Sweet Spots in a Patchy Oil Price Landscape: Frank Saldana
Interview

The Energy Report: What's your analysis of the U.S. oil market, and do you expect sharp price differentials to continue far into the future?

Frank Saldana: It certainly is confusing and volatile, not just to average investors but to professionals as well. On the oil front, conflict with Iran has taken oil prices higher in this election year and caused speculators to get even more involved in the game. West Texas Intermediate (WTI) oil has disconnected from the price of Brent and some people argue that WTI isn't as relevant a benchmark as it once was.

Increased Canadian heavy oil production, as well as surging Bakken production has resulted in robust storage levels at the Cushing Oklahoma terminal. Cushing has limited distribution to certain refiners on the Gulf Coast that have had to import oil that is priced off premium Brent crude. Louisiana light, for example, often receives a substantial premium. One of the companies I cover, Saratoga Resources Inc. (SARA:NYSE.A), gets crude pricing based on Louisiana light, which is at times $20 or more above WTI.

If the Keystone Pipeline ever comes to fruition, it will alleviate some of the problem. A nearer-term partial solution would be the reversal of the Seaway pipeline, which Enbridge Inc. (ENB:NYSE) announced last year. That could cause a net differential of 300,000 barrels (bbl) of oil out of Cushing into the Gulf Coast. Some refiners have instituted capital projects to process heavier crudes from Canada. As they gain more access to these discounted crudes, they should have less need to buy crude that is priced off Brent, which could also eliminate some of the price differential between WTI and Brent.

Natural gas is a whole other story. The fundamental landscape is terrible right now. Even a normal injection this season would cause gas in storage to hit capacity limits—there could literally be nowhere for the gas to go.

Some big natural gas players, like Chesapeake Energy Corp. (CHK:NYSE), Encana Corporation (ECA:TSX; ECA:NYSE) and Ultra Petroleum Corp. (UPL:NYSE), have announced that they intend to cut back production, but I don't think it's happened yet to the extent that makes investors comfortable that the market can recover within the next 12–24 months.

TER: How does the big differential between oil prices and gas prices influence the focus of your research?

FS: A lot of investors are focusing more on companies with oil rather than natural gas. One element that has helped some natural gas producers has been natural gas liquids (NGLs), which are by-products of the gas stream. NGLs, such as propane, butane and ethane, tend to receive average pricing of about 40–50% of WTI, which amounts to about $40–50/bbl. This has greatly enhanced the economics, given the weak natural gas prices we've seen lately.

Exploration and production (E&P) companies that are oil focused are getting better valuations now, especially if they have a lot of acreage on some of the hotter oil shale plays, such as the Eagle Ford and the Bakken. Companies with NGL components to their production are also getting better valuations.

TER: You mentioned Saratoga, on which you've recently initiated coverage. What's the story on that company and why did you decide to start covering it when you did?

FS: Saratoga is a conventional company in an unconventional world. Everybody nowadays is shale driven and horizontal driven, for the most part. You don't see too many companies anymore that are still focusing on conventional plays with vertical drilling. Saratoga is one of those.

It was under the radar for a lot of investors, but has had pretty nice production ramp-ups with a good mix between natural gas and oil on both production and reserves. In Grand Bay, one of the company's key areas, there have been over 60 historically productive zones. On deeper exploratory tests, the abundance of pay zones allow for what Saratoga calls "bailout" prospects, or shallower sources that can potentially make up for any deeper exploratory failures.

In November, the company announced production at 3,500 barrels of oil equivalent per day (boe/d), of which 60% is oil. The late-March production rate is up to 4,200 boe/d. The market likes the oil component in its production even though 60% of its reserves are natural gas.

Saratoga also has some promising prospects that it's going to try to develop using a joint venture (JV) partner. One of these prospects, Long John Silver, is near some potentially lucrative acreage held by McMoRan Exploration Co. (MMR:NYSE), and Saratoga is actually in JV negotiations with McMoRan. Even though it's mostly natural gas, these prospects are big enough that even if only 10–20% comes in as oil, that would make a material difference to a company the size of Saratoga.

In early December, the company announced it was in negotiations with McMoRan, and the stock had a huge run-up of about 25%. I initiated with a price target of $10, and we recently upgraded our price target to $11.50 based on our NAV estimate of $11.70.

TER: Does it produce from multiple pay zones at one time?

FS: No, it produces from one zone for a little while, and then it pulls up and produces from another zone. It does not typically commingle zones.

TER: After last year's big disaster in the Gulf, what's the current regulatory situation for offshore drilling? How does that affect companies like Saratoga?

FS: This doesn't affect Saratoga because its acreage is in the transition zone on the Louisiana coastline, and is subject to state regulation only.

