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How to Protect your Wealth by Investing in AI Tech Stocks

Stick with Wet Natural Gas, Heavy Crude Oil Investment Plays

Companies / Oil Companies Aug 03, 2010 - 02:11 PM GMT

By: The_Energy_Report

Companies

Best Financial Markets Analysis ArticleOil and Gas Investments Bulletin Editor and Publisher Keith Schaefer specializes in Canadian oil and gas plays. Despite the languishing gas price, he sees opportunities in some hedged Canadian gas companies and unhedged "wet-gas" producers. If you're not into gas, Keith is big on oil. In this exclusive interview with The Energy Report, Keith will tell you how radial drilling is creating opportunities in heavy oil, too.


The Energy Report: Keith, when The Energy Report talked with you in December, you said that a gas price below $5 would be "hell." Well, welcome to hell. Gas is hovering around $4.50 right now. Where's the bottom?

Keith Schaefer: It has been a very tough year for gas producers. Since January, the gas price has been on a straight downhill slide, with very few bumps up along the way. It has been hell, particularly for the juniors that are unhedged. These companies are creating no value for their shareholders. Their cash flow is anemic.

Where is the bottom? I think there's a good chance we're going to find that out in the next month or so, because gas traditionally bottoms in August. Last year, it bottomed around $2.50, $2.75 per MCF. Then in September, it started to take a big jump back up to $5. These stocks had a huge run along with that. It's almost funny, because none of these companies were really making money at $5, but the fact that they were losing a little bit less made the market very happy, and that took the stocks for a big run.

TER: At the same time, a lot of producers are hedged. Most of them are right around the $6 mark.

KS: Many of the seniors are hedged at $6. The forward curve has allowed them to do that. Good for them and their shareholders, because it looks like we could be in for a multi-year low gas price if these U.S. shale plays hold up.

TER: What's your view on the gas price through the end of this year and the end of 2011?

KS: I think this year we're going to get a little bit higher, but not much. Right now gas in the States is running around $4.50. In Canada, it's running at about a dollar less. These shale gas plays in the U.S. are doing a superb job at increasing production. Unless there's a dramatic increase in demand or a significant falloff from production, we're going to be staying right around here; maybe a little bit higher, but not much.

TER: And that's through the end of 2011 as well?

KS: The end of 2011 could be very interesting, just because many of these shale gas plays are relatively new. Right now companies stake a bunch of land and they have to drill the land to hold it. Once they've drilled a certain amount of holes, that land is theirs. When that happens, I expect these companies to stop drilling. That should actually be quite positive for the gas price. Companies are being forced to drill to keep their land when the market says they shouldn't.

TER: Are there companies that, despite the low gas prices, continue to perform?

KS: Oh, yes. You're seeing several companies do better than expected, for a couple of reasons. Some have been smart enough to hedge, which has benefited their balance sheet and their cash flow. Bellatrix Exploration Ltd. (TSX:BXE) is at the top of that list, and it's in our Oil and Gas Investment Bulletin Portfolio. They've hedged 50% of their gas at close to $7, so their cash flow has been fantastic this year. A second reason Bellatrix is doing better than expected is that they have a large land position in a burgeoning oil play in Alberta known as the Cardium. That stock has outperformed its peers this year, and in my mind, it will continue to. Another company that's done really well is Angle Energy Inc. (TSX:NGL), a wet-gas producer. Wet gas gets about twice the amount of money as dry gas.

TER: Is this what's known as natural gas liquids in the U.S.?

KS: Yes, liquid-rich gas. Angle has a huge growth curve in front of them. They're not hedged. If you're looking to play gas, that's a good one, because from their wet gas, they have downside protection with good cash flow, at current gas prices. They also have huge exposure to the upside if gas moves.

TER: Are we seeing companies with assets that have a high percentage of natural gas liquids getting higher valuations?

KS: Absolutely. Companies are getting higher valuations because of their higher wet gas percentages. Not across the board, but most of them are, companies like Angle and some of the other high wet-gas producers, which are mostly in the Deep Basin area of Alberta, right outside the foothills. And up in the Montney shale play, as well, they're getting higher liquids contents. They're getting 10, 20, 30, 40 barrels of wet gas per million cubic feet of dry gas, which could basically double the economics.

