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Baby Steps: Mackie's Bill Newman Finds Oil & Gas Plays that Produce No Matter What

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Bill Newman Volatility in the oil and gas markets continues, with prices plunging yet again in the recent chaos surrounding Greece's default negotiations and other global political and economic uncertainties. But a rebound is inevitable, and Mackie Research's Bill Newman has his eye on companies that have managed to grow, step-by-step, even in hard times. In this interview with The Energy Report, Newman identifies companies with individual stories that will, in the end, defy the trend.

The Energy Report: With the collapse of the crude oil price and the timing of a recovery difficult to predict, the energy sector has fallen out of favor with investors. In the current oil and gas investment climate, are there any stocks that are immune to the negative sentiment and can still perform?

Bill Newman: Yes, there are. But investors need to choose companies that are decoupled from oil prices in the short term and have other drivers that can gain investor attention to move the stock price up.

And yes, you're right. The sector is out of favor right now, so investors should look for companies that don't have to rely on accessing the debt or equity markets, and are able to fund operations with internally generated cash flow.

"The real upside in Pan Orient Energy Corp.'s story in the near term is exploration drilling in Indonesia."

Also, we think investors want to see step growth in production. Most oil and gas companies have slashed their budgets and are focused almost entirely on low-risk development projects, so they're just treading water. You can understand the lack of enthusiasm for the sector. Unfortunately, almost every oil and gas company has traded down with the sector as a whole, even if the individual story has nothing to do with oil prices. We think this presents a double opportunity. The first is that, as the company demonstrates step-growth production, the stock should go up. Second, we expect another lift when the price of oil rebounds and the sector is back in favor again.

TER: What are your favorite stocks right now?

BN: We like Ithaca Energy Inc. (IAE:TSX), which has operations focused in the North Sea. The company has current production of just over 12,000 barrels of oil equivalent per day (12,000 boe/d) with 9,000 barrels per day (9,000 bbl/d) hedged at US$76 per barrel (US$76/bbl) until June 2016, and another 4,000 bbl/d hedged at US$69/bbl from July 2016 to June 2017, so a significant portion of the production and cash flow base is protected. The big event next year is the tie-in of the Stella oil and natural gas field, which is expected to be on production in mid-2016. This should add approximately 16,000 boe/d of production net to the company's 55% interest. That's the step growth in production that we think will be a catalyst for the stock.

TER: What's left to do to get Stella online?

BN: Ithaca has completed drilling and testing of five production wells, which tested at a total combined rate of about 53,000 boe/d, which exceeded management's expectations. Nearly all the subsea pipeline work has been completed, so all that's needed now is to complete the floating production facility. The construction of the production facility is currently on schedule, and it should sail out to the Stella field late in the Q1/16. Once Stella is online, we expect Ithaca's production will increase to approximately 27,000 boe/d.

TER: What's next for Ithaca after Stella?

BN: Once Stella is on production, Ithaca should generate a substantial amount of free cash flow, which it can use to pay down debt. The company will also fund the tie-in of the satellite fields in the greater Stella area, which should help keep the Stella production facilities near capacity so they can sustain a free cash flow base for several years. We also expect that Ithaca can keep growing by acquiring and developing other producing assets in the North Sea.

TER: Is there another company that you like?

BN: We also like Canacol Energy Ltd. (CNE:TSX; CNNEF:OTCQX). Last year, Canacol completed the acquisition of the VIM 5 block, which completely surrounds its producing Esperanza block, and the VIM 19 block, which is adjacent to Pacific Rubiales Energy Corp.'s (PRE:TSX; PREC:BVC) La Creciente field. Canacol now has a 100% interest in all three blocks, which are located in the Lower Magdalena Basin in Colombia. The primary focus in 2015 is on the appraisal and tie-in of the potentially large Clarinete natural gas field, which was discovered on VIM 5 late last year. Natural gas production from the Esperanza and VIM 5 blocks is expected to increase from about 20 million cubic feet per day (20 MMcf/d) to 83 MMcf/d by the end of this year. Canacol has secured long-term, take-or-pay contracts for its natural gas production at prices ranging from US$5 per million British thermal units (US$5/MMBtu) to US$8/MMBtu. The company also has ~1,700 bbl/d of tariff production in Ecuador, and is paid US$38.54 for each incremental barrel of production over a baseline. With tariff production, Canacol is paid a fee for its production, so there are no production costs.

"If Madalena Energy Inc. can repeat its success with the Loma Montosa, we see a lot of potential production additions in 2016."

We expect current production of ~12,000 boe/d to increase to more than 20,000 boe/d by year-end, with approximately 80% of the production locked in at contracted prices. That will provide a predictable cash flow base in 2016, which the company will use to pay down debt and to fund exploration targeting oil on the LLA 23 block in the Llanos basin, and natural gas on its large land base in the Lower Magdalena Basin.

TER: Can you give us another name?

BN: We also like Valeura Energy Inc.(VLE:TSX.V). Valeura is a natural gas producer with operations focused in the Thrace Basin in western Turkey, which is considered the European side of the country. Most members of the management team worked together at Verenex Energy Inc., which was a highly successful oil and gas company with operations in Libya.

Current production of approximately 7 MMcf/d is from the company's non-operated, 40%-working interest, joint venture lands. Valeura is currently selling its natural gas for around $10 per thousand cubic feet ($10/Mcf), so we expect Valeura to fund most of its capex with cash flow.

