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Alexander Montano: "Technology Is Key" with E&P Plays
Source: Brian Sylvester of The Energy Report (9/21/10)
Alexander Montano, managing director of the Corporate Finance Group with California-based C. K. Cooper & Co., puts a lot of faith in technology when it comes to making oil and gas plays pay. Alex sees major opportunities for new technology in old oil basins and suggests some names making good on that thesis in this exclusive interview with The Energy Report.
Alexander Montano: Well, we understand that oil prices are to some extent linked directly to economic growth. But we think that more and more, the outlook for oil prices is going to be less dependent upon U.S. economic growth and is going to become more a factor of global growth. We are not extremely bullish on the U.S. economy in 2011. We believe the recovery is happening, but we expect it to be slow and drawn out. We don't think it's going to be much fun.
But we believe that global demand is growing. We believe that the macroeconomic picture looks very strong. We remain bullish on oil into 2011, with a price between $70 and $85 a barrel.
TER: In which regions of the world do you see growth occurring?
AM: We think that it's going to continue to come from China and India. We think Latin America is going to remain pretty strong. We think that a lot of the emerging players are whetting their appetite on oil and that appetite is going to continue to grow.
TER: Along those lines, OPEC, the Organization of Petroleum Exporting Countries, turned 50 last week. Its control of the oil market is obviously less substantial than it used to be. What impact is OPEC having on the market now?
AM: Well, I think you correctly said that its direct impact in the supply/demand equation has been watered down over the last couple of decades. But I think that from a market leadership standpoint, they are still the clearest voice out there. I think that when OPEC establishes what they believe the oil price should be, whether it's directly a result of their production or not, the oil markets generally adapt to that. As far as short-term swings in production and the ability to fill necessary gaps go, OPEC remains the primary supplier. It's an organization that's been up and down, but I think they continue to be the leader as far as sentiment on world oil prices. I think people still respect that position.
TER: OPEC leaders are on record saying that they consider the current oil price "ideal" and that they will try to keep the oil price where it is. Do you think that they still hold enough influence to keep oil in the $80 range?
AM: I do. We're believers that demand growth is going to continue. I think if you couple demand growth with OPEC's willingness to basically manage supply better than they have historically, then we think that that price target is doable. If you could have a relatively defined price range and the commodities stay within that range, it is a win-win. It's a win for the industry. It's a win for the consumer. We understand that and believe in what they're trying to accomplish.
TER: What's your investment philosophy when it comes to oil and gas?
AM: We focus on technology. We believe that this is a much more technology-driven industry than anything else. Here in California there's a lot of heavy oil. Heavy oil has become a very fundamental piece of the supply picture in the United States. You take a look at what's happening with the heavy oil from the oil sands in Canada. Technology is revolutionizing the economic threshold there. We believe that there are lots of known reserves that will have a meaningful impact on the market in the future. It'll be technology that will make those resources work.
We generally try to target companies that are going to apply proven technology in areas that have not been subjected to that technology before. We believe that as these companies are successful, they become an attractive target for larger companies.
We tend to focus on companies with a market cap of $1.5 billion or less that we believe have some core thesis that's going to drive their share price. We believe there are companies working in certain geological plays that are hopefully bringing a proven technology to unlock the value there.
TER: Are you talking about things like old oil basins that are no longer economic with vertical wells, but that could perhaps be economic again through horizontal drilling and other newer extraction methods?
AM: Yes, horizontal fracking, water floods and tertiary recovery. The amount of knowledge in the industry is increasing quickly. A lot of times it's just a question of applying the right technology.
TER: What are some names that have found the right technology in some older plays?
AM: Evolution Petroleum Corporation (NYSE:EPM) is a company that, in our opinion, developed and put together a play for a carbon dioxide (CO2) flood at the Delhi Field in the southeastern U.S. They were able to turn that over to Denbury Resources Inc. (NYSE:DNR). They got a pretty nice upfront payment, and they have a production royalty. That was four or five years ago. Denbury has since basically developed the project to a point where it's a solid, safe annuity.
Evolution just came out with year-end reserves in the neighborhood of 9 million barrels, and it's a little company. Here's a company that's got a base value, but at the same time they're going into the Austin Chalk to apply new technology there and hopefully increase value. And they've got this new "artificial lift" technology that they're applying to uneconomic wells in Texas. With Evolution, the downside is protected because of their Delhi Field with Denbury, and all the other stuff is upside. If you're an investor and you've been waiting for three or four years, that risk has been basically removed and you're in a position to reap the upside.
TER: What's their position in the Delhi Field versus Denbury's?
AM: They basically have a back-in option after Denbury recoups its investment. That's somewhere between 20% and 25%. The reserves they booked are based on that deal. Our equity analysts have a target price in the $9 range for Evolution. They believe that the company is already worth $7 or $8, and the stock's still trading at a discount to that.
TER: Is there another investment thesis you like that's being applied and that looks appealing?
AM: Like I said, we like the idea of somebody buying an asset, unlocking its value and having another company buy them. That's why we like a company called Miller Energy Resources (NASDAQ:MILL).
