Keith Schaefer: Stick with Wet Gas, Heavy Oil
Source: Brian Sylvester of
Oil and Gas Investments Bulletin
Editor and Publisher Keith Schaefer specializes in Canadian oil
and gas plays. Despite the languishing gas price, he sees
opportunities in some hedged Canadian gas companies and unhedged
"wet-gas" producers. If you're not into gas, Keith is big on oil.
In this exclusive interview with
The Energy Report,
Keith will tell you how radial drilling is creating
opportunities in heavy oil, too.
The Energy Report:
The Energy Report
talked with you in
, you said that a gas price below $5 would be "hell." Well, welcome
to hell. Gas is hovering around $4.50 right now. Where's the
It has been a very tough year for gas producers. Since January, the
gas price has been on a straight downhill slide, with very few
bumps up along the way. It has been hell, particularly for the
juniors that are unhedged. These companies are creating no value
for their shareholders. Their cash flow is anemic.
Where is the bottom? I think there's a good chance we're going
to find that out in the next month or so, because gas traditionally
bottoms in August. Last year, it bottomed around $2.50, $2.75 per
MCF. Then in September, it started to take a big jump back up to
$5. These stocks had a huge run along with that. It's almost funny,
because none of these companies were really making money at $5, but
the fact that they were losing a little bit less made the market
very happy, and that took the stocks for a big run.
At the same time, a lot of producers are hedged. Most of them are
right around the $6 mark.
Many of the seniors are hedged at $6. The forward curve has allowed
them to do that. Good for them and their shareholders, because it
looks like we could be in for a multi-year low gas price if these
U.S. shale plays hold up.
What's your view on the gas price through the end of this year and
the end of 2011?
I think this year we're going to get a little bit higher, but not
much. Right now gas in the States is running around $4.50. In
Canada, it's running at about a dollar less. These shale gas plays
in the U.S. are doing a superb job at increasing production. Unless
there's a dramatic increase in demand or a significant falloff from
production, we're going to be staying right around here; maybe a
little bit higher, but not much.
And that's through the end of 2011 as well?
The end of 2011 could be very interesting, just because many of
these shale gas plays are relatively new. Right now companies stake
a bunch of land and they have to drill the land to hold it. Once
they've drilled a certain amount of holes, that land is theirs.
When that happens, I expect these companies to stop drilling. That
should actually be quite positive for the gas price. Companies are
being forced to drill to keep their land when the market says they
Are there companies that, despite the low gas prices, continue to
Oh, yes. You're seeing several companies do better than expected,
for a couple of reasons. Some have been smart enough to hedge,
which has benefited their balance sheet and their cash flow.
Bellatrix Exploration Ltd. (
is at the top of that list, and it's in our
Oil and Gas Investment Bulletin
Portfolio. They've hedged 50% of their gas at close to $7, so their
cash flow has been fantastic this year. A second reason Bellatrix
is doing better than expected is that they have a large land
position in a burgeoning oil play in Alberta known as the Cardium.
That stock has outperformed its peers this year, and in my mind, it
will continue to. Another company that's done really well is
Angle Energy Inc. (
, a wet-gas producer. Wet gas gets about twice the amount of money
as dry gas.
Is this what's known as natural gas liquids in the U.S.?
Yes, liquid-rich gas. Angle has a huge growth curve in front of
them. They're not hedged. If you're looking to play gas, that's a
good one, because from their wet gas, they have downside protection
with good cash flow, at current gas prices. They also have huge
exposure to the upside if gas moves.
Are we seeing companies with assets that have a high percentage of
natural gas liquids getting higher valuations?
Absolutely. Companies are getting higher valuations because of
their higher wet gas percentages. Not across the board, but most of
them are, companies like Angle and some of the other high wet-gas
producers, which are mostly in the Deep Basin area of Alberta,
right outside the foothills. And up in the Montney shale play, as
well, they're getting higher liquids contents. They're getting 10,
20, 30, 40 barrels of wet gas per million cubic feet of dry gas,
which could basically double the economics.
Wow. Do you have some specific names with exposure to those plays
Orleans Energy Ltd. (
has a good wet gas count.
Cinch Energy Corp. (
has a wet gas count.
Vero Energy Inc. (
. . .
All right, what about Vero?
I love Vero. I think it's a great company. The stock trades very,
very well for how few shares-only 30 million-are out. Vero has one
of the top management teams in the business, Doug Bartole and his
vice president of exploration, Kevin Yakiwchuk. They have a great
property in the Edson area of Alberta. They've shown great
discipline in producing when the gas price is good and shutting
down production when it's not. They've managed their finances very
well. Vero keeps a high debt ratio, which means they don't have to
issue many shares because they're generating most of their growth
by using debt. They've got this new Cardium oil play, which has
over 90 net sections. That's a lot of oil that they can bring
onstream, very profitable oil.
Are they in production right now?
They're producing 8,000-8,500 barrels a day.
Are there any other gas companies that you're excited about? You
Peyto Energy Trust (TSX:PEY-U; OTC:PEYUF)
. Tell us about that one.
