The Energy Report: Oil prices have been bouncing around quite a bit. Where do you see them headed over the next year?
Ray Kwan: As a firm, we're actually pretty constructive on the oil complex. There are three main reasons behind that. First, global refineries are exiting a large maintenance season. Second, we believe that there's going to be a slow but steady transport demand recovery in Asia as well as in the U.S. Finally, we're going to see stronger demand for power generation in emerging economies and throughout Asia. We expect the Organization of the Petroleum Exporting Countries (OPEC) to balance out excess supply by reducing production. The bottom line is that we think West Texas Intermediate (WTI) prices will increase to the $90–100/barrel ($90–100/bbl) range by year-end.
TER: Will China's economic growth—or lack thereof—have a significant influence on the market?
RK: Macquarie has pretty good insight into the Asian markets, especially China. We expect a soft landing. That is going to bode well for a lot of the commodities, including oil.
TER: On the other hand, low natural gas prices have been a problem for producers for a couple of years now, although consumers are benefiting from it. What do you see going on there?
RK: We're not as positive on gas, unfortunately. The supply side continues to offer little help in rebalancing the market, and it's still flat-to-growing, despite the drop in the rig count. The only silver lining is the coal-to-gas switching on the demand side and the hot summer, which has improved U.S. storage levels. Unfortunately, it's just not enough, in our view. I think coal-to-gas switching is effectively tapped out, and it should set a ceiling for natural gas prices over 2012 and 2013. Interestingly, if natural gas comes close to the $3/thousand cubic feet ($3/Mcf) range, utilities could potentially start switching back to coal. Next year, we expect natural gas to stay in the $3.50–3.70/Mcf range.
TER: You just mentioned strip pricing, and you talk about this in your research reports. Can you explain that concept in layman's terms?
RK: Strip prices are the future prices for both oil and natural gas. Future contracts give buyers the right to purchase a set amount of a given commodity on a set day in the future. In the U.S., the most liquid futures contracts are Henry Hub as well as WTI. Both of those are found on the NYMEX. Futures contracts give investors a picture of what producers, as well as speculators, are willing to pay for the commodity to be delivered at that time.
TER: What is the best valuation metric for determining which stocks are true bargains?
RK: We look at two valuation tools: The first is enterprise value to debt-adjusted cash flow (EV/DACF). The second is net asset value (NAV). EV/DACF is essentially enterprise value (EV) divided by debt-adjusted cash flow. Debt-adjusted cash flow is funds from operations and adding back the interest costs. So it's somewhat equivalent to earnings before interest, taxes, depreciation and amortization (EBITDA). This figure will indicate a company's valuation based on near-term cash flow. With EV/DACF, the cheaper it is, the more it represents a true bargain. NAV, on the other hand, is simply the present value of the company's Proven and Probable (2P) reserves at a particular oil and gas price. You subtract the debt and add any option proceeds as well as the value of the company's land. If a company is trading below NAV, that naturally represents a bargain. In addition to that, if a company has a huge resource that's not accounted for in its 2P reserves, we add its risked-resource NAV to that equation so we can see the ultimate potential of the company.
TER: Do you use different discount factors?
RK: Yes. For the NAV, especially in the junior oil and gas space, we use a standard 10% discount rate. Sometimes we use sensitivities for an implied discount rate.
TER: Your coverage list is fairly broad. Most of these stocks range between $3–12, and you have a couple of cheapies in there. How do you determine which companies to cover?
RK: We look for high-growth exploration and production (E&P) names that are generating solid cash flow while growing their NAVs through the drill bit and/or through acquisitions. Our coverage universe is narrowly focused on names that have the capability of showing high growth potential or that have interesting asset bases.
TER: Have your cheaper holdings simply depreciated, or do they have a lot of hidden value that the market isn't recognizing?
RK: There are some gas names I picked up when we had a better gas environment, expecting that they were going to show quite a bit of growth in cash flow and NAV. With the recent volatility in both oil and natural gas prices, however, the junior oil and gas space has really fallen off. I think this represents a great time for investors to look at these specific names and see what hidden value and optionality these companies have. A lot of them fall in that category.
TER: You call some of your holdings "discount darlings." Who are they?
