The Energy Report: Brickburn Asset Management's monthly report for May indicates good news for energy resource investors in Western Canada. Please explain.
Bill Bonner: There are two elements to consider. One is that the Canadian energy market dynamics for extracting natural gas are changing significantly. Second, positive signals abound in the world of oil and oil transportation, in spite of concerns about pipelines crossing borders, like the Keystone XL Pipeline.
TER: What is going to happen with the Keystone situation?
BB: Keystone has become politicized, unfortunately. And Canada's initiative to pipe oil to the east and west coasts of Canada is meeting similar objections. But the oil and gas industry is figuring out a way through the problem. The crude-by-rail option has become an important variable in moving Canadian crude into the right markets. Rail is having a positive effect on the domestic price of oil.
TER: The financial press is reporting that the cost of production is so high for North American crude that investors are backing away from that sector.
BB: Drilling two-mile horizontal laterals wells in North Dakota can cost $8–10 million ($8–10M), and the completion costs are astronomical relative to the drilling costs. It is necessary to get a lot of production out of a well that costs so much. But there is a significant lift in domestic production in the U.S., so the real debate is whether the pace of lifting production can continue. I expect the growth curve to flatten out.
TER: What will a flattening growth curve mean for investors in juniors?
BB: A Canadian well costs $1–1.5M to drill. Sophisticated completion technologies can pull more production out of the same wellbore. After the primary reserves are exploited, enhanced recovery programs can draw more reserves out of the reservoir. This style of play is well suited to the smaller operator.
It is important to note that the production mix for a typical producer in Western Canada includes oil and gas, especially gas with liquid: ethanes, pentanes and butanes. The liquid molecules deliver more heating power—more BTUs for the buck—than do the dry molecules.
TER: What junior oil and gas firms do you favor in this space?
BB: By way of background, about 18 months ago there was a pipeline bottleneck in Cushing, Oklahoma. The oil flowed in and could not pipe out. Crude by rail saved the day, bypassing Cushing. We bought stock in companies that were able to transport heavy oil to market using crude by rail. One of those companies was Rock Energy Inc. (RE:TSX). Rock is successfully developing its light oil assets, as well as heavy oil. Rock should ultimately trade for about five times cash flow, at about $10/share. We bought the stock at $1 plus change; it is about $7 today and a core position in our energy fund.
TER: Other firms?
BB: Tamarack Valley Energy Ltd. (TVE:TSX.V) is only a double so far in our portfolio, and it is similar to Rock Energy. Its management is very competent. CEO Brian Schmidt was president of the very successful Apache Canada before he created Tamarack Valley. Brian quickly acquired a company called Echoex, which was known for its gas production, but which also had a good oil asset. Tamarack went after Echoex's Viking oil play, and the company is now producing close to 6,000 barrels a day (6,000 bbl/d), up from just 2,000 bbl/d just two years ago.
TER: What are the particularities of the Viking oil play?
BB: There are two plays that have caught the market's attention in Canada, the Cardium and the Viking. The Cardium entry point costs about $3M to drill and complete a well, and another $0.5M to $1M to tie it in. The Viking has a lower entry point: somewhere between $1M and $1.5M to get the job done. The productivity rates in the Viking are lower and the oil is lighter, but Tamarack's internal rate of return on the Viking oil projects is between 80% and 100%. At a couple of dollars a share of cash flow, my target for Tamarack is $10.
TER: What firms in this space are attractive takeover candidates?
BB: Manitok Energy Inc. (MEI:TSX) has the Stolberg play in the foothills of the Cardium Basin. The Cardium generally registers 175 to 250 barrels of initial production. The foothills are registering three or four times that amount. Manitok is at its 23rd healthy well in the gas/oil Stolberg play. Plus, Manitok pulled off a really interesting deal earlier this year. Encana Corp. (ECA:TSX; ECA:NYSE) is a big Canadian multinational with properties in the U.S. It was farming out royalty lands on the order of 5–6M acres. Encana owns the railway mineral rights to the freeholds. Encana has now carved those rights out and is trading them in a public company called PrairieSky Royalty Ltd.
