Look for Underlying Crude Oil and Natural Gas Catalysts
Commodities / Oil Companies Sep 17, 2010 - 03:41 AM GMT
Eric Nuttall, portfolio manager of Sprott Asset Management's Energy Fund, believes there are opportunities in both oil and gas, regardless of commodity prices. "I'm entirely agnostic when it comes to the commodity price. It all comes down to the valuation," Eric explains. He seeks companies with existing production priced at a reasonable multiple and, as he puts it, gets all the exploration upside for "free." Eric talks about some companies that fit that bill in this exclusive interview with The Energy Report.
The Energy Report: Eric, please give us an overview of what's been happening in the oil and gas sector since we last talked with you in May.
Eric Nuttall: Last time we spoke, I was pretty cautious on the space both because of the macroeconomic data points that we were getting and a pretty negative outlook on both natural gas and oil pricing. That's remained relatively constant. It's an extremely difficult environment to navigate when you're looking for strong performance.
Generally, I still think there's quite a bit of headwind for oil and natural gas stocks. Most of the data points that we see seem to suggest that there's a deterioration in the overall economic well-being in the United States and globally. That has a profound impact on the demand for crude oil. We've seen oil prices soften from the mid-$80s down into the mid-$70s. I think for the next year to two we're looking at a pretty tight range, with a floor of about $70 and a ceiling about $85, because of weak global demand, multi-decade high inventory levels in the U.S. and OPEC sitting on roughly 5.6 million barrels a day (bpd) of spare capacity.
Roughly speaking, you would need about a 12% expansion in global GDP to bring that 5.6 million barrels a day number down to a more reasonable 2.5 to 3 million barrels. It's my guess that that would take another two years or so. Until then, I think there's a plentiful amount of oil. Any time oil approaches the mid-$80s, OPEC will just turn on the taps and bring on more oil to an already oversupplied market.
It's really a call on global GDP expansion. That's what you need. It's more a demand question than it is a supply question.
The outlook for non-OPEC supply growth beyond the next year is pretty cloudy. A lot of non-OPEC projects have been brought on this year; we're looking at about a 700,000-bpd increase in 2010 from non-OPEC sources, which is pretty strong, certainly stronger than people would've anticipated a year or two ago. However, we still continue to believe that we're going to be hard pressed to increase global production beyond 87 to 90 million bpd.
TER: In terms of natural gas, there's some opposition to exploration fracking in some states, especially in New York and Pennsylvania, where there are some large shale plays. Can you comment on those concerns and how they could affect the gas price?
EN: I think it's really important and it's impacting some producers in some of the northeastern states, such as New York, where there's a fracking moratorium, and in Pennsylvania, where there are growing concerns. But we need to separate fact from fiction. Politicians are not involved in the industry, so they're obviously somewhat amenable to suggestions from the lobby groups countering the oil and gas business.
I'm not an engineer, but about 98% of fracking fluid is water and sand. Beyond that, there are some chemicals in diluted quantities.
Secondly, the distance of separation between the zones being fracked and an aquifer often surpasses 5,000 ft. Sometimes the distances are as high as 8,000 ft. It's somewhat beyond me to imagine that a vertical frack plane can permeate that much rock when no producer has permeated more than 200 ft., let alone 2,000 ft.
It's my initial impression that there's a lot of overhype and a lot of ignorance. That just means the public needs to be educated about fracking. I know the industry's working hard at that, but it's going to take time. For politicians, it's much easier for them to have a moratorium or to slow down development until they have 100% of all facts.
TER: Perhaps, but perception is often reality. Could those fears impact the gas price?
EN: Potentially, but I really don't think they will. We've mostly seen concerns in the northeastern U.S., where it would impact development of the Marcellus Shale. We're seeing that now in New York, where the Marcellus is totally on hold. However, in other states, such as Louisiana, which has a slightly more mature oil and gas business, I don't think you're seeing nearly as much environmental opposition.
And it's not just pollution in groundwater. There are concerns about emissions from the drilling rigs and that type of thing. Personally, I think it's overblown. Is it going to impact the overall short-term supply? I don't think it will. We're certainly not seeing that. The most recent data I have is for the first week of September, and natural gas production's up about 4 billion cubic feet (BCF) a day in an already oversupplied market.
TER: What are your gas projections then over the short term?
