really healthy credit market out there right now.
Clearly, a default by the U.S. Treasury on government bonds would be a very bad thing, but I think there's about a 0% chance of that happening. There will be much talk over the summer as it's negotiating. Cooler heads will prevail, and I'm sure we will do what needs to be done on the debt ceiling with a combination of austerity measures; but the bottom line is that there's a healthy economy out there. If it weren't, credit spreads would not be this tight. So, I'm actually pretty positive on the economy right now. This summer could be a little tricky as we hear more about the debt ceiling and as, you know, investors can be short-term minded sometimes. Ultimately, I think this plays out well for the economy. The dollar is probably due for a rally, but it doesn't necessarily mean that commodity prices will go down. Sometimes they go up with a stronger dollar; it doesn't happen often, but it can. So, the bottom line is I am positive on the global economy. I think we will get our debt ceiling figured out and we will just keep humming along.
TER: Aside from buying small caps for your portfolios, what is your general investment thesis?
AM: I like to look at companies that have a proven reserve, cash flow or something else that I can get my hands around for a base-case evaluation. In addition to that, I like to see some kind of embedded call option in the form of a large land package—that is at the top of the learning curve where there's a lot of leverage for upside.
TER: Is it hard to find stable cash flows and rising production, especially in politically stable jurisdictions?
AM: I don't think so. Domestically, in this latest cycle, we've seen the emergence of unconventional oil through the development of the Bakken Shale, which is probably the most widely known unconventional oil play. But other plays are developing now that have a lot of upside running room. And it's very much analogous to what we saw in the last cycle with the emergence of unconventional shale gas. Now, I think we're just seeing the same thing as history repeats—or let me say, 'as history rhymes'—this time it's the emergence of unconventional oil, where I think there's a lot of running room. And there are other sources out there besides the Bakken that are starting to emerge, which also have good running room.
TER: Where are you finding these characteristics right now?
AM: Not to be confused with the Bakken Shale in North Dakota, there's an emerging play called the Alberta Bakken that stretches through Montana and into Southern Alberta. I think it's going to see a lot of drilling and appraisal work done over the summer. You can't do much over the winter. In Alberta, a lot of the roads are closed for spring break up, and now we're just getting on the other side of that.
Rosetta Resources Inc. (NASDAQ:ROSE) and Newfield Exploration Co. (NYSE:NFX) are the two big players south of the border in Montana, and they've been doing science and vertical wells to test the Alberta Bakken. From what we've heard on recent conference calls, both companies are pretty excited about it and are going to start horizontal wells.
On the northern side in Southern Alberta, you've got a handful of micro-cap players with good land positions. Just in the last couple of weeks, we've seen the first results come out that were made public by DeeThree Exploration Ltd. (TSX.V:DTX). I think we're at the top of the learning curve, and the initial results look really good. So, there's a lot of running room here for these guys.
TER: Is DeeThree a company that you own?
AM: It is.
TER: DeeThree is mostly natural gas, which is expected to be stable over the next 12 months at best. Where does the upside come from here?
AM: Well, it is currently doing a couple thousand barrels oil equivalent per day (boe/d), and most of that is gas—probably 70% gas and the rest a mixture of light oil and liquids—so you have a little bit of cash flow there, which I like to see. It also has a couple hundred thousand acres in the Southern Alberta Bakken play, and I think, at least 70,000 acres in what I call the "sweet spot." So, there's a lot of running room there. DeeThree just drilled its first well and completed a frack. The average one-day test rate was 250 boe/d. The company is now removing the frack string and putting in production pipe. That's a very positive first result for its first horizontal well. And there are other excited players also in the play—big players, at that.
Murphy Oil Corp. (NYSE:MUR) signed a joint venture (JV) with DeeThree and has drilled a couple of wells that are rumored to be pretty good. Murphy has committed to drilling four wells on DeeThree's acreage by year-end to earn a 60% working interest in about 15,000 acres. DeeThree is being carried on the wells and will receive revenue from first production.
TER: Is that JV with Murphy on the Lethbridge property?
AM: It sure is.
TER: You sound optimistic about this play.
AM: Well, I've seen the cycle repeat over and over wherein you have an unconventional play that's in its drilling stages, and it takes a few months for industry to crack the right science to produce the most assets in the most optimal way. The wells should become more prolific with time, and drilling cost should trend lower.
TER: Where else are you looking?
AM: Well, there's a company I mentioned in my interview a year ago with The Energy Report that I really like over in Egypt called TransGlobe Energy Corp. (TSX:TGL; NASDAQ:TGA). Since then, the company has identified a new play called the Nukhul Fairway, and it extends across several of TransGlobe's acreage blocks in Egypt. The wells cost $1M–$1.5M, and some of them are coming on at 1,000 barrels per day (bpd) and holding up fairly well. It's become more of a developmental play where the company just keeps punching holes, and production is going to increase pretty rapidly this year.
