Alistair Toward: As illustrated in Exhibit 1, we are seeing a disconnect between oil pricing and valuations for heavy oil companies. There's recently been a dramatic recovery in heavy oil pricing, but we have not seen that recovery in the equity valuations for these heavy oil producers. That disconnect creates an opportunity. As companies come out with their financials results, we're going to see that disconnect exaggerated. That should cause more excitement and interest in the heavy oil producers.
TER: Why are heavy oil producers more interesting than other producers?
AT: Heavy oil producers tend to be a higher beta energy investment; they tend to mirror the moves within the energy universe as a whole, but in an exaggerated fashion. Additionally, these producers typically survive in a low-margin environment because they've historically offset low margins by minimizing development costs. As a result, when pricing improves, a lot of that benefit goes right to the bottom line and results in dramatic increases in netbacks compared to light oil producers. When the outlook is strong for heavy oil, producers' share prices often increase more significantly. Likewise, they tend to underperform the energy segment when pricing turns against them. To some extent, we've already seen the underperformance, and now we're seeing the recovery.
Another consideration is that the group as a whole is made up of both cold flow producers and thermal producers. The thermal producers in particular tend to have very large inventories of long-life projects that could be brought on and produce at a certain range for over 50 years. When the environment for heavy oil isn't so good, the value attributed to these inventories tends to evaporate in the eyes in the investors, but on the other hand, we often see these potential long-life inventories increase in value when heavy oil prices are improving. The current improving outlook for heavy oil prices means these project inventories should once again attract greater investor attention and market value.
TER: Why is now an inflection point for heavy oil producers? And how long do you expect the short-term uptrend to last?
AT: It's an inflection point because we've already seen heavy oil prices improve substantially. We haven't seen a dramatic improvement in the equity prices, but we think now is the right time to start accumulating shares because these higher heavy oil prices will be translating into much improved financial results, which we believe will push share prices higher. The pricing environment has continued to improve into the third quarter. The Q2/13 results for most of these companies are just coming out now. For example, a company like Palliser Oil & Gas Corp. (PXL:TSX.V) is expected to see almost a tripling in cash flow in Q2/13 relative to Q1. We expect cash flow to increase further in Q3. In Palliser's case, increased cash flow resulted from a combination of changes in pricing, volumes and operating costs. We're seeing dramatic improvement, and a lot of it is based on the climate for heavy oil.
TER: What infrastructure improvements are responsible for this development?
AT: There are two main things. First, we're seeing lots of debottlenecking where we traditionally ship our crude. Most of Western Canada's crude gets shipped to the U.S., but it gets shipped into the midcontinent, and it often gets trapped there. Right now, we're seeing a dramatic improvement in pipeline egress, from the midcontinent particularly, to markets like the Gulf Coast, where there's lots of refining capacity. We're also seeing expansions in refining and upgrading capacity in that market.
The other factor has been rail. We're seeing a dramatic increase in the amount of crude transported by rail, particularly for heavy oil producers. There's a specific benefit for heavy oil producers because when they ship by pipeline they're required to have quite a bit of diluent in order to move this heavy crude along the pipeline. When producers ship by rail, they're not required to add much diluent, if any. It certainly cuts down on the cost for the producers. The cost of transport is a little bit higher, but since they're not spending on diluent, which is sold at a loss to what you purchase of it, the producers are actually finding that the rail works very well for them and it gives them a tremendous amount of flexibility.
TER: How will the Lac-Mégantic rail disaster affect the improvement of crude transport?
AT: We're probably going to see a lot more regulations and scrutiny. I think that's going to benefit everybody, including producers. Nobody wants to be associated with a disaster like that. Improving the rules and procedures to avoid such circumstances enhances the transport. Longer term, it also forces governments to weigh the costs of not having the pipeline infrastructure in place. The increase in rail activity is a direct consequence of not having a pipeline alternative. Statistically, a pipeline is always going to be a safer alternative.
It appears the rail industry can certainly make changes to improve the safety of a rail line. A lot of it has to do with rail design. Pipelines have always been built to avoid high-population areas, whereas rails have always been constructed to join them up. If we continue to be forced to rely on rail, we might see some more rail lines that avoid large populations, like a superhighway that gets crude and other products where they need to be without taking them through densely populated areas.
TER: What effect will TransCanada Corp.'s (TRP:TSX) Energy East Pipeline project have on the uptrend?
AT: Although the pipeline has been proposed but not yet approved, it's a very positive development. In the last 18 months, the industry fell behind with regard to its takeaway capacity for Western Canadian Basin and we found ourselves somewhat glutted. Now we're seeing the pendulum swing the other way. Everybody's thinking about making sure we not only rectify the bottleneck that has been created, but that we avoid it in the future. To see us moving ahead with pipelines that are going to make an impact in the 2016–2017 timeframe is very encouraging. The heavy oil industry is quite profitable, providing producers can access a market for their product.
TER: What other major infrastructure improvements are in the works?
AT: The most important are all the improvements that are taking crude out of the midcontinent into other places. Keystone XL would be a cross-border pipeline, and we're not even using all the cross-border takeaway capacity we already have right now because it's flowing into a glutted market. Addressing the midcontinent bottlenecks will allow for more capacity.
