Look for High-Growth Oil and Gas Juniors
Source: Alec Gimurtu of The Energy Report (6/26/12)
Companies Mentioned: Apache Corp. - AusTex Oil Ltd. - BreitBurn Energy Partners L.P. - Cabot Oil & Gas Corp. - Chariot Oil & Gas Ltd. - Encana Corp. - EOG Resources Inc. - Gale Force Petroleum Inc. - Gastar Exploration Ltd. - Molopo Energy Ltd. - Pacific Coast Oil Trust - Range Resources Corp. - Red Fork Energy Ltd. - Sonde Resources Corp. - Southwestern Energy Co. - Westbridge Energy Corp.
The Energy Report: It's been a tough market for energy stocks since your last interview. What is your take on the state of the market?
Josh Young: It's been a tough few months for energy stocks. Over the last few years, there have been risk-on and risk-off cycles. Commodities and smaller energy stocks have done well when the world economy appeared to be recovering; last November through March was one of those periods. Beginning in April, the market turned down. Investors got more cautious, oil and natural gas prices came down, as did energy stocks.
This is an interesting time because it is not clear what will happen next. Unless there is a big, unforeseen global event, commodities and energy will continue to trade in the wide range that we've seen over the last few years.
TER: What companies can succeed in this environment? Gale Force Petroleum Inc. (GFP:CVE) is one that you've talked about in the past. How do you evaluate them?
JY: I've found that companies achieving the highest valuations are not just cheap based on cash flow and reserves. They are also rapidly growing. Growth can be organic or by acquisition, but there needs to be the potential to grow rapidly and economically. Any capital spending must lead to high growth. Highly valued, large companies such as Southwestern Energy Co. (SWN:NYSE) or Cabot Oil & Gas Corp. (COG:NYSE) are rewarded with a premium multiple in the market after having achieved years of economic, high production growth. I look for companies that are smaller and are in the process of economically growing production, but that aren't necessarily showing the results just yet in their financials, and where people don't yet believe there will be consistent growth. That transitional period when companies are growing and drilling with high rates of return is the sweet spot for an equity holder.
Unlike most oil and gas stocks, Gale Force is up for the year. It is well financed, growing rapidly and trading at a discount to the value of its cash flow and reserves. Gale Force recently announced production guidance in excess of 800 barrels per day (bbl/d) by the end of the year versus 275 bbl/d at the start of the year. It is possible that the company could get to 1 thousand barrels per day (Mbbl/d) by the end of the year. With a current enterprise value of around $20 million ($20M), it is undervalued relative to its peers and relative to the liquidation value of its assets. Gale Force is in the process of drilling to prove undeveloped locations and recompleting three producing wells. Production could exceed 600 bbl/d by the beginning of August. These projects have a very high rate of return—a triple-digit internal rate of return in many cases. It should create a lot of value over the next year or so through this capital program. Over time, the equity price will begin to reflect that. If Gale Force traded to a normal industry multiple of $100,000 (100K)/flowing barrel, with 1,000 bbl/d production by the end of the year, that could make for a $100M market cap versus the current $20M market cap. There is a lot of potential upside.
TER: Does this multiple apply to junior producers or is that more for mid-tiers and majors?
JY: That's a great question. It's not really still applicable for really small companies, but what Gale Force is doing will make it very applicable. Gale Force has been looking at royalty trusts that have been spun off by companies like SandRidge Energy (SD:NYSE), Chesapeake Energy Corp. (CHK:NYSE) and the management of BreitBurn Energy Partners L.P. (BBEP:NASDAQ). Once production exceeds 1,000 bbl/d, Gale Force will stabilize production with continuous drilling and workover programs. Those assets are being evaluated for spinning out to a royalty trust. The valuations on royalty trusts are well in excess of $100K/flowing barrel. Even now, after a few months of weakness in energy stocks, most of the royalty trusts are trading in excess of $250K/flowing barrel. There's a capital expenditure requirement, but even netting the capex requirement, 1,000 bbl/d of stabilized production could be worth more than $200M. In general, a $100K/flowing barrel metric is more appropriate for a larger company, Gale Force does have a near-term monetization plan. I think the $100K is fair. As a potential royalty trust offering becomes more of a reality, the stock could price it in.
