A few bargains – Oil and Gas

I’ve been examining the wreckage of the market carnage over the past few days (these types of high volatility situations tend to create opportunities) and in general I have not been too impressed with what I have seen. Either that, or what I have been examining has been unfruitful material.

The big exception: the oil and gas sector.

The reason why they have cratered is because of this chart:

wtic

Then I start scouring the list of TSX oil and gas sector companies that are over a market capitalization of a billion dollars. The TSX maintains a comprehensive list of listed companies which I find to be of surprising value when I look for quick lists of companies. I generally don’t tread below a billion in capitalization for resource firms since companies of that capitalization are dominated by insider information where a good drilling result will make the difference between life and death and the last person to get this information will be the outside public.

Larger capitalization companies also receive the benefit of financial economies of scale as they will be able to raise capital in meaningful amounts at lower costs – just imagine if you were a bank lending to a $10 million microcap exploration company versus lending to Suncor – a world of difference.

I also exclude anything international (e.g. CNOOC) as my comfort level with companies with international operations (outside Canada/USA) is quite low. There are some Canadian companies with international operations (e.g. Husky) but I have not excluded them from the list.

This leaves the following:

NameRoot
Ticker
QMV(C$)
31-August-2014
O/S Shares
31-August-2014
Price Aug 31Price Oct 17Diff
Suncor Energy Inc.SU65,392,529,9631,465,214,653$44.63$37.43-16.1%
Canadian Natural Resources LimitedCNQ51,752,147,4691,092,047,847$47.39$38.64-18.5%
Imperial Oil LimitedIMO49,042,078,776847,599,011$57.86$51.56-10.9%
Husky Energy Inc.HSE32,835,380,634995,641,711$32.98$27.89-15.4%
Cenovus Energy IncCVE26,251,047,328756,950,615$34.68$26.44-23.8%
Crescent Point Energy Corp.CPG19,054,037,160423,423,048$45.00$37.80-16.0%
Encana CorporationECA18,575,904,053740,961,470$25.07$20.99-16.3%
Talisman Energy Inc.TLM11,519,723,5791,044,205,268$11.03$7.41-32.8%
Canadian Oil Sands LimitedCOS11,349,573,179484,610,298$23.42$17.97-23.3%
Tourmaline Oil Corp.TOU11,093,225,024201,438,624$55.07$46.15-16.2%
ARC Resources Ltd.ARX9,961,515,096316,942,892$31.43$28.70-8.7%
MEG Energy CorpMEG8,663,315,635223,684,886$38.73$29.03-25.0%
Baytex Energy Corp.BTE8,074,310,078166,069,726$48.62$36.10-25.8%
Vermilion Energy Inc.VET7,547,863,325106,713,747$70.73$64.36-9.0%
Paramount Resources Ltd.POU6,310,684,139104,654,795$60.30$51.77-14.1%
Peyto Exploration & Development Corp.PEY5,921,706,832153,690,808$38.53$34.20-11.2%
PrairieSky Royalty Ltd.PSK5,135,000,000130,000,000$39.50$34.00-13.9%
Enerplus CorporationERF5,108,169,000205,229,771$24.89$17.15-31.1%
Whitecap Resources Inc.WCP4,521,895,736245,621,713$18.41$14.98-18.6%
Penn West Petroleum Ltd.PWT4,182,765,734495,001,862$8.45$5.51-34.8%
Pengrowth Energy CorporationPGF3,938,186,665531,408,321$7.41$4.90-33.9%
Athabasca Oil CorporationATH3,181,210,140401,667,947$7.92$4.46-43.7%
Trilogy Energy CorpTET3,034,453,657105,071,110$28.88$20.80-28.0%
Bonavista Energy CorporationBNP2,991,583,651201,861,245$14.82$11.61-21.7%
Africa Oil Corp.AOI2,120,742,964312,333,279$6.79$4.14-39.0%
Bonterra Energy CorpBNE2,112,574,63332,086,492$65.84$53.82-18.3%
Gran Tierra Energy Inc.GTE2,003,447,146274,821,282$7.29$5.37-26.3%
Raging River Exploration Inc.RRX1,980,564,289180,051,299$11.00$8.14-26.0%
Birchcliff Energy Ltd.BIR1,969,417,138150,796,625$13.06$9.16-29.9%
Freehold Royalties Ltd.FRU1,925,524,14674,058,621$26.00$21.48-17.4%
Northern Blizzard Resources Inc.NBZ1,914,042,495101,810,771$18.80$15.85-15.7%
Surge Energy Inc.SGY1,889,478,484217,681,853$8.68$6.54-24.7%
Parex Resources IncPXT1,877,462,466126,287,061$14.87$10.73-27.8%
Kelt Exploration Ltd.KEL1,731,091,845126,727,075$13.66$10.55-22.8%
Bankers Petroleum Ltd.BNK1,721,811,689260,880,559$6.60$4.67-29.2%
Bellatrix Exploration LtdBXE1,611,292,542191,364,910$8.42$5.59-33.6%
NuVista Energy Ltd.NVA1,583,757,118135,944,817$11.65$10.05-13.7%
Legacy Oil + Gas IncLEG1,563,886,292199,730,050$7.83$5.06-35.4%
TORC Oil & Gas Ltd.TOG1,362,827,02893,344,317$14.60$11.29-22.7%
Painted Pony Petroleum Ltd.PPY1,362,274,68393,627,126$14.55$11.38-21.8%
Crew Energy Inc.CR1,359,860,601121,960,592$11.15$7.90-29.1%
Oryx Petroleum Corporation LimitedOXC1,296,506,662119,825,015$10.82$9.47-12.5%
Lightstream Resources Ltd.LTS1,257,107,698200,176,385$6.28$4.08-35.0%
Advantage Oil & Gas Ltd.AAV1,228,830,837170,651,966$7.20$5.10-29.2%
Long Run Exploration Ltd.LRE1,097,545,166194,204,965$5.65$3.58-36.7%
Spartan Energy Corp.SPE1,096,574,094262,338,300$4.18$3.22-23.0%
RMP Energy Inc.RMP1,068,310,163122,092,590$8.75$6.30-28.0%