Last year, about 30% of TransGlobe's production came from Yemen—most of which has been shut down due to the political turmoil there, but the Egyptian production has ramped-up so strongly that it's already eclipsed the Yemen production. This has allowed the company to keep its guidance that originally included Yemen. I expect that to continue this year, and I like the strong cash flow that's associated with the wells TransGlobe is drilling right now. There's just a lot of upside there and a lot of strong cash flow backing up the stock. So, TransGlobe is a company I am still very excited about.
TER: Amazing that the stock could be up 76% over the past 52 weeks with the shutdown in Yemen, which was producing 2,300 bpd.
AM: The Egyptian play has a lot of running room, and it has more than made up for the Yemen shortfall. Eventually, Yemen will become straightened out. I don't know if it will be three months from now or six months from now, but that production will come back. I am not counting on it, and I can get a good valuation without it at the current stock price level. So, I think there's a lot of upside for TransGlobe based on the rapid production increase in Egypt and possibly bringing Yemen back online later this year.
TER: Ok, you're in Egypt and the Alberta Bakken in Canada. Where else in the world are you currently looking?
AM: Well, the Colombian oil companies have been hit hard over the last six months, after having been a little frothy last year. We're now starting to figure out which ones are the real players and which ones are not. The premier oil company in Colombia is Pacific Rubiales Energy Corp. (TSX:PRE; BVC:PREC). I still think it has the best land package with more than 10 million acres for exploration upside. But what I really like about Pacific Rubiales is that the stock has been beaten down a bit and there are some very strong cash flows. It will increase production by about 20% to more than 110,000 boe/d by year-end, and I have it generating over $2B in EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) this year. It has a very strong, healthy balance sheet and it's proven the premier operator in Colombia. So, for Colombia, I'm going to stick with the "best of breed" and that's Pacific Rubiales.
TER: The company has a $7B market cap and is buying back up to 4.3% of its outstanding equity. That shows some confidence, I would think.
AM: Yes, Pacific Rubiales has a strong balance sheet, which gives it the ability to buy back stock when its value is not reflected in the market. I agree with management, and I think the stock has tremendous value here. It's going to generate $2B in EBITDA this year, and it's trading at about one-half the multiples that we see here in the States. I like the stable production profile, strong cash flow, management team and, like I said, I think this is the blue chip of Colombia and a great way to play Colombia.
TER: Is there any place in the U.S. that you're looking?
AM: Well, I like to go back to the old Permian Basin. It's been a long-standing producing region for Texas. We still keep finding new ways to get more oil out of the ground, as technology gets better and we do horizontal drilling and multistage fracking. One company I like, in particular, is Approach Resources Inc. (NASDAQ:AREX), which has some good reserves on the books.
What's gotten me excited is its new 130,000-acre Wolffork oil shale play. The first wells have just recently been announced and the horizontal wells are producing 200–300 bpd. I think the ultimate recoveries on these wells could be as high as 200,000–300,000 bpd. I should also mention that EOG Resources (NYSE:EOG) is just north of that play and is seeing a little better rates in the 400- to 500-bpd range on its first producers, and it's also rumored that Apache Corporation (NYSE:APA) is acquiring acreage in the area. So, there's a lot of running room with 130,000 acres in Approach's portfolio, and the company believes it has derisked about 70,000 acres of it—more than 1,000 locations. The returns on these wells are going to be good, and they're only going to get better as Approach works down the learning curve. It fits my preferred profile, as you have some base reserves to kind of get a conservative valuation of maybe $20/share. You have a lot of upside and running room as this new play is being developed.
TER: Is there anything else interesting you'd like to hit on?
AM: Well, I would like to mention one speculative name in Colombia. I know we already talked about one with a larger market cap, Pacific Rubiales, but the other one that has gotten my attention is Canacol Energy Ltd. (TSX:CNE), which has about 10,000 bpd light oil production. That is good for both cash flow and funding for growth initiatives. But it also has one of the best heavy oil land packages that I've seen in the Putumayo Basin, and that's something that's going to take some time to derisk. Once the company derisks this, there's a lot of upside to the heavy oil component of the company—and it makes it an extremely attractive acquisition target. I do like the fact that Canacol has some good cash flow to back up its valuation. I think it's an excellent acquisition candidate.
TER: It's been a pleasure speaking with you today, Adam.
AM: Thank you.
Adam R. Michael, 36, founded Platform Advisors, a California registered investment advisor that manages the Platform Energy Fund. Mr. Michael has over 10 years of experience in the energy industry in various capacities. With the majority of his career based in Houston, Texas, he is able to use his energy background and industry contacts alongside his investment experience to identify energy investment opportunities in geopolitically stable countries with attractive geological prospects and fiscal regimes. Mr. Michael has a bachelor's degree in industrial distribution from Texas A&M University (1997) and an MBA from Rice University (2004).
Source: George Mack of The Energy Report (5/26/11)
May 28th, 2011
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1) George Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: TransGlobe.
3) Adam Michael: I personally and/or my family own shares of the following companies mentioned in this interview: DeeThree Exploration, Approach Resources, Pacific Rubiales and TransGlobe. I personally and/or my family am/are paid by the following companies mentioned in this interview: None.