Keith Schaefer: Predicts Market Rebound After Solution to European Debt Crisis
Interview

The Energy Report: With this debt ceiling debate behind us now, the markets are frayed. What's your take on this across-the-board selloff that we saw the last week of July through the beginning of August?

Keith Schaefer: This is a normal crescendo of fear in the markets that we're getting each year or so after the financial crash of 2008. The financial crash of 2008 has prepared us for all the debt talk. The political system and the monetary system know what to do to get us out of this problem. It's the indecision in taking action that's causing all of the turmoil. Everybody knows that there needs to be a restructuring of debt where both the private and public sectors take a bit of a haircut and move on. I don't think that we're going to see a global recession that will have any huge impact on equity valuations.

TER: You just used two words that caught my attention: "restructuring" and "haircut." Are you talking about Europe—Spain, Portugal, Greece, Italy?

KS: Yes. Right now, the European situation is by far the most important driver of this stock market pullback. As soon as the market can figure out that it is resolved, the rest of the issues—the lingering U.S. unemployment, the high debt in the U.S, the declining dollar—will all be managed, maybe with a bit of pain, but they will be managed. It's the indecision and turmoil around resolving the European debt crisis that is giving us this problem. Once this gets done, and everyone swallows the medicine, you're going to see a pretty big rebound.

TER: How badly is this going to affect the oil and gas sectors and for how long?

KS: For natural gas, none of this economic turmoil is going to make any difference. Around the world, gas is still a relatively regional commodity that doesn't have any politics in its price. Natural gas prices and the market are completely insulated from all this political turmoil.

Oil is a completely different story. It's a very political commodity. It goes up and down with politics, if not more, as with fundamentals. I see oil having a bit of a range. The market and the world economy have said in very clear terms earlier this year that when oil gets to $120/barrel (bbl.), it starts to price in recession and the oil and gas stocks stop moving. I'm going to suggest that if oil does start to get up there towards $120/bbl. again, the market is going to start pricing-in a recession that will cause the oil price to come down. It might come down to $85/bbl. I think that the range is probably going to be a little bit higher. I see Brent and West Texas Intermediate (WTI) crude trading in a range here that's going to be somewhere between $90 and $110/bbl.

TER: You're talking about WTI coming down to $85/bbl.?

KS: I would love to see oil stay at $85/bbl. for the next two or three months for a couple of reasons. If oil can stay under $100/bbl. as we move into the Northern Hemisphere's heating season this fall, that would be great for oil stocks. One, it would convince the market that we're not going to see such a high oil price that the world will fall into recession again. That would give investors a lot of confidence in buying oil and gas stocks. Two, the valuation on the juniors has gone through the roof over the last year. Part of that is quite deserved because of the new technology of horizontal drilling and fracking, which has enabled us to get a lot more oil and gas out of formations and increase profitability of the sector. The valuations got very high. Now you're seeing valuations come back down to a much more historical norm. That is a great place for investors to reload on the junior energy stocks that have been beaten up. A lot of fear has come into the market and weeded out a lot of the weak holders. This is a great opportunity for investors to pick up some of their favorite stories very cheaply.

TER: Do you see this as a combination of value story and point of maximum pessimism?

KS: Yes. I say that cautiously because this pessimism and this value could still last for another one to three months. Personally, I don't think so. I think we're going to end up getting this situation resolved sooner than that.

TER: You tweeted on Aug. 4 that the put:call ratio was 1.2:1, which you said usually signifies a bottom.

KS: That particular ratio at 1:1.2 is a very strong, historical turning point for markets.

TER: Do you feel like there's a lot of cash on the sidelines right now?

KS: There is a ton of cash on the sidelines and not just for the market but also corporately. Corporate America, which is still by far the largest economy in the world with 25% of global production, is full of cash. And the buyside in the investment market is full of cash. So there is a huge opportunity to see a lot of sustained buying coming into the market. Fear and volatility mean that interest rates are going to stay very close to zero. People think economics is the main driver of the market, but that's not true. Cheap money is just as much a driver of the market.

TER: We're actually seeing a negative interest rate right now where the large deposits are being charged a fee by some of the money center banks.

