The Energy Report: It's been about one year since we last spoke, Robert. What do you think have been the most significant developments in the North American oil and gas industry since then?
Robert Cooper: It's a dynamic business, and a number of changes have occurred. First, the macroeconomic backdrop remains murky, resulting in persistent volatility in equity and commodity markets. Investors remain wary of putting on riskier trades because the visibility simply isn't there. The fear that some Monday morning we'll wake up with a negative surprise is inhibiting risk taking and impacting small-cap growth equities, particularly.
"The winners tend to be experienced managers with proven track records."
Second, the rapid increase in U.S. oil production has negatively impacted Canadian producer net-backs. The spread between Canadian light oil prices and the U.S. equivalent has been much more volatile than historical rates. The lack of pipeline capacity has exacerbated this trend and given rise to alternative methods of transportation, such as oil-by-rail. But overall, the "differential risk" has been added to the list of risk factors investors assume when investing in the oil and gas sector.
Finally, the natural gas market, after a period of massive oversupply, has, in our view, self-corrected and appears to have returned to balance.
TER: In terms of pipeline capacity and building potentially new pipelines and better distribution, do you have any further thoughts on where you think that might be headed at this point—or is it all regulatory?
RC: There is a juicy arbitrage between waterborne markets and domestic markets. There are a lot of smart companies and individuals looking at ways to solve that, but in the end, these things sometimes have political masters who need to be appeased. The current president has indicated he's not amenable to it. We'll see what happens.
TER: In your last interview, you were seeing a potential downside in oil prices in the $60–70 range, if the economy took a turn for the worse. Things now seem to be slowly improving in North America. Oil has been up and down, but it's still kind of weak. Some analysts are thinking we could still see lower prices. What's your thinking?
RC: Higher or at least stable prices are primarily a function of the global economy continuing to muddle through with positive, but not thrilling, economic growth. We've seen a lot of competing evidence on this, but on the whole, the global economy is doing just that. Conversely, I am still of the view that global shocks, such as sovereign default or a hard landing in China, would likely deflate the oil market. We saw the impact of economic concerns in Q2/12, when crude tumbled from over $100 per barrel (bbl) to about $76/bbl at the end of June. That downside risk remains. That's not our base-case forecast, but we're certainly cognizant of the potential for black swan events that can really deflate the equity and commodity markets.
TER: Is the new trading range somewhere between $80–90/bbl, or is this just a temporary setback?
RC: The oil market is highly volatile, so you could probably make a case for somewhere between $75–100/bbl. The longer it's at $75/bbl, the more likely it is to move higher. Alternatively, if it hovers in the $100/bbl range, the more likely it is to move lower. The sweet spot is somewhere in between, and that's what we've seen on the whole in the last several quarters.
TER: Natural gas is a different story. We've bottomed out already. Where is it headed from here?
RC: The gas market is very similar today to what it was a year ago, and yet different in a number of respects. Last year, the market knew that production from shale gas reservoirs, particularly in the U.S., was rapidly increasing, and had taken the step change down to the $4 per thousand cubic feet (Mcf) range as a result. But the winter was one of the warmest on record. Consequently, gas collapsed along with demand.
The difference between this year's storage overhang in April versus normal was basically equal to the lost heating demand over the winter. In other words, we can retrospectively demonstrate that the market was balanced a year ago. Between October of last year and April of this year, it went from balanced to well oversupplied. What changed in the summer was what we refer to as the power burn rally, in that utilities switched from coal to gas en masse. In the span of three or four months, that phenomenon has returned the market to essentially the same place it was this time last year. In fact, prices are approximately equal to last year, as are storage levels.
The difference now, however, is that there are other positive factors at work. One, the number of gas-directed drilling rigs have fallen from the 800s into the low-400s. Second, producers have pivoted to liquids-rich gas and/or oil. Natural gas liquids (NGL) prices have declined precipitously year over year (YOY). The average weighted NGL barrel as a percentage of crude oil is down 25% YOY. This change still results in economic, liquids-rich gas projects, but it reduces the cash flow associated with them. With lower cash flow comes lower reinvestment and less drilling, and then you should see a further cannibalization of the gas rig count. Finally, gas supply has stopped increasing. After several years of higher production, it looks like exit 2011 to average 2012 production is basically flat. All of those, in aggregate, are good signs.