Manitok farmed into Encana in an area of west-central Alberta called Entice, which has been underdrilled. Manitok has a commitment to drill a number of wells during the next three years. Not only is the company running the successful Stolberg gas/oil play, it now has multizone potential in the shallower part of the basin. And it has the cash flow to develop that. Manitok needs to spend $106M during the next three years; its cash flow is about $50M a year.
TER: So Manitok will not have to go into debt or raise more equity?
BB: Correct. The market was recently critical of Manitok. One of the senior managers left, and the market thought that was the end of the company. But one individual does not a company destroy. Manitok put the right managers and technical people into the driver's seat. It has 30 or 40 more wells to drill in the foothill land, and about 300 to drill on the Encana block.
TER: How has Manitok's share price been faring?
BB: It has been flat for the last six months. My target is $5, 4.5 to 5 times cash flow. My rule of thumb is to buy companies that are financially sound and are trading at less than 5 times cash flow. When the market gets going, I expect to see 5, 6, 7, 8 times cash flow multiples in the market.
TER: What other triggers cause you to invest?
BB: I pay attention to the balance sheet. Does a company have too much debt or not enough debt? Canadian companies are debt-averse. A debt level of 2 times annual cash flow is considered to be at the risky end of the spectrum. A more comfortable range is 1–1.5 times debt to cash flow.
I pay attention to the actual plays a firm is involved in relative to total corporate cash flow. If a company has $30M cash flow and wants to drill in North Dakota, it will cost $10M to drill three wells. If it is in the Cardium in Alberta, it can drill 10 wells. A $30M cash flow will deliver 20 wells in the Viking.
TER: Do you ever invest on a gut feeling, all else being equal?
BB: Absolutely. For example, DualEx Energy International Inc. (DXE:TSX.V) has a $20M market cap. It is in an onshore concession in Tunisia. We have owned DualEx stock for six years. And that is how long it has taken for DualEx to drill one $8M well on the concession. Talk about being patient! We believe in DualEx's technical interpretation. And there were all kinds of understandable roadblocks, the Arab Spring being one. DualEx found a joint venture partner to finance 100% of the well costs for 47.5% of the play, and the well was drilled.
TER: What does the joint venture do to the value of your investment in DualEx?
BB: We are waiting for the well to be completed. The service company that DualEx hired screwed up on the completion, and DualEx had to locate another service rig. Working in Tunisia is not the same as working in central Alberta, where one phone call is made and a new rig is on the road in an hour.
TER: What other companies do you like in Western Canada?
BB: We like Spartan Energy Corp. (SPE:TSX.V). This is our third time making money investing with this management team. The managers have formed several companies with iterations of the word Spartan, such as Spartan Oil. Spartan Energy is the most recent one. It is predominantly an oil story. This team has enjoyed great success in the Cardium oil play in central Alberta, and that track record is undiminished for the new enterprise, alongside the productivity of Spartan's new assets in Saskatchewan. Spartan's management team is recognized as a value creator. The stock is a double and it is just getting started. Our target is $10.
TER: Is the current market rewarding managerial competence?
BB: The market definitely rewards managerial competence. Spartan is a great example of that. Another example is Tourmaline Oil Corp. (TOU:TSX), a multibillion-dollar enterprise. Its management team has built two companies. The first one sold for $2 billion ($2B), and the second sold for $4B. Tourmaline has an $11B market cap and the stock is at $56. In the IPO, we bought it at $20.75.
TER: Does Tourmaline pay dividends?
BB: None of the companies I have mentioned so far pay dividends. They are all growth stories. The opportunity is to figure out which companies have a suite of assets that will appeal to one of the dividend-paying enterprises in the market.
TER: Have any of your oil and gas investments underperformed?
