Josh Young: Transition Can Deliver Value in
Source: George Mack of
The Energy Report
Portfolio Manager and Founder Josh Young of Young Capital
Management (YCM) looks for value in oil and gas exploration and
production (E&P) companies. In this exclusive interview
The Energy Report
, Josh discusses some of his best ideas-strategies that could
well deliver the significant upside and reduced risk investors
might not expect from natural gas producers.
The Energy Report:
Are you overweighted to natural gas right now?
Josh Young: Yes, at the moment, I am. It's challenging right
now because natural gas prices are low, so companies aren't
making a lot of money drilling for gas. In such an environment,
there are strong incentives for nat gas companies to diversify
their product mix and improve margins by drilling for oil; and
the market is rewarding companies that manage to increase oil
production and improve their margins with substantially higher
stock prices. As gas companies have transitioned a portion of
their production to oil, their stocks have outperformed
significantly; in fact, they've been the highest-performing
stocks across this space over the last year or two. And,
generally, the ones that have transitioned have retained their
upside potential from exposure to gas prices, which,
historically, are cheap versus other energy sources like oil.
That is part of what has driven their stock price
I hate to overuse the term "value," but I'm guessing that your
investment theory here is that gas is a value-rich universe.
Yes. Actually, it's sort of interesting because there's been a
bifurcation in valuation based upon the size of the company. The
larger companies that are followed closely and are better
understood have started pricing in fairly high natural gas
prices, and that correction is already priced in. The market is
already expecting gas at $5-$6 per thousand cubic feet (tcf)-and
higher in some cases, depending on the stock. So, for me, it's
almost like getting a free ride on the backs of smart, large
investment funds that are bidding up the stocks of these big
companies based on expectations of the natural gas curve.
Typically, these large investment firms can't invest in the
smaller companies that I follow.
Smaller investors have been slow to follow this investment
trend, so the shares of smaller natural gas companies haven't
gotten bid up in a same way similar to the larger ones. That's
part of what's created this tremendous, and I think temporary,
dislocation. Also, despite superior performance versus the market
and other larger hedge funds, it is a very challenging time for
small funds to raise capital-especially in the oil and gas
As capital has flowed to larger funds, it has been deployed to
buy stock in larger-cap companies. This has helped feed the
current valuation discrepancy. It has been a temporary
phenomenon, as allocators to funds are beginning to overcome
their inhibitions toward investing in smaller funds in favor of
the (generally) higher returns and lower risk available in those
funds. Between additional funds flowing into smaller funds that
invest in smaller companies, and larger funds "stretching" and
starting to buy stock in smaller-cap companies, there is the
chance for a substantial correction in this valuation gap. Of
course, many of the companies I'm invested in are going through a
transition process, which should drive substantial value creation
and share price improvement regardless of fund flows into the
The whole area of natural gas sounds counterintuitive to me. That
must sound like a bullish signal for you.
Well, that's the interesting thing-natural gas isn't out of
favor, really, only certain smaller nat gas stocks are out of
favor. If you look at companies like
Ultra Petroleum Corp. (
Range Resources Corp. (
Southwestern Energy Co. (
Cabot Oil & Gas Corp. (
EQT Corp. (
, they've all traded up. These stocks are trading with rich
earnings and cash flow multiples and are at or near their 52-week
highs. So, it's more of a big versus small arbitrage than it is
oil versus gas. I don't even have to be a contrarian; I get to
make a bet that other smart investors with substantial research
resources are already making and I get to take advantage of their
inability to invest in smaller company stocks.
Josh, you worked in a private equity firm in Los Angeles where
I'm guessing you crunched a lot of numbers. There were no
quarterly reports, conference calls, analyst days or 8-Ks for
reporting unscheduled material events. What did you learn in
doing due diligence, and how did that experience inform what you
It definitely had an impact on my research process. Between my
experience in private equity and subsequent experience investing
money for a multibillion-dollar single-family office, I learned
to do detailed research. I was identifying and quantifying value
drivers and risk factors to develop an independent and,
sometimes, contrarian view of a company.