A cursory look reveals that the quoted market price of all of these corporations are significantly less than what they were from August 31st, however, some got hammered more than others.

Whenever one invests in a resource company, there is always the implicit assumption that you believe the commodity price underlying the resource will rise. There is absolutely zero point in investing otherwise unless if there is a very special situation to warrant it (e.g. the firm in question has a huge hedged position on the resource that will allow it to economically outlast its soon-to-be bankrupt peer group).

Ideally you want to invest in a company with a cost structure that is at the marginal point of profitability and that has the market pricing the company assuming it will make little money in the future, and then have the commodity price increase. The embedded leverage in these high cost producers is significant – and I will keep on repeating this – under the assumption that the underlying commodity price increases.

Looking at the “least and most killed” list, we have two companies that I consider to be the cream of the crop in the Canadian oil and gas industry, ARC Resources (TSX: ARX) and Peyto Exploration (TSX: PEY) that are scratched – about 9 and 11% losses, not too bad considering the drop in commodity prices. These two companies have quite good managements and they are very focused on financial return on investment. I actually consider it too bad they did not get a 25 or 30% haircut as they are reasonably good “grandmother and grandfather” type equities that should be able to weather the full storm of a commodity cycle.

On the “ripped to shreds” list, we have Athabasca Oil Corp (TSX: ATH) that I will not touch because they simply have the incorrect economic structure (this can be saved for another post although you can read me correctly passing up on their IPO on this post).

Working the way down the losers list, a few names caught my attention. Lightstream Resources (TSX: LTS), formerly Petrobakken (TSX: PBN) is an entity that I will not be investing in, but I amusingly note that it is finally reaching what I would consider to be a fair value. There was a very dedicated individual out there that was deriding my analysis on its over-valuation which the market finally appeared to have corrected. (Feel free to read these articles here).

However, a couple old titans from the income trust era, Penn West (TSX: PWT) and Pengrowth (TSX: PGF) caught my attention. Penn West notably went through an accounting scandal when they changed top management and the subsequent audit resolved some issues pertaining to the capitalization of what should have been operating expenses. This involved the inflation of the net income line. Having the commodity oil market fall from underneath them did not help either. PWT made the unfortunate mistake of going to natural gas development at precisely the wrong time, but they hold a bunch of other more conventional oil assets which firmly put them in the ordinary category.