TER: Have other small companies successfully spun off or converted into a royalty trust?
JY: Absolutely. Recently, the management that runs BreitBurn Energy had a private company that was smaller and grew over the last few years. They spun it out as Pacific Coast Oil Trust (ROYT:NYSE). The initial valuation was about $300K/flowing barrel. Production was approximately 3,000 bbl/d. Gale Force produces less but is higher margin. I don't think there's necessarily a size requirement beyond the 1,000 bbl/d Gale Force will achieve. A spinoff needs to be a certain size for investors to want to participate and for liquidity, but I don't think it should matter too much if it's 1,000 or 50,000 bbl/d as long as the yield is similar and the cash flow per unit is similar.
TER: It's good to go down a path that's been traveled successfully.
JY: Gale Force has always been on the XTO path, which is a little different. Many juniors will lease a bunch of land, then try to raise money on the back of it. Next, they drill wells and try to raise money on the back of those well results. Gale Force has done it the other way around. First, they buy production at a low price. Next, they rework the wells to increase production. Lastly, they borrow money, hedge production to protect the debt and repeat. Gale Force also raises equity, but it has been on the back of production, not because of large land positions. Most of Gale Force's production has a stable decline rate. That's why the royalty trust model could work well, whereas for a lot of smaller companies, it's not really an option.
TER: Is Gale Force mostly active in Texas?
JY: Most current production is in East Texas. Royalty trusts are best if geographically concentrated—it helps to have fields in just a few areas. Gale Force has a field in South Texas, but it is close to current production. It helps to have one center of operations. The company looks at additional acquisitions and drilling, but it's all within that small area.
TER: When you look at other companies, is it important to you that they have established fields in drilling-friendly jurisdictions like Texas?
JY: Yes, it's obviously helpful, but I care more about the field being highly economic than I do about location. I also care about political risk. In New York, you can't drill horizontally and do hydraulic fracturing. Internationally, there are all sorts of political risks that I generally avoid, although occasionally I'll participate for the right risk-reward ratio.
A position I recently added is AusTex Oil Ltd. (AOK:ASX). It is traded in Australia, which is unusual for a small energy stock with most of its assets in the Mississippian play of Oklahoma and Kansas. That could be why it trades at a discount to its asset value and to its peers. AusTex is next to Range Resources Corp. (RRC:NYSE) on the Nemaha Ridge. Range has drilled more than 100 vertical wells in the area. Many have had more than 100% rates of return. More recently, Range has drilled eight horizontal wells within two miles of AusTex's position. AusTex was in one of those wells from which they expect a 30-day average rate of 1,000 bbl/d or more. With a well cost of less than $4M and production of 1,000 bbl/d, the well could pay out in a few months. AusTex is a minority working interest partner in that particular well, with approximately 14–15% interest. AusTex has 6,000 net acres adjacent to that well. The company has drilled a few vertical wells on the land with well costs around $600K and 30-day rates in excess of 100 bbl/d. Those are very high rates of return.
Another AusTex neighbor is Apache Corp. (APA:NYSE), which just had its analyst day. Apache has hundreds of thousands of acres in the Mississippian in Kansas, where it envelops AusTex's position in Kansas. Apache is going to drill wells all around AusTex. It is possible that AusTex is in the center of a newly discovered oil field. It's exciting, but too early to give it too much credit in my valuation.
TER: Your valuation on AusTex is based on production and cash flow plus a big growth component?
JY: Yes. There will be a lot of growth from the 6,000 acres next to Range. AusTex will be able to drill hundreds of vertical wells or dozens of horizontal wells that will each have net present values well in excess of the cost of the well. You can more than double your money every time you drill a well. The market cap right now is just above $30M. It's a small company, but if it drills a few wells, it can ramp up production and cash flow significantly. It will be able to internally finance the drilling and get payback in approximately six months for each well.