Original research is what you have to do.
Yes, original research and also applying appropriate valuation
methods. But, you know, I'm not reinventing the wheel. I'm
applying what I've learned, in an innovative way, to these
smaller- and micro-cap companies. I pay attention to what both
the market and Wall Street want, from a financing perspective.
I'm also focusing on what the larger companies want, from an
acquisition perspective, and translating that knowledge over into
investments in the smaller-cap space. Then, obviously, I'm
interacting with the smaller company executives to understand
what they're thinking and how they approach things. It's a
multifaceted approach to find value in a niche.
Where can value be found?
I'm interested in finding really significant mispricings. And in
the smaller cap O&G space, there are some great value
opportunities-particularly in companies going through transition
processes. One example is a company I'm investing in that's in
this process of transition; in fact, it's practically a textbook
case for transition. Most investors who have heard of it haven't
looked at it in a few years because it was a mess-it was
overlevered and was forced to sell one of its core assets to pay
down that debt. It was asset rich but did not have a lot of
production, and it was forced to take meaningful write-downs on
the book value of those assets. And it was producing 100% natural
gas in a rising-oil-price/falling-gas-price environment.
Today, the story is different and the market is just beginning
to recognize that. The company sold an asset and, virtually, has
no debt. It joint ventured (JV'd) an asset and is in the process
of ramping-up production. It has major liquids discoveries in
both of its core assets and will be increasing the percent of its
production coming from liquids and oil substantially and is the
most levered company on an acreage versus enterprise value (EV)
basis to the Marcellus Shale. The company is trading for a
fraction of the valuation of other Marcellus companies and the
market misunderstood its recent oil discovery, which could move
the needle significantly.
Gastar Exploration Ltd. (GST)
, also has 17,000 acres of the lowest-cost onshore dry gas play
in the U.S.-80,000 net acres in the Marcellus and a JV that will
be funding the majority of the 8-10 net wells it is drilling
primarily in the liquids-rich area of the play in 2011. Gastar
has an oil discovery in East Texas with 30 locations and
substantial potential value from the development of that play,
which the market does not seem to understand and has yet to price
in. And it has 17,000 net acres prospective for oily Eagle Ford
and Deep Bossier gas, which is widely recognized as one of the
lowest-cost natural gas plays in the U.S.
Gastar trades at a big discount to its Marcellus-levered
peers, such as Cabot, EQT, Range Resources,
EXCO Resources Inc. (NYSE:EXCO)
, etc. In fact, it trades at almost one-quarter the price per
acre, despite having similarly prospective acreage. This value
gap should close as the company drills numerous wells this year,
most of which will be funded by a JV agreement it entered into
last year, and ramp-up its production and cash flow.
That doesn't even consider Gastar's recent oil discovery in
East Texas, which could contribute substantial additional value.
The company recently announced a Glen Rose well producing 250
barrels of oil per day (bpd) and 1,300 barrels of completion
fluid, with inclining oil production. Generally, as a well
produces, the amount of completion-fluid production declines and
the oil production inclines. From some of the wells I've seen,
the initial production (IP) rate on this well could be over 500
bpd with an implied EUR (estimated ultimate recovery) of more
than 250,000 barrels of oil. For a $4 million per-well cost on
the 30 remaining locations, this could significantly shift
Gastar's production toward oil and lead to a substantial
revaluation of the company after the official initial production
rate of this well is announced.
Gastar is up 25% over the past six months but flat over 12
It is; and despite the recent move, it hasn't come close to my
estimate of its intrinsic value or where I think it could trade
at in the near term. When I think about the transition Gastar is
making, I think about companies like
Approach Resources Inc. (AREX)
, which was very similar to Gastar. Approach was in a
conventional natural gas field and was having trouble growing
production and making the economics work. Although the well
economics were great at the well level, it was just hard for a
company of its size to really make it work. Then, Approach
figured out that it had some oil under the areas it had been
drilling for gas; so, it started drilling for oil and the wells
came on great-similar to Gastar.