TER: Wow. Do you have some specific names with exposure to those plays besides Angle?

KS: Orleans Energy Ltd. (TSX:OEX) has a good wet gas count. Cinch Energy Corp. (TSX:CNH) has a wet gas count. Vero Energy Inc. (TSX:VRO). . .

TER: All right, what about Vero?

KS: I love Vero. I think it's a great company. The stock trades very, very well for how few shares—only 30 million—are out. Vero has one of the top management teams in the business, Doug Bartole and his vice president of exploration, Kevin Yakiwchuk. They have a great property in the Edson area of Alberta. They've shown great discipline in producing when the gas price is good and shutting down production when it's not. They've managed their finances very well. Vero keeps a high debt ratio, which means they don't have to issue many shares because they're generating most of their growth by using debt. They've got this new Cardium oil play, which has over 90 net sections. That's a lot of oil that they can bring onstream, very profitable oil.

TER: Are they in production right now?

KS: They're producing 8,000–8,500 barrels a day.

TER: Are there any other gas companies that you're excited about? You cover Peyto Energy Trust (TSX:PEY-U; OTC:PEYUF). Tell us about that one.

KS: Peyto is the lowest-cost producer in Canada. Their suite of properties is best of breed. Management has done a fantastic job. Over the last 10 years, that stock went from $1 to $45. I actually owned that stock when it was $1 a share, back in 1998. Now, of course, after the crash, everything's changed; but they continue to have the lowest- cost production, and a great growth profile. If you were only going to buy one gas company to get some exposure to a potentially rising gas price, Peyto—being the lowest-cost producer—would be it.

TER: A recent report on the U.S. shale plays by Credit Suisse talked about some of the gas shale plays with the best internal rates of return (IRR). The Marcellus was ranked second, with a 42% IRR. What are some companies with significant exposure to the Marcellus?

KS: One of the best companies that I like for exposure to the Marcellus shale play is actually an energy services company that does a lot of the drilling work and mud work for the producers in that area. It's called Canadian Energy Services and Technology Corp. (TSX:CEU). They've been able to make huge inroads into the Marcellus by selling their products to the drillers and producers there. Their mud allows drillers to complete a well in the Marcellus about 10 days sooner than normal. That dramatically reduces costs, which is one of the reasons the Marcellus is turning into a much more profitable play. On the producer's side, I think one of the safest plays in the Marcellus is a company called Epsilon Energy Ltd. (TSX:EPS). They have a deal with Chesapeake Energy Corp. (NYSE:CHK), the second largest gas producer in the United States. Between cash payments and work commitments, they've paid Epsilon about $200 million to get access to Epsilon's Marcellus ground in Pennsylvania. Epsilon basically has a free ride. In one sense it doesn't really matter what gas prices do, because Chesapeake is paying the freight. I love companies like that.

TER: I think we'll switch over to oil. Oil remains just below $80 a barrel. Do you think that's a psychological barrier? Does oil need to get past $80 to have a run?

KS: No, not at all. Oil doesn't need to run. I'm happy to see oil trade here for the next five years, because there are lots of companies that make fantastic profits at $75 oil. Technology is lowering costs in the oil patch. With the new horizontal drilling technology and multi-stage fracking, all kinds of new plays are opening up. Literally. Just yesterday, a new play opened up in Canada that no one had really paid much attention to. One of the independent consultants estimated that there are over 6 billion barrels of oil just in that one formation in Alberta in B.C. So all over the place you're seeing new basins, new formations being opened up with all this new technology, and it's relatively low-cost oil, not compared to the Saudis per se, but by the standards everywhere else in the world, it's very profitable oil at these prices. The oil price does not need to go any higher.

TER: Do you see it staying in that range for the next couple of years?

KS: That's a question that only history is going to be able to tell us. But I would suggest that, with the decline in demand in the U.S. and Western Europe being offset by the rise of China and India, we're going to see a fairly stable oil price for a while.

TER: You were talking just a few seconds ago about technology opening up some new plays. At the same time, fracking is not all that new. Multi-stage fracking has been around for a while. and horizontal drilling has been around for a while. What are new technologies in oil and gas exploration that we haven't heard about?