They probably did the deal of the year in 2009 when they acquired the assets of a Canadian company called Pacific Energy. Pacific had bought those assets from Forest Oil Corporation (NYSE:FST) and probably invested in the neighborhood of $500 million in them. But when the credit crunch hit, Pacific was overleveraged and it ended up in bankruptcy.
Basically, through tenacity, Miller bought the cherries of Pacific's Alaskan assets for $5 million. Their fair market value is probably somewhere around $300 million. It's almost too good to believe. But as Miller restores a lot of the production that was shut down or fixes the wells that aren't producing at maximum rates, the market is really going to take notice. We think Miller's fair value is in the $12 range; it's currently trading somewhere just below $5. There's very little institutional ownership at this point. We think it's one of those companies where somebody is going to come along and say, "OK, thanks guys. You really cleaned up these assets. We'll take it from here."
TER: Among the micro-cap stocks on a list I saw recently, Miller is listed as fourth in terms of return on assets over the last 12 months. Obviously, they're getting a lot out of those assets already. But what about their being in Alaska?
AM: While Alaska may be maturing, I still would characterize Alaska as a bigger company kind of play. I think that Miller pulled off a small miracle, but to develop everything that's there is going to take really, really deep pockets. I think there will be a point where somebody with a lower cost of capital than Miller is going to buy it. I don't know if that's in two years or six years, but I think that is the ultimate exit strategy.
TER: All right, so buy and hold Miller Petroleum. What are some other E&P plays that you're excited about?
AM: Domestically there's a smaller company that we like called EnerJex Resources Inc. (OTCBB:ENRJ).
We made a decision about four years ago that we thought oil was a better commodity to invest in versus gas. If we could find oil in proven, safe locations, then that was the place to go and bet that technology could make it work. So we like Canadian production. We like U.S. production. EnerJex operates only in eastern Kansas, which is maybe not recognized as a leading hydrocarbon region. But Kansas is among the top eight oil-producing states. The thing about eastern Kansas is that it's older production, so ownership is very fragmented. I think there's something like 10,000 different operators in Kansas with the majority producing 50 to 80 barrels a day (bpd).
EnerJex basically said: "We're going to acquire those mom-and-pop shops and aggregate them." Most of these operations are so small that they aren't water flooding. They aren't down spacing. They aren't using artificial lift; they aren't using any kind of horizontal-drilling technology. Enerjex believes that they can apply these technologies and take production from their current 200 or 300 bpd to 3,000, 4,000, 5,000 bpd over the course of four or five years. At that point they become a nice target for somebody.
There's very little exploration risk. It's more of a manufacturing process because we know the oil reserves are there. It's just a question of getting them out economically by achieving economies of scale.
TER: But that premise depends largely on the acquisition costs. And how is the company going to afford to buy many of these assets? They're going to have to dilute their equity, and that reduces value.
AM: They can use bank credit pretty effectively because there's very little risk. They're good assets to leverage. They have also found that so many of these assets have been neglected that in many cases the producers are also the landowners. It might have been a farmer that drilled two or three wells just because that's what everybody was doing 20 years ago. EnerJex has had some instances where people are willing to give them the well leases on the condition that they will go and drill it out because the royalty revenue would be greater to that landowner than what they're getting currently. I think that if they can maintain a certain pace of activity, then that starts to create the traction. In 2007 and 2008, they took about $9 million of capital and turned it into $40 million of proven value.
TER: It's certainly an interesting business model. But what about the cost of exploration drilling?
AM: Their biggest issue isn't the exploration risk. The biggest sensitivity in the company is operational leverage. Right now they're producing 200 or 220 bpd. Their fixed costs associated with that don't really change if oil prices go down. Could they produce 400 or 500 bpd without really changing their cost structure? They probably could. But they have tended to be very sensitive to commodity prices. When oil prices went down in late 2008, it really hurt them. But if they can add mass, then their operating margins will improve and their sensitivity to commodity prices will decline.
TER: Alex, you talked earlier about the global market for oil. Are there some companies that C. K. Cooper likes that are not based primarily in the United States?
AM: Yes, there are, although we try to shy away from political risk. We think that's a risk that cannot be quantified or that you can't factor into a model.
TER: Well, you can use a steeper discount.
AM: Yes, but how do you discount what Hugo Chavez might do in Venezuela next month? We're basically looking for plays in what we believe are politically stable regions with strong markets. One company that we like is a natural gas player called FX Energy Inc. (NASDAQ:FXEN). They are focused on natural gas production in Poland.
Poland normally imports the bulk of its gas from Russia. And as we've seen over the last couple of years, gas can become more of a point of leverage if the Russian government chooses to utilize it. That means there's a ton of pressure in Europe, and in Poland in particular, to develop alternative supplies of natural gas. It's not that Poland doesn't have the reserves, it's that they're just underdeveloped. We think that FX got in early. They have a huge land position there. It is one of these plays where they have so much land under lease that anything else positive that happens in Poland indirectly benefits them.
FX has gone from the incubation stage to a program of steady drilling. They're starting to become more of a production and development company. We think that if Eastern Europe experiences a really cold winter, they could become a very attractive takeover target.
TER: Possibly by Russian company?
