Finding Profits in Volatile Energy Markets: Nav Malik
Source: George Mack of
The Energy Report
Fishing for value is no easy task in a stormy economy, but
investors can still come up with a profitable catch. Oil and gas
analyst Nav Malik of Octagon Capital uses due diligence to
identify select value plays with great growth potential. In this
exclusive interview with
The Energy Report,
Malik discusses three cream-of-the-crop picks and a hot new play
in the United Kingdom's North Sea.
The Energy Report:
Nav, what is your current investment thesis?
Given the commodity price environment, we prefer oil and
light-oil plays at the moment. The economics are much more
favorable. We also like liquids-rich gas plays, which serve to
boost project economics. Given natural gas prices, we're not as
favorable on dry gas plays at this point.
You would think of the liquids as icing on the cake?
Absolutely. Projects have better economics via more favorable
pricing in the liquids. With dry gas around $3.50/thousand cubic
feet (Mcf), it's not as economic to drill purely for gas, but
when you add a liquids component to it, that serves to boost the
overall production revenue stream.
What do you look for in small exploration and production
For both explorers and producers, the first thing we look at is
the management team. We look at management's track record, how
familiar they are with the assets and what their plans are for
the assets going forward. That's certainly a key part of it. For
producing companies, we also look at growth potential, and that
could be a function of the number of potential drilling locations
and inventory that they can exploit. We look at the potential to
boost operational efficiencies to lower operating costs. For
developers, we look at the quality of the resource base, how much
it has been derisked and what steps management has taken to
derisk the project.
When you're looking at developers, does it make you more
comfortable when you are able to see other producers in the
Yes, absolutely. That certainly is a key component of derisking,
whether there's some well control in the area surrounding a
company. That is helpful and gives us more confidence.
Are there certain channel checks that you perform?
We talk to the energy services providers. Their relative level of
optimism helps to put the puzzle together. We also look at
available industry statistics, such as license data and land sale
activity. There is a lot of information available in the oil and
gas space, particularly in Western Canada, which helps us gain an
understanding of how the future is going to unfold. We also talk
with industry associations like the Canadian Association of
Petroleum Producers (CAPP), and we attend conferences. There are
all sorts of indicators that keep us in tune with industry
sentiment regarding future plans.
Do the service providers have pricing power?
They do. It's a very active drilling period at the moment and
considering the extended spring breakup that we had earlier this
year; the latter half of the year has been a very busy time for
service providers. Most of them are guiding for continued strong
activity right through into next spring and the next breakup
period. Their capital expenditure (capex) budgets have been
growth-oriented and higher than last year's spending. That's what
we saw with Precision Drilling Corp. (PD:TSX) very recently, as
well as several other smaller service providers. That general
theme has been playing out even in this uncertain economic
environment, and the feeling is still positive when it comes to
Can you be bullish on small E&Ps if commodity prices are in a
Yes, absolutely. Many of the small E&Ps offer good growth
potential. It comes down to their land base and drilling
inventory. You can certainly see production and cash flow growth
in a flat commodity price environment based on how active and how
successful companies are at executing their drill programs. If a
junior company has a solid inventory of potential targets and is
able to execute on those, we do see production growth.
Do you see investors flow funds in small E&Ps in a flat oil
Yes, and I think there are companies that offer good value and
growth potential in this market. Those are the types of companies
that investors should look for. Even if you assume commodity
prices are going to be relatively flat, there is tremendous
potential still remaining, and new technology is opening up
further potential. Hydraulic multistage fracturing (fracking) and
horizontal drilling have really opened up potential in many
resource plays that were previously thought to be near the end of
their lives. They've now been rejuvenated with the improved
Can investors make money in this environment?
There are opportunities to profit. The economic environment is
still uncertain, so if we saw a significant downdraft in economic
growth followed by a corresponding decline in commodity prices,
that would certainly be a risk for an investor. But we're
assuming relatively flat commodity prices going forward. We think
the $90-110/barrel (bbl) for WTI (West Texas Intermediate) level
is a very positive environment in which investors are able to
make money. Opportunities are there as long as the economy
doesn't decline significantly.
What is your forecast for oil and for gas?
We forecast WTI at $90/bbl in 2012. For gas, we're looking for
about $3.50-3.75/Mcf for NYMEX.
