The Energy Report: Let's start with your macro forecast. What lies ahead for oil and natural gas?
Tim Murray: The nice run in oil the last few months has not been generally reflected in the Canadian junior or small-cap space, and only a little bit among the oilier mid caps. Currently, the key theme is volatility in Canadian differentials to West Texas Intermediate (WTI). Recently, Western Canadian Select (WCS), a heavy oil benchmark, has traded at a $40 discount to WTI, nearly double the traditional differential. In addition, the differential between Edmonton Par, a light oil benchmark, and WTI has widened, and we fully expect volatility to continue this year for both light and heavy oil benchmarks. Limited pipeline takeaway capacity for oil has led to a resurgence in railcar transportation to move crude to key refinery markets. While we like the long-term prospects for heavy oil and are buyers on weakness presented by the widening differentials, we are looking for more normalized price levels in H2/13. The three names with the largest heavy oil exposure in our coverage universe area are Baytex Energy Corp. (BTE:TSX; BTE:NYSE), BlackPearl Resources Inc. (PXX:TSX) and Palliser Oil & Gas Corp. (PXL:TSX.V).
As for natural gas, we're pretty much through the bulk of the heating season and I don't expect a big run in natural gas at this point. I've always talked about a $4.25–4.50 per thousand cubic feet (Mcf) cap, and the price got pretty close to $4/Mcf at one point. Looking at the summer months, we don't expect sub-$2/Mcf prices again. It could drift south of $3/Mcf, but I expect a range of about $2.75–4.
TER: Do you think WTI will stay over $90/bbl or is there a chance it might still dip down into the eighties again?
TM: We fully expect oil prices to be volatile again this year and continue to be comfortable with our $80–100 per barrel (bbl) range.
TER: What's been going on in the oilfield services sector?
TM: Our services analyst Jamie Murray at Desjardins Securities has been more bullish on the space in the last month or so and feels that a bottom is taking place. His favorite name in the space is Trinidad Drilling Ltd. (TDG:TSX). He also likes any companies with international exposure because there are a lot of growth prospects in that space and valuations still look good. As for the Canadian space, most of those companies have good, clean balance sheets and pay a dividend, but need activity levels to improve before adding significant capacity to their existing lines.
TER: What's your assessment of the move by some junior producers to start paying out larger dividends in hopes of attracting greater investor interest?
TM: There's definitely been a movement toward that in the Canadian explorer and producer (E&P) small-cap environment. Three names in my coverage universe have recently moved to this model: Whitecap Resources Inc. (WCP:TSX.V), Renegade Petroleum Ltd. (RPL:TSX.V) and Equal Energy Ltd. (EQU:TSX; EQU:NYSE). Moving to a dividend has attracted new yield-hunger investors.
The main reason companies are moving to the dividend model is the increased capital available to them. On average, dividend E&Ps are receiving higher multiples than their peers, and this advantage allows them to be very active in acquiring assets, which is a key component for the dividend model.
Whitecap is a good example. The stock has traded up since it announced its dividend and has outperformed its peers, giving it a stronger cost of capital on a relative basis. With a better cost of capital, we fully expect the company to transact on some assets this year. In addition, if Whitecap can transact on a larger asset and acquire it accretively, we feel there is a good chance it will increase the dividend, which should attract additional investors.
The key for the dividend model is to show long-term sustainability, and we believe Whitecap has devised this model. Whitecap has also been one of my better small-cap stocks (up ~35%) since the summer. It has now moved to the dividend model, so you get a ~6% yield with, hopefully, a ~3–5% growth rate, year over year. I continue to like the prospects going forward. We recently moved Whitecap to a Buy from a Top Pick due to the outperformance compared to peers. The jury is still out on Renegade and Equal.
TER: What other companies have been good performers?
TM: Spartan Oil Corp. (STO:TSX) has recently merged with Bonterra Energy Corp. (BNE:TSX) and has been one of the best small-cap performers since August (it's up ~50%). I started covering the stock in the $2.50 range and it went out at about $5.50, so it was an excellent performer.
Strategic Oil & Gas Ltd. (SOG:TSX.V) has been one of my best-performing junior names. It was around the $0.65 level last time we talked and is now around $1.20. I actually have a Hold on the stock now, due to price appreciation. A lot of news will probably come at the end of this quarter on its two light oil resource plays targeting Sulphur Point and Muskeg Stack, which should impact the stock.
TER: Last time you talked about Equal Energy's strategic review. Where did that end up?
TM: Equal sold all of its Canadian assets, so it's a U.S. company focused on the Hunton play in Oklahoma. On the back end of selling those assets, it declared a dividend and now has a squeaky-clean balance sheet. We estimate a year-end 2012 working capital surplus of about $20M. However, propane pricing at Conway is trading at historic lows, at ~35% of WTI and needs to move much closer to the 50% range in order for Equal's model to be sustainable in the long term. We expect propane prices at Conway to revert back to more typical levels in late 2013 or early 2014, so the dividend model should work in the long term. Due to the excellent balance sheet, we see no dividend risk this year. We have a $4.25 target on the stock.
TER: Is it going to be out on the hunt for new projects?
TM: I expect Equal to make what we call "bolt-on" acquisitions, where it buys a couple of sections of land or a small private company in its key Hunton play. We currently do not see the company making any large acquisitions.
TER: What other companies are on your radar right now?
