Oil Distribution Hiccups Will Be Resolved: Alistair Toward
Interview

The Energy Report: As the oil and gas analyst for PI Financial, you have your finger on the pulse of this industry—both in the U.S. and Canada. What are the dominant market forces right now, and what trends may unfold over the next year or two in this sector?

Alistair Toward: On the oil side, we do have a bit of a dilemma right now with regard to differentials for West Texas Intermediate (WTI) as well as various Canadian products. Just south of the border in North Dakota, for example, today there is about a $30 discount to WTI, which is in turn about an $18 discount to Brent. That's a huge differential, and it doesn't take a massive amount of imagination to see these disconnects being resolved, even with the environmental issues surrounding getting the necessary pipeline infrastructure in place. We do strongly believe that this problem will be resolved and we think investors should consider buying oil inventories while they are still available at a discount, particularly light oil.

Gas is a totally different situation. The advent of a multistage fracking technology has probably added five decades or more of low-cost inventory. There's no easy way to get out of the gas pricing box. I would also caution investors who are lulled into any false sense of security with companies that are pursuing the liquids-rich component of gas, expecting that the liquids component will raise their bottom lines.

A 20% liquids component used to be a good place to be, but now 30% is the economic cutoff. Recent wells in the Duvernay are testing at 50% liquids, so any inventory that doesn't meet the new threshold is at risk of not being commercialized. Companies have taken on a lot of debt building these inventories and much of these inventories are not going to be pursued any time soon. So I think there's still a lot of heartache ahead for some of the gas players, including some of the liquids-rich gas players.

TER: Is the sizable discount in North Dakota due mainly to abundant supply and a lack of distribution?

AT: That's right. Companies once used railways to distribute additional supply. But because there's such a discount to WTI and Brent, people are taking oil off pipelines all over the place and having it ride rails to capture that discount. This has created a shortage of rail car capacity and driven up the price for shipping. That situation will be fixed. Count on it.

TER: Are producers able to cut back on production on these wells? Or are they locked into producing whatever the wells yield?

AT: It's a combination of both. The escalation in these cost structures is causing some activity slowdown. But it doesn't change the fact that producers have a massive opportunity to tap these deposits. It just takes some plumbing.

TER: Are there any strategies investors can use at this point to play the natural gas market, or is it a sector they ought to simply stay away from?

AT: Consider what investments will benefit from a low gas price as opposed to investing in gas players alone. Unfortunately, there is no Western Canadian petrochemical business to speak of that you can invest in, and even still, that business is based heavily on the ethane component, which hasn't changed much. I would consider opportunities such as thermal heavy, because that uses natural gas as an input. The cost structure has never looked better than it does today for those companies. Furthermore, the gas that's created is producing a lot of condensate, which is what we use to transport heavy oil. Players like that will most likely be beneficiaries of low gas prices, which we can expect for the foreseeable future.

TER: What are other sub-products that are produced from gas production and how are those markets doing?

AT: In Canada, there is a product called C5+, which trades at a discount to WTI. It can be used to make gasoline and it's also used as a dilutant in fracking fluids and a variety of other products. It's quite valuable. In the U.S., some of the companies produce quite a bit more propane as a component of their liquids. One of the issues with propane is that it traditionally traded at, say, 60% of WTI. Lately it's trading as low as 40% of WTI. I'm not sure whether that's a new pricing paradigm or just another byproduct of a really warm winter, but it has an impact on some of our companies.

TER: How are gas producers attempting to cope with this pricing environment? Do they have brighter times ahead?

AT: There's been a massive shift toward liquids-rich components, or even just pursuing oil. The challenge is that oil is a very capital-intensive production. Many of the new plays exhibit really rapid initial declines and weak gas prices have cut the cash flow available for reinvestment, which has slowed the pace of activity. Some of these companies that have been going at it very hard with a lot of rapidly declining production are feeling the pinch. Many companies have relied too heavily on debt in the past, and that is going to be a concern with tightened credit lines.