Notably they are trading at about a third of their stated book value. One would have to ask themselves if they were to start up that company from scratch how much would be paid to do so. Even when dumping goodwill and accumulated exploration assets (money already spent to do exploration work), there’s still about $4.9 billion in equity on the balance sheet while the market cap is around $2.7 billion today. Just from a fundamental value perspective, while previous investors got hosed, it may be a better entry point than not. The stock is likely to face tax loss selling pressure between now and the rest of the year so there’s not likely any rush to get in on a retail level.

Pengrowth is also going through an ambitious capital plan with the development of a heavy oil resource (their “Lindbergh” project) that apparently has good economics, along the lines of a Cenovus project. There is obvious execution risk with this project as many oil and gas companies have touted the promise of heavy oil while being able to produce nothing. The couple differences I see here is that Pengrowth has been in the game long enough (they’ve been public since 1989) that they should by now know what they’re doing, and also they’ve successfully executed on a pilot project that has dredged up a not trivial amount of oil from the ground already. Time will tell.

Dumping goodwill and exploration assets from PGF’s balance sheet leaves $2.4 billion in book value, while market value is about $2.6 billion presently. On its face it does not appear to be as good a value as PWT, but it appears relatively cheap from a valuation perspective.

Notably, Penn West’s equity is trading with incredibly high implied volatility – about 85% on the January series for an at-the-money option. Pengrowth’s volatility is muted (around 35%). Liquidity in their option markets is garbage, plus trading options on Canadian exchanges is a very expensive process in terms of trading costs.

Both firms give out dividends and are roughly at 10% yield at present market value. Yields might be compromised in the future if oil prices continue to decline. At least investors here clearly are not paying any premium for yield since I think most of them have been scared away from the common stock when they stare at their capital losses – a few months ago they were paying for a 5% yield and while they received that, they got a 50% capital loss in exchange.

The last time oil was at around US$80/barrel was in June 2012. Both companies’ equities were trading at significantly higher levels than they are now, plus they have the advantage of the Canadian dollar being about 10 cents lower than what it was a couple years ago.

Do I have any clue where oil is going in the future? No. However, if you believe things have stabilized, certain oil and gas producer stocks seem to have been sold off disproportionately and would probably make a decent entry point.

Reviewing track record of IPOs and other matters

Now that I have been thinking about some IPOs that I have covered in the past, we have the following:

Whistler Blackcomb (TSX: WB) – I stated in an earlier article that this is one to avoid and I might think about it at $5.30/share and so far nothing has changed this assessment.

Athabasca Oil Sands (TSX: ATH) I did not have a firm valuation opinion other than that the shares seemed to be overpriced at the offering price ($18/share) and stated the following (previous post):

Once this company does go public it would not surprise me that they would get a valuation bump, and other similar companies that already are trading should receive bumps as a result. I have seen this already occur, probably in anticipation of the IPO.

If you had to invest into Athabasca Oil Sands and not anywhere else, I would find it extremely likely there will be a better opportunity to pick up shares post-IPO between now and 2014.

While the valuation pop from the IPO did not materialize (unlike for LinkedIn investors!) the rest of the analysis was essentially correct – investors had the opportunity to pick up shares well below the IPO price (it bottomed out at nearly $10/share in the second half of 2010), although I don’t know whether the company represents a good value at that price or not. I didn’t particularly care because Athabasca Oil Sands has some other baggage that made it un-investable (in my not-so-humble opinion).

While I am reviewing my track record on this site, one of my other predictions dealt with BP, Transocean and Noble Drilling, that:

Over the course of the next 2 years, $10,000 invested in BP (NYSE: BP) at the closing price of June 16, 2010 will under-perform $10,000 evenly invested in Transocean (NYSE: RIG) and Noble (NYSE: NE). Assume dividends are not reinvested and remains as zero-yield cash.

