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Keith Schaefer: Pushing the Boundaries

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Keith Schaefer Junior oil and gas companies are snatching up land surrounding the Bakken formation, pushing its boundaries further and further into Canada and the U.S. In this exclusive interview, Keith Schaefer, publisher of the Oil and Gas Investment Bulletin, tells The Energy Report which companies have the property and technology to profit from this ever-expanding frontier.

The Energy Report: Keith, the Oil and Gas Investment Bulletin primarily covers the Canadian oil and gas (O&G) industries. What's newsworthy north of the border right now for our U.S. readers?

Keith Schaefer: The shale-oil revolution is still going full force, particularly around the high-profile Bakken area. We're hearing that new areas are opening up, expanding what were previously considered the boundaries of the Bakken. The main area of the Bakken is in southern Saskatchewan, but now it's been shown that it's productive right down to the U.S. border. It's also going over as far as Alberta. The Bakken is potentially very productive in Alberta.

There are new staking rushes that are happening. A lot of the juniors are leading the way and they are getting some great land positions. That's setting the average retail investor up for a lot of new plays where they can make some money.

TER: Why are companies exploring these areas now?

KS: The shale-oil revolution started in the Bakken in about 2002 and continued for five years, then the market crash hit. For two years, none of these companies has done much exploration work. They only drilled the land they already had that had no exploration risk.

Only very recently have companies started to venture out and do some true exploration work. They are saying, "Let's just test the limits of this Bakken formation. Where does it end? Is it still productive here? Is it still productive there?" It wouldn't surprise me to learn in a few years that the Bakken is a massive formation that stretches for hundreds of miles. It's going to be patchy. Some areas are going to be productive and some are not. But right now, companies are making discoveries in areas progressively further away from where the core was seven years ago.

TER: Where are some of the productive patches?

KS: The play that's really got Canadian and U.S. investors going is the Alberta Bakken that stretches from just south of Lethbridge, Alberta, to south Calgary and down through the U.S. border and Glacier National Park into northern Montana. On the U.S. side, there are some pretty big players that have bought some very large land positions: Newfield Exploration (NFX:NYSE), Quicksilver Resources Inc (NYSE:KWK) and Rosetta Resources Inc. (NASDAQ:ROSE). These are all big, intermediate producers that are very well followed by analysts. They have large enough land positions in the area that their stocks could be impacted, even though they're 50,000-barrel-per-day (bpd) companies.

Newfield has said it has a producing horizontal well, so it has proven the play. The company has said, "Yes, this is going to be commercial." That has given all the juniors a very material lift in the last month.

TER: Are other large companies looking to acquire some of the juniors with land positions in the Alberta Bakken?

KS: Absolutely. The only way they're going to get in now is a joint venture, by gobbling up these juniors or taking a risk of their own by staking a huge land position even farther away from where the core of this new play has been.

There's been a big staking rush. Crescent Point Energy Corp. (TSX:CPG) bought 1 million acres on the Canadian side where the Alberta Bakken is. Land that is known to be good has been quickly snapped up. But the Bakken is continually being expanded.

TER: Is there scientific evidence that this area is, in fact, still the Bakken?

KS: Yes, there's a lot of well data. Companies drilled right through it looking for other formations.

TER: What are some juniors with some sizeable positions in the Alberta Bakken?

KS: On the U.S. side, there's Primary Petroleum (TSX.V:PIE). It has about 235 sections and its stock has done very well. It could still do quite well.

On the Canadian side, there's Bowood Energy Inc. (TSX:BWD) and DeeThree Exploration Ltd. (TSX.V:DTX).

Some smaller players would be Covenant Resources Ltd. (TSX:CPG) in Canada and Mountainview Energy Ltd. (TSX.V:MVW) in the U.S.

TER: Some companies on the supply side have developed different technologies that are aiding in the process. Are those technologies being applied in these shale oil plays?

KS: Yes, they are. A horizontal well costs twice as much as a vertical well—maybe even a little more. Companies are always looking at ways to reduce the cost of those wells. This is a very young industry. The horizontal drilling has only been going for 12 years since the Barnett Shale became commercial. All these companies are putting their brainpower into how they can drill less expensively.

Canadian Energy Services and Technology Corp. (TSX:CEU) has drilled what's called "smart mud." When you drill a well, the oil or gas will just immediately spout out because it's under pressure deep underground. Companies put in mud that's heavy enough to keep the oil and gas down in the well but light enough that it doesn't totally pack it in. Canadian Energy sells mud to the O&G drilling sector. Canadian Energy's smart mud has shown that, particularly in the Marcellus Shale, it can reduce drilling by up to 10 days, which saves the producer a lot of money.