The bigger concern we see is lost value because the market is discounting the inventories that have been assembled when they don't get drilled. That applies not only to natural gas, but even to large light oil inventory.

TER: What do you look for in promising oil and gas investment situations?

AT: At this point, I'm biased towards the validation opportunities and we're always looking for management teams that are chasing the next big opportunity, as opposed to what's already hot. There are risks associated with this and it's possible to get in too early. There's been a bit of reluctance and a move away from higher-risk endeavors of all sorts. This has worked against us a little bit, but I still think there are opportunities with big rewards.

TER: What's the general market performance been like for Canadian juniors relative to the price of oil, and is this a good time for people to be buying?

AT: I'd distinguish between oil opportunities and gas opportunities. It certainly is a good time for oil opportunities. The number of companies out there with attractive light oil inventories is getting smaller by the day. Companies like Crescent Point Energy Corp. (CPG:TSX), with its very low capital costs, are able to pay big premiums for these inventories, and light oil producers are getting taken out at a pretty rapid clip. This is a trend investors should definitely be paying attention to. Companies have certainly underperformed relative to WTI or Brent prices, but some of that relates to pricing differentials. Again, we expect solutions to come over time.

TER: How soon do you think those solutions might come?

AT: I think you'll see staggered improvement, because right now some of the pricing discrepancies are a function of refinery turnaround. Later into the spring, the Seaway pipeline reversal should take effect, which should provide a bit of an uptick, allowing more crude out of the Cushing, Oklahoma storage hub. This will be staged starting with the approval of the southern portion of the XL pipeline, which will remove more of the glut. Longer term, I expect the full XL pipeline to come on-line. Still longer term, Canada may potentially expand its own exit capacity with lines to the Pacific. But that's a more challenging undertaking.

TER: Let's talk about some of the companies you follow. Who do you like and why do you like them?

AT: I definitely like Arcan Resources Ltd. (ARN:TSX.V), which fits into the mix of companies with a very high-quality light oil inventory. In fact, Crescent Point has recognized that and taken a large interest in the company already. With high-quality inventory, it's just a matter of time before a company gets taken out. Yet Arcan's share price is still good, so we would suggest that it's definitely a worthwhile investment.

TER: What sort of a price target do you have on it?

AT: We're carrying $10, but it depends on timing. The longer this company is around, the higher it will go because it's rapidly adding production. Providing it doesn't stumble anywhere, the share price could go higher.

Another smaller company we really like is Palliser Oil & Gas Corp. (PXL:TSX.V). It's pursuing heavy oil production at much higher-than-average rates. This also results in much higher water production, which needs to be disposed of. This was kind of a storied stock with a high multiple, which was a function of good strategy and a very impressive growth track record. Last year, the share price fell off when its operating costs inflated as a result of producing a lot of water that had to be trucked and disposed of in third-party facilities. Now the company is internalizing its disposal requirements and will be self-reliant. That's going to make a huge difference in the cost structure. I think there's a real opportunity here as the market recognizes Palliser's good strategy and its ability to show a lot of cost-effective growth.

Another light oil company we like is Strategic Oil & Gas Ltd. (SOG:TSX). In the past year the stock's been relatively stable, and the market recognized the opportunity at Maxhamish property, which the company has been slowly pursuing. Another company, Legacy Oil & Gas Inc. (LEG:TSX), has taken over as operator. In the meantime, Strategic has been forging ahead on its Steen River property, and that's basically taken the production from 300 barrels of oil equivalent per day (boe/d) to about 2,400 boe/d in about 15 months.

That momentum is eclipsing the potential we see in Maxhamish, but the market hasn't really given the stock enough credit for its achievements at Steen. Again, this is predominantly light oil and very efficient from an investment standpoint. Most of these wells cost $1.5 million (M), and Steen is coming in at rates of considerably better than 150 boe/d. It's been a very impressive program.

TER: Are these three companies cash-flow positive?