What companies do you currently like?
Equal Energy Ltd. (EQU:TSX; EQU:NYSE) is one of the names that we
like. This is a company that has about 9,500 barrels a day (bpd)
of production. It's in the liquids-rich Hunton play in Oklahoma.
It also has an asset base in the Cardium and in the Viking in
Canada. So it's in some light oil-focused plays in Canada and a
liquids-rich gas play in Oklahoma. The economics are very
favorable, and it's been executing very well on its plays.
It just recently sold some noncore assets and applied the
proceeds to its debt. It also has potential upside from an area
in Oklahoma where it has about 20 sections in the Mississippian
formation, which has become a highly attractive light-oil play in
the U.S. A lot of the major companies in the U.S. are drilling
here, including SandRidge Energy Inc. (SD:NYSE), which has been
very active in this play.
Will Equal develop its Mississippian play in 2012?
Yes, I think we'll see some cash flow from Equal's land base in
the Mississippian next year. I think it's looking for potential
partners to keep its own capital costs low.
Equal decreased its guidance down for 2012. You had expected it
to produce 11,600 barrels oil equivalent per day (boepd) in 2012,
but the company is now projecting 9,400-9,800 boepd with a lower
percentage of oil as well. What are the issues that resulted in
these revised expectations?
Part of it was that it sold off some non-core assets recently,
which lowered its production numbers. We also find management to
be very conservative, which is a good thing. They want to ensure
that they are putting out achievable numbers in the investment
community, erring on the side of caution. Finally, the company is
not including potential development of the Mississippian in its
cash flow and production guidance. Thus, there is certainly more
So, the Mississippian could be a key catalyst for upside?
Yes, absolutely. However, the market isn't giving Equal much
credit for the potential growth its acreage suggests. I think
once it announces development plans there, or when it has
partnered with somebody in the area to develop that play, that
should really be a catalyst for the stock to move higher. The
current share price level does not reflect this value.
Is paying down debt the best use of proceeds from Equal's asset
For Equal Energy specifically, it is the best use of proceeds.
Its debt level was more than 2.5x its debt-adjusted cash flow
number. That's on the higher end of the scale for most companies
in the energy space. I would say around 1-1.5x is the level most
energy companies probably strive to remain below. So its debt is
slightly higher than the industry average, and I think for that
reason, using these proceeds to bring down its debt was really
prudent on management's part.
Because of Equal's lowered production forecast, you reduced your
target price from $11.20 to $9, which still represents an 80%
Yes, exactly. It's still trading at a relatively attractive
valuation. On an enterprise value (
) to debt-adjusted cash flow basis, it's trading at less than
4.5x, which is at the lower end of the range. Most companies in
the energy space are trading around the 4-6x multiple. It's at
the lower end of the range, so valuation is attractive. Even our
$9 target price represents solid upside from current levels.
Equal sounds like a classic value play.
Absolutely. It's a good value play with an attractive valuation,
a strong set of assets and a very strong management team as well.
I think it's doing all the right things. As it continues to
execute, it should be reflected in its valuation going forward.
So it's a good time to step into the stock, and I think you could
certainly see the stock price get closer to our target price over
the next year or so.
If Equal is producing on its Mississippian play a year from now,
would you consider this company a legitimate growth story?
I think there is growth potential out of the Mississippian. Plus,
it has a number of locations available to drill in all of its
plays, in the Cardium, the Viking and in the Hunton formation. So
there certainly is solid growth potential there. I think we will
see that down the road.
What else do you like?
I also like Spartan Oil Corp. (STO:TSX), which is a junior
company primarily focused on the Cardium play in Alberta. What we
like here is that it's an emerging growth story. By the end of
this year, it should be producing about 1,500 bpd. It has a very
contiguous land base and is very low risk in the sense that
there's a lot of historical production from its specific area of
the Cardium in East Pembina. It is basically exploiting
horizontal drilling and multistage fracking to further increase
production from its land base. So we're looking at production
doubling from current levels by the end of next year. Spartan
recently increased its guidance for 2011 from about 1,050 bpd to
likely hitting 1,500 bpd by the beginning of 2012. It's been
getting good results from the wells it has been drilling, and I
think we'll see that continue. The other thing I like about
Spartan is that it has been reducing its capital costs on well
drilling. Originally, the company was expecting to spend about
$3.3 million/well in the Cardium. The company reduced that figure
to about $2.5M/well, and it will likely go even lower than that.