TER: How much could that save a producer?

KS: If it takes about 30 days to do a well, it's $100,000–$150,000 a day.

TER: What are some companies on the Bakken's Canadian side that are starting to see a little more play?

KS: One of the areas that I'm really intrigued by is right along the U.S. border. The main Bakken area is probably about 40–50 miles north of the border called Viewfield. This new area is down southwest of the Viewfield crater right along the Canadian border—it's starting to get a lot of attention.

Bigger companies like Enerplus Resources Fund (TSX:ERF) are starting to drill there. The junior Torquay Oil Corp. (TSX.V:TOC.A; TSX.V:TOC.B) and Painted Pony Petroleum Ltd. (TSX.V:PPY.A) have joint ventured into some land there.

TER: Have you heard any merger chatter?

KS: Merger and acquisition (M&A) activity seems to have slowed down. There hasn't been a big Bakken buyout for a while despite the fact that oil prices have made these plays a lot more attractive. However, there were three Cardium Formation buyouts early in the year by PetroBakken Energy Ltd. (TSX:PBN): Result Energy Inc., Berens Energy and the Pembina oil assets of a private company.

TER: Could another bump in the oil price launch another round of mergers?

KS: Absolutely. I think the whole market has been surprised by the price of oil and a disbeliever in the higher prices. That's why there hasn't been as much M&A activity—because nobody wants to buy at the top.

The reason we're not seeing much M&A on the gas side, despite these companies being in pretty dire straits, is that these management teams are going to lose their jobs. Before they get bought out, they go out and start another company, fund it, and then roll it. That's not going to happen this time. There's a very strong argument that there are too many management teams in Calgary. This is a great little weeding-out time.

TER: So, will there be some initial public offerings (IPOs)?

KS: Yes, there will be some IPOs. There will also be what's called 'recaps,' where new management comes into a vehicle and raises a cheap private placement, brings in a new land package to go with it, and then the public pays a substantially higher price for their round of stock. These new oil plays are being found right under our noses. There is a huge resurgence of homegrown plays. Only three years ago, everybody thought western Canada was a mature basin with no more discoveries.

TER: What kind of oil is in the Alberta Bakken?

KS: It's medium to light oil.

TER: Is there a premium for that because there's less refining necessary?

KS: It will be pretty standard Western Canadian Select (WCS) crude. Based on early indications, it's not going to be any better or worse. That's because no one has said what they've got yet in this play. It's very nebulous.

The big three in the U.S., Newfield, Rosetta and Quicksilver, don't talk about this play yet because they're all still buying land. They are keeping the pump primed by saying, "Hey, we've got another big play coming. We can't tell you about it yet because we're still buying land." We know they've got one producing well but they haven't told us the production level or the type of crude. Regular Bakken oil is 37 API, which is pretty light oil. I'm expecting this to be fairly close to that.

TER: Are there any oil sands plays that interest you?

KS: Yes and no. The oil sands game is a big man's game. It's very unusual to see junior oil players in heavy oil, but usually that's what's called 'cold-flow heavy oil.' In our last interview in August, we talked about how that's the most profitable oil in the world because the heavy oil discount has shrunk from 35%–20% as U.S. refineries in the Gulf of Mexico (GOM) are experiencing difficulties getting Mexican and Venezuelan crude due to the declines and politics. This has caused Canadian heavy oil to become a lot more profitable. Plus, it's very shallow oil. Costs are low and it's almost the same price right now as regular light oil.

TER: The margins have narrowed.

KS: The cash flow and the profit has increased quite a bit. If West Texas Intermediate (WTI) crude was about $80 five years ago, heavy oil would've been only $40. But now it's about $55–$60. The heavy oil differential has gotten smaller. What that means is great profits for a lot of these junior producers on the heavy oil side. Companies like BlackPearl Resources Inc. (TSX:PXX), Emerge Oil & Gas Inc. (TSX:EME) and Rock Energy Inc. (TSX:RE) are getting fantastic profits off these heavy oil plays. It's very close to the surface, very cheap to get out. They're getting a great price for it. It is the most profitable oil in North America.

Rock Energy is run by Allen Bey and John Van de Pol—two very bright guys in the oil patch. The company has a large inventory of prospects. It's using a really neat technology called 'radial drilling.' Currently, when a company drills a heavy oil well, it gets a certain radius of drainage into the well. Radial drilling sticks an arm out deep into the formation to create a wormhole and all the oil from around there goes into the well. It's improving the economics even more. That's a fantastic use of that technology and the company is able to increase reserves a lot.