As Approach started showing good wells, its stock went from $7
at the time to the current price of around $29-in just over nine
months. You can look at Gastar's history, metrics and chart and
see that it has a lot of characteristics in common with Approach
and some of the other companies that have gone through similar
transitions, such as
Brigham Exploration Co. (BEXP)
Magnum Hunter Resources Corp. (NYSE.A:MHR)
, or companies in the process of transition like
Double Eagle Petroleum Co. (DBLE)
. Gastar's stock has a high probability of outperforming in a
Is Gastar your favorite play?
It's one of my largest positions, and it's among my favorite
investments at the moment. Another favorite investment at the
Molopo Energy Ltd. (ASX:MPO)
, which has the distinction of owning assets in some of the
best-known plays with some of the best-known economics while
being one of the least-known stocks. It has over 50,000 acres in
the Bakken formation and over 17,000 acres in the Permian Basin.
It's actually right in the middle of Approach's Wolfcamp oil play
and has over 750 billion cubic feet (bcf) of 2P gas reserves in
Australia, ready to meet the growing energy needs of Asia.
Activist investors came in, kicked out the old management team
and installed a new team and a new board-but only after prior
management monetized the only existing production it had. Molopo
owned the Spearfish play in Canada, which it sold to
Legacy Oil & Gas Inc. (LEG)
. The company's known for that but, otherwise, few people have
heard of it.
Why has it been so unloved by the market?
One reason is that the old management team got kicked out, which
led a number of shareholders who were close with the old
management to sell. Secondly, it's an Australian-traded company
with Australian, U.S. and Canadian assets, and management has not
done a good job in approaching the Canadian or U.S. investment
communities. I know almost no one who has heard of the company
here in the U.S. or in Canada. But the company's in an
interesting situation because it has a market cap of just over
$220 million, with around $200M cash and marketable securities,
and no debt. So, it has all these assets all in the right places
and, historically, has gotten great returns on investment (ROI)
in identifying, developing, and then monetizing plays.
Molopo is among your largest positions, right?
Yes, it is. I like it because it has all this asset value and
upside. I try to figure out how I can lose money owning the
stock, and I have trouble seeing significant fundamental risk in
the company. Gastar and Molopo are my favorite investment ideas.
I think they both meet this template of companies in transition.
And they're both trading at very large discounts to their peers
in their respective plays, as well as to their intrinsic values.
Both companies have the potential to be multibaggers over a
relatively short period of time.
One other aspect to Molopo's story worth discussing is its
exposure to Asian energy demand. Specifically, in the aftermath
of the terrible tragedy in Japan, demand for liquid natural gas
(LNG) has shot up; and the value of LNG feedstock in politically
stable countries in close proximity to end markets has likely
also increased substantially. Look at companies like
INPEX Corp. (IPXHY)
, which supplies LNG to Japan, or
Sentry Petroleum Ltd. (SPLM)
, which has no proved or probable reserves but has acreage near
Molopo's and a valuation of over $150M. Its recent, significant
stock price movements should give you an idea of how Molopo's
significant 2P reserve base should be valued-and it's effectively
getting zero value in today's stock price.
There are a couple of Canadian companies that are also
interesting and aren't very well understood or closely followed
here in the U.S. There's
Equal Energy Ltd. (TSX:EQU; NYSE:EQU)
, which is in some of the most interesting unconventional oil
plays. It's in the Viking and Cardium oil plays, the latter of
which is a play that's very similar to the Bakken in Canada. It's
also in the Hunton Dewater play here in the U.S., which is sort
of hard to explain, but it's a liquids-rich play. In addition,
Equal has exposure to about 15,000-20,000 net acres in a
Mississippi play that is becoming famous now through
SandRidge Energy Inc. (SD)
Chesapeake Energy Corp.'s (CHK)
Equal is growing cash flow by about 15%-20% per year.
Production is flat this year, which is part of the reason I think
it's so cheap. It is trading for its proved reserve value, which
is odd because, if you look at the value of its unconventional
acreage, which is not included in its reserve value, it's pretty
easy to see that acreage being worth as much as it's trading for.
