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Josh Young: Transition Can Deliver Value in E&Ps
Source: George Mack of The Energy Report (4/12/11)
Portfolio Manager and Founder Josh Young of Young Capital Management (YCM) looks for value in oil and gas exploration and production (E&P) companies. In this exclusive interview with The Energy Report, Josh discusses some of his best ideas—strategies that could well deliver the significant upside and reduced risk investors might not expect from natural gas producers.
Josh Young: Yes, at the moment, I am. It's challenging right now because natural gas prices are low, so companies aren't making a lot of money drilling for gas. In such an environment, there are strong incentives for nat gas companies to diversify their product mix and improve margins by drilling for oil; and the market is rewarding companies that manage to increase oil production and improve their margins with substantially higher stock prices. As gas companies have transitioned a portion of their production to oil, their stocks have outperformed significantly; in fact, they've been the highest-performing stocks across this space over the last year or two. And, generally, the ones that have transitioned have retained their upside potential from exposure to gas prices, which, historically, are cheap versus other energy sources like oil. That is part of what has driven their stock price outperformance.
TER: I hate to overuse the term "value," but I'm guessing that your investment theory here is that gas is a value-rich universe.
JY: Yes. Actually, it's sort of interesting because there's been a bifurcation in valuation based upon the size of the company. The larger companies that are followed closely and are better understood have started pricing in fairly high natural gas prices, and that correction is already priced in. The market is already expecting gas at $5–$6 per thousand cubic feet (tcf)—and higher in some cases, depending on the stock. So, for me, it's almost like getting a free ride on the backs of smart, large investment funds that are bidding up the stocks of these big companies based on expectations of the natural gas curve. Typically, these large investment firms can't invest in the smaller companies that I follow.
Smaller investors have been slow to follow this investment trend, so the shares of smaller natural gas companies haven't gotten bid up in a same way similar to the larger ones. That's part of what's created this tremendous, and I think temporary, dislocation. Also, despite superior performance versus the market and other larger hedge funds, it is a very challenging time for small funds to raise capital—especially in the oil and gas (O&G) space.
As capital has flowed to larger funds, it has been deployed to buy stock in larger-cap companies. This has helped feed the current valuation discrepancy. It has been a temporary phenomenon, as allocators to funds are beginning to overcome their inhibitions toward investing in smaller funds in favor of the (generally) higher returns and lower risk available in those funds. Between additional funds flowing into smaller funds that invest in smaller companies, and larger funds "stretching" and starting to buy stock in smaller-cap companies, there is the chance for a substantial correction in this valuation gap. Of course, many of the companies I'm invested in are going through a transition process, which should drive substantial value creation and share price improvement regardless of fund flows into the space.
TER: The whole area of natural gas sounds counterintuitive to me. That must sound like a bullish signal for you.
JY: Well, that's the interesting thing—natural gas isn't out of favor, really, only certain smaller nat gas stocks are out of favor. If you look at companies like Ultra Petroleum Corp. (NYSE:UPL), Range Resources Corp. (NYSE:RRC), Southwestern Energy Co. (NYSE:SWN), Cabot Oil & Gas Corp. (NYSE:COG) or EQT Corp. (NYSE:EQT), they've all traded up. These stocks are trading with rich earnings and cash flow multiples and are at or near their 52-week highs. So, it's more of a big versus small arbitrage than it is oil versus gas. I don't even have to be a contrarian; I get to make a bet that other smart investors with substantial research resources are already making and I get to take advantage of their inability to invest in smaller company stocks.
TER: Josh, you worked in a private equity firm in Los Angeles where I'm guessing you crunched a lot of numbers. There were no quarterly reports, conference calls, analyst days or 8-Ks for reporting unscheduled material events. What did you learn in doing due diligence, and how did that experience inform what you do today?
JY: It definitely had an impact on my research process. Between my experience in private equity and subsequent experience investing money for a multibillion-dollar single-family office, I learned to do detailed research. I was identifying and quantifying value drivers and risk factors to develop an independent and, sometimes, contrarian view of a company.