TM: I don't cover Bellatrix Exploration Ltd. (BXE:TSX), but it did a big JV recently for $150M with a Seoul, South Korea-based company. That's obviously shored up some access to capital and the stock reacted very favorably. We expect more of that to happen as international money flows to the basin, with the government of Canada giving the green light to more international investment in the sector.
Novus Energy Inc. (NVS:TSX.V) is currently in a strategic review process. Its headline asset is the Viking play in the Dodsland area of southwest Saskatchewan. The stock has moved up nicely, trading recently between $1.05 and $1.15. Everybody is expecting an outright sale of the company or a spinout of some assets, which the current management team would administer. We believe the company is worth $1.20 to $1.40. If a buyer really wants the assets, the stock could easily climb to the upper end of that range.
TER: Which other situations look like they have some decent upside?
TM: Two names that I've recently moved to Top Picks are Surge Energy Inc. (SGY:TSX) and Pinecrest Energy Inc. (PRY:TSX.V). Both stories have been very poor performers recently. Pinecrest has been under pressure since its failed attempt to merge with Spartan. I continue to like the company's key light oil resource asset targeting Slave Point at Red Earth and the company is initiating a number of waterfloods this year that could impact corporate declines positively. If these waterfloods work, it should work across its entire suite of assets at Red Earth and dramatically bring down corporate decline rates. We have a $2.85 target on the story.
Surge is down over 30% this year and has turned into a value play, as it's trading right around our calculated proven net asset value. You essentially receive the probable reserves for free, which we think is terrific value for what has traditionally been a name that has traded at least in line with peers. One concern some investors have is the company's balance sheet, which is more leveraged than its peers. However, we see no minimal balance sheet risk with the company due to its recently increased bank line and strong hedge book. We feel Surge is too cheap, considering its strong management team and growth prospects. We have an $8.50 target on the story.
TER: A couple of other companies in your coverage universe are Arsenal Energy Inc. (AEI:TSX) and TriOil Resources Ltd. (TOL:TSX.V). What's the status on those?
TM: Arsenal recently announced it expects to be free-cash-flow positive by year-end on its Bakken assets in North Dakota and is exploring ways of returning some cash back to shareholders. The market did respond positively to this news and we believe there are two options: Pay a small dividend or, potentially, spin out the U.S. assets and pay a dividend. I definitely would like to see its balance sheet cleaned up if it goes to a full dividend model of a 6–10% yield, as the market is really focused on sustainability. We do not believe the market would react favorably if the company were to pay only 2–3% yield. We'll have to see what develops and we currently have a $0.70 target price on the stock.
I just initiated on TriOil in January. It has two light oil resource plays. The Dunvegan play at Kaybob is just beginning to be developed as TriOil and other operators have been drilling for just over a year with very good results to date. TriOil's other key light oil assets are at Lochend, targeting the Cardium. Equal recently sold its assets at Lochend for almost $120,000 per flowing barrel, or $5 million per section, which is on the upper end of light oil transactions. TriOil has the largest land package in the area (70 net sections), although a lot of that is outside the "sweet spot," where Equal sold its land, so it's not going to fetch quite the same numbers for the unproven acreage.
The last couple of weeks have been an interesting time for TriOil. An activist shareholder in Calgary, who owns ~5% of the stock, sent a letter to the board asking for a strategic review process, and last week TriOil responded by putting together a special committee to consider additional means of enhancing shareholder value. The stock reacted positively on the news and we believe a potential takeover price is in the $4.00–4.75 range. If somebody really bids aggressively, I could easily see that being pushed to the high fours.
I also like Marquee Energy Ltd. (MQL:TSX.V), which we have not talked about previously as I only recently started covering the company. I like the asset package the company has developed at Michichi targeting the Banff and Mannville formations. It currently has access to 118 net sections and is one of the most active players in the region. The play is just beginning to take shape and it has seven horizontal wells planned this year. If Marquee continues to post positive results, we would expect material production and reserve adds. We also expect Marquee to continue to sell non-core assets and deploy the proceeds into Michichi. We currently have a $1.55 target price.
TER: To conclude, Tim, where do you think investors can make some decent money this year?
TM: We definitely think being selective on stocks is one key element, considering the wide range of stock returns in the E&P space. We continue to see good value in the small-cap space and highlight Surge, Pinecrest and Whitecap. If you have the stomach for a bit more risk, we would highlight Marquee and TriOil in the junior space.
We continue to look for juniors that have good growth strategies that are actually building out their core areas as opposed to selling them off. Being one of the bigger players in an area makes a company more attractive as an acquisition target. As always, it's important to have a strong management team with a good vision of value creation through either the drill bit or acquisitions. One name we would highlight is TORC Oil & Gas Ltd. (TOG:TSX).
The junior space in Canada has traded cheaply for about 18 months and as long as commodity prices stay at these levels, we think investors will slowly move back into the junior space.
TER: We appreciate the opportunity to talk with you again Tim. You've given us a lot to consider.
TM: It's always a pleasure talking with you.
Tim Murray joined Desjardins Securities in July 2011. Prior to this, he was an oil and gas analyst for almost six years at several investment boutiques covering junior and mid-cap companies. He also spent over a year at AltaGas Income Trust performing risk and credit analysis on natural gas and power assets for the company's midstream business and served as an investment advisor for three years. Tim was awarded the CFA designation in 2003.
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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. Interviews are edited for clarity.
3) Tim Murray: 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 Reports for participating in this interview.