TER: AusTex stock has been pretty hot this year—tripling up to a few weeks ago and then selling off. Is the word getting out or is this still somewhat under the radar?
JY: I think one or two investors in Australia figured it out. In February and March, people got excited. Prior to that it, it was stable in the $0.08–0.11 range for a long time.
The stock started to move after announcing excellent vertical well results. Range's results were also great. Based on both companies' results, investors were comforted that it was not a "one-off" well. Recently, the stock has declined with the sector as a whole. With additional drill results, the stock could rebound and head higher. Competitors like Red Fork Energy Ltd. (RFE:ASX) and a few other Mississippian-focused companies have higher per-acre, per-flowing barrel and cash-flow valuations. It has a lot of room to the upside. I have bought this dip.
TER: What other companies are you following?
JY: Gastar Exploration Ltd. (GST:NYSE) has positions in Texas and West Virginia. It is executing on its plan, growing rapidly and generating high rates of return on its wells. Its financing is lined up. Last year, it doubled proven reserves and it's likely to do so again. The stock is down 50% since the beginning of the year, and it has far underperformed its peers. Exposure to natural gas and natural gas liquids didn't help. Despite that, Gastar's wells are highly economic on a new, mid-continent oil play. A partner has drilled a number of highly economic wells that cost $3–4M and came on at 30-day rates of 600–800 bbl/d. It also has a historic natural gas field that it hasn't been active in but still holds the land by production. EOG Resources Inc. (EOG:NYSE) recently drilled an Eaglebine shale well nearby with reports of stabilized production of approximately 1,000 bbl/d. Encana Corp. (ECA:TSX; ECA:NYSE) drilled a well nearby with an initial high production that flattened out at around 200 or 250 bbl/d. The company recently announced several others at similar production rates and is now drilling a longer lateral well, which it expects to produce at substantially higher rates.
TER: But how do you value that?
JY: Gastar's West Virginia land is probably worth more than the current enterprise value. In addition, it has 15–20K acres that are prospective for the Eagle Ford that EOG may have just delineated. Encana is also drilling around it. It also has the mid-continent oil play that looks like it's going to be highly economic. Gastar is participating in the first one of its wells in a few weeks. I believe the stock is cheap. Apparently, so does the CEO, because he bought $100K of the stock a couple of weeks ago. He said he got some flack because he only bought $100K. He told me that almost all of his personal net worth is already in the stock. When you go from 90% of your net worth in the stock to 91% of your net worth in the stock, even if it's a small dollar value, it's a big deal because obviously it's further concentrating your wealth. I think he was joking, but he said he was rummaging through his couch seats for change to go and buy a little bit more. Hearing that made me go through my couch seats to pick up a little more stock myself.
TER: It's really been beaten up over the past year on the price chart.
JY: Yes, it's gotten beaten up. It's tough as a current holder. I've owned the stock for a while. But it's also a great opportunity. I bought a little bit more recently. I may buy some more going forward. I see opportunity in stocks that are beaten down, executing well but are unloved for some reason. As they go back into favor, they have the opportunity to outperform.
TER: Does Gastar look like an acquisition target?
JY: Yes. The CEO has talked about getting inbound calls from private equity. I'm not sure that the whole company is for sale. However, the Marcellus asset is probably worth more than the whole company. Half could be sold for $100–200M to pay down debt and the balance re-deployed elsewhere. Such a scenario could double the stock.
TER: Are there other special situations that you are watching?
JY: I like companies that are cash rich. Neither Gastar, AusTex nor Gale Force have a lot of cash on hand. They have sufficient liquidity to execute their plans, but they don't have a ton of excess cash.