RK: The two oily names I like are Whitecap Resources Inc. (WCP:TSX.V) and Surge Energy Inc. (SGY:TSX). I like them despite volatile prices because they're still able to maintain a fairly profitable margin. Both are close to 70% light oil. They're the "growthy" mid-cap oil producers with operations in Western Canada. They're both recognized as having top-tier management teams. Both are growing their production on a per-share basis by well over 34% year-over-year (YOY) in 2012. By comparison, our mid-cap median group is only generating about 20% YOY growth in production volume. Whitecap and Surge are top-tier in these factors. They're generating operating netbacks well over $35/bbl at current levels and are well hedged. They have strong balance sheets and should do well in an oil price recovery.
While we're not specifically bullish on gas, Celtic Exploration Ltd. (CLT:TSX) is one of my favorite gas-weighted stocks and, in my view, represents a prime takeout candidate. It has two sizable and contiguous land blocks, chasing the liquids-rich, gas-prone Kaybob Duvernay shales and Montney at Resthaven. For its Montney land base, Celtic has one of the largest land positions in Western Canada at nearly 700 net sections. Liquids yields from Celtic's Montney wells at Resthaven help improve the overall well economics and should aid in buffering the company against the low gas price environment. In addition, its 172 net sections of Duvernay land are in the sweet spot of the play and are surrounded by larger players, such as Encana Corp. (ECA:TSX; ECA:NYSE), Chevron Corp. (CVX:NYSE), Husky Energy Inc. (HSE:TSX) and Talisman Energy Inc. (TLM:TSX), that are chasing the exact same formation. Given the recent sale of Progress Energy Resources Corp. (PRQ:TSX) to Petronas, we believe Celtic could be next to be taken out.
TER: Do you have any others that could have some reasonable upside?
RK: Another name I'd mention is Renegade Petroleum Ltd. (RPL:TSX.V). If you're looking for oil, it's over 95% light oil, and close to 4,000 barrels per day (4,000 bbl/d) production wise. The company is expected to grow that to 5,200–5,400 bbl/d oil, over 95% light oil, by year-end. If you want to talk about who has one of the best operating margins or operating netbacks, Renegade would certainly be in that camp. Even at $85/bbl oil, it should be generating more than $45/bbl in operating netbacks. It's a solid company that has a strong balance sheet and is growing, despite the current volatility in oil prices.
TER: Are most of these small-cap and mid-tier companies potential takeover targets?
RK: I certainly think so. We believe the theme over the next couple of years is "bigger is better." Given the shift toward horizontal multistage fracture stimulation, per-well costs are moving up, requiring junior oil and gas companies to achieve a certain cash flow or production base in order to fund their program. To get to that level, acquisitions will be part of that equation. Nowadays, we believe acquirers are being more selective about the asset bases they want. Typically, acquirers will want to purchase a producer that has a lot of production and a well-delineated and contiguous land base, so there is little risk going forward. Small-cap and mid-tier producers that have these qualities are the first to be considered as a takeover target, in my view.
TER: It seems like the average life expectancy for most of these smaller companies is less than 10 years.
RK: I agree. What's great about Western Canada is that oil and gas executives here are an entrepreneurial bunch and are good at creating new companies, looking at new plays, turning people's capital into production and cash flow and eventually selling it to a larger company. It's formulaic: "Rinse and repeat." That's why you don't see many companies with over a 10-year life span: These executives are moving on to the next big idea.
TER: It's sort of an easy business to get into and an easy business to get out of, if you play things right.
RK: Definitely. The one thing I would probably highlight is that the quality of the management team is key in this industry. As you said, it is easy to get in but you need to be well connected and have a strong technical background to extract the most out of the company's assets.
TER: To summarize, how should investors pick their oil and gas stocks?
RK: In my view, it's really a stock picker's game. Oil and gas stocks are definitely going to ebb and flow with the macro environment, but investors with a longer-term view should start accumulating over the summer. We expect oil prices to firm up by year-end, and the equities will follow.
TER: You've given us some interesting names. Thanks for joining us today.
RK: Thanks. I appreciate it.
Ray Kwan has been with Macquarie since 2007, where he covers small- and mid-cap oil and gas producers and reports on activities in emerging and established resource plays. Prior to Macquarie, Kwan was employed at a major Canadian integrated oil and gas company, where he gained experience through various technical roles, including design, project management and production engineering. He holds a Bachelor of Science degree in chemical engineering from the University of Alberta and is a registered professional engineer.
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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.
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3) Ray Kwan: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.