KS: That's right. I just tweeted that. Everyone wants to go to cash, and Federal Deposit Insurance costs the banks money. So the banks are now charging clients to own cash. I think that's hilarious where they're saying, "We don't want your money." The market is saying, "You need to have your money in the stock market." There is just no incentive for investors to hold cash.

TER: You've written extensively about the Bakken as "source rock" and fracking to harvest the resources in the formations. Now we're starting to see more media reports about fracking, and they have been on the negative side. What will be the ultimate outcome of this added attention?

KS: The biggest outcome from all this added attention is going to be more regulation and more paperwork, which could translate into higher fracking costs. We've heard Obama talk about fracking a couple of times, so this issue is already at the highest levels of the U.S. government. Over the next year, we are going to start to see much greater regulation and paperwork. The flipside is that we haven't hit the limits on fracking yet. We're still improving that technology, not annually, but quarterly. That's the flipside, even though it's going to cost more to do all this fracking.

TER: Would you talk about some of your ideas that you've been telling your readers?

KS: I've been saying for several months to leg out of small, junior oil and gas producers and move into the energy services sector—the drillers, the frackers and the chemical companies. There's a whole supply chain of companies in sub-industries that supply a lot of equipment and manpower to the energy producer. New high-tech products coming out in these supply chain areas have fantastic financials. This is now the only sector that has pricing power in the market, and you're seeing energy service rates go up probably 5%–10% a year, and sometimes 5% per quarter. Demand is strong for these types of products because they increase the profits of the producers so much that the producers can afford to pay. These companies have a backlog of sales to the producers for probably the next three to five years, whether oil goes to $50/bbl. or $150/bbl. These energy services stocks take a lot of the risk out of the equation.

One of my absolute favorites right now is Open Range Energy Corp. (TSX:ONR). This is a very interesting hybrid company. It was a gas company, and it is still a gas company producing almost 4,600 barrels of oil per day (bopd.) of natural gas in western Canada. It has developed what it calls the Poseidon Concepts system that handles water and fracking fluids for producers. It allows oil and gas producers to hold large amounts of water in heated tanks. They're very cheap to install, cheap to build and they save companies two days of transport costs. This product is remarkably profitable for the company. Gross margins in its last quarter were 89%—unbelievable profitability. It's growing like crazy. I see that as an absolute must-have in the oil and gas sector. I'm buying the stock consistently at ever-higher prices because it could be a huge winner over the next one to two years.

TER: Open Range shares have more than tripled over the past 52 weeks. Even in the last three months, it's still up 26% even after this stock battering. Wouldn't this be one of the first companies that people would sell in this kind of environment?

KS: Not when you have that kind of profitability.

TER: You said 89% gross margin, right?

KS: On this frack fluid handling system, Poseidon Concepts.

TER: Another services company idea?

KS: One of my favorites is GasFrac Energy Services Inc. (TSX:GFS). The fracking companies right now are absolutely on fire. One of the larger companies in Canada, Calfrac Well Services Ltd. (TSX:CFW), just reported its Q211 numbers and beat The Street by almost double. That is almost unheard of, and it's still growing and increasing its capacity 48% this year. That's a huge growth curve, but the demand is there. GasFrac has a special, patented technology where it does fracking and horizontal drilling with propane rather than water, thus eliminating a lot of environmental problems. Water is expensive. There are water treatment costs and the regulation around water is going to get bigger and tougher.

I just love Canadian Energy Services and Technology Corp. (TSX:CEU), a company we mentioned in our last interview. The company has done so well. It just split the stock 3 for 1, so now it's only $12. The business is growing quickly. The management team has been so disciplined in its acquisitions, and its performance has been so strong in growing the business. It's just fantastic.

TER: Canadian Energy had been down about 8% over the past 12 weeks. Is it a value?

KS: It's both a value play and a growth play. It trades at a bit of a premium to its peers, but the growth curve more than justifies that.

TER: Is there a non-technology services play that you're following today?

KS: One interesting company is Black Diamond Group Ltd. (TSX:BDI). I don't own the stock because it's a $30 stock, but it's a nuts-and-bolts play. This team has been able to grow its business so strongly. Black Diamond was up 80% last year, and it is really doing a great job of providing high-quality accommodations to oil sands workers. Only a few years ago, housing for these workers was very rudimentary and not very pleasant, but the game has changed a lot. You better have nice accommodations and high-speed Internet because competition for the workforce is intense. Guys can just walk across the street and go work for a different company.

