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Atticus Lowe: Scouting for Good Value
Source: Brian Sylvester of The Energy Report (8/19/10)
Atticus Lowe, chief investment officer with West Coast Asset Management, is the kind of guy you would want making your investment decisions. In this exclusive interview with The Energy Report, Atticus discusses his value investing strategy. He also talks about the long-term potential of natural gas, questions shale gas production projections and offers a few names with oil exposure that he believes are not getting enough love from the markets.
Atticus Lowe: Institutions are light on energy right now because nearly all of the independent oil and gas companies out there are leveraged to natural gas. The outlook for natural gas is pretty foggy, at least in the short term. The discovery of massive shale gas resources has been a blessing for the country and to some extent a curse for the exploration and production (E&P) industry. The implication of these shale gas discoveries is that natural gas prices are likely to remain quite elastic until demand increases.
There's so much shale gas out there that it's going to keep a cap on gas prices, albeit perhaps somewhat higher than where we are today. Credit Suisse recently averaged the cost structure of more than 40 independent producers and found the total unit cost to be $5.74 per Mcf of natural gas equivalent. Current prices are $4.25 and the 12-month strip is at $4.65, which creates a puzzling situation. Why would companies be drilling today if they can't make a return on capital, let alone break even? There are several reasons.
First off, oil prospects are scarce and most companies don't have much to drill other than natural gas prospects. Second, many companies are drilling to hold leases with the hope that natural gas prices will increase in the future and provide attractive economics for further drilling on these leases. In addition, many companies feel pressure from shareholders to spend money and increase production and cash flow. All of these issues are weighing on natural gas, and that has backed a lot of institutions away from energy.
TER: How about longer term?
AL: Long term, I fully expect domestic natural gas demand to increase, and I expect that to be a driver for gas prices and to be fantastic for the industry, our country and our economy. I don't know whether you have seen the "Pickens Plan" or if you've seen T. Boone Pickens talking on CNBC during the past couple years, but he points out that domestic natural gas is clean, it's cheap, and it's American. I expect demand for gas to increase as a result of compressed natural gas vehicles, primarily from the fleets of larger vehicles, and also from plug-in electric vehicles, which source their power through electricity, which is often generated from natural gas. Honda already makes a compressed natural gas vehicle and they are big in Europe. In that context, you're paying less than half the price for the same amount of energy from natural gas versus oil and emitting far less CO2, and you're supporting the economy while creating tax revenues and jobs.
I also expect more dirty coal-fired power plants to be replaced by natural gas-fired power plants over the long term.
TER: With institutions shying away from natural gas companies, does that create opportunities for the retail investor?
AL: I really think it does. Oil prices right now are tied closely to the economy; historically, it's been an uncorrelated asset, a hedge. But right now everyone is confident that supply and demand for oil is very tight, and long-term demand is going to significantly exceed supply. I don't know if supply and demand will converge in one year, two years or five years, but I definitely expect to see $150 oil again this decade, and I wouldn't be surprised to see oil touch $100 by next year.
The independents are being penalized for being really gas heavy right now. You're seeing the oil and gas companies scrambling to get domestic oil exposure, and that includes acquisitions. Buyers are often paying more than $100,000 per flowing barrel of oil right now and oil reserves are trading hands at more than $20 per barrel. SandRidge Energy, Inc. (NYSE:SD) recently bought one of the few publicly traded pure play oil companies out there, Arena Resources. They paid $182,000 per flowing barrel and $22 a barrel for proven reserves, two-thirds of which were undeveloped. As all that relates to retail investors, most of the big oil was had in America decades ago. There's still a lot of oil out there, but it's in small pockets that typically aren't enough to move the needle for the larger independents and the majors. But for the micro- or small-cap exploration and production (E&P) company, there is a lot of opportunity.
TER: How so?
AL: There's opportunity to create value through aggregating assets, and through discovering relatively small fields that may have been overlooked. And there is definitely opportunity to apply modern technology to established tight oil deposits that weren't commercially viable at lower historic prices. With modern technology, you can go back into a lot of known deposits and make them into economic plays. Some of these are big enough to attract the majors, such as the oil window of the Eagle Ford shale, but a lot of them are small company plays.
TER: That's certainly happening in the Permian Basin.
AL: Sure, it's happening in the Permian. It's also happening up in the Bakken Formation, and it's happening in the Niobrara Shale play. What you've seen the technology do with the shale gas plays, well, you can take that same basic technology and apply it to certain tight oil plays.
TER: Are you talking about radial drilling and that kind of thing?