At present, BP would have returned US$14,392.46 to investors, while RIG and NE would have returned US$14,198.52. If I had the ability to close this bet for a mild loss, I would – the political risk for the three companies in question have completely gravitated toward the “status quo” once again after the Gulf of Mexico drilling accident. Drilling capacity is likely to rise, depressing the value of the contractors and favouring BP in this particular bet.

Athabasca Oil Sands IPO – First day of trading

The first day of trading of Athabasca Oil Sands resulted in a 6% drop in valuation from $18 to $16.90. I had written about my quick researched valuation of the IPO in a prior post, and also said that I wouldn’t be surprised if there was a post-IPO “bump”:

Once this company does go public it would not surprise me that they would get a valuation bump, and other similar companies that already are trading should receive bumps as a result. I have seen this already occur, probably in anticipation of the IPO.

If you had to invest into Athabasca Oil Sands and not anywhere else, I would find it extremely likely there will be a better opportunity to pick up shares post-IPO between now and 2014.

This kind of surprised me in light of the fact that this was much touted by the media before it started trading and it was appearing as if there would be droves of retail investors that would pile into the stock (before it went down). Instead, it just went down from the start of trading:

Probably what will be even more affected by this drop in valuation is the valuation of other related oil firms, which might get sold off now that the hype has been extinguished.

Inevitably, Athabasca Oil Sands will be running net operating losses for the next four years, so investors will have to be very patient before they will see any dividends coming from their common equity.

Athabasca Oil Sands IPO valuation – summary

I am reading plenty of news how Athabasca Oil Sands is planning a very large public offering. According to their final prospectus, they will raise $1.35 billion @ $18/share of gross proceeds and about $1.26 billion net.

Since this got on the media’s radar, it should be a foregone conclusion that the option to purchase more of the offering will be exercised, so the final offering should be around $1.55 billion gross, and $1.45 billion net. The following analysis assumes the latter will be the case.

Note this is just a summary analysis. It only scratches the surface, but it covers what I figure are the salient details.

After the offering, they will have about 400 million shares outstanding, and assuming an $18 purchase price, this is a market capitalization of about $7.2 billion.

What exactly would an IPO subscriber be purchasing? This is why looking at the prospectus (all 288 pages in its full glory) is a valuable exercise. The company is a development stage company that has interests in a few tar sands near the Fort McMurray area of Alberta. They are currently not performing, but they are expected to come online in a few years, per the following schedule (page 8):

It would be reasonable for an investor to think this company will be producing net losses until around 2014-2015 when their oil sands projects come online.

After the offering, the company will have about $2 billion in the bank and about $400 million in long term debt. Thus, it will mostly be capitalized with equity and should have sufficient room to finish most of what they need to by 2014 – they will have to raise a little more money between now and then.

Page 78-84 of the prospectus contains some significant assumptions and analysis of the company’s estimated reserves. The first chart is based on a discounted net present value given the best estimates:

What this says is that if you have a 10% cost of capital and bought this company’s resources at the various sites for $11.2 billion, it would be a neutral decision. Of course, assumptions such as whether the company will be able to realize the “best estimate” or something better or worse is something for an investor to determine. Also, the following assumptions on future oil prices are made:

Roughly, it is assumed that (the media-quoted oil price source – there are different prices for different classes of oil) oil in 2010 will be US$80 in 2010; that the CDN/USD exchange will be 0.95, and that oil will increase $3/barrel until 2014, and then up 2% from there.

If projected oil prices are lower than this, you “lose” as an investor. If projected oil prices are higher, you “win”.

My quick take is that there are other companies out there using steam-assisted gravity drainage technologies to extract oil from tarsands. It takes a little (and I literally mean this; a little) research to figure out who those players are (beyond Suncor) and looking at their economic profiles. I can safely say that if I were offered shares of Athabasca Oil Sands at the IPO price, I would pass from a valuation perspective. From a market perspective, however, it would be worth considering strictly to sell it off at a post-IPO price. It kind of reminds me of the internet stocks in the late 90’s.

Once this company does go public it would not surprise me that they would get a valuation bump, and other similar companies that already are trading should receive bumps as a result. I have seen this already occur, probably in anticipation of the IPO.

If you had to invest into Athabasca Oil Sands and not anywhere else, I would find it extremely likely there will be a better opportunity to pick up shares post-IPO between now and 2014.