TER: Original research is what you have to do.
JY: Yes, original research and also applying appropriate valuation methods. But, you know, I'm not reinventing the wheel. I'm applying what I've learned, in an innovative way, to these smaller- and micro-cap companies. I pay attention to what both the market and Wall Street want, from a financing perspective. I'm also focusing on what the larger companies want, from an acquisition perspective, and translating that knowledge over into investments in the smaller-cap space. Then, obviously, I'm interacting with the smaller company executives to understand what they're thinking and how they approach things. It's a multifaceted approach to find value in a niche.
TER: Where can value be found?
JY: I'm interested in finding really significant mispricings. And in the smaller cap O&G space, there are some great value opportunities—particularly in companies going through transition processes. One example is a company I'm investing in that's in this process of transition; in fact, it's practically a textbook case for transition. Most investors who have heard of it haven't looked at it in a few years because it was a mess—it was overlevered and was forced to sell one of its core assets to pay down that debt. It was asset rich but did not have a lot of production, and it was forced to take meaningful write-downs on the book value of those assets. And it was producing 100% natural gas in a rising-oil-price/falling-gas-price environment.
Today, the story is different and the market is just beginning to recognize that. The company sold an asset and, virtually, has no debt. It joint ventured (JV'd) an asset and is in the process of ramping-up production. It has major liquids discoveries in both of its core assets and will be increasing the percent of its production coming from liquids and oil substantially and is the most levered company on an acreage versus enterprise value (EV) basis to the Marcellus Shale. The company is trading for a fraction of the valuation of other Marcellus companies and the market misunderstood its recent oil discovery, which could move the needle significantly.
The company, Gastar Exploration Ltd. (NYSE:GST), also has 17,000 acres of the lowest-cost onshore dry gas play in the U.S.—80,000 net acres in the Marcellus and a JV that will be funding the majority of the 8–10 net wells it is drilling primarily in the liquids-rich area of the play in 2011. Gastar has an oil discovery in East Texas with 30 locations and substantial potential value from the development of that play, which the market does not seem to understand and has yet to price in. And it has 17,000 net acres prospective for oily Eagle Ford and Deep Bossier gas, which is widely recognized as one of the lowest-cost natural gas plays in the U.S.
Gastar trades at a big discount to its Marcellus-levered peers, such as Cabot, EQT, Range Resources, EXCO Resources Inc. (NYSE:EXCO), etc. In fact, it trades at almost one-quarter the price per acre, despite having similarly prospective acreage. This value gap should close as the company drills numerous wells this year, most of which will be funded by a JV agreement it entered into last year, and ramp-up its production and cash flow.
That doesn't even consider Gastar's recent oil discovery in East Texas, which could contribute substantial additional value. The company recently announced a Glen Rose well producing 250 barrels of oil per day (bpd) and 1,300 barrels of completion fluid, with inclining oil production. Generally, as a well produces, the amount of completion-fluid production declines and the oil production inclines. From some of the wells I've seen, the initial production (IP) rate on this well could be over 500 bpd with an implied EUR (estimated ultimate recovery) of more than 250,000 barrels of oil. For a $4 million per-well cost on the 30 remaining locations, this could significantly shift Gastar's production toward oil and lead to a substantial revaluation of the company after the official initial production rate of this well is announced.
TER: Gastar is up 25% over the past six months but flat over 12 months.
JY: It is; and despite the recent move, it hasn't come close to my estimate of its intrinsic value or where I think it could trade at in the near term. When I think about the transition Gastar is making, I think about companies like Approach Resources Inc. (NASDAQ:AREX), which was very similar to Gastar. Approach was in a conventional natural gas field and was having trouble growing production and making the economics work. Although the well economics were great at the well level, it was just hard for a company of its size to really make it work. Then, Approach figured out that it had some oil under the areas it had been drilling for gas; so, it started drilling for oil and the wells came on great—similar to Gastar.