AL: Primarily fracture stimulation, through either vertical or horizontal wellbores. A lot of the tight oil plays have responded well to fracture stimulations in vertical wells, and some of them are now responding well to horizontal wells. Long laterals with multi-stage fracture stimulations are having great early success in the Eagle Ford shale, the Bakken, and in the Niobrara Shale. Now, this kind of success is at the very front end of the production curve, and we don't have a lot of data yet. I don't know how the oil shale plays are going to ultimately work out, but there is already a lot of long-term evidence supporting the benefits of fracture stimulation in tight conventional reservoirs. With modern fracture stimulation technology, even conventional reservoirs that may not have great permeability can really be opened up and improve economic returns.
TER: What are some companies in those types of plays?
AL: One company that we follow— and we don't own it—is Evolution Petroleum Corporation (NYSE:EPM). Evolution has done an outstanding job leasing up older fields and bringing in development partners at fantastic terms to redevelop the assets utilizing carbon dioxide (CO2) floods. Venoco, Inc. (NYSE:VQ) had done a great job at this as well. Typically the prospect generator in this scenario can reap a large upfront cash payment while retaining an overriding royalty interest and a sizeable back-in after payout interest. Evolution and Venoco both partnered their CO2 plays with Denbury Resources Inc. (NYSE:DNR), which specializes in tertiary oil recovery using CO2. Evolution is a publicly traded micro-cap oil and gas company that appears very cheap, and insiders own a lot of the stock.
We own, through one of our own investment vehicles, a sizable stake in a small-cap company called EnerJex Resources Inc. (OTCBB:ENRJ). We own about 20% of the equity. The market cap is barely over a million dollars, but the company's got nearly 2 million barrels of oil reserves. Those reserves—based on the company's reserve report in its recently issued 10-K—have a present value of more than $20 million, which assumes a 10% discount rate back to present. The stock is trading at less than $1. Net of the company's debt, the proven reserve value based on that discounted valuation scenario exceeds $2 per share. If you apply a $100,000 per-flowing-barrel metric to the company's net production, you're in that same ballpark. Institutions aren't able to get this type of oil exposure because these companies are so small. They're not liquid enough, and they're not big enough to really move the needle for institutions. I think micro-cap oil stocks are an interesting place for retail investors to look.
EnerJex has debt, of which our firm represents a portion, and I think this must be holding the stock back, but it appears to us that the asset value exceeds the value of its debt. I know the company has been pursuing some strategic alternatives, and we're hopeful that EnerJex can bring in a few million dollars to help the company move forward and pursue its strategy, which I think is a really good one.
They're basically an aggregator of oil reserves from mom-and-pop operators out in Kansas, which as a state is a large producer of oil. Kansas produces around 30 million barrels of oil a year, and the top 15 producers in the state make up a very small percentage of the production, less than 30%. The remaining oil production from Kansas comes from around 2,000 different producers. There are just tons of tiny producers out there that probably aren't operating very efficiently and therefore aren't realizing the value of their assets.
TER: And some probably just want to sell.
AL: Oh, absolutely. Being a public company, EnerJex has the ability to use its stock as a currency, which makes great sense as long as they're making acquisitions that are accretive to shareholders.
These are some of the oil opportunities available to retail investors that I don't think most institutions even look at. There aren't many pure oil plays out there for the institutions to invest in other than the majors. There are some independents in the Gulf of Mexico that have pretty significant oil exposure, but the whole Gulf of Mexico situation is very cloudy because of the drilling moratorium and the uncertainties about future insurance costs. People are pretty leery of that and are not willing to pay what they would have paid before the BP Plc (NYSE:BP; LSE:BP) spill.
TER: Where do you think EnerJex's stock price could go?
AL: In the 10K that was just filed, the stock net of debt could increase exponentially from its current price. There's no reason they can't use the same strategy moving forward, continuing to make accretive acquisitions, and increasing shareholder value every step of the way. The only obstacle we see is the debt overhang, and we are hopeful this will be addressed in 2010. We have high hopes for EnerJex.
TER: You have a three-pronged approach to energy investing, and that involves ultimately knowing a few companies really well. As part of that approach, as you have stated in previous interviews, you put the strongest emphasis on management. But others might argue that good assets trump good management because you can always bring in good people to get the most out of existing assets, whereas even the best management can do little with poor assets. Why do you put such a strong emphasis on management over assets?
AL: It's funny you say that about good assets trumping good management. We've been guilty of making that assumption before, and some bad experiences have really led us to our emphasis on management. You can certainly bring in good people, but bad management won't necessarily bring in good people. They might not be "incentivized" to. And good assets can be ruined by bad management; bad management can take a good asset base and overleverage a company and kill it. They can allocate the cash flow poorly; bad management can do all kinds of things with good assets that destroy shareholder value. It doesn't mean that the underlying asset won't still be good, but it does mean that there is a lot more risk to making money as an investor because the company won't necessarily be creating per-share value. That's what we're intensely focused on: per-share value creation. We're not looking for a company to grow exponentially if its share count or debt grows at an even more rapid pace.
