Christopher Brown: Juniors are able to leverage off previous technical information that majors typically leave behind in a number of these jurisdictions. The technical expertise of these juniors is so specialized. They find their niche in particular areas where they think they can unlock more value than was previously unlocked. Because of the speculative nature of going back into these older basins and looking for new unconventional plays, junior companies often source funding from institutions that are willing to take on the risk for significant potential rewards. Institutions based in New York as well as Europe have provided capital support to technically skilled juniors.
TER: The companies in your portfolio operate largely in the unconventional oil and gas space. Why haven't the majors moved in and taken them out?
CB: The majors have their plates full. They can't be everywhere at once. Keep in mind that the majors are looking for materiality, especially when you're dealing with companies like Exxon Mobil Corp. (XOM:NYSE), which has 25 billion barrels (25 Bbbl) of proven reserves. Exxon needs to see that it's worth the time to come back to these basins.
TER: How have Cub Energy Inc.'s (KUB:TSX.V) Ukrainian and Turkish gas prospects performed?
CB: On the Ukrainian side, Cub has done well at introducing new technologies to the country. Cub has received the approvals to bring in this new technology and apply it. It's going to be a slow process, but as the company continues to unlock value, there's no denying that its region and fiscal terms are very good and provide a lot of incentive to keep on working hard to grow the production base.
Turkey hosts a more difficult unconventional basin. The Anatolia Basin is still in its earlier stages, whereas the Ukrainian assets have some proven opportunities. In the Anatolia Basin, you do have some majors that are tentatively playing around the edges, but there has not yet been anything that's really unlocked that basin. But it didn't cost Cub much to enter the basin and the Turkey play provides shareholders with potential future value, which they don't pay for at Cub's current share price.
TER: Your research report noted that Ukraine's gas production was quite high in the 1960s, but then fell off because the Soviet Union just quit investing in it. Is there a reason to think that it might reach those heights again?
CB: Well, we're not sure if it will achieve those heights, but Cub's success to date indicates it has potential. The issue we're dealing with right now is that Gazprom (OGZD:LSE; GAZ:FSE; GAZP:MCX; GAZP:RTS; OGZPY:OTC) dominates the systems for gas production in the region. It does not want significant competition. On the flip side, Ukraine is motivated to service its domestic needs with domestic gas rather than paying high prices from Gazprom. History has proven Ukraine has access to significant volume. That's why Cub is in this country: It believes it can unlock more value.
TER: Have the fields that Ukraine was producing back in the 1960s been completely exhausted, or are they still useable?
CB: They're still useable. But Cub has tried to avoid moving into government-operated situations. In most cases Cub wanted to have independent operations. But I feel, as a reservoir engineer, there is still incremental opportunity to exploit if the operators of the larger fields were motivated to bring in new technology. I think they're probably monitoring Cub's behavior right now to see what technologies are most applicable, and then we will start to see that mimicking effect likely four or five years down the road as others start to adopt that newer technology once it's proven to be successful.
TER: Many of Cub's licenses in Turkey are near the Syrian border. Are these licenses exposed to political risk?
CB: There's never a guarantee that some disruptions won't occur, but Turkey does have a very strong military force. I think that if there were any temporary disruptions or terrorist activities, it would be on a small scale. It's something that we've almost grown used to internationally with our operations in numerous jurisdictions that we monitor and provide investment research on. We often deal with these disruptions with production, and they tend to only be three- to five-day disruptions on pipeline repairs and things like that at most, nothing that carries on for multiple years.
TER: Several plans for major takeaway pipelines crossing Turkey, such as the Nabucco pipeline and the Trans-Anatolian, folded in July. Is there a takeaway route for the gas produced in Turkey now?
CB: Right now in Turkey there are multiple opportunities to service even domestic requirements, where you can do industrial sales with competitive contracts using international pricing. I'm confident that just on a domestic basis Cub would find a home for the gas, but Cub would have the ability to export if its volumes reach a decent amount.
TER: If Ukraine's talks with the International Monetary Fund fail, you expect the country to devalue its currency and possibly tax foreign exchange transactions and deposits. How would that affect Cub Energy?
Kimberly Thompson: We don't expect it to have a major impact because although Cub's gas prices are in hryvnia, the local currency, they're tied to Russian import prices denominated in U.S. dollars. Basically, a lower hryvnia would be offset by higher local prices. In terms of the tax situation, Cub mitigates its risks by having its funds flow through Cyprus through its subsidiary, KUBGas Holdings. Cub doesn't see this as a risk.
TER: Cub Energy's stock price has trended down for most of the last year, but appears to have turned upward. What's driving that?
CB: Well, the dominant force has been management's commitment to the company. They have taken it upon themselves to buy back the shares, but they are buying them back with their own dollars; they're not using shareholder money. Through its ownership in a separate private holding company (Pelicourt Ltd.), management holds a major position in Cub Energy, and recently it decided to put in additional dollars to show confidence in the future of Cub. As of its last statement in October 2013, it owns 39.54% of the shares outstanding. That's provided a decent amount of market support.
TER: Coastal Energy Co. (CEN:TSX.V) is entertaining the $20/share offer from a private equity fund in Hong Kong. Is that happening now?
CB: I don't think it's going to go through. Coastal Energy's prospects—combined with the reserve base of $20–21/share and its prospect inventory of over 500 million barrels (500 MMbbl) of future opportunities and resources—I think that $20 is quite a bit under what management would accept to put forward to the public for a takeover. I think we won't hear anything more about this in the near future.
