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Josh Young: Forget Commodity Prices; Invest in Undervalued Companies
Source: Zig Lambo of The Energy Report (7/28/11)
Oil and gas prices may go up or down, but that doesn't bother Josh Young, portfolio manager and founder of Young Capital Management. In this exclusive interview with The Energy Report, he tells us why his key to finding potential winners in the oil and gas (O&G) business is based on finding stocks with attractive assets trading at a large discount to their intrinsic values rather than particular commodity prices.
Josh Young: My investments generally aren't contingent on specific commodity prices. I do expect that oil will continue to trade in a range and I think that natural gas prices are below the marginal cost of production and should trend up over time. The types of things I'm looking for are really mispriced situations where it doesn't matter quite as much whether oil is $80 or $120/barrel (bbl.). It only matters that a company is undervalued.
TER: So, basically you're looking for bargains that are undiscovered or unrecognized by other people. Is that correct?
JY: Yes, I try to find situations where a stock is cheap enough at lower commodity prices that it would still be a good investment and where an identifiable event is likely to unlock substantial value in the near future.
TER: We see all these references to various areas and geological formations such as the Marcellus, Barnett, Bakken and Eagle Ford shales. For those readers who aren't familiar with these areas and names, maybe you could give us a quick tutorial that could help to make references to them a little clearer?
JY: Sure. I'll give them in the context of specific investments I've made, which run the gamut across some of the better known and more economic shale plays.
The Marcellus Shale is widely known as the most economic natural gas shale play and one of the most economic natural gas formations in the U.S. It ranges from West Virginia all the way up through Pennsylvania into New York. Typically, wells there are economic even at natural gas prices below $4/thousand cubic feet, making them very favorable compared to other gas shale plays.
I have exposure to the Marcellus Shale through an investment in Gastar Exploration Ltd. (NYSE:GST). Gastar is the cheapest way to play the Marcellus on a per-acre basis and has over 15,000 acres in the core of the liquids-rich portion of the play with over 83,000 total net acres in the play. The company has some well results coming out soon from the liquids-rich portion of the play that should highlight their value.
Switching over to oil shale, two of the most favored oil shale plays are the Bakken oil shale up in North Dakota, which ranges across northwestern North Dakota and eastern Montana and the Eagle Ford Shale play, which ranges across much of southern Texas.
I have exposure to the Bakken through an investment in U.S. Energy Corp. (NYSE:USEG). In the early development of the Bakken a couple of years ago, USEG financed Brigham Exploration Co. (NASDAQ:BEXP), which is now one of the largest pure Bakken play companies in the world. U.S. Energy has a fantastic position in, and is trading at a large discount to its peers in the Bakken Shale. Wells there, at current oil prices, earn anywhere from a 35% to 100% internal rate of return, depending on the specifics of the well. Wells come on with very high initial oil production that declines fairly rapidly, but the company gets paid back fairly quickly.
Similar to Gastar in the Marcellus, U.S. Energy is one of the cheapest ways to get exposure to the Bakken and they already have meaningful production and reserves. Eventually the market will discover them and the stock will trade up in line with or potentially in excess of its peers.
The Eagle Ford Shale ranges from dry gas in the south up to a wet gas play with a combination of natural gas and oil or natural gas liquids. Further north, you get pure oil production and very little gas or natural gas liquids. I have exposure to the Eagle Ford from a couple of investments. It is one of the most economic shales to drill. U.S. Energy recently announced it is drilling a few thousand net acres in partnership with Crimson Exploration Inc. (NASDAQ:CXPO). The market gives them zero value for that acreage. The company has completed one well, but hasn't announced the results yet. It's in a really good area right next to a Chesapeake Energy Corp. (NYSE:CHK) well that did extremely well. I expect that U.S. Energy may have some good exposure.
Some companies, like U.S. Energy, trade at a large discount to their peers. Other companies trade at an extremely rich valuation compared to their peers. One company that is comparable to a company like U.S. Energy is Aurora Oil and Gas Ltd. (TSX:AEF; ASX:AUT). Aurora has a small amount of acreage in the Eagle Ford, not much more than U.S. Energy, and less than U.S. Energy has in the Bakken and Eagle Ford combined. But Aurora trades for almost a $1.5 billion valuation. So, compare a U.S. Energy, which is getting almost no credit for its Eagle Ford and has a $120M (million) valuation, to a company like Aurora, which is getting a tremendous, almost $90,000/acre credit for its Eagle Ford acreage. It definitely gets you excited about U.S. Energy's prospects.