TER: What happens if we have another warmer-than-normal winter?
RC: My view now is that the gas market is balanced. Whether or not it goes higher or lower in the near term is largely a function of winter weather. You give me normal weather, and I can probably give you $4/Mcf gas. If you don't, then it's history repeating.
TER: Have the prices over the last six months to a year had any significant impact on the way that oil and gas companies are planning their future operations, based on what's visible to them at this point?
RC: Speaking about Canada, the small- and mid-cap Canadian producers have embraced hedging to a greater degree than I can recall. Generally speaking, pre-2008, the prevailing view of exploration and production (E&P) managers was that companies existed to provide investors beta to commodity prices. In other words, they were unhedged. Since then, we've noticed a distinct trend toward risk management, which means greater and more consistent hedging among the producers. This has been driven by a number of factors, including more challenging equity markets in which raising capital is much more difficult. It's a function of highly volatile commodity prices and, on average, larger capital budgets that require some certainty in the cash flow. E&Ps have attempted to take some risk out of the business plan by providing a degree of cash-flow certainty via hedging.
Second, E&Ps have become much more focused on cost control. One manifestation of this is that, in Canada, a number of producers have made conscious decisions to avoid drilling during peak seasons. The goal is to utilize the best rigs and services at off-peak times. A number of them have had success, which has made a positive impact on capital costs and returns. The downside is that drilling in Canada remains seasonal, and spring breakup remains an impediment for many companies. But, overall, I think the theme is toward risk management, simply because the equity markets of late have been rather unforgiving of mistakes.
TER: Everybody has to adapt to changes, and it's a fluid market. You joined Haywood Securities since we last spoke. Has that had any impact on the way you approach your investment selections and general analysis?
RC: No. Nothing has changed in how I evaluate equities, although I've added an international dimension to my coverage universe.
TER: Maybe you can bring us up-to-date on developments with some of the companies we talked about last year and how they look now.
RC: Let's start off with Open Range Energy Corp. (ONR:TSX). Open Range was a huge win. We said then that once the E&P was split, the tank business had a significant growth runway and that the company was likely to get acquired. We got both of those right. The tank business is now called Poseidon Concepts Corp. (PSN:TSX). It's taken off, paying a dividend and trading at about $15/share. Growth in the U.S. has accelerated. We were predicting at that time, $130 million ($130M) in 2012 earnings before interest, taxes, depreciation and amortization (EBITDA). Management guidance for 2012 is now $210M in EBITDA. The E&P spinout was acquired by top-tier producer Peyto Exploration & Development Corp. (PEY:TSX).
Crocotta Energy Inc. (CTA:TSX) was another one. It has performed as I expected. We said then that there was $4/share upside, and it got there in January. It has since pulled back some, but the business is further advanced now at a lower stock price than it was then. Crocotta has proven its Edson liquids-rich gas asset and has added an emerging Cardium oil play as well. With gas strip prices as they are now, we're likely to see further development in the Montney play in northeast British Columbia. All the while, Crocotta management has maintained a sterling balance sheet, so we like this story a lot. Right now, it's about $3.20. In October of last year, it was around $2.60.
Yoho Resources Inc. (YO:TSX.V) is the final one. I said last year that I liked Yoho because it had the most resource exposure of any junior company I knew of combined in the Duvernay and the Montney. That is still the case, and it remains one of my favorite stories. What's changed is that Yoho has drilled some Duvernay shale wells. The development of any shale basin tends toward lower productivity and higher well costs at the outset, and as the plays mature, production increases and costs decrease. Yoho is following that in the Duvernay. What's most interesting is that Exxon Mobil Corp. (XOM:NYSE) recently paid $2.6 billion for Yoho's partner in the Duvernay, Celtic Exploration Ltd. (CLT:TSX). This shows you that the Duvernay is the real deal, and that large companies want exposure here. The thesis remains the same on Yoho as it was 13 months ago.
TER: Do you expect it to be taken out, at some point?
