Leverage Surging Crude Oil Demand
Commodities / Crude Oil Mar 04, 2011 - 06:51 AM GMT
The rising tide of commodity prices has had a multiplier effect on the smaller unrecognized and undervalued oil explorers and producer. Private investor Chen Lin is leveraging ever-increasing demand for oil via micro- and small-cap stocks. He looks for companies with strong balance sheets that can generate the cash flow to become self-funding in a relatively short period of time. In this exclusive interview with The Energy Report, Chen explains how he determines which companies have the potential to double, triple or even quadruple and shares some promising stocks he owns.
The Energy Report: You were once a technology entrepreneur. People tend to stay with what they focus on initially. So, why have you have focused on resources as vehicles for growth today?
Chen Lin: I still have a lot of interest in technology. The reason for my interest in resources is that I believe it is still an under-researched area, and that the technology area is already well researched. I had been talking to analysts for years, telling them this stock or that one is the buy of a lifetime, and nobody listened. Then the stock would explode because people recognized the demand. Actually, I do still cover and follow technology stocks from time to time when I see them very undervalued. But I mostly like resource stocks because I know the area very well. I know where the trend is going, so it's relatively easy to make money.
TER: Could you tell me how you are currently weighting your portfolio?
CL: I'm pretty heavy in energy, followed by precious metals. I also have some base metals, and some forestry and direct agriculture plays.
TER: What do you look for in energy companies? I know that you are seeking growth, but how do you start?
CL: There are a couple of factors. One of the most important is to look at a company's balance sheet. If a company cannot pay its bills, it needs to keep coming to the market to raise money. Energy companies can be very friendly to small investors: it's easy, or relatively easy, for small energy companies to be successful. A company can drill one good well, pump the oil, truck it and sell it. They can immediately generate cash flow, and use that to drill the second well and the third well, and build the business from there. All you need is a few good wells, and then you have a success story.
Mining companies might drill a first hole and find gold or copper metal or silver, but they still have to raise a lot of money to drill more and define the deposit. So, there will be a lot more dilution coming. It could take 5 to 10 years. But oil companies drill, and in a few weeks or months, they get their oil out, and they're in business. They have cash flow, and don't need to go to the market anymore. That's the advantage for the energy companies.
What I'm looking for, in addition to the balance sheet, is the company's property. How good is it? How deep is the well? What's the flow rate? What's the decline? (Decline is very important. You can have pretty high initial production, but it can decline very rapidly.) How much cash flow can a company generate? How fast can they pay back the drilling costs of the well? After that, it's like a cookie cutter; they drill more and more wells. Then, the question is, how much do they have in reserves? Reserves are updated every year. You cannot just look at the reserves and say, "this company is worth so much," because it changes.
TER: Generally speaking, would you say there is more value today in energy than in metals stocks?
CL: Well, it depends on how you define value. Why do I overweight energy right now? It's because there's a seasonality factor. February usually is the month of the lowest oil price. The oil price always goes higher from here. As oil price improves, energy companies do well. Then, secondly, there is a big discount between WTI (West Texas Crude) and Brent crude—the U.S. oil price and the worldwide oil price. In computer trading, this WTI rate, which is a very low rate, is used. I think energy companies are not being priced at the Brent rate, which is 70%–80% of world oil pricing. There is a $15–$20/barrel gap between those two. So, the valuation of energy companies is still extremely low. That's the reason I'm overweighting energy right now.
TER: We'll periodically see a situation in which resources are in price decline. Obviously these things are cyclical. Is there any scenario you could envision in which you would still invest in companies that explore or produce in a declining commodity market?
CL: In a declining commodity market, I think it's very hard to invest in any commodity stock. For example, in 2008, if you invested in anything, you lost money. That's why I would stay in liquid stocks. For example, in 2008 I owned only one energy stock. It's a low-cost producer, land-based and with very good cash flow. My stock was still cut in half, but it didn't go down 95% like many other juniors. It was still hit very hard, because people were just giving up on the sector. They were just selling and selling. That's the tough part, and that's the business I am in.
However, I know that the commodity is always going up and down. When it goes down, it just creates a lot of opportunity for the up cycle. If you stay with a company, a stock, with a strong balance sheet and good cash flow, usually your stock declines much less. In 2008, I finally decided to invest heavily in Yamana Gold Inc. (TSX:YRI; NYSE:AUY; LSE:YAU).
TER: What company is your favorite play in energy?
CL: My largest position in energy is Mart Resources Inc. (TSX.V:MMT). It's an exploration play, and they have already discovered oil. All they need to do is to pump the oil, and enjoy incredible cash flow. If you calculate cash flow using their recent drilling success, once they bring the next two wells into production, they'll still be trading at less than their current cash flow. They will easily do $300 million of cash flow, but their market cap is only about $200 million now. Their recent drilling results tested at over 14,000 barrels per day (bpd) over four zones. Right now they only produce from two zones. They are going to produce two more wells on the same pad; therefore, using their historical production data, they will be easily over 20,000 bpd. Next, they are going to do a pipeline, so they will have a 30,000 bpd capacity followed by another production increase.
So, just from the production and cash flow point of view, it's going to be very hard to find an energy stock trading at less than one times cash flow. There's an enormous amount of oil there, and it will come out in a few months when they drill the next two wells. When they get a new reserve report, the cat will be out of the bag. So, for right now, because it hasn't shown up in the financial or reserve reports yet, the stock hasn't really moved. That's why I like the stock; that's why I'm holding a lot of shares in my personal account.