Rock also has a big gas play that it's going to be drilling very shortly, if it's not already. That has the ability to triple the reserves of the company. The reality is the market value is, basically, zero, which is crazy because there are some very valid resources there. For the patient investor, Rock's a gift. But you might have to be very patient.

TER: How patient?

KS: I'm going to say three years. The reality is that these things have a way of turning out exactly the opposite way of what you might think. Right now, everybody is as bearish as they can get on gas and every statistic seems to bear that out. At the same time, the world is full of stories that just turn out different. It could get very cold very quickly. That could make a difference.

TER: At these prices, there's been quite a bit of movement in the U.S. toward coal plants switching to natural gas because it burns cleaner and is more cost effective. Do you see that happening in Canada?

KS: Ontario Hydro in Canada says it's going to get off coal and just do gas. That's very big—that's eight million people. The trend is starting to move around the globe and the environmental benefits in the first world are obvious.

TER: I recently read a presentation that said the gas price is not going to go up for about five years, and that could be a threat to coal.

KS: Natural gas bulls have two hopes: 1) That companies will stop drilling so intensely to hold on to their leases; and 2)That declines at Marcellus or Haynesville are so intense that they may as well shut-in the well after four or five years. That's not happening yet and I'm not holding my breath for that. But for the bulls, that's really their only hope. But anything is possible, and there is really only one shale play—the Barnett—that has had a long enough life to have a very definitive data set.

TER: I know you follow the Montney Shale in Alberta. What's going on up there?

KS: Celtic Exploration Ltd. (TSX:CLT) just announced a big new discovery that extends the Montney to the southeast. It put together a monstrous land package there. Its first well was announced last week at 2,235 bpd of oil equivalent. It's mostly gas with a nice strong wet-gas kicker. That has helped a couple of the juniors out in that area. Donnybrook Energy Inc. (TSX:DEI) has been a huge beneficiary with about 40 cross-sections in this new area. Cequence Energy Ltd. (TSX:CQE) is drilling its first well in the next two weeks in a new area called 'Resthaven.'

The Montney is the lowest cost gas because of its high wet-gas content. It's continuing to boom like mad, which is opposite of the dry-gas play in Horn River in northeast BC. Even though there's been billions of dollars spent up there already, I think the players are apprehensive—the economics to feed the North American market aren't good. They need to export that gas through the Kitimat, BC-based export facility to Asia.

TER: That facility hasn't been developed yet.

KS: Exactly. I think there's a good possibility we could see that play stall for a bit until the companies get very firm contracts with Asian gas buyers.

TER: Is the Montney the only profitable gas play in Canada?

KS: It's definitely one with the lowest cost plays; I can't think of a play that is lower cost. Conventional gas is dying off pretty fast right now. The rig count in Canada has just fallen off a cliff, which should be good, right? That's what you want to see. You want to see them stop drilling so Canadian production can continue to fall off a cliff, which should be good for prices. The balance on that is U.S. gas. Does the U.S. need any of our gas? That's the question.

TER: Right now, it doesn't. In fact, we can't get there even if we wanted to give it away to them.

KS: Exports have been declining pretty steadily, and they're going to continue to decline. The big concern is that the U.S. might not need any of our gas in a couple of years. It will be interesting to see how that situation plays out.

TER: Is there enough domestic demand in Canada to sustain those small gas companies, or could a lot of them go out of business?

KS: I'm not very hopeful for the junior gas producers in Canada. The oil sands use an increasing amount of gas, which is great. They are actually starting to pay a lot more for their gas; so, that's good.

TER: What message should investors take away from our discussion?

KS: Investors need to understand that we are going to continue to find new shale oil deposits in areas that we'd never thought of before. There are lots of opportunities right under our noses that companies haven't yet gone after in any significant way. Investors are going to be very surprised by how much oil we end up finding here in North America from these shale deposits. We haven't found the limit, the edge of what is possible.

Also, we would like to extend a special offer to your readers—we're offering a free Oil & Gas Investments Bulletin report, which includes an exclusive stock pick—one that I believe still has lots of room for share-price growth, despite it more than doubling for my subscribers already. In addition, we're offering readers a 25% discount on current subscription rates for a limited time only. For more information on this special offer, please visit our website at: The Oil & Gas Investments Bulletin generated 114% gains in 2009 and this year is on track to be another winner!

TER: Keith, this has been very informative, as usual. Thanks.

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. Keith 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.

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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: Primary Petroleum and Rock Energy.
3) Keith Schaefer: I personally and/or my family own shares of the following companies mentioned in this interview: Primary Petroleum, Bowood Energy, DeeThree Explorations, Torquay Oil, Painted Pony, Petrobakken, Black Pearl and Donnybrook. I personally and/or my family am paid by the following companies mentioned in this interview: None.

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