RC: If you look at where Yoho is and its Duvernay acreage, it is surrounded by the majors—Chevron Corp. (CVX:NYSE), Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE), Exxon, Talisman Energy Inc. (TLM:TSX), Encana Corp. (ECA:TSX; ECA:NYSE) and Husky Energy Inc. (HSE:TSX). And then there's Yoho. So chances are Yoho will not be around in 12–18 months. That would be my guess. It's been our Top Pick this year on the basis that resource exposure is an investable theme among the juniors. And we still feel that way today.
TER: Do you have any new names that you'd like to talk about at this point that look interesting?
RC: I do. One is called Tamarack Valley Energy Ltd. (TVE:TSX.V). Tamarack has emerged as a very well run junior light oil producer. The company is active in Alberta's Cardium light oil trend as well as Alberta's Viking light oil trend. It produces about 2,550 barrels of oil equivalent per day (boe/d) currently. The company is led by the former CEO of Apache Canada (APA:NYSE). We like the company for a number of reasons. First, Tamarack has a number of oil projects that have payouts in about a year. This is an attractive attribute because it means that the company is able to self-fund under reasonable commodity price assumptions. Second, Tamarack has demonstrated that it has been able to reduce costs and increase productivity in both the Viking and Cardium formations. Obviously, decreased costs and increased productivity drop right down to the bottom line in improved economics. Third, we really like management. They work hard. They take a risk-managed approach to their business, and they tend to meet or exceed expectations. Finally, we like the risk-reward profile of attractive valuation coupled with a number of near-term drilling catalysts.
TER: That's certainly one to keep an eye on. How about any others that look interesting?
RC: The second company is called Novus Energy Inc. (NVS:TSX.V). Novus is also a Viking producer but in west-central Saskatchewan. We like the Viking generally, for a number of reasons, especially for a junior producer. The Viking in west-central Saskatchewan is well defined geologically. It's low risk, low capital cost and repeatable. The key to success is having scale, because the initial well productivity is lower than some of the deeper, tight oil plays in Alberta. Novus has the dominant land package in the area and is growing production. It is guiding to 4,400 boe/d at year-end. We have written that we think Novus' asset base could ultimately support a dividend. Based on the comparables, this should result in some value creation. Alternatively, it's our view that the west-central Dodsland area is going to be the domain of larger producers, and that consolidation is likely. In either scenario, we see Novus benefiting.
TER: Could Tamarack and Novus get taken out?
RC: I think Tamarack is earlier in its life cycle than Novus is. Larger companies need scale and scope and a number of them have indicated that west-central Saskatchewan is going to be a focus for them. If you want scale and scope in west-central Saskatchewan, you pretty much have to go through Novus.
TER: So it's pretty well-situated there as far as its land position.
RC: Yes, it is.
TER: Generally speaking, what do you think the focus should be for our readers and people interested in playing the energy markets in North America at this time?
RC: I think volatility creates winners and losers. The winners tend to be experienced managers with proven track records. In times of stress, proven managers tend to retain their multiples relative to their peers and are able to raise capital, if required. This enables them to grow, either organically or through mergers and acquisitions. And in the worst of times, they survive. When the rising tide isn't lifting all boats, investors should gravitate toward the best-in-class.
TER: That's a good closing thought. Thank you, Robert.
RC: I said this last time, and I'll say it again this year: I hope I'm right.
TER: As does everybody. We appreciate your time today.
Robert Cooper, CFA, is Senior Oil & Gas Analyst at Haywood Securities in Calgary. He has a diverse background including commodity trading and merchant banking. Cooper has spent the past six years in equity research focused on high-growth energy equities both in Canada and across the world and is regularly called upon for insight on the oil and gas industry by various local and national media. He is a CFA charter holder and is a past president of the Calgary CFA Society.
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DISCLOSURE:
1) Zig Lambo 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: Royal Dutch Shell Plc.
3) Robert Cooper: I personally and/or my family own shares of the following companies mentioned in this interview: Crocotta Energy Inc. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
4) Haywood Securities Inc. or one of its subsidiaries has managed or co-managed or participated as selling group in a public offering of securities for Poseidon Concepts Corp., Crocotta Energy Ltd., Yoho Resources Inc. and Tamarack Valley Energy Ltd. in the past 12 months.
5) As of the end of the month immediately preceding this publication either Haywood Securities, Inc., one of its subsidiaries, its officers or directors beneficially owned 1% or more of Yoho Resources Inc.
