Josef Schachter: Get Ready for a Natural Gas
Source: George Mack of
The Energy Report
Schachter Asset Management Analyst and Investment Advisor
Josef Schachter, who provides oil and gas research to Maison
Placement Canada clients, is recommending a group of Canadian
companies that are maintaining the delicate balance between oil,
on which he is bearish, and natural gas, which he believes will
soon enrich both producers and investors. In this exclusive
The Energy Report,
Josef shares some value-priced names he feels are poised
for big gains, along with natural gas' rising price.
: DANA GAS PJSC DELPHI ENERGY CORP. ENCANA CORPORATION GALLEON
ENERGY INC. IMPERIAL OIL LTD. NIKO RESOURCES LTD. QUESTERRE
ENERGY CORPORATION SEA DRAGON ENERGY INC. STERLING RESOURCES LTD.
SUNCOR ENERGY INC. TALISMAN ENERGY INC. VERO ENERGY INC.
WESTERNZAGROS RESOURCES LTD.
The Energy Report:
You recently said that if gasoline prices continue to rise
we should see West Texas Intermediate (WTI) oil in the low-$70s
in the third through fourth quarters of 2011 (Q311-Q411). That
represents an approximate 25% decline from current levels. Does
that mean that the North American economy will be in trouble?
That's the key. When you get $4/gal. gasoline at the pump,
or $1.25-$1.35/liter in Canada, you start seeing demand
destruction. If we look at the weekly Energy Information
) data for the week ending June 3, we can see that demand for
finished motor gasoline was 9.16 million barrels (Mbbl.)-down
268,000 barrels on the week. And year-to-date (YTD), it's down
0.3% to 8.956 Mbbl. per week. So, we're already seeing demand
destruction in the States from the handle of $4/gal. In Canada,
we're seeing the same thing; and Europe, of course, is showing
much weaker demand. Japan also is showing much weaker demand, and
we have the tightening of credit in China. Quantitative easing 2
(QE2) is now out of the way, so the stimulus is gone in the
There is probably a $30/bbl premium in the price of WTI oil,
and 50% of that relates to Middle East issues with about 900,000
barrels per day (bpd) that have been cut off from Libya. If we
see the Libya issue resolved in the next three to six months with
Muammar Gaddafi going out, that production will come back on and
will remove the pressure of the
premium. The other 50% is the hedge and commodity
If we see weakness in the economy, the whole commodity board
will come down and we'll see the U.S. dollar rally. We believe
oil prices will lose that $15/bbl premium held by speculators in
commodities and exchange traded funds (ETFs). The combination of
the two could take $30 off the price of WTI oil, which is just
around $93.40 today. Remember, when you have weak economic
conditions, you trade below fair value. Recall Q109, while the
fair value price might have been $50 for oil, we traded in the
You use technical analysis quite extensively in your
research reports, more than many sellside analysts. What are the
charts telling you?
My background is fundamental. I have an accounting
background and am a Chartered Financial Analyst (CFA), so I come
at it from a fundamental point of view. But I have had healthy
respect and training from the technicians during my +30 years in
the business, so I do look at the charts. We were at $112/bbl of
WTI, now we're at $98-and $94 is not that far away. If we break
$94 on the charts, then it's going down and looks like low-$70s.
So, I think you must have respect for, and use all of, the
disciplines. But I come at it from a supply/demand point of view;
and, while the price of oil ran to $112 due to concerns about
supply removal in the Middle East, that could be reversed if
Libyan production comes back on because it's a big producer.
With $4/gal. gasoline, we've seen oil demand falling in the
U.S. But what about natural gas, isn't the reverse true? At the
$4-$5 per-thousand-cubic-foot (Mcf) level, shouldn't we be using
a lot more gas? Isn't that equivalent to about $1/gal.
Yes, we could see natural gas prices triple and still be
the fuel of choice. The inventory picture has been high, but
that's coming down. Because of the Haynesville and the Marcellus
and everything else, there was a perception that we have a
natural-gas glut. We believe natural gas prices will go
significantly above $5/Tcf this summer with big air-conditioning
demand during the hurricane season. Over the winter of 2011-2012,
we think NYMEX gas will trade north of $7/Mcf.
Nat gas is quite a bit higher in Europe and Asia. Is there
an arbitrage opportunity?
There is currently no arbitrage capability, in terms of
shipping natural gas from the United States to Europe or Asia.
Remember, there are costs to do that. If prices in Japan are $10
or $12/Mcf and today we're trading at $4.35/Mcf for NYMEX July,
there's an arbitrage there; but there are
in building a facility. Cheniere Energy Partners L.P.
(NYSE.A:CQP) and other companies are talking about this. It may
cost $5/Mcf more to convert that into liquefied natural gas (
) and ship it to Japan due to distance, and it may not be enough
of an arbitrage to attract the kind of capital needed.