I follow two companies that have more than 50% of their market cap in cash and no debt—Sonde Resources Corp. (SOQ:NYSE) and Molopo Energy Ltd. (MPO:ASX). Both happen to be selling international assets. Molopo is selling a natural gas field in Australia that could be used for liquefied natural gas transport. Sonde is selling a North African oil field. Both companies could have negative enterprise values if their sales happen at the management-guided prices. They're special-situation investments, and they theoretically shouldn't be very high beta. Oddly, they have traded in line with the market over the last few months. As their asset sales proceed, the stocks should diverge from trading with the market. Both should be able to create value through stock buybacks and maybe even distress acquisitions.
TER: Molopo has a large portfolio of different types of projects all over the world. Would it make sense to focus on its best prospects?
JY: Yes. It has a lot of valuable assets, but the company is hard to value because not all its projects are generating cash. Molopo needs to focus. Ironically, even if it gave away some assets, it could go up in value because it would be easier to understand. Its South African holdings are an example. It has hundreds of thousands of acres there that may have shale gas or other assets. How do you value that? My estimate is that it could be worth $10–20M or more in the future. For now, Molopo is not selling the South African holdings, but the asset has value. Molopo is selling an Australian asset, but it's also hard to value. Hopefully, proceeds will be used to buy back stock because the market is having trouble valuing the company. Buybacks would help to resolve the issue.
TER: Are there any other interesting companies that you would like to mention?
JY: Yes. The last one is unusual for me in that its only asset is offshore West Africa and it has no production or cash flow. It has a very low valuation based on the oil that could be underneath its leases. It is in Namibia, and it is called Westbridge Energy Corp. (WEB:TSX.V). Southern Namibia has a known offshore field. Chariot Oil & Gas Ltd. (CHAR:LSX) recently drilled an exploratory well. That well was uneconomic, but it showed a petroleum system in the area. That well looks to be on the side of the same reservoir as Westbridge. There is a lot of activity in the area, with many wells located and permitted offshore by a number of different operators. It will only take one economic well to get numerous buyout bids for Westbridge. For now, Westbridge is starting at a low valuation and taking a more pragmatic approach, which starts with coming in early, paying little for acreage and building relationships. Westbridge has attractive back-ins with Namibia. As an investor, their low-cost approach mirrors my own. A large, inexpensively acquired land package with lots of exploration activity should result in value creation that someone will pay well in excess of current market valuation.
TER: That is a lot different from your other picks, but it fits a different portfolio need.
JY: It's a flier—but it's a cheap flier. I know management well and I like how they work. If Namibia heats up, Westbridge could sell a portion of current holdings for a substantial profit to fund ongoing exploration. That would ensure that early investors are rewarded. Management recognizes that West Africa is a high-risk prospect and they are acting to maximize gains for themselves and early investors.
TER: How would you sum up your advice for our readers?
JY: It looks likely that we're going to get some quantitative easing and bailouts in the U.S. and Europe, particularly running up to the U.S. election in November. If so, energy stocks could run. Investors should consider the international dynamics for oil prices, especially with regard to Russia's role. I want to be on the same side of the table as Russia in this regard. The current Russian regime has strong incentives to maintain a high oil price. Their finances need $110 Brent. There are many strong geopolitical incentives for Russia and oil exporters to maintain the high oil price. That's part of why I feel comfortable maintaining exposure to oil, despite all of the geopolitical and economic turmoil. People with the power to maintain high oil prices are doing so. I expect a reasonably high price of oil over time, even if there is an economic downturn.
TER: Thank you for your time, it has been interesting.
Josh Young is the founder and portfolio manager of Young Capital Management LLC, which launched Young Capital Partners L.P. in 2010. He previously served as an analyst at a multibillion-dollar single-family office in Los Angeles. Prior to that, he was an investment analyst at Triton Pacific Capital Partners. He was also a corporate strategy consultant at Mercer Management Consulting and DiamondCluster. He holds a Bachelor of Arts in economics from the University of Chicago.
Source: Alec Gimurtu of The Energy Report (6/26/12)
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DISCLOSURE: 1) Alec Gimurtu of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: Encana.
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