So, basically, Equal Energy is trading at one-half of its asset
value and at a significant discount to comparable companies. The
company is further along in the transition process than are
Gastar or Molopo, but it still has substantial upside. I learned
from exiting my position in Approach Resources early that there
is often substantial upside to companies in plays with leading
economics. Approach almost tripled after I sold it for a big
profit, and I think Equal has a lot of room to trade up
significantly and be priced appropriately relative to its
The other Canadian company that's particularly interesting is
Galleon Energy Inc. (TSX:GO)
. One of the more fascinating things that I've seen in my
investment career is what happened to this company when the
got indicted by the SEC. As it started getting press around this
indictment and the ensuing trial, you could see GO start trading
down with no fundamental news, and then not participating in the
upward stock moves of many of its peers as oil prices moved up
over the past few months. Obviously, the company has no
association with the Galleon Group hedge fund management firm in
New York. Galleon Energy has fewer specific catalysts versus
these other companies I've mentioned; so, it is possible for GO
to trade at a lower valuation for longer. But on the flipside, it
has so much cash flow and trades at such a low multiple compared
to that cash flow that, ultimately, it will get rectified.
How have some of these names performed since your last interview
The Energy Report
A few of the names I discussed in the last interview worked out
really well. One of the companies I talked about was
Lucas Energy Inc. (NYSE.A:LEI)
, which is a micro-cap oil and gas company. Through its residual
or historical activities, the company built up an interesting
land position in the oily part of the Eagle Ford Shale.
I realize this is a true micro-cap company, but it's up
three-and-one-half times from 12 months ago. Do you still see
Well, I didn't say I still own a lot of stock. I said that it's
worked out really well. The company has great acreage at this
point. It has real production and is growing that production. But
I think it's a little bit further along in its transition and is
being valued in line with its recently increased production and
the improved value of its acreage.
Cabot was another company I talked about in the last interview
that worked out really well. It had traded down because of an
error. It's almost like the Galleon story where it traded down
for a reason that was almost unrelated to the company.
Do you still own shares in Cabot?
No, I don't. I sold my Cabot stock and I used the proceeds to buy
additional shares of Gastar, which I think is trading at a much
more compelling valuation. I also talked about
RAM Energy Resources Inc. (RAME)
, which was pretty interesting and did very well. It was around
$1.60 when I told The Energy Report about it. It traded up to
$2.50 and is now around $2.04. I still own some but I sold most
of my position as it approached $2.50 and got closer to fair
Any new ideas you'd like to share with our readers?
There's one other company I wanted to talk about that I own now
that I haven't talked about before. It's
U.S. Energy Corp. (USEG)
. It did the original JV with Brigham in the Bakken, which helped
Brigham unlock the value of its acreage. Right now, it's trading
at a big discount to a lot of the other Bakken companies on a
production, cash flow and per-acre basis. In addition, it owns a
molybdenum mine, which makes things a bit complicated for oil and
gas investors. That's because people who invest in mining
companies don't typically invest in O&G and vice versa. But,
it looks like that moly mine is worth a lot of money, and it
looks like the Bakken acreage and production are worth a lot of
money. If you add the two together, it seems to be worth much
more than what I'm paying for at the current stock price.
Josh, I've enjoyed meeting you very much. Thank you for taking
Josh Young is an honors graduate of the University of
Chicago, where he majored in economics. Before founding his own
investment management partnership, he worked with Mercer
Management in Chicago, after which he joined a private equity
firm in Los Angeles. He also worked as a buy-side analyst and
money manager in a single-family investment office with more
than $1 billion under management.
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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: None.
2) The following companies mentioned in the interview are
sponsors of The Energy Report: Equal Energy, U.S. Energy.
3) Josh Young: I personally and/or my family own shares of the
following companies mentioned in this interview: Gastar
Exploration, Molopo, Equal Energy, Galleon Energy, U.S. Energy
Corp., Lucas Energy, Ram Energy and Double Eagle Petroleum. I
personally and/or my family are paid by the following companies:
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