TER: But what can good management do with poor assets?
AL: We're not looking for good management with poor assets, but we would certainly consider it if the price were right. Good management can create opportunities that create future value. That is one of the first things that we look at: is the company a good steward of capital? Does management have their own skin in the game? How are they incentivized? What is their track record of allocating capital? What is their focus? We like to find people who are focused on creating per-share value and have a track record of doing so.
TER: Do you have a management ownership threshold that you think is ideal? For instance, if a manager owns 10% of a company, is that good? If they own 30%, is that too much?
AL: We like it if it's meaningful to them. If it's someone who has a giant net worth and they have hardly any skin in the game, then it's a turnoff. But if it's someone who isn't necessarily wealthy, but they've got a sizable amount of their net worth in the company, then that is more important to us than owning a specific percentage.
Another thing we pay close attention to is company culture. Our co-founder here at West Coast Asset Management is the founder of Kinko's. He really built that company into a success based on a positive company culture. We like to eat in the lunchroom when we visit a company, talk to the co-workers and get a feel for the people. Are they hungry for success or are they just there to collect a paycheck? That's an intangible that you can't quantify, but it's something that we pay attention to. Management has a lot to do with that.
TER: The other two prongs of that strategy are the assets and catalysts for growth. Please explain those.
AL: We like to find underpinning asset value that not only supports the price the stock is trading at, but also provides upside. We want to buy a stock at a discount to what we think its underlying proven reserve value is. We will look at the proven reserves, the expected cash flow from those reserves, and try to buy the company at a discount to those values.
And the third prong would be catalysts, whether that's something the company has on its plate or something that the company is able to pursue through its strategy. A catalyst might be a company sitting on a lot of undeveloped acreage that is highly prospective and not accounted for in its reserve value and share price. Or it might mean a strategy like the one EnerJex has, where the company can deploy capital opportunistically in a sweet spot: something that could provide a catalyst over the long term to increase shareholder value.
TER: In an interview you did with Oil & Gas Investor, you said: "I'm skeptical about a lot of these average type curves you see for the shale plays. We shouldn't be surprised to see the economic threshold of these plays really increase over the next five years." That seems a bit bearish.
AL: Bullish on prices, but bearish on the information that is being given to Wall Street.
TER: Are you saying these companies are lying to The Street?
AL: I personally looked into a number of these gas shale plays where management teams are holding out curves of what the production from a single well on average is expected to do over its life. If you look at the actual production of the wells they've drilled to date, the median is nowhere near the curve they're showing people. It's looking at the potential through rose-colored glasses in my opinion. The results from the wells that have been drilled often don't jive with the type of curves we're being shown. Even if they did, you're at only the very front end of the well's life in these shale plays. In some cases, we only have data for less than a year of production on some of these large horizontal shale plays. Yet projections for production are being made 20–30 years out about what the wells will be producing down the road. And those projections are being extrapolated back to present quantities of proven reserves and associated value. I think it's quite risky to assign value to reserves based on future production that is largely unknown.
TER: You coauthored a book on long-value investing titled The Entrepreneurial Investor: The Art, Science, and Business of Value Investing. What are three solid value investments in the E&P space?
AL: We have a large position in Sonde Resources Corp. (NYSE:SOQ). That's a Calgary-based company that's got western Canada oil and gas production and some enormous assets offshore Trinidad. The company was recently recapitalized from the capital structure all the way up to the management team and the board of directors. The market cap right now is around $180 million. I think their western Canada assets are worth double that over the next two years, and the company has assets in Trinidad that are potentially worth multiples of the current share price. They're partners with BG Group Plc (OTCQX:BRGYY; LSE:BG) and have discovered somewhere in the neighborhood of 5 trillion cubic feet (TCFs), of which they own 25%. Trinidad is one of the largest liquefied natural gas (LNG) hubs in the world, and those are valuable gas reserves. As the company moves forward on the development plan with BG in the coming year or two, I think the company will start to realize value for those reserves. I also think that at the current share price, it's a likely acquisition target for any number of companies that have western Canada and international exposure.