That said, the Gulf is a frustrating environment. A report late last year by a group out of New Orleans said the Bureau of Ocean Energy Management, Regulation and Enforcement (BOEMRE) approved only 35% of oil-drilling plans year-to-date in 2011. They used to accept about 75% of drilling plans in the region prior to the BP incident. The average time to approve or make decisions is 115 days, compared to 61 days previously.

There is more rigorous testing now for blow-out preventer equipment and companies have to develop more rigorous environmental contingency plans. In shallow water there's been some improvement in the drilling permit approval, but in the deep water, I read that they're allowing five permits per month, whereas before the BP disaster they were approving something like six per month.

TER: What are the prospects for gas producers these days in the current pricing environment and how do you decide which ones look attractive under the circumstances?

FS: The switch over the last 10 years from conventional E&P strategies to shale-based, acreage-based ones required time to gather the science and the acreage and to figure out the best drilling and completion techniques. That's what's referred to as a learning curve. The Eagle Ford and Bakken, for example, have worked out well for the majority of E&Ps involved there. Even the smaller E&P companies have done a good job of gathering the science and learning how to complete wells more efficiently.

When I look at a company, I want to see the acreage in the right areas. But companies can't simply do location math based on spacing and calculate potential recoverable reserves according to what other companies are saying. They eventually have to show some acceptable results from their own drilling efforts or the market will punish them sooner or later.

I look for an attractive inventory of drilling locations, as well as production that is ramping up at a reasonable pace. I want to see the wells exhibit shorter drilling periods and increasing initial production rates over time. Companies that the market favors tend to have these characteristics in conjunction with acreage and an inventory deep enough to last several years. And, of course, oil versus natural gas also helps a lot in this environment.

All in all, I tend to take an asset-value approach. Initially, some of the metrics are going to look rich, whether it's price-to-earnings or price-to-cash-flow. However, as companies start ramping up, the multiples should compress to more rational levels. In the meantime, if a company can just keep proving itself along the way, the market should continue to give it the benefit of the doubt.

TER: What are some stories that you like at this point?

FS: One I really like is Approach Resources Inc. (AREX:NASDAQ). It's a West Texas play that was initially gas-heavy, but it is getting a lot oilier, with a nice NGL component as well. Its big play is Wolfcamp Shale, an oil play, as well as the Wolffork Shale, where the company is pursuing a vertical strategy.

Approach fits that mold I was just talking about, with over 140,000 net acres out in the Wolfcamp/Wolffork. It's in the same backyard with the likes of ConocoPhillips (COP:NYSE) and other large players such as EOG Resources Inc. (EOG:NYSE) and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK). Its acreage position is sizeable enough that it could move the needle for some of these larger companies.

It's had some nice horizontal results in Wolfcamp. The first four pilot production tests averaged 377 boe/d. By Q311, it had a set of three pilots that averaged almost 900 boe/d. The latest four wells, which they announced recently, averaged 919 boe/day.

So it's really shown improvement and it has a deep inventory with almost 400 more locations in the horizontal Wolfcamp. We estimate each location has the potential to hold 330,000 boe on average, post-royalty. At an estimated in-ground present value of approximately $7.50/boe, we think the Wolfcamp could be worth almost $1 billion.

Approach's Wolffork vertical inventory is also deep. I'm only giving it credit based on a 10-year drilling program of 211 net vertical locations, whereas the company says it has 1,800 gross locations out there. In this case, we're using about a $9.50/boe present value. Our all-in NAV is $55 per share. If a major or large independent were looking to acquire Approach, it could drill both the Wolfcamp and the Wolffork targets quicker, which would enhance the present value of these wells. If we were to start giving more credit to the entire vertical program in the Wolffork, it could potentially add another $15–20.

The stock has done well and it tends to run up into the earnings call because investors are anticipating the release of its latest horizontal Wolfcamp wells. Management is moving at just the right pace relative to my expectations.

TER: Are there any other companies you like?

FS: Another area heating up is the Niobrara play in the Rockies. The area with the best exposure to the Niobrara has probably been the Wattenberg, which is a mature field with historical success rates of about 99%. If you poke a hole, you're going to get something there. Now companies are focusing on the Niobrara zone, along with the Codell zone, within the Wattenberg.

Anadarko Petroleum Corp. (APC:NYSE), Noble Energy Inc. (NBL:NYSE) and Petroleum Development Corp. (PETD:NASDAQ) are some of the E&Ps ramping up activity in the Niobrara portion of the Wattenberg. They've issued some impressive estimates of potential reserves per horizontal location in the Niobrara and Codell zones. These estimates currently range from 300,000–600,000 boe per well. One company we cover that is right in the heart of that play and is partnered with Noble and Petroleum Development on some horizontal wells is Synergy Resources (SYRG:NYSE.A). It has over 10,000 net acres in the Wattenberg. I've got a price target of $6.50 on it.