TER: What do you consider to be a reasonable offer price?
CB: We currently have a target price on Coastal of $23/share. We've accounted for $20–21 of base value for the company and we've actually given them a couple of dollars of credit for future risked resource opportunity upside. So, $23 would be the minimum offer an international company should make for Coastal, at least to get its attention to move forward and have it open a data room for more technical review. I think if you really want to provide incentive for shareholders to hand over their shares, any offer would likely have to be north of $23/share.
TER: What is Coastal Energy's long-term goal, sale or growth?
CB: I think ultimately it's going to be put up for sale as a long-term strategy, but in the meantime it wants to improve the value to make sure it captures a higher premium per share. I don't think that an international company is going to see enough evidence to give it a premium until 2014. The reason I say that is that Coastal has a number of near-term production growth opportunities. We're going to see the current production go from 22,000–23,000 barrels of oil equivalent per day (23,000 boe/d) to upwards of 30,000 boe/d. I think once Coastal has shown the ability to grow production, it will probably be in a much better position to show other technical groups that it's worth far more than $20/share.
TER: Cub is relying pretty heavily on hydraulic fracturing. Is Coastal doing the same?
CB: Yes. Coastal's offshore Thailand reservoirs have an acceptable permeability that allows the company to produce just with conventional completions. Coastal has gone back and done some recompletions with fracks and it has been able to tap into incremental reserve opportunities. Coastal, going forward, is in the same stage as Cub in terms of using new technology to unlock incremental reserves for shareholders.
TER: Why are you recommending a buy for Coastal and Cub?
CB: The buy is driven by the disconnect the market currently has on these companies that receive solid pricing internationally. Cub receives great gas prices in the Ukraine. Coastal receives very strong pricing for its oil in offshore Thailand. Combined with acceptable balance sheets, good cash flow and a discount to proven and profitable reserves, and given the discoveries both companies have made over the past year, we see their reserve bases continuing to grow. We feel that eventually shareholders will begin to bridge that gap between the discount to reserves and the reserve values. We're going to maintain that strong buy recommendation on these companies until we see that value gap bridged.
TER: What is the current price for Cub and your target for Cub?
CB: Cub is trading at around $0.25 a share and we have a target price of $0.70 per share for Cub.
TER: What other companies in your portfolio are you excited about?
CB: There are two others that we talk about quite often with our international investment community. One is listed in London, Caracal Energy Inc. (CRCL:LSE). This is a fascinating company because it is operating in Chad, so if you're talking about political risk that tends to be one that raises red flags when you discuss this with investors. The company is just bringing on production right now. Last month, it was not in production. It is literally ramping up to 35,000 barrels a day (35,000 bbl/d) within the next six months.
It's another company that trades at a reasonable discount on the market. We have a buy recommendation and a £9.20 target price. It currently trades at around £5. This is another situation of a discount to reserve. Even to date, the company's exploration success has already added incremental reserves, so that 2P reserve number should to continue to grow. That has been one name we've been talking about quite actively.
TER: What is the other company?
CB: Canacol Energy Ltd. (CNE:TSX). This is another one that is a mix of conventional operations in Colombia, but for us the excitement is really on the unconventional shales the company is pursuing in Colombia. The company is partnered with Exxon, ConocoPhillips (COP:NYSE) and Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and it's a situation where, again, you have a junior producer that amassed a decent land position on an unconventional play and then invited the majors to drill an initial grouping of up to 13–15 wellbores.
Again, I like to focus on these unconventional opportunities because I think the market will eventually come around to how much upside is associated with them, similar to what we have seen in the U.S. over the past five years. The U.S. is ahead of the curve on the unconventional development, and the investor base understands U.S. unconventional. I think internationally, people are just starting to understand how large the unconventional space could be. We have a buy recommendation with a target price of $7.50 and it currently trades at $4.50.
TER: Do you have parting thoughts to share on the oil and gas space?
CB: Now that the U.S. performance has been exceptional this year and the multiples are starting to get relatively high for a number of investments in the U.S., we see institutions starting to express interest in learning more, both on the domestic Canadian side, which still trades on discount, and more important on the international side, which trades at even more of a discount to reserve base. We're hoping that this will continue through until year-end and perhaps provide investors with some excitement going into 2014.
TER: Christopher and Kimberly, thank you both very much for your time. This has been an enlightening discussion.
CB: Excellent. I've enjoyed it.
KT: Thank you very much for having us.
Christopher Brown serves as director, research, international oil and gas at Canaccord Genuity and has provided international analytical coverage since 2006. Previously, Christopher worked as the international oil and gas analyst for BMO Capital Markets. Brown's industry experience includes reservoir engineering work at various large-cap oil and gas companies. Prior to that, he was employed at an international M&A firm with mandates out of London. Brown holds a Bachelor of Science in chemical engineering.
Kimberly Thompson is a research associate with Canaccord Genuity. With ten years of finance and accounting experience, she conducts analysis, evaluation and synthesis of investment opportunities in the international oil and gas space. Kimberly holds a Bachelor of Commerce from the University of Saskatchewan and is a Certified Management Accountant.
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DISCLOSURE:
1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family owns shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Royal Dutch Shell Plc. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Christopher Brown: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Canacol Energy, Caracal Energy and Cub Energy. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Kimberly Thompson: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Canacol Energy, Caracal Energy and Cub Energy. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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