As Approach started showing good wells, its stock went from $7 at the time to the current price of around $29—in just over nine months. You can look at Gastar's history, metrics and chart and see that it has a lot of characteristics in common with Approach and some of the other companies that have gone through similar transitions, such as Brigham Exploration Co. (NASDAQ:BEXP) or Magnum Hunter Resources Corp. (NYSE.A:MHR), or companies in the process of transition like Double Eagle Petroleum Co. (NASDAQ:DBLE). Gastar's stock has a high probability of outperforming in a similar manner.
TER: Is Gastar your favorite play?
JY: It's one of my largest positions, and it's among my favorite investments at the moment. Another favorite investment at the moment is Molopo Energy Ltd. (ASX:MPO), which has the distinction of owning assets in some of the best-known plays with some of the best-known economics while being one of the least-known stocks. It has over 50,000 acres in the Bakken formation and over 17,000 acres in the Permian Basin. It's actually right in the middle of Approach's Wolfcamp oil play and has over 750 billion cubic feet (bcf) of 2P gas reserves in Australia, ready to meet the growing energy needs of Asia. Activist investors came in, kicked out the old management team and installed a new team and a new board—but only after prior management monetized the only existing production it had. Molopo owned the Spearfish play in Canada, which it sold to Legacy Oil & Gas Inc. (TSX:LEG). The company's known for that but, otherwise, few people have heard of it.
TER: Why has it been so unloved by the market?
JY: One reason is that the old management team got kicked out, which led a number of shareholders who were close with the old management to sell. Secondly, it's an Australian-traded company with Australian, U.S. and Canadian assets, and management has not done a good job in approaching the Canadian or U.S. investment communities. I know almost no one who has heard of the company here in the U.S. or in Canada. But the company's in an interesting situation because it has a market cap of just over $220 million, with around $200M cash and marketable securities, and no debt. So, it has all these assets all in the right places and, historically, has gotten great returns on investment (ROI) in identifying, developing, and then monetizing plays.
TER: Molopo is among your largest positions, right?
JY: Yes, it is. I like it because it has all this asset value and upside. I try to figure out how I can lose money owning the stock, and I have trouble seeing significant fundamental risk in the company. Gastar and Molopo are my favorite investment ideas. I think they both meet this template of companies in transition. And they're both trading at very large discounts to their peers in their respective plays, as well as to their intrinsic values. Both companies have the potential to be multibaggers over a relatively short period of time.
One other aspect to Molopo's story worth discussing is its exposure to Asian energy demand. Specifically, in the aftermath of the terrible tragedy in Japan, demand for liquid natural gas (LNG) has shot up; and the value of LNG feedstock in politically stable countries in close proximity to end markets has likely also increased substantially. Look at companies like INPEX Corp. (OTCPK:IPXHY), which supplies LNG to Japan, or Sentry Petroleum Ltd. (OTCBB:SPLM), which has no proved or probable reserves but has acreage near Molopo's and a valuation of over $150M. Its recent, significant stock price movements should give you an idea of how Molopo's significant 2P reserve base should be valued—and it's effectively getting zero value in today's stock price.
There are a couple of Canadian companies that are also interesting and aren't very well understood or closely followed here in the U.S. There's Equal Energy Ltd. (TSX:EQU; NYSE:EQU), which is in some of the most interesting unconventional oil plays. It's in the Viking and Cardium oil plays, the latter of which is a play that's very similar to the Bakken in Canada. It's also in the Hunton Dewater play here in the U.S., which is sort of hard to explain, but it's a liquids-rich play. In addition, Equal has exposure to about 15,000–20,000 net acres in a Mississippi play that is becoming famous now through SandRidge Energy Inc. (NYSE:SD) and Chesapeake Energy Corp.'s (NYSE:CHK) activities.