The current focus, in 2015, is on the company's 100%-owned Banarli block, which directly offsets the Gurgen natural gas discovery made last year on the non-operated 40% lands. Valeura recently completed a 150-kilometer-square, 3-D seismic program on Banarli, and should spud its first exploration well in September or October. If successful, the company should be able to accelerate growth in 2016, with more of production and cash flow generated from the higher working-interest Banarli block.

TER: Are there companies that investors who are less risk-adverse might consider?

BN: Companies dependent on high-impact exploration success are completely out of favor right now. But there is a company that caught our attention—Falcon Oil & Gas Ltd. (FO:TSX.V; FOG:AIM; FAC:ESM). This company completed an AU$200M (~CA$189M) farmout agreement last year, which exposes it to an eminence unconventional oil and natural gas resource in the Beetaloo Basin in the northern territory of Australia. The farmout was structured so that Falcon assumes little or no capital risk. Falcon completed the farmout deal with Origin Energy Resources Ltd. (a subsidiary of Origin Energy Ltd. [ORG:ASX]) and Sasol Petroleum Australia Ltd. (a subsidiary of Sasol Ltd. [SSL:NYSE]), with the first-phase drilling program consisting of a fully funded, five-well drilling program at an estimated cost of AU$64M (~CA$60M).

"Investors need to choose companies that are decoupled from oil prices in the short term."

And Falcon is not responsible for any cost overruns on those five wells. If Origin and Sasol walk away after the first well, they still have to pay Falcon for the cost of drilling the remaining four wells. A drilling rig is being mobilized to the block right now, so the first well should spud in July. If the partners have positive results from the first-phase drilling program, then there is a second phase, for which Falcon is carried and costs are capped at AU$53M (~CA$51M). If the partners have positive results from the second-phase drilling program, then there is a third-phase drilling program consisting of two further horizontal wells that will be fracture-stimulated. The third-phase costs for which Falcon is carried are capped at AU$48M (~CA$45M). We don't have research coverage on Falcon, and this is only for investors with a high-risk tolerance who understand that it's a binary outcome story. But we like the upside if Falcon is successful.

TER: Can you update us on stories that we've talked about in previous interviews?

BN: Sure. Let's start with Pan Orient Energy Corp. (POE:TSX.V), which recently sold a 50% interest in the L53 block in Thailand for CA$49M. The company retains a 50% interest in the block. With the sale, we estimate Pan Orient has net positive working capital of approximately CA$92M, which works out to $1.66 per share versus the current market price of about $1.50 per share. The company is trading below cash value right now. Part of the reason for the discount is likely due to that fact that Pan Orient is nearly a pure exploration company, although it does have about 300 bbl/d net of production remaining in Thailand.

The real upside in the story in the near term is exploration drilling in Indonesia. In August, Pan Orient expects to spud the Akeh-1 exploration well on the Batu Gajah block, and if the well is successful, then the company should immediately follow up by drilling two more Akeh appraisal wells. We believe this is a relatively low-risk play because the Akeh prospect is located a few hundred meters away from the Selong oil and gas discovery, which is located on the adjacent block. Also, in Q2/16, Pan Orient plans to drill the Anggun prospect, which is a very large prospect on the East Jabung block. Pan Orient recently farmed out a 51% interest in the block to a subsidiary of Talisman Energy Inc., which is now Repsol-YPF S.A. (REPYY:OTCPK), in return for a cash payment of US$8M and the funding of the first US$10M toward the drilling of the Anggun-1 exploration well. If the well is successful, we see a lot of upside in the stock.

Moving on, 2014 was a transformational year for Madalena Energy Inc. (MVN:TSX.V; MDLNF:OTCPK) after it acquired Gran Tierra Energy Inc.'s (GTE:TSX; GTE:NYSE.MKT) assets in Argentina. The transaction was accretive on most metrics, and substantially increased Madalena's opportunity base. More importantly, the acquisition increased Madalena's production to approximately 4,000 boe/d. That production base provides a good cash flow base to fund operations.

The domestic oil price in Argentina is regulated by the government, and the current oil price is about US$76/bbl, so that's a good premium to the current West Texas Intermediate (WTI) and Brent oil price. The key focus in 2015 is on appraising four different, potential, large resource plays in Argentina. The four resource plays are the Vaca Muerta and Agrio shales, and the Mulichinco and Loma Montosa tight sands. Earlier this year, Madalena completed a highly successful test of the Loma Montosa formation on the Puesto Morales block. The horizontal well was completed with 12-stage, ball-drop, fracture stimulation, which was a first for Argentina. The well initially flowed at 860 boe/d, and the longer-term tests are encouraging. Madalena holds a 100% interest in the 31,000-acre the Puesto Morales block, and also a 100% interest in the Puesto Morales facilities, so if the company can repeat its success with the Loma Montosa, we see a lot of potential production additions in 2016 from this one play.

TER: Thank you for your time, Bill.

Bill Newman is vice president of international oil and gas with Mackie Research Capital Corp. He has been an energy analyst for 19 years. He holds a bachelor's degree in commerce from the University of Calgary, and has a CFA designation.

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DISCLOSURE:
1) Staff compiled this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report and The Life Sciences Report, and provides services to Streetwise Reports as employees. They own, or their families own, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: Madalena Energy Inc., Pan Orient Energy Corp. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services.
3) Bill Newman: I own, or my family owns, shares of the following companies mentioned in this interview: Pan Orient Energy Corp. 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: Within the last three years, Mackie Research Capital has managed or comanaged an offering of securities for, and received compensation for investment banking and related services from Canacol Energy Inc. and Madalena Energy Inc. 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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