EN: I'm more bearish on natural gas at least from a historical pricing perspective. I think there's been a total paradigm shift, which still isn't being appreciated by the market in terms of the changing economics and the price needed to bring on reasonable amounts of supply. Historically, we would've thought that a $7.00, $8.00 price was required for a reasonable rate of return. Take Encana Corporation (TSX:ECA; NYSE:ECA), a company that is the number-one independent natural gas producer in America. They're responsible for 4% to 5% of total production. They suggest that they need a price of $3.85 on their total portfolio to earn a 10% or 12% rate of return. Many other companies have suggested similar numbers. There are two reasons. One has been the evolution of technology: the ability to drill horizontally and then be able to place multiple stages of fractures into the formation to stimulate much more meaningful amounts of gas. The second reason is an overall change in fiscal regimes in some states and in some provinces in Canada. There have been pretty large incentives to do in situ drilling.
The overall required price threshold has dropped to a ceiling of $5 and then a lower band of about $4 in short-term pricing. NYMEX pricing is at about $3.56. Canadian gas is in the low $3s. I don't think that's sustainable. But until we see more discipline from producers in terms of reducing the rig count, I don't see any upward pressure on the price of gas—certainly not above $5, which I think over the next two years is probably a very reasonable ceiling.
TER: In your last interview with The Energy Report, in reference to Tethys Petroleum Ltd. (TSX:TPL) you said: "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" in Kazakhstan. What's the update on Tethys?
EN: We're still waiting for a material update. There was a press release out about a week ago where they announced a delineation well that encountered hydrocarbon showings in the primary reservoir. But I'd be more comfortable once we get a flow rate. It seems like their drilling program is progressing quite nicely. I think over the coming weeks and the coming months as they get a test rate on this one well and are able to drill a sidetrack and several subject wells, we'll have a better feel for the total size of the accumulation. But it certainly seems to be one of a very decent size.
TER: In terms of percentage what's your position in Tethys?
EN: For our Energy Fund it'd be about 2%.
TER: Tethys' largest project is in Kazakhstan, but they are undertaking exploration in some other countries surrounding Kazakhstan. Could those be catalysts for growth?
EN: In my view, the real upside is Kazakhstan. Everything else is somewhat noise.
TER: Another company you talked about in that interview was Corridor Resources Inc. (TSX:CDH). Corridor recently posted a $2.2 million loss in the second quarter. Its operations are based in the province of New Brunswick where banning fracking has become a provincial election issue. Is this a buying opportunity or should investors just say goodbye?
EN: Corridor's last quarter results are pretty immaterial. The real catalyst that we're waiting on are drilling results from Apache Corporation (NYSE:APA) on their Frederick Brook Shale gas program later this quarter. It was announced last week that Apache had finished drilling the first horizontal well. We're just awaiting fracture stimulation later this fall with very, very important results to be published in early 2011. That's really what's going to move the needle on the story. If Apache is successful in achieving economic flow rates, it could be sitting on 50 trillion cubic feet (Tcf) net of resource potential, which is just unbelievable. That kind of compares to the major natural gas producers on the continent. Their current operation is really irrelevant when compared to the upside from their shale gas program. I would still define it as somewhat of an exploration story because the current production doesn't backstop the current share price. However, if they're successful, you could see this stock increase several times over.
TER: They also recently received approval to do some exploration in the Gulf of Saint Lawrence on the Old Harry prospect. Could that be a catalyst for further growth?
EN: They got approval to do some sub-sea observations, but I didn't see approval on drilling. They've been waiting for several years. I don't think drilling would occur for another year and a half to two years, but that would be a very, very significant catalyst. They think it could be a tremendously large oil or natural gas accumulation.
TER: What about the CEO who is retiring this fall? What sort of impact might that have?
EN: Norm Miller is retiring. Norm has been with the company since its inception. I think he's done a good job of putting together a really attractive land base. The company is looking for a successor who can carry the torch so to speak. I don't see it as a negative by any stretch.
TER: So if investors have a position in Corridor, they should probably stick with it?
EN: I would. I would view it as a medium- to a higher-risk story, typically the type of investment that I'm looking for. I'm looking for the ability to purchase a company on existing production at a reasonable multiple and get all the exploration for free. In Corridor's case you're not quite getting that because you probably have core net asset value (NAV) of about $2.00 to $2.50 based on their current operations. But this could be easily a double-digit share price, if they're successful.
TER: In our last interview you also liked Rock Energy Inc. (TSX:RE), a heavy oil producer in Alberta. The company at that time was testing gas targets. How are those tests going and what are Rock's prospects?