Finally, any discussion of shale fields would be incomplete without mentioning the Barnett Shale. The Barnett is one of the original natural gas shale plays where the technique of drilling horizontally and using multiple-stage hydraulic fracturing was developed. I don't currently have any investments with meaningful exposure to the Barnett. But, the Barnett is a really good example of what to expect from other plays where a lot of small companies were involved and as the play matured, were bought out or consolidated or traded up to a fairly rich valuation. Companies like Gastar and U.S. Energy could trade up to rich valuations too or potentially be taken out as their respective plays get developed.
TER: You talked in April about Equal Energy Ltd. (TSX:EQU; NYSE:EQU), which is an interesting Canadian company. Can you bring us up to date on what has developed with them since April?
JY: I still think Equal is trading at a very large discount to its peers. It hasn't announced well results recently and there hasn't been a lot of news flow beyond an acquisition and subsequent equity offering, so the stock has languished. There will be well results over time but there is nothing in particular coming up in the near future, at least from an operational perspective.
There is some possibility the company could spin off one or more of its assets into a royalty trust, which Chesapeake is actually in the process of doing and SandRidge Energy Inc. (NYSE:SD) successfully did with the SandRidge Royalty Trust. If Equal Energy went this route, it could potentially achieve a much higher market valuation than it currently has. In the interim, Equal could be a bit quiet for the next few months.
TER: How about some where you think there is going to be some action coming up that people can get excited about?
JY: I've made interesting investments recently that I'm quite excited about. The first one is a company called Gasco Energy Inc. (NYSE:GSX). The company recently completed an equity offering in which I participated. It is a natural gas company with a field in Utah's Uinta Basin, which is more of a conventional gas field play. Despite having a small production base, the company needed money to survive for the next 18 to 24 months while it develops the new oil plays it thinks it found. I'm inclined to agree that there is oil in place and that it will be recoverable. The company currently has around a $30M market cap and $120M in debt. If Gasco discovers oil and it is of the order of magnitude that it expects, this could be a tremendous home run.
In California, Gasco developed a number of prospects and sold them to a large, undisclosed, publicly traded company that is active in California. This undisclosed partner is funding 100% of the well cost on five different exploratory wells in order to earn an 80% interest in the wells. Gasco gets to keep 20% without having to pay for the drilling. That is very exciting for a small company to be able to get exposure to some potentially 20 Mbbl. or greater prospects and not have to pay anything for it. The company expects to drill the first well in the third quarter of 2011, the second in the fourth quarter and the remaining ones in 2012. That adds a lot of upside potential from there.
Gasco's main gas field is actually in the Uinta Basin, situated between Newfield Exploration Co.'s (NYSE:NFX) Monument Butte Field, which has been really successful as a conventional oil play, and Questar Corp. (NYSE:STR). Questar drilled an oil well in the Green River block on the trend that the Monument Butte Field produces from, immediately on the other side of Gasco's acreage. Questar will be drilling more wells on their acreage. So, it looks like there's an area that has been delineated by that well.
Gasco also has some old wells on that same Green River trend, drilled in the 1980s, which had been producers for a long time. Some of them are still producing a few bbl/d. It is very likely that when Gasco drills a couple of wells on the Green River trend, it will hit oil and those wells will be highly economic. The impact of having an economic oil play could produce a multiple times valuation uplift. The most I can lose is the money I invested, but I could make five or ten times my investment.
TER: That is a nice multiple for anybody. So, what else do you like?
JY: I seldom buy debt, but there is a natural gas company in which I actually own preferred stock. This preferred is convertible and it's currently yielding 12.5% and trading around par. The common is trading only 15% away from the conversion price. It is a very undervalued natural gas stock that is out of favor called GeoMet, Inc. (NAS:GMET).
The preferred stock provides a margin of safety and pays me to wait. If the company went insolvent or if there were some sort of prolonged downturn, the preferred offers more protection than the common. Plus, it pays 12.5% annually. If natural gas prices recover, GeoMet could be worth two or three times what it is trading for now.
I have done a lot of work on GeoMet and on the field it is developing. The company had a problem in one of its fields where its wells were not producing as expected. It changed its fracking technique and it looks like it fixed the problem and could potentially be looking at substantial additional reserves, which are definitely not priced into the stock. There is a lot of operational upside in addition to potential from natural gas prices.