Equal is growing cash flow by about 15%–20% per year. Production is flat this year, which is part of the reason I think it's so cheap. It is trading for its proved reserve value, which is odd because, if you look at the value of its unconventional acreage, which is not included in its reserve value, it's pretty easy to see that acreage being worth as much as it's trading for. So, basically, Equal Energy is trading at one-half of its asset value and at a significant discount to comparable companies. The company is further along in the transition process than are Gastar or Molopo, but it still has substantial upside. I learned from exiting my position in Approach Resources early that there is often substantial upside to companies in plays with leading economics. Approach almost tripled after I sold it for a big profit, and I think Equal has a lot of room to trade up significantly and be priced appropriately relative to its peers.
The other Canadian company that's particularly interesting is Galleon Energy Inc. (TSX:GO). One of the more fascinating things that I've seen in my investment career is what happened to this company when the Galleon Group got indicted by the SEC. As it started getting press around this indictment and the ensuing trial, you could see GO start trading down with no fundamental news, and then not participating in the upward stock moves of many of its peers as oil prices moved up over the past few months. Obviously, the company has no association with the Galleon Group hedge fund management firm in New York. Galleon Energy has fewer specific catalysts versus these other companies I've mentioned; so, it is possible for GO to trade at a lower valuation for longer. But on the flipside, it has so much cash flow and trades at such a low multiple compared to that cash flow that, ultimately, it will get rectified.
TER: How have some of these names performed since your last interview with The Energy Report?
JY: A few of the names I discussed in the last interview worked out really well. One of the companies I talked about was Lucas Energy Inc. (NYSE.A:LEI), which is a micro-cap oil and gas company. Through its residual or historical activities, the company built up an interesting land position in the oily part of the Eagle Ford Shale.
TER: I realize this is a true micro-cap company, but it's up three-and-one-half times from 12 months ago. Do you still see value?
JY: Well, I didn't say I still own a lot of stock. I said that it's worked out really well. The company has great acreage at this point. It has real production and is growing that production. But I think it's a little bit further along in its transition and is being valued in line with its recently increased production and the improved value of its acreage.
Cabot was another company I talked about in the last interview that worked out really well. It had traded down because of an error. It's almost like the Galleon story where it traded down for a reason that was almost unrelated to the company.
TER: Do you still own shares in Cabot?
JY: No, I don't. I sold my Cabot stock and I used the proceeds to buy additional shares of Gastar, which I think is trading at a much more compelling valuation. I also talked about RAM Energy Resources Inc. (NASDAQ:RAME), which was pretty interesting and did very well. It was around $1.60 when I told The Energy Report about it. It traded up to $2.50 and is now around $2.04. I still own some but I sold most of my position as it approached $2.50 and got closer to fair value.
TER: Any new ideas you'd like to share with our readers?
JY: There's one other company I wanted to talk about that I own now that I haven't talked about before. It's U.S. Energy Corp. (NYSE:USEG). It did the original JV with Brigham in the Bakken, which helped Brigham unlock the value of its acreage. Right now, it's trading at a big discount to a lot of the other Bakken companies on a production, cash flow and per-acre basis. In addition, it owns a molybdenum mine, which makes things a bit complicated for oil and gas investors. That's because people who invest in mining companies don't typically invest in O&G and vice versa. But, it looks like that moly mine is worth a lot of money, and it looks like the Bakken acreage and production are worth a lot of money. If you add the two together, it seems to be worth much more than what I'm paying for at the current stock price.
TER: Josh, I've enjoyed meeting you very much. Thank you for taking the time.
JY: Thank you.
Josh Young is an honors graduate of the University of Chicago, where he majored in economics. Before founding his own investment management partnership, he worked with Mercer Management in Chicago, after which he joined a private equity firm in Los Angeles. He also worked as a buy-side analyst and money manager in a single-family investment office with more than $1 billion under management.
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1) George Mack 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: Equal Energy, U.S. Energy.
3) Josh Young: I personally and/or my family own shares of the following companies mentioned in this interview: Gastar Exploration, Molopo, Equal Energy, Galleon Energy, U.S. Energy Corp., Lucas Energy, Ram Energy and Double Eagle Petroleum. I personally and/or my family are paid by the following companies: None.