EN: In October, Rock will be studying their first Montney delineation well. In Alberta, it was an extraordinarily wet spring and summer, not just for Rock but for almost every company. A lot of the exploration activity in Alberta was postponed or delayed. Rock, along with everybody else, is just getting back at it. We should have results by late fall.
Rock's trading at around 4.5 times next year's cash flow using $75 oil. If they're successful at delineating this Montney resource, it has the ability to triple their reserves. Again it's the type of story where you're not paying for the upside because it's already trading at a pretty reasonable cash flow metric.
TER: Are there any other catalysts that could propel that stock?
EN: They're testing some different technologies to increase the recovery rates on their existing heavy oil acreage in Lloydminster. But the real company maker would be if they're successful proving up their Montney acreage.
TER: In June they added Ken Severs to the board. What did you think of that appointment?
EN: That was fine. It's really a competent management team with strong technical expertise with a good resource base. We're hoping they can finally get at testing the gas upside.
TER: What are some other companies you're bullish on?
EN: Before I give individual recommendations, I need to state that I'm pretty cautious on the overall environment both in the general market and especially for the oil and gas sector. In the short term, I think you will see continuing weakness in North American gas pricing and in oil. While we may see a rebound into the low $80s in oil, I think it's range bound. It's very, very important to focus on companies that have a balance sheet that will allow them to weather low commodity prices, be it gas or oil. You want to avoid companies that were overly aggressive and leveraged up the balance sheet.
I continue to like Bankers Petroleum Ltd. (TSX:BNK) very, very much. They recently did a large financing that shored up the balance sheet. They can now weather a lower natural gas price and, because they are something of a heavy oil producer, they are somewhat vulnerable to heavy oil differentials. Their oil is discounted off of Brent, but it's trading at essentially a discount to the NAV of its proven and probable reserves using $80.00 oil.
Bankers is delineating a resource onshore in Albania. Yet at the same time, they have enormous potential to grow their reserves by four to five times if they're successful delineating the resource using horizontal wells. Your downside is limited because it's not trading at an egregious multiple. Yet at the same time, it has enormous upside through the delineation of the reserves. That's one name.
Another small name that would be somewhat high risk is Renegade Petroleum Ltd. (TSX.V:RPL). It's about a $175 million light oil company. Ninety-seven percent of its current production is geared towards light oil, the economics of which are roughly three times better than natural gas. It's stewarded by a young, driven management team that I like. They've got a good land base in southeastern Saskatchewan. What's interesting is that a lot of the light oil plays in Saskatchewan are being held by a few of the large companies. But because of Renegade's size, they're able to pursue much smaller deals that simply wouldn't be material to a large company like a Crescent Point Energy Corp. (TSX:CPG) or a PetroBakken Energy Ltd. (TSX:PBN). Renegade has been very successful at accumulating acreage.
Now that the weather has dried things up, they're going to be initiating a very, very active drilling program. We're looking for Renegade to potentially double production in 2011. I think it could be trading at under four times enterprise value cash flow using $75.00 oil. So it's trading at a cheap multiple and yet it has tremendous upside.
TER: In terms of an investment thesis, are you looking for companies with an oil and gas mix or leaning more toward the oily names?
EN: I'm entirely agnostic when it comes to the commodity price. It all comes down to the valuation. What's important, especially for natural gas companies right now, is that they absolutely have to be low-cost operators. They also need some critical mass because there's been an evolution in the nature of the wells that we're drilling. Typically, a horizontal multi-stage frack well is going to cost around $3.5 to $4.5 million. If you're a little company, you can only afford to drill a few wells a year. If that's the case, you better hope that they all hit. I'm trying to target companies that if they're going to be "gassy" are producing around 10,000 barrel of oil equivalents (BOE) a day, because they'd better be able to generate enough cash flow to fund an adequate drill program. But when it comes down to whether I favor oil or gas, it's pretty irrelevant. It comes down to each individual opportunity.
TER: Do you have some parting thoughts on the sector that you'd like to leave us with?
EN: There are times to be offensive and times to be defensive. Now, given the level of uncertainty when it comes to both the economy and the underlying commodities, I think it's time to be somewhat defensive. My fund is currently carrying a healthy cash weighting of about 17% and then a short weighting of about 5%. I'm seeing opportunities in shorting. But at the same time it's important to distinguish that you don't have to be a bull on the underlying commodities to be bullish on individual investment opportunities. We still see quite a few opportunities in that small- to mid-cap space where the companies aren't totally relying on the commodity price increasing to get the share price moving. You need to focus on stocks with underlying catalysts, either the ability to grow production or delineate some type of resource that will get the stock to appreciate.
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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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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