KS: There are new ones coming up all the time. But let's just go back to fracking and horizontal drilling for a second. Although those technologies have been around for 40, almost 50, years, it was just 10 or 12 years ago that the technologies got perfected enough so that they could start producing oil and gas out of rock. That was the Barnett shale.

What you've seen here now is that many new plays around Canada and the U.S., where the technology was developed, have become newly commercial. Even though they're old technologies, they're still opening up many, many new plays all around the world—the European shale gas plays, the African shale gas, and that's just scratching the surface. We're going to see huge growth in Europe and Africa shale gas over the next 20 years. You're right, they are old technologies, but they're being used in new basins for the first time and that's creating big value for shareholders.

One of the new technologies that I'm really intrigued by is radial drilling, which is used in heavy oil basins. I believe this is a technology developed by Halliburton Co. (NYSE:HAL). Little jets are sent into the very porous heavy oil formations and are able to create wormholes 100 meters out into the formation, to get oil to flow back to the well. Before this technology was being used, you could only get about 3 to 5 meters outside of the wellbore. It's a huge increase in potential production and reserve creation.

TER: And that's making some of these old basins profitable again?

KS: Yes. What's happening is that the old basins that have been worked over now have a new lease on life. I would say that heavy oil formations haven't really been used or exploited that much. The world's been very focused on getting the light oil out. But over the last dozen years, much more time has been spent focusing on the heavy oil. They're continually finding ways to improve the technology and lower the cost.

TER: What are the big differences between heavy oil and light oil?

KS: Light oil is easy to process, and doesn't need much work to get into the form that would go into your car. Heavy oil has heavy products in it like metals; it's the basic component of asphalt. We have to spend a lot of money to remove the asphalt, rocks, and bits of metal to make heavy oil into various types of fuel. Heavy oil doesn't go into your car; it will go into heating products or diesel, or products where it doesn't need to be refined quite as much.

TER: It's more expensive to process, but are there still some companies that you like that are big into heavy oil and are profitable. Could you tell us about some of those?

KS: Yes. That's a great point. What's happening here is that many of the U.S. refineries, particularly those down in the Gulf of Mexico, are geared toward heavy oil. You just can't change your refinery at the flick of a switch and say, "Alright, today we're going to do light oil. Tomorrow we're going to do heavy oil." When you're a heavy oil refinery, that's the type of feedstock you need.

The two biggest sources of heavy oil, Mexico and Venezuela, are in steep decline—Mexico for geological reasons, Venezuela for political reasons. That means that the heavy oil from Canada is in hot demand in U.S. refineries. There's a new pipeline being proposed to take oil from Canada down to the U.S. refineries. Many heavy oil producers that are used to getting only 50%–60% of the regular oil price for their products, because it costs so much more to process them, are now getting 85%–90% of the regular oil price. Over the last two or three years, there has been a huge increase in the heavy oil price. What they called a "heavy oil discount" has gotten much smaller. And the heavy oil in Canada is very shallow, so it does not cost much to produce. Wells only cost $300,000–$700,000, versus $3 million–$5 million for a deep light oil well. So when your costs are low and the price of your product has gone up a great deal, that's a recipe for profits.

TER: Tell us about some of those companies that are profiting from this trend in heavy oil.

KS: Well, one of my favorites is a company called Emerge Oil and Gas Inc. (TSX:EME), which has lots of heavy oil in Alberta and in Saskatchewan. They have done a great job securing large land packages that have highly prospective oil leases. Emerge has been able to deliver good production growth and will continue to do so over at least the next two years.

TER: Any others?

KS: Another one that I like is a company called Rock Energy Inc. (TSX:RE). CEO Al Bey knows how to secure land positions, and he has a very good cost-control system in place. Some of their properties are able to deliver profits of three to seven times the money that Rock puts into them. For every dollar that they put into the search for the oil, they're able to return $3–$7 to the shareholders. That's a fantastic "recycle ratio."

TER: What other things has management done?

KS: They just brought on John Van De Pol as President and CFO. John's been involved in a couple of winners in the past, has a lot of experience and does it right. He's very methodical. For a shareholder, he's exactly the type of guy who gives you a lot of confidence.