We may well see other pipelines in Canada, and ultimately we are going to see some Canadian upgrading. The Alberta government is working with Canadian Natural Resources Ltd. (CNQ:TSX; CNQ:NYSE) to develop an upgrader that will convert bitumen to diesel in Alberta. That's just one example of a domestic solution.
TER: What is your forecast for the heavy oil sector as a whole and for the individual companies you cover?
AT: We are forecasting $75 per barrel ($75/bbl) Western Canadian Select. This is below the current spot of $84/bbl, yet all the producers that we cover would do very well at that price, and the price could go much higher than that. In terms of specific producers, there may be more upside with some of the smaller companies that have not seen their valuation hold up as well. For example, Twin Butte Energy Ltd. (TBE:TSX) is one of the larger cold flow heavy oil producers that we've covered in our report, and it has managed to hold on to a good part of its valuation through restructuring into a dividend company. Its valuation didn't deteriorate as much as some of the smaller companies. We think the opportunity is a little bit better with some of the smaller producers, whose valuations were more negatively impacted by the pricing environment.
TER: What kind of investor should emphasize cold flow producers and which ones should focus on thermal?
AT: It's really a function of risk. The thermal producers will always be more volatile than the traditional cold flow producers. You pay a lot more per flowing barrel per day for a company that's associated with a thermal project. A lot of that is because once one of these projects is on, it produces for a very long time. You can't really compare the cash flow between something with a relatively short reserve life and something that has a long reserve life.
TER: What gives you the most confidence about BlackPearl Resources Inc.'s (PXX:TSX) prospects and what are its weaknesses?
AT: The management is very strong. A lot of people made quite a bit of money from this management team when it ran Blackrock Ventures. Management successfully sold the company for $2.4 billion to Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and created a lot of value for Blackrock investors. It's a management team that definitely knows the heavy oil business and has demonstrated a track record of generating shareholder value. Known as somewhat of a celebrity management team, they were able to look at a lot of opportunities, and they spent two years doing so. They found BlackPearl, specifically the Blackrod project. The company has some very high-quality assets, not only on the cold flow side but also on the thermal side.
The risks associated with BlackPearl include the fact that the thermal initiatives are generally unfunded, so the company is required to raise capital. That will involve quite a bit of debt, and that will change the risk outlook for the company, particularly during the period where the company is building out the project.
TER: What about Palliser—the good and the bad?
AT: What we really like about Palliser is its unique strategy it applies to the heavy oil business. While it is pursuing the cold flow part of the heavy oil business, it is doing so in a way that we think is quite synergistic. Palliser's specific expertise is in a strategy called High Volume Lift (HVL). The company is producing from all the same zones, areas and horizons as most of the typical cold flow producers, but doing it with a method that produces a lot more water and oil. It works very well with mature fields and wells. It requires a lot more infrastructure, but it allows the company to recover a lot more oil and to do so at a higher rate of production.
The company has demonstrated dramatic success with the strategy, but it also suffered when it didn't have the infrastructure required to handle all the water itself. It has since addressed its infrastructure constraints and is now expanding this capacity. As such, it is increasingly well positioned to keep taking on other producers' mature wells. The company has historically demonstrated strong production growth and low costs when its HVL operations are working well.
Right now these HVL operations are not only producing well, but performance is much improved relative to the first quarter. For example, in Q1/13, Palliser was producing a little over 2,100 barrels a day (2,100 bbl/d), and since then it has increased volumes to just shy of 3,000 bbl/d—a dramatic improvement in production. Because Q3 is the busiest drilling season, we should see more volumes added over the summer. In terms of the weakness for Palliser, HVL works very well except when there are operational hiccups, which tend to have a dramatic impact on volumes. Palliser suffered an upset in the first quarter, but has shown it can recover relatively quickly.
TER: So what companies do you like in this space altogether?
AT: Of the cold flow producers, we would definitely gravitate toward Rock Energy Inc. (RE:TSX) and Palliser. In the thermal space, we like BlackPearl. It's very well positioned. It's got very little debt, 9,000 bbl/d of relatively low-risk production and lots of very attractive thermal projects that it's waiting to build out. I think it's very well positioned to potentially show dramatic share price appreciation as we see the climate continue to improve and that gets recognized. Southern Pacific Resources Corp. (STP:TSX.V) could also perform very well but there are some company-specific risk factors, which, combined with a large debt load, make it a far more risky investment opportunity.
TER: Alistair, I appreciate your time today.
Alistair Toward joined PI Financial Corp.'s Calgary office in April 2010 focusing on junior to mid-size domestic energy companies. Alistair brings over 16 years of financial and industry experience to PI, including 10 years as an oil and gas analyst. He began his analytical career with Gordon Capital/HSBC. He also covered the explorer and producer segment at Research Capital, Clarus Securities Inc. and most recently, Thomas Weisel Partners. Toward has a Bachelor of Arts degree in communications from McGill University and is a chartered financial analyst.
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1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family owns shares of the following companies mentioned in this interview: None.
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