You're bullish on natural gas and bearish on oil. Do you
feel like gas prices will rise at the expense of oil, with
investable dollars being redeployed into gas and gas stocks?
That's what we've been recommending to Maison's
institutional clients. If you look at some of the big-name oily
stocks, they've already come down a bit from where they were. For
Suncor Energy Inc. (TSX.V:SU; NYSE:SU)
was trading at $47 in February, and now it's trading at
$38. So, there's been a bit of a haircut there. The big Canadian
Imperial Oil Ltd. (TSX:IMO; NYSE.A:IMO)
was $54 in February, when WTI oil was at $112/bbl, and now
the stock is trading at $44.56.
So, we've already seen a correction in the oil names, and we
think that will continue, especially if we see another
$20-$30/bbl come off the price of oil. Gas stocks have done the
reverse. At the beginning of the year,
Encana Corp.(TSX:ECA; NYSE:ECA)
was a $29 stock, and now it's a $31 stock. That's not a big
move, but it's gone up versus the oily names going down.
Back in March, the Government of Quebec
halted shale gas drilling
until a safety evaluation could be completed. This could
take up to two years and, with court challenges and
environmentalists converging on this area as a battleground, it
might take longer. What's your feeling on this?
There's a pilot phase that will go on for the next two
years. I believe six wells are forecast, two of which are being
worked by a joint venture (JV) between
Talisman Energy Inc. (
Questerre Energy Corp. (TSX:QEC)
. They're going to be monitored by the government, which will
have people onsite. What the companies will have to do is deal
with local people and environmentalists, get approval from the
farmers and explain what's going on. They're going to measure the
methane before and after they start drilling since the companies
want to prove that they're not increasing the amount of methane
from their activity. So, the industry has to prove its
Quebec has a history of environmental legislation for mines;
but in the end, it does approve the mines if they go through the
environmental hurdles. I think the case will be the same here
with natural gas. Companies might not be able to drill close to
Montreal or Quebec City, but that's the same issue with New York.
However, in our minds, there will be activity; it's just a
question of when it happens. Remember also, there's an election
in Quebec in two years; and I believe the government wants to
wait until after the election on this issue. So, it's going to
take that two-year window or more.
What are the plays that you're recommending for investors
We like companies in Western Canada, where there are
multizone liquids-rich natural gas areas. Oil is in some of the
plays like the
or the Doe Creek. So, we like companies like
Delphi Energy Corp. (
Vero Energy Inc. (TSX:VRO)
Galleon Energy Inc. (TSX:GO)
. We also like some Canadian-domiciled companies dealing with
international markets like
Niko Resources Ltd. (
, which is in India, Indonesia, Kurdistan, Trinidad, Madagascar
and a number of other places.
In the past, we've been fans of
Sterling Resources Ltd. (TSX.V:SLG)
, which is in the North Sea, the Netherlands and offshore
Romania; however, currently we are on the sidelines due to their
ongoing difficulties in Romania. We like
WesternZagros Resources Ltd. (TSX.V:WZR)
, which has just completed a very exciting well, Sarqala-1, in
the Kurdistan region of Iraq and will spud another well, called
Mil Qasim-1, in July. We like a company in Egypt, called
Sea Dragon Energy Inc. (TSX.V:SDX)
. It has the same management team that was successful with
Centurion Energy International Inc., which was acquired by
Dana Gas PJSC (ADX:DANA)
in 2007. A lot of Canadian-domiciled companies are taking
the modern technologies around the world and are doing very well
You mentioned Delphi and WesternZagros, which are your
top-two picks. One thing that jumps out at me is that neither of
these companies has had spectacular returns. So, is this your
contrarian gas play?
Yes. DEE got hurt because of their gas bias, but they
always had land with liquids-rich capability. For example, in
2009, Delphi was producing about 15% oil and 85% natural gas.
This year, it's going to do about 27% oil and liquids-and that
number will go north of 30% by the end of the year. It's going to
generate over 50% of its revenue from oil and liquids; so cash
flow will go up, and production volumes will go from 6,700 boe/d
in Q109 to north of 9,500 boe/d by year-end. Delphi is doing the
right things, in terms of the mix. It's going after the
liquids-rich capabilities on its land, but the company always has
sitting in its inventory; so, when gas prices go back to
$7-$8/Mcf, Delphi can move those assets. In the meantime, it can
increase its net asset value (NAV) and cash flow by going after
the liquids. It's similar to the gold business-when prices are
low, you go after your best veins; and when prices are high, you
go after your bad veins.
Your target price on Delphi is $4, which implies a 60%-65%
return, but I noticed the company's NAV is $3.78. It sounds like
a very conservative target price.
Yes. And that's because we're looking for Delphi to trade
at a ratio of its cash flows, and we're looking at it annualizing
about $0.60 in cash flow by Q411. The cash flow multiple should
be no greater than the proven reserve life index (RLI); and, if
you have seven-and-one-half years of proven reserves, you also
have probable and possible reserves, tax pools and land value to
protect the value for shareholders.