TER: Keith, what about international or global plays?

KS: Usually that's where the big risk-reward scenario is for investors because sometimes you are dealing with countries that have a little bit of extra political risk so you need to have a bigger prize in the ground to warrant spending the money. One of my favorites is Coastal Energy Co. (TSX.V:CEN). The company has been having huge success drilling wells in the Gulf of Thailand. It hit two big wells a couple years ago, and the stock had a great run before it fell off. Since then, its team has been able to figure out the geology and its last nine wells have all been successful. These wells have come in at greater-than-expected flow rates. This company is going to double production from 8,000 bpd. and that is slowly getting priced into the stock. It's a great opportunity for investors here with this pullback.

TER: What else are you looking at globally?

KS: Globally, one of my favorite stories has been Tag Oil Ltd. (TSX.V:TAO). This company has way outperformed all expectations. It was one of the first to discover an international shale play. It's in New Zealand, so it's in an Anglo-Saxon country with English rule of law. Tag Oil is about to drill their first big well into this asset, probably in November. So the market is very excited about this story. But in the two years leading up to this drill, it has actually been able to find a lot of oil, but mostly gas, in a different basin in New Zealand. Like Coastal Energy, Tag Oil has discovered a lot of oil and gas, almost more than 5,000 bpd., which will be brought on stream over the next 6–10 weeks. It is going to go from 1,000 bpd. to 6,000 bpd. over the next three months. Their high impact east coast shale play is thick; all the early indications are that it's going to be a Bakken lookalike. Of course, until the drill comes back on the first hole, we won't know.

TER: A domestic play?

KS: I think Painted Pony Petroleum Ltd. (TSX.V:PPY.A) remains a very strong story. The company has fantastic land packages in both the oil patch in the Bakken in Saskatchewan and in gas in the Montney play in Alberta. President Pat Ward has done just a fantastic job on assembling land packages and quality joint venture partners, and he's executed flawlessly. The stock has had a run from $6–$14 in the last year, but I can see this stock having even greater upside.

TER: You've been writing about companies drilling just outside the Bakken to tap into that.

KS: What I said on that topic is actually not on the periphery of the Bakken. It's an entirely new basin of Bakken play called the Alberta Bakken. The first few wells have come in with mixed results, but we're going to start to see a much larger number of wells get reported over the next couple of months. I really believe this play is going to be a winner. I've been telling my subscribers that they need to own some stock in this play. That would be companies like Primary Petroleum (TSX.V:PIE), which could have a fantastic run, if successful, in 2012; DeeThree Exploration Ltd. (TSX.V:DTX) on the Canada side; Argosy Energy Inc. (TSX:GSY); and Bowood Energy Inc. (TSX:BWD). They are all stocks that have medium to large land positions in the Alberta Bakken. If that play proves up as I expect it to, it could be very positive.

TER: Thank you very much. It's been enlightening.

KS: Thank you, too.

Also, we would like to extend a special offer to your readers—we're offering a free Oil & Gas Investments Bulletin report, which includes an exclusive stock pick—one that I believe still has lots of room for share-price growth, despite it more than doubling for my subscribers already. In addition, we're offering readers a 25% discount on current subscription rates for a limited time only. For more information on this special offer, please visit our website. The Oil & Gas Investments Bulletin generated 114% gains in 2009 and this year is on track to be another winner!

Keith Schaefer writes on energy and junior energy stocks in a simple, easy-to-read manner. In his newsletter, the Oil and Gas Investments Bulletin, he finds the fastest growing producers and energy service companies for his subscribers. The new shale discoveries plays are steadily creating new opportunities for investors.

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DISCLOSURE:
1) George Mack 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 in the interview are sponsors of The Energy Report: Primary Petroleum.
3) Keith Schaefer: I personally and/or my family own shares of the following companies mentioned in this interview: Bowood Energy Inc., DeeThree Exploration Ltd., Primary Petroleum, Painted Pony Petroleum Ltd., Coastal Energy Co., GasFrac Energy Services Inc., Open Range Energy Corp., Canadian Energy Services and Technology Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None.