Sonde is starting a very high-impact exploration project offshore Tunisia later this fall. From my understanding they will be drilling a stone's throw away from a Marathon Oil Corp. (NYSE:MRO) discovery made 10–20 years ago that tested at more than 5 thousand barrels of oil per day. Marathon abandoned this discovery for political or economic reasons when oil prices were much lower. In addition, I believe this prospect adjoins a very large structure that is defined on a 3D seismic survey where another operator, PA Resources AB (NASDAQ OMX Nordic:PAR), is already producing oil on a large scale. I think Sonde is teed up to make a very large oil discovery and prove up a very large oil reserve base in Tunisia. That's special because oil is so rare in the market right now, and the company is so small that it could have a major impact on the share price.
TER: What's your target price on Sonde?
AL: We don't have a target per se, but I think the stock will trade hands at multiples of its current price in the next three years. I don't see why the stock couldn't double within the next year if they execute as they have been.
TER: Are there others?
AL: We also have a large position in Contango Oil & Gas Co. (NYSE.A:MCF). It's primarily a shallow water, Gulf of Mexico exploration and production company. We consider the CEO, Ken Peak, to be the Warren Buffet of oil and gas. He's very shareholder friendly; he's created a $700 million company with negative equity capital into the business. He capitalized it with very little money, and he's repurchased more equity than he's raised. He also made a grand slam discovery—one of the biggest discoveries on the Gulf of Mexico shelf in the last few decades—and that really put the company on the map. He also made a few other unique investments that were quite opportunistic and turned out to be grand slams. He's not afraid to jump on an opportunity even if it isn't within the company's current business focus. He was one of the first to get into the Fayetteville Shale. He acquired a lot of acreage on the cheap, and sold it for hundreds of millions of dollars just a few years ago to Petrohawk Energy Corporation (NYSE:HK) and XTO Energy Inc., which was recently acquired by Exxon Mobil Corp. (NYSE:XOM). Also, he opportunistically purchased a limited partner (LP) interest in the Freeport LNG facility some years ago for only a couple of million dollars, and ended up selling that for $68 million just a few years later. Ken owns around 20% percent of Contango, so he's got a lot of skin in the game.
TER: What are Contango's catalysts for growth?
AL: From our perspective, the stock is trading at only about two-thirds of the value of its proven producing reserves. So, just with the existing reserves alone, you're buying at a pretty substantial discount, and you're getting the value that management can create in the future with the cash flow from Contango's underlying assets. I think that's a very valuable catalyst, although it's not something you can point to specifically. It's an intangible that we think is quite valuable.
TER: By buying Contango, you're sort of buying shares in Mr. Peak.
AL: Yes, and we're paying a discount, a substantial discount, in doing so. The company is actively repurchasing stock. It's got zero debt and more than $50 million in cash.
TER: What you're saying, too, is that they are focused on earnings per share. If they're buying back stock and they're making money, obviously their earnings per share will increase.
AL: Yes, that's true. And Peak has got two of the best prospect generators in the world on his team, and they're basically incentivized to find big prospects that have a good chance of success. The company is well capitalized to drill those prospects. This team is responsible for putting together the large discovery that the company made just a few years ago, which has really put them on the map.
TER: Do you have a target price on Contango?
AL: We think the stock is worth north of $60 per share, and I think Ken would like to sell at the right price. We're in such a depressed natural gas price market that he is being patient, and I don't think he's in any hurry to sell the company. But I think he would sell the company at the right price.
TER: With oil hovering around $80 per barrel, what are some E&P names with significant oil exposure?
AL: Well, a few that I mentioned—Evolution Petroleum, EnerJex. There are a few Gulf of Mexico companies that appear to be extremely cheap that are fairly levered to oil such as W&T Offshore Inc. (NYSE:WTI) and ATP Oil and Gas Corp. (NADAQ:ATPG).
There are some larger independents that have emerging shale-oriented plays that certainly have upside, but less certainty as to the quality of the assets. For instance, regarding this Eagle Ford shale, the oil window of the shale has become extremely active. A few companies have large exposure to that play, such as Pioneer Natural Resources Co. (NYSE:PXD) and Swift Energy Co. (NYSE:SFY). If these plays work out, as people are expecting, they could really perform well in the months ahead.
Atticus Lowe is the chief investment officer of West Coast Asset Management, Inc. , a founder and principal of Montecito Venture Partners, LLC, and a director of Black Raven Energy, Inc. Atticus has been a featured speaker at the Value Investing Congress as well as the Value Investing Seminar in Molfetta, Italy. He is a CFA Charterholder and holds a Bachelor of Arts degree in Economics and Business from Westmont College in Montecito, California.
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1) Brian Sylvester 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 or The Gold Report: EnerJex Resources.
3) Atticus Lowe: I personally and/or my family own shares of the following companies mentioned in this interview: EnerJex Resources and Sonde Resources. I personally and/or my family am paid by the following companies mentioned in this interview. None.