So, we take an approach in which a company's maximum cash flow
multiple should be equal to its proven RLI. However, we didn't
even use that in this case. So, you could argue that we may have
an even higher target, but our view is to use a reasonable target
that we can see makes sense. Then, if it gets to that target and
the company is doing better than expected, we can always review
it again and come up with a new target.
Your other top pick was WesternZagros, on which you have a
target price of $1.50. That represents a roughly 175% return.
What are the risks here?
Well, this is in Kurdistan and now the Baghdad and
Kurdistan governments are getting their collective act together,
in terms of allowing money to be paid to the players in the area,
which makes a lot of sense to us. WesternZagros has a lot of cash
on the balance sheet, so it has enough for the next phase of
drilling. What we like about the company is that the Sarqala-1
well has tested at 9,444 bpd light, +40-degree oil. So, it may
have a massive oil field there. WesternZagros' biggest
shareholders are George Soros and John Paulson. Thus, we have
big, international investors that believe this company has a big
land spread, very attractive base and has proven that there is
light oil on it.
You went to the SEPAC Oil & Gas Investor Showcase in
Calgary at the end of May. What was the atmosphere there? What
did you hear?
If a company is in natural gas only, it's not generating a
lot of cash flow and not making any money. And if it has any
debt, it has problems. So, almost every company was trying to
draw attention to itself saying, "Let's find the liquids-rich or
oily stuff and use the new technologies to harvest our lands."
Nearly every company was carrying the flag of "liquids-oily" to
From my perspective, they're doing what they have to do in
these tough times. But it is getting easier. The basin in Western
Canada is gassier, with small pools where the new technologies
will help with the oil recovery. But in the long run, we're going
to need a much higher natural gas price for the industry to be
successful-not only to get a cash flow but also to start
generating free cash flow and net income. That's when people can
see that it's not just trading dollars in the industry, but also
making real money.
Can the small guys survive?
Again, they've got to go get land where the big boys aren't
pushing up prices exorbitantly. That means they will have to go
into areas that are not 'hot.' Everybody loves the
or the Cardium, but land prices are rising above
$5,000/acre. A little company can't do that today. So, it must
have had the land in inventory that it holds or has farmed in
from a big boy. But the key thing is that the company will have
to be away from where the big boys are located. Companies like
Delphi, Galleon and Vero were buying low-priced land in these hot
the big boys come in-and where the little guys now just
That makes sense. Josef, do you have any further thoughts
that you'd like to leave with our readers?
Just that we're cautious right now with QE2 over and with
all the country risks in Europe. I think almost everybody agrees
that Greece has problems that cannot be fixed. At some point, it
will have to face the moment and resolve these issues with
haircuts everywhere, which is deflationary. So, if that's the
case, and we have a weaker U.S. economy along with Europe, China
and Japan, we think there's a chance for a severe correction. So,
we're not saying investors should go out and buy things right
away, but rather build up their buy lists.
Sometime this fall, the market could have a 10%, or even 30%,
correction. I'm not sure which one it will be; it depends upon
how serious the problems in Europe become. And, of course,
Americans are facing their debt issues. So, if we do see a severe
30% correction, some stocks could go down much more than that;
so, you want to be ready to be a buyer. We're saying if you have
oily names right now, sell them and lighten up your exposure. If
you have to be exposed to energy, be in the natural gas-focused
names, but sit there with some decent cash reserves
underweighting the sector and be ready to be a buyer sometime
this fall when the pain is over.
Great advice. Thank you, Josef.
After a successful investment stewardship at Richardson
Greenshields of Canada Limited (RGCL), and the Royal Bank
purchase of that firm,
set up his own investment advisory business,
Schachter Asset Management Inc.
(SAMI) in late 1996. Mr. Schachter has nearly 40 years of
experience in the Canadian investment management industry. He
was the market strategist and director at Richardson
Greenshields, as well as a member of its Investment Policy
Committee. He holds the Chartered Financial Analyst designation
and is a past chairman of the Canadian Council of Financial
Currently, Mr. Schachter and his research team provide oil
and gas research coverage to the institutional clients of Maison
Placements Canada and presents to, and consults, various industry
companies and organizations. Mr. Schachter is a frequent guest on
BNN and is regularly quoted in such news and financial
publications as the
Globe and Mail, National Post
the latter of which awarded Mr. Schachter its "Stock Picker
of the Year" award in 2003, 2004 and 2007. He is also a regular
on various radio shows including Michael Campbell's "Money
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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 in the interview are
The Energy Report:
3) Josef Schachter: I personally and/or my family own shares of
the following companies mentioned in this interview:
WesternZagros Resources and Delphi Energy Corp. I personally
and/or my family am paid by the following companies mentioned in
this interview: None.
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