BB: We hold Palliser Oil & Gas Corp. (PXL:TSX.V) in our portfolio. Its board has decided on a strategic review process, which means it is for sale. We really liked Palliser in the context of chasing a heavy oil theme in Saskatchewan. Palliser had a primary recovery program and a secondary or enhanced recovery program for its heavy oil wells. But it overcapitalized the play. Management spent too much money and loaded on too much debt. It bought Cadillacs when Chevrolets would have worked. The company had reached 3,000 bbl/d when production fell. It did not have the financial strength to carry on. Palliser is a lesson in the perils of overcapitalizing a play with bank debt. That is always a mistake. The bankers want their money back for some reason.
Now we are sitting on stock at a quarter of our value. Fortunately, there are some tax pools resident in this investment. And the play itself is good. Someone will want to own it. We are waiting for the conclusion.
TER: Let's talk about natural gas stories in Western Canada.
BB: We like Bellatrix Exploration Ltd. (BXE:TSX), which is capitalized at about $1.6B. It is busy developing a gas/oil play. Bellatrix is another example of good execution. It has attracted a large joint venture partner from Korea to help it develop oil and gas plays in the Duvernay. It is not small by Canadian standards.
Painted Pony Petroleum Ltd. (PPY.A:TSX.V) is a liquefied natural gas (LNG) story. There are no LNG plants built yet in Canada, but we are working toward that, with a half dozen projects on the west coast. Natural gas from northeast British Columbia (B.C.) will be pipelined to the west coast, liquefied and sold to Asia. Painted Pony is one of the intermediate-size producers that will benefit. It has a northeast B.C. gas play, the Montney. The Asians are paying attention to the Montney. Petronas, the Malaysian company, bought a company called Progress Energy Canada Ltd. for several billion dollars because of its northeast B.C. gas assets.
Another gas story is Crocotta Energy Inc. (CTA:TSX), in which we have recently invested. It is a Canadian producer with less than $500M in enterprise value. To survive in the natural gas business during the last few years, firms have had to become low-cost operators because the gas price was so low. Now the gas price has turned. With the cold winter and gas storage in both the U.S. and Canada at almost unprecedented lows, the question is: Will storage fill up before the heating season starts? That is going to be a challenge, and it will keep an upward pressure on gas prices.
Because Crocotta has proven itself as a low-cost producer, rising prices mean rising cash flow. At a $2.50 per thousand cubic feet breakeven point, Crocotta survived when gas prices were horribly low. Now it is automatically reaping the benefit of the higher gas price. That is part of the theme we play. When we find a low-cost producer with good management that has the ability to survive, we are going to make money with them. Crocotta is a $5 stock. It is at $3.60 currently. Hang on. Did it go up today? It's at $3.93. [Editor's note: Crocotta stock was at $4.03 at market close on 6/11/14.] So, there you are.
TER: Thanks for the tips, Bill.
Bill Bonner is cofounder and president of Brickburn Asset Management, a Calgary-based investment counseling firm largely focused on the Canadian energy sector. He is directly responsible for managing energy investments in public market portfolios, private client portfolios and private equity pools. With more than 30 years of energy capital markets experience, Bonner brings a perspective to Brickburn Asset Management that has been built on a solid foundation and in-depth knowledge of Canada's energy sector. Prior to founding Brickburn Asset Management, Bonner was a founding director of Network Capital, the predecessor to Brickburn. His career also included 14 years with Peters & Co. Ltd., where he was a significant shareholder, member of the executive committee and managing director of institutional sales and trading.
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1) Peter Byrne conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: none.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: Rock Energy Inc. and Manitok Energy Inc. Streetwise Reports does not accept stock in exchange for its services.
3) Bill Bonner: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. My company's funds hold shares of the following companies mentioned in this interview: Rock Energy Inc., Crocotta Energy Inc., Painted Pony Petroleum Ltd., Bellatrix Exploration Ltd., Palliser Oil & Gas Corp., Tourmaline Oil Corp., Spartan Energy Corp., DualEx Energy International Inc., Encana Corp., Manitok Energy Inc., Tamarack Valley Energy Ltd. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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