Secondly, you can see from the company's existing wells how much of a decline they have had. Mart has had wells in production for two years, and there's no decline. This is very rare. If you drill in the Bakken in Canada, in three months it will dry up by more than half, right? In a year, it drops 80%–90%. But two years have passed, and Mart's well production is almost constant. In fact, recently production went up.
TER: Another energy stock?
CL: I also own another energy exploration play called Vaalco Energy Inc. (NYSE:EGY). It operates out of Gabon, Africa, offshore, and produces about 5,000 bpd. The company has an excellent balance sheet with about $100 million cash, and it's been in production for a pretty long time, with a very experienced management team. Producing 5,000 bpd and with so much upside ahead, usually a stock would be trading much higher, but it isn't because no one has really noticed it. In addition, the company is going to drill a few very important wells this year with a higher production profile. I like that it has very persistent, established production already, and even based on current production, the company is still very much undervalued. It has a very strong balance sheet and cash flow, and the coming drilling is fully funded, as with Mart Resources. You can see all the upside.
The funny thing is that both of these companies—VAALCO and Mart—are financially independent, and they don't need to raise money from the market because they have so much cash flow. For Mart Resources, it is even more so. You're talking about cash flow that's more than the market cap. So, they don't need to raise money from the market, and they don't need to go to a Canadian broker to raise money. That's why there's very little analyst coverage on these companies. Brokers usually cover the companies for which they raise money.
The next company is Pan Orient Energy Corp. (TSX.V:POE). It's similar to the previous one, but with a little twist. This company's stock really didn't do anything in the past year. It has steady production of about 3,000–5,000 bpd. It generates very good cash flow, which it's using to fund its next operation—a very big land position in Indonesia. The company's been doing the seismic preparation for three years, and it's about to drill the most important well in company history.The stock hasn't really had any of its potential discoveries priced in, and so I think it's a very good moment to buy. They start drilling next month. This is a company I like; the downside is limited because they already have production and cash flow, and there's a lot of upside.
TER: Another energy company?
CL: This company is a little more risky. It's called Groundstar Resources Ltd. (TSX.V:GSA), and it's an exploration play. It has three plays over the next few months, in Guyana, Iraq and Egypt. The Guyana and Egypt projects are being funded by a partner who is paying for the drilling. The partner pays all the costs. This is a very small market cap play, about $30–$32 million. Positive drilling results in just one well could easily double, triple, quadruple the stock from here. It's a reasonable downside for a lot of upside. It's a very interesting time because they have three important drillings coming at about the same time. That's very rare to find in an exploration play.
TER: Is it worth the risk in the dangerous areas where this company is exploring?
CL: In Kurdistan and Iraq, the risk is relatively high. Egypt could potentially hurt them. But other companies operating in Egypt, like TransGlobe Energy Corporation (TSX:TGL; NASDAQ:TGA) were not hit that badly, and have rebounded fast. Groundstar's operations are very remote, very far from demonstrations in Egypt. From an energy exploration point of view, the risk/reward is excellent.
TER: What else do you own?
CL: Vast Exploration Inc. (TSX.V:VST) is also on my recommendation list. They are Groundstar's partner in Kurdistan, but Vast owns 37%, not 6% like Groundstar. The well is getting pretty close, and we should have results in a few weeks. This one is more like a one-shot deal, but it's one big shot because they have a big percentage in that play. So, risk/reward is excellent. But it's a little different. Groundstar has three shots in three different continents.
TER: When will we know something about the Kurdistan project?
CL: Well, there's talk that by March we should know—sometime in the next few weeks. That's the exciting part. With oil so high, if they really got a big hit I can't imagine how high it could go for both Vast and Groundstar.
TER: Do you want to mention another one?
CL: Yes. I also invest in the energy service area. I recently picked up Leader Energy Services Ltd. (TSX.V:LEA). This is a very small company with only about a $13 million market cap. But their cash flow is extremely high, and they are trading at about one times cash flow. In a recent press release, they said last year's revenue was $26 million and increasing dramatically. They're doing energy services in Alberta, a very hot area. There's a big backlog of business. And the company has done a very good thing in buying back their convertibles, and reduced dilution. In the last quarter they earned $0.08, and they will earn $0.10 in Q4—probably more now since they are in such high demand. So, there's potential to have a lot of upside going forward.
TER: Thank you.
CL: Likewise.
Listen to Analyst Chen Lin on Jay Taylor Radio (2/22/11)Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc., publisher of J. Taylor's Gold, Energy & Technology Stocks newsletter and Roger Wiegand's Trader Tracks. Using his wife's Roth IRA account, Lin invested $5,411 in December 2002, and by December 31, 2010 it was worth $1,188,993—with no cash added. You can see his portfolio chart here.
A doctoral candidate in aeronautical engineering at Princeton, Chen found his investment strategies were so profitable that he put his Ph.D. on the back burner. Chen worked in the Internet and computer area where he founded a few start-up companies. After the tech bubble burst of 2000, Chen was able to move his technology portfolio into the resource sector with considerable success. Chen employs a value-oriented approach and often demonstrates excellent market timing due to his exceptional technical analysis. To subscribe to Lin's What Is Chen Buying? What Is Chen Selling? newsletter click here, or call Claudio Bassi at (718) 457-1426.
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DISCLOSURE:
1) Brian Sylvester and Karen Roche of The Energy Report conducted this interview. They personally and/or their families own shares of the companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Greg Gordon: See Morgan Stanley disclosure that follows.*
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