For the most part, Synergy is focusing on vertical wells even though it's right in the heart of what is becoming a horizontal play. It's participating in some horizontal wells, but still taking a vertical strategy to drilling these wells. As the results start coming in from some of the other major players like Anadarko and Noble, investors could start looking at the prospects for Synergy as if they were valued on a horizontal basis rather than a vertical basis. Synergy has yet to indicate it plans to implement a 100% horizontal drilling approach to this play, but if it did, I could see the NAV showing some nice improvements, assuming horizontal results come in as expected from industry players.

Right now it's just poking holes and seeing some production momentum. The stock's been in the $3–3.50 range lately, but as the horizontal results keep coming in from the likes of Anadarko and Noble, among others, you'll see more attention focused on Synergy and what it could be worth if it were valued on its horizontal potential rather than vertical.

TER: What about companies in the services businesses? They can always make money regardless of oil and gas prices.

FS: Right. There's been incredible demand and tightness for fracking services as more and more E&Ps drill horizontal wells that sometimes involve 25–40 fracking stages per lateral well. The smaller E&P guys have suffered in terms of access to services because these service companies want to be able to get long-term contracts with substantial repeatable work so that they can concentrate their efforts geographically and lower their costs.

I've heard recently that the Haynesville shale experienced about a 70% decline in proppant sales because everyone's bailing, given the gas price situation. Many of these service companies are now trying to reallocate their fleets and their resources to areas that are oilier or have NGLs in the gas mix, and pricing has come down a little bit.

TER: So who do you like in that business? Obviously they've got to be making some money these days.

FS: Well, I don't cover services specifically, but I do cover Unit Corp. (UNT:NYSE), which is a hybrid energy company. It has an E&P arm, a mid-stream business and its own rig fleet that is, for the most part, contracted out to other E&Ps. It hasn't seen any drastic reduction or change to its rig fleet utilization, which has been hovering around 60–65% for some time. Pricing has held up as well.

TER: Is this the old Unit Rig and Equipment Company from many years ago?

FS: It is. And I cover the stock thinking that the sum of the parts is obviously greater than what the market indicates. I don't think it has ever really seriously looked at breaking up the company, but I have a $75 price target on it. Its mid-stream business is growing, as it has been focusing on areas where operators have been growing NGL production. I see a valuation disconnect with Unit. Either the reserves are priced right, or the rigs are priced right, but not both. If that ever corrects itself, I think it's a $70–80 stock.

TER: What general thoughts would you like to leave with our readers on how to best play the current oil and gas markets?

FS: I think investors should focus on oil situations trading close to the proved NAV with potential upside from acreage in the right shale plays. As mentioned, companies that have impressive inventories and core acreage should do well, provided they show operational efficiency.

As far as natural gas is concerned, there's always been a self-correcting mechanism in the natural gas market that typically corrected itself much quicker than we're seeing now. The old saying is, "the solution to low prices is low prices and the solution to high prices is high prices." There's going to be some pain, but eventually the situation will correct itself.

It'll be tough to time it, but if you can, there's some nice money to be made on the natural gas side. There are some E&Ps with a natural gas focus that are really solid, with seasoned management teams. We've seen some people even looking for dry gas acquisitions in this environment. That tells me that maybe the smart money is getting ready to get involved in a serious way. But it's a horrible picture right now and it's going to take longer than usual to turn around.

TER: Thanks for your insight today.

FS: I appreciate the opportunity.

Frank Saldana is a senior E&P analyst for CK Cooper and Co. He has over 11 years of experience covering energy stocks, both on the buy side and sell side. He got his start at Credit Agricole and then Credit Lyonnais, focusing on E&P companies. He has also covered energy at several hedge funds, including Bonanza Capital, where he was a director for energy and natural resources.

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DISCLOSURE:
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.
2) The following companies mentioned are sponsors of The Energy Report: Saratoga Resources Inc. Streetwise does not accept stock in exchange for services.
3) Frank Saldana: 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 for participating in this story.
4) At the time of this report C. K. Cooper & Company has not provided investment banking services to Saratoga Resources, Inc., Double Eagle Petroleum Corp. or Unit Corp. within the past 12 months. C. K. Cooper & Company may solicit future investment banking business from the companies covered in this report, which could result in the payment of investment banking related fees. As of the time of this report, the covering analyst and or his family does not have an ownership position in Saratoga Resources, Inc., Double Eagle Petroleum Corp. or Unit Corp. As a policy, C. K. Cooper & Company does not allow its analysts to own the securities they cover. C. K. Cooper & Company does make market for Saratoga Resources, Inc., Double Eagle Petroleum Corp. or Unit Corp.