AM: I doubt the Poles would support that. Their partner is the Polish National Oil Company, so I'm sure they would have some say in that.
But you're seeing a lot of transactions that are effectively technology transfers. A lot of companies in Europe are trying to bring U.S. and Canadian drilling and completion technologies to apply on their unconventional plays. I think that as that starts to gain traction, people will look for low hanging fruit, companies with proven assets and a decent reputation. I think FX fits the bill.
TER: Moving over to natural gas, the U.S. Department of Energy expects total natural gas consumption to increase 4% this year. That means an extra 65 billion cubic feet of gas per day. And the CEO of one of the majors, Royal Dutch Shell Plc (NYSE:RDS.A), recently said that Shell will be more gas than oil by 2012. What's that telling us about the natural gas market, and should investors be taking long-term positions there?
AM: We think that natural gas is the fuel of the future for the United States. You can't look at the abundance of it, the infrastructure that's generally in place and reach any other conclusion. I think in the long term, you absolutely need to have a position in natural gas. The problem is that there's been such an advancement in technology in developing gas out of unconventional plays that there's an oversupply of gas in the market. And there probably will be for the next 12 or 18 months. While we favor oil in the short term, we believe that you can selectively add natural gas companies to your portfolio and you'll do well. But in the meantime, there's going to be a rough period as the market adjusts to the new supplies.
TER: Are there some predominantly natural gas plays that our readers might be interested in?
AM: We really don't have any that are at the top of our list. We like particular plays. We think that the Eagle Ford Shale is going to make sense. The Marcellus obviously is going to make sense. There are a lot of companies that are positioned there, but there's nobody near the top of our recommendation list that is really gas focused.
TER: But are you recommending that investors should be cautious when it comes to plays in the Marcellus, given that there's a moratorium on fracking in New York and there's growing concern about a similar ban in Pennsylvania?
AM: Yes, absolutely. But I think that in the long term, economic necessity is going to outweigh those issues and technology will continue to improve.
A lot of gas development, in my opinion, is about a land grab. I mentioned that none of the companies near the top of our list are focused on gas. That doesn't mean they don't have gas or don't have exposure to gas. They're just not putting a lot of money into it.
If you've got companies that have large acreage positions in places like the Marcellus, but aren't being forced to drill it to defend those acreage positions, it's like having a long-term annuity. Those positions are going to be worth something in the future.
TER: But we will likely see some consolidation because companies may have to take writedowns on those acreages, and that will result in shrinking share prices.
AM: Well, it either makes them targets or it drives them to go out and acquire assets elsewhere where they can do something over the next two or three years. I think that a lot of companies that maybe made a push into the Haynesville or the Marcellus have their acreage positions and can manage that land. The question becomes: Where can I go and buy something that I can sell to the Street for the next two or three years? To us, the opportunity lies in these more proven oil basins.
TER: Are there some companies that have sizeable positions in the big shale plays that are looking to diversify?
AM: I think a good example is Goodrich Petroleum Corp. (NYSE:GDP). They spent a lot of money to push into the Haynesville in northern Louisiana and eastern Texas over the last couple of years. I think they kind of realized: "Hey, this isn't bad stuff, but we don't want to have all of our eggs in this one basket." Now you've seen them go out and start moving aggressively into the Eagle Ford Shale, which has a lot more oil in it.
Another company you can look at is EXCO Resources Inc. (NYSE:EXCO). They aren't abandoning their gas plays, but they're trying to diversify their asset portfolio either through acquisitions or joint ventures. If they fail, then they will likely become targets.
TER: Do you have some parting thoughts on the sector today?
AM: Well, we would say that technology is the key. With lots of plays, when capital is relatively tough to come by, you want to be able to manage your capital budget. Most of the time that means long-term lease positions—acreage held by production. If you have that, then you can wait. You can let technology develop. You can let guys with deeper pockets develop new completion or fracking techniques. You basically benefit through serendipity. Those are the companies we target.
TER: Alexander, this has been great. Thanks.
Alexander G. Montano is managing director of the Corporate Finance Group for C. K. Cooper & Company, a full-service investment bank. Montano has been responsible for the development of the firm's investment banking practice, including cultivating client relationships, strategic planning and transaction management and execution. Prior to joining C.K. Cooper, since 1991, Montano was an equity analyst, and focused on smaller exploration and production companies starting in 1995. His comments and analysis have been quoted in such publications as Hart's Oil & Gas Investor, CNNfn, Forbes, BuySide magazine, Standard & Poor's Platts Oilgram News and various regional newspapers. In addition, Mr. Montano was rated a 5-Star, All-Star Analyst by Zacks Investment Research in 2002 and top oil analyst by The Wall Street Journal in May of 2003.
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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: Enerjex and Royal Dutch Shell.
3) Alexander Montano: I personally and/or my family own shares of the following companies mentioned in this interview: None. C. K. Cooper & Company owns equity of EnerJex Resources, Inc. I personally and/or my family am paid by the following companies mentioned in this interview: None. However, C. K. Cooper & Company has provided investment banking services to EnerJex Resources, Inc. and FX Energy, Inc. and may solicit investment banking business from other issuers mentioned herein.