TER: What are Rock's prospects for growth?

KS: They still have a large undeveloped land package, with a drilling inventory of at least two to three years ahead of them. They'll be able to continue to grow production quite strongly. Rock is also one of the pioneers in using this new radial drilling technology. They're finding that the amount of oil they can get out of each of their land sections is increasing quite dramatically, and that's been a big, big bonus.

TER: Are there any other companies you like in the heavy oil space?

KS: Not too many. Rock and Emerge are two of the best. Another one is BlackPearl Resources Inc. (TSX:PXX), which has a strong growth profile. Their growth is actually going to come in chunks. Unlike Emerge and Rock, which are able to drill a lot of small wells, BlackPearl has slightly larger assets that take more time and more capital to develop. Their growth is going to come more in steps and stages, as opposed to the steady growth that Rock and Emerge will have. But it's a well-respected team, and the market loves BlackPearl.

TER: How so?

KS: They trade at a much higher valuation, for example, than Emerge does. Its market cap relative to its production is very high. With almost 300 million shares issued, the company is worth almost $1 billion. For the level of production that it has right now, BlackPearl is a relatively expensive stock.

TER: Yesterday, BP (NYSE:BP; LSE:BP) sold most of its Canadian assets to Apache Corp. (NYSE:APA). Will that create any opportunities in Canada?

KS: I think it's too early to say. But let's consider Apache the general contractor in a construction job. They are going to cherry-pick the assets that they really want and sell off the smaller assets that they don't want. You're going to see a filtering-down of these assets to smaller companies over the next year. That should create a pretty big opportunity for the right team that's able to get a good land position.

TER: What could it do for Apache?

KS: Apache has been spending a lot of money up here, which is interesting. They're one of the largest gas producers in Canada. They bought the controlling interest in the LNG (Liquefied Natural Gas) terminal being built at Kitimat, British Columbia. That gas will go to Asia, where the price is much better. This is one of the strategic things Apache has been able to do: basically, set themselves up as huge land and major infrastructure owners to send gas overseas, where it gets a much better price.

If Apache had to send this gas down to the U.S., it would not be very profitable, because it's way up near the Yukon border. And with Marcellus production coming on-stream, that's really cutting out a lot of Canadian gas into the States. But if they can keep that gas producing and send it over to Asia, via the LNG terminal on Canada's west coast, that could be a huge profit center for Apache.

TER: Are there parting thoughts you want to leave us with?

KS: Many natural gas companies are trying to rebrand themselves now as wet-gas companies, to try to get higher valuations. We're going to see a lot of that type of talk over the next six months. But I don't see any sustained pick-up in the gas price for a year. Having said that, as soon as we get a sign that some of these U.S. shale plays are going to fizzle quicker than expected, that situation could change very, very quickly.

Also, we have a special offer exclusively for Energy Report readers—we're offering a free Oil & Gas Investments Bulletin report, which includes an exclusive stock pick, one which I believe has lots of room for growth—despite it having already doubled for my subscribers. As well, we're offering your readers a 30% discount on current subscription rates for a limited time only. For more information on this special offer, please visit our website at: www.oilandgas-investments.com/special-offer/. Our returns have done very, very well this year and with the annual subscription there is a 60-day money back guarantee.

Keith Schaefer of the Oil & Gas Investments Bulletin writes on oil and natural gas markets. His newsletter outlines which TSX-listed energy companies have the ability to grow, and bring shareholders prosperity. He has a degree in journalism and has worked for several dailies in Canada, but has spent the last 15 years assisting public resource companies in raising exploration and expansion capital.

Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.
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.*

*The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. As used in this disclosure section, "Morgan Stanley" includes Morgan Stanley & Co. Incorporated, Morgan Stanley C.T.V.M. S.A. and their affiliates as necessary.

For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA.

The ENERGY Report is Copyright © 2010 by Streetwise Inc. All rights are reserved. Streetwise Inc. hereby grants an unrestricted license to use or disseminate this copyrighted material only in whole (and always including this disclaimer), but never in part. The ENERGY Report does not render investment advice and does not endorse or recommend the business, products, services or securities of any company mentioned in this report. From time to time, Streetwise Inc. directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.


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