I think it's commendable to management on how they've been able
to reduce capital costs.
Spartan's relative strength has been extremely high. It's up 27%
over the last six months and up 14% over the past month. It's
really a mirror image of many of its peers that have gone the
other direction. Is it a legitimate growth story?
Absolutely. I think it's one of the best junior names in the
industry at the moment based on the land base and potential for
growth alone. It's just a matter of getting the resource out of
the ground. The company's growth trajectory should continue to
accelerate, given those characteristics.
I guess this is a case that proves investors can make money in
this kind of market.
Exactly. Spartan Oil is a great example of a very solid,
growth-oriented, junior oil and gas company.
Any other promising value plays?
Another company we like is Xcite Energy Ltd. (XEL:TSX.V). Xcite
has a play in the United Kingdom's North Sea called the Bentley
Field, which it was awarded back in 2003. The field is located
about 160km east of the Shetland Islands. It has derisked that
field significantly by drilling some exploratory wells and some
appraisal wells that have demonstrated commercial flow rates. Its
most recent reserve report outlines about 28 million barrels
(MMbbl) of proven and probable reserves, and it also has about 87
MMbbl of contingent resources that we think should be
reclassified as reserves once the company actually starts
developing the field and begins producing. There are about 115
MMbbl potentially recoverable from the Bentley Field, which we
think is very valuable. Our target price of $5 is based on our
net asset value (
) model for that field, and represents considerable upside
compared with the current share price.
Yes, an upside of about 250%.
Given that Xcite is not producing at the moment, there is
obviously a higher level of risk, but it offers a very compelling
risk-reward opportunity, in our opinion. We expect solid
production out of the Bentley Field, upwards of 40 thousand
barrels per day (Mbblpd) in about Q414.
That's three years from now, which is a lifetime in the energy
sector. But if this kind of production can be achieved, this is a
multibillion-dollar market cap company.
Just over a $1 billion is roughly where our valuation is on it
Shares of Xcite are down 74% from one year ago. Is this due to
the play's built-in risk, or is there something else that has
caused such a brutal drop in its share price?
In this case I think it's more about the economic environment.
Capital is required to execute on the Bentley Field development
strategy. When the financial markets are uncertain, it may be
more difficult to access or raise capital. That being said, Xcite
actually does have enough capital available to begin the first
step of the process. In my opinion, the company is not really
constrained by any means, but some investors may feel that there
is a high level of risk still involved. I think the other issue
that may have brought the share price down slightly is that the
company is awaiting Department of Energy and Climate Change
(DECC) approval for its Bentley field development plan. Xcite
recently revised those plans, which may have caused some
uncertainty in the investment community. We think that it will
receive DECC approval shortly, which should serve as a positive
catalyst for the share price.
Even though the company's share price has been beaten down
dramatically, it still has a $251M market cap, which means it
could be owned by a lot of mutual funds. Sometimes a company's
market cap can drop so low that mutual funds can't own them, but
that's not the case here.
Absolutely. I think that speaks to the value of its asset in the
Bentley Field, a very valuable resource. There are other large
players in the North Sea, such as Statoil ASA (STO:NYSE:
STL:OSLO) and Apache Corp. (APA:NYSE). There are a lot of
companies in the North Sea that can appreciate the value in the
Bentley Field. For those reasons, we also consider Xcite a
potential takeout target down the road.
This Bentley Field play is a huge and complex project.
Yes, absolutely, but lots of potential, in our opinion.
Many thanks to you, Nav.
Thank you very much.
Nav Malik joined Octagon Capital Corporation in late 2010
as a research analyst covering the oil and gas sector. He has
over 15 years of capital markets experience, primarily focused
on companies in the energy, transportation and
industrial/manufacturing industries. Mr. Malik was ranked as
the number-one Business Trust Stock Picker in the 2009 StarMine
Analyst Awards, and has also been highly ranked in other
investment industry surveys. He has a Bachelor of Commerce
degree from the University of Calgary and a Masters of Business
Administration from the University of Western Ontario.
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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:
2) The following companies mentioned are sponsors of
The Energy Report:
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3) Nav Malik: 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
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