AT: They're all cash-flow positive.

TER: What other opportunities interest you?

AT: One I'd like to point out is Equal Energy Ltd. (EQU:TSX; EQU:NYSE), which falls into the liquids-rich category. Yet it is different in that, for some time now, it has been going at it slowly with very stable production and doesn't suffer a lot of the deceleration issues that some of its liquids-rich peers face. It has abundant borrowing capacity and no major bullet payments until 2016. The company is trading at such a discount to its net asset value (NAV) that if you take only the proved components of the NAV, throw away the value assigned to the gas in that component, give nothing for the land and divide by the share price, you're close to where the shares are trading today. So there's a lot of inventory there, mostly light oil, that is not being recognized.

TER: Any other diamonds in the rough?

AT: There's Sonde Resources Corp. (SOQ:NYSE), which is a bit complicated right now because it's got lots of opportunities, both international and domestic. I think that combination presents a bit of a challenge as the company decides which strategy to embrace in the coming months. I think this dual strategy has caused a discount because it creates uncertainty for investors who prefer one or the other but not both. Sonde definitely has an exciting Duvernay shale opportunity in Canada, as well as an opportunity in Montney oil. It also has an opportunity in North Africa, where it is in the process of looking for a buyer or a joint venture partner for that asset. If it ends up selling that asset, it would have lots of capital after the Duvernay. It already has $54M in cash on its balance sheet. I think with greater clarity in the corporate strategy, higher market valuations will come.

TER: How would you summarize your investment theme right now?

AT: I would encourage investors to be cautious with regard to the value of natural gas inventories that companies have on their books. There's an awful lot of inventory out there. There is, however, a real scarcity of light oil, regardless of the pricing. To the extent that the market discounts these as a result of the current pricing environment or the weak market, investors should be really looking at those light oil opportunities. Actually, both light and heavy oil opportunities are worth consideration.

TER: Do you have any sort of target time here when you think the whole market may turn around for these junior stocks? Or does it depend on a whole lot of different factors?

AT: I think on the gas side, we're not really looking for a big turnaround. In fact, some players with exposure to the very liquids-rich gas, particularly the Duvernay, could perform well. For the majority, I think there's more heartache ahead. On the oil side, already we're seeing some companies perform very well. I don't cover it, but TriOil Resources Ltd. (TOL:TSX.V) has almost tripled since November. I think there are still lots of opportunities on the light oil side—although those players are not as numerous as the gas players.

TER: Where do you see the oil price heading? It looks like there may be some resistance at around $110/bbl. Will it take a substantial move above that to effect stock performance?

AT: It depends on whether you're talking about Brent or WTI. The world price of oil has a lot to do with the uncertainty in the Middle East. Our ability in North America to catch up to the world price has everything to do with the distribution issue we've talked about. The important point is that I don't think we're going to get to a point where oil producers are going to be suffering economically if oil prices go down. However, the liquids-rich gas players are already near the margin and could be hurt by a declining oil price. Oil could go much higher given the geopolitical situation, but even if it goes lower, oil producers will fare quite well. They're already facing these challenges now, as a result of price differentials.

TER: We appreciate your input today.

AT: Thank you.

Alistair Toward joined PI Financial Corp.'s Calgary office in April 2010 focusing on junior to mid-size domestic energy companies. Alistair brings over 16 years of financial and industry experience to PI, including 10 years as an oil and gas analyst. He began his analytical career with Gordon Capital/HSBC. He also covered the explorer and producer segment at Research Capital, Clarus Securities Inc. and most recently, Thomas Weisel Partners. Toward has a Bachelor of Arts degree in communications from McGill University and is a Chartered Financial Analyst.

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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 in the interview are sponsors of The Energy Report: Equal Energy Ltd. Streetwise does not accept stock in exchange for services.
3) Alistair Toward: 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 a small retainer by the following companies mentioned in this interview: None. I was not paid by Streetwise for participating in this story.