This has been a very illiquid situation and it was hard to build my position. But, people really want yields and this is a nice way to get this combination of yield as well as a chance for a substantial equity return.
TER: Well, it sure beats 2% to 3% in Treasuries.
JY: It does, and GeoMet has meaningful natural gas production, cash flows and reserves that backstop the value of the investment and provide some potential inflation protection and exposure to an improvement in natural gas prices. GMET is far and away my favorite debt security at the moment.
TER: Anything you like in Canada?
JY: There are a couple of other companies that I own stock in that are worth mentioning. Petro-Reef Resources Ltd. (TSX.V:PER) is one of the more promising junior oil and gas companies in Canada that U.S. investors may not have heard of. It has a conventional natural gas field where there appears to be highly prospective oil zones above and below the gas zones from which it is already producing. The July production rates are about 300 bbl. of oil plus about 700 bbl. of oil equivalent (boe) natural gas per day. Their current enterprise value is about $30M.
Using a $100,000 per flowing bbl. of oil metric, you get the natural gas production for free. Using a natural gas metric, you get their oil for very cheap. In addition to being cheap on current production, it looks like Petro-Reef is on the path to meaningful rampup by drilling additional oil wells. It has around a 20,000-acre position in an unconventional play in Canada called the Swan Hills, where it has completed a well. The company is still looking at the data and might actually lease a little more acreage before announcing results. I invested on the assumption that the Swan Hills play won't work. But, there has been a lot of activity and positive well results in the area; it sounds like the company likes what it sees. If the play actually works, it will be a huge home run.
TER: Do you have some other ones that you would like to talk about?
JY: There is one more company that I have been involved with off and on for years and built up a position in again, relatively recently. It's called Sonde Resources Corp. (NYSE:SOQ). It has $50M in cash, no debt and a market cap of around $200M. It is trading for around the value of its existing production. It has a lot of unconventional acreage in Canada from residual natural gas production that it is in the process of developing, with a lot of un-booked upside.
Sonde recently sold one of its assets and repatriated the cash to develop its unconventional oil acreage. It also owns a portion of a recent large oil discovery on the border of Libya and Tunisia. Prior to the problems in the Middle East, it looked like this discovery could be worth hundreds of millions of dollars to Sonde. The company said it was in active discussions with potential joint venture partners to farm out some of its interest to get carried in the development, or possibly to sell it. The possible upside is in excess of its market cap and total enterprise value right now. Development of the find is on hold but the company has continued to study and delineate it. It sounds like it is sitting on over 100 Mbbl. of oil in this one discovery. And it has a tremendous amount of additional acreage, where it will be able to explore for other prospects with similar potential. So, this could be a real game changer that isn't reflected in the stock price. Neither is the company's unconventional acreage. Only existing production appears to be priced in.
There is potential upside whenever the situations in Libya and Tunisia get resolved. Meanwhile, you get a great, undervalued natural gas and oil company in Canada. Sonde also has well results expected shortly from an area called the Drumheller, which could be a meaningful driver. I have a lot of respect for the Sonde's CEO, Jack Schanck. For a number of years, he was the co-CEO of Samson Oil, a private company out of Tulsa and helped the company get into North Dakota and a number of other areas. He grew it from a smaller company to a larger, more successful company before leaving to go off on his own. He has assembled a team, some from Samson and elsewhere. I am very excited about Sonde because it has quality management and you get to actually invest at a substantial discount to net asset value.
TER: Any final thoughts on what investors should be looking at or concerned about in the coming months regarding the energy market and what could be a catalyst to make it go up or down drastically?
JY: A number of things could go wrong or could go right. From my perspective, the important thing is whether you are in a good company that is value priced like a U.S. Energy or an Equal, a Gastar or a Gasco. If the company hits oil or sells an asset, the stock is going way up and if not, the stock isn't. A lot of really talented people out there are analyzing the macro-picture and trading oil commodities. I focus on these small, under-followed public oil and gas companies with attractive risk/reward odds.
TER: Those all sound like pretty interesting and undervalued opportunities. Thank you for taking the time to tell us about them.
JY: I appreciate it. Thank you very much.
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) 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: U.S. Energy Corp., Equal Energy Ltd.
3) Josh Young: I personally and/or my family own shares of the following companies mentioned in this interview: Gastar Exploration, GeoMet, U.S. Energy Corp., Equal Energy, Sonde Resources, Gasco Energy, Petro-Reef Resources. I personally and/or my family am paid by the following companies mentioned in this interview: None.