Peyto is the lowest-cost producer in Canada. Their suite of
properties is best of breed. Management has done a fantastic job.
Over the last 10 years, that stock went from $1 to $45. I actually
owned that stock when it was $1 a share, back in 1998. Now, of
course, after the crash, everything's changed; but they continue to
have the lowest- cost production, and a great growth profile. If
you were only going to buy one gas company to get some exposure to
a potentially rising gas price, Peyto-being the lowest-cost
producer-would be it.
A recent report on the U.S. shale plays by Credit Suisse talked
about some of the gas shale plays with the best internal rates of
). The Marcellus was ranked second, with a 42% IRR. What are some
companies with significant exposure to the Marcellus?
One of the best companies that I like for exposure to the Marcellus
shale play is actually an energy services company that does a lot
of the drilling work and mud work for the producers in that area.
Canadian Energy Services and Technology Corp. (
. They've been able to make huge inroads into the Marcellus by
selling their products to the drillers and producers there. Their
mud allows drillers to complete a well in the Marcellus about 10
days sooner than normal. That dramatically reduces costs, which is
one of the reasons the Marcellus is turning into a much more
profitable play. On the producer's side, I think one of the safest
plays in the Marcellus is a company called
Epsilon Energy Ltd. (
. They have a deal with
Chesapeake Energy Corp. (
, the second largest gas producer in the United States. Between
cash payments and work commitments, they've paid Epsilon about $200
million to get access to Epsilon's Marcellus ground in
Pennsylvania. Epsilon basically has a free ride. In one sense it
doesn't really matter what gas prices do, because Chesapeake is
paying the freight. I love companies like that.
I think we'll switch over to oil. Oil remains just below $80 a
barrel. Do you think that's a psychological barrier? Does oil need
to get past $80 to have a run?
No, not at all. Oil doesn't need to run. I'm happy to see oil trade
here for the next five years, because there are lots of companies
that make fantastic profits at $75 oil. Technology is lowering
costs in the oil patch. With the new horizontal drilling technology
and multi-stage fracking, all kinds of new plays are opening up.
Literally. Just yesterday, a new play opened up in Canada that no
one had really paid much attention to. One of the independent
consultants estimated that there are over 6 billion barrels of oil
just in that one formation in Alberta in B.C. So all over the place
you're seeing new basins, new formations being opened up with all
this new technology, and it's relatively low-cost oil, not compared
to the Saudis
but by the standards everywhere else in the world, it's very
profitable oil at these prices. The oil price does not need to go
Do you see it staying in that range for the next couple of
That's a question that only history is going to be able to tell us.
But I would suggest that, with the decline in demand in the U.S.
and Western Europe being offset by the rise of China and India,
we're going to see a fairly stable oil price for a while.
You were talking just a few seconds ago about technology opening up
some new plays. At the same time, fracking is not all that new.
Multi-stage fracking has been around for a while. and horizontal
drilling has been around for a while. What are new technologies in
oil and gas exploration that we haven't heard about?
There are new ones coming up all the time. But let's just go back
to fracking and horizontal drilling for a second. Although those
technologies have been around for 40, almost 50, years, it was just
10 or 12 years ago that the technologies got perfected enough so
that they could start producing oil and gas out of rock. That was
the Barnett shale.
What you've seen here now is that many new plays around Canada
and the U.S., where the technology was developed, have become newly
commercial. Even though they're old technologies, they're still
opening up many, many new plays all around the world-the European
shale gas plays, the African shale gas, and that's just scratching
the surface. We're going to see huge growth in Europe and Africa
shale gas over the next 20 years. You're right, they are old
technologies, but they're being used in new basins for the first
time and that's creating big value for shareholders.
One of the new technologies that I'm really intrigued by is
radial drilling, which is used in heavy oil basins. I believe this
is a technology developed by
Halliburton Co. (
. Little jets are sent into the very porous heavy oil formations
and are able to create wormholes 100 meters out into the formation,
to get oil to flow back to the well. Before this technology was
being used, you could only get about 3 to 5 meters outside of the
wellbore. It's a huge increase in potential production and reserve
And that's making some of these old basins profitable again?
Yes. What's happening is that the old basins that have been worked
over now have a new lease on life. I would say that heavy oil
formations haven't really been used or exploited that much. The
world's been very focused on getting the light oil out. But over
the last dozen years, much more time has been spent focusing on the
heavy oil. They're continually finding ways to improve the
technology and lower the cost.
What are the big differences between heavy oil and light oil?
Light oil is easy to process, and doesn't need much work to get
into the form that would go into your car. Heavy oil has heavy
products in it like metals; it's the basic component of asphalt. We
have to spend a lot of money to remove the asphalt, rocks, and bits
of metal to make heavy oil into various types of fuel. Heavy oil
doesn't go into your car; it will go into heating products or
diesel, or products where it doesn't need to be refined quite as
It's more expensive to process, but are there still some companies
that you like that are big into heavy oil and are profitable. Could
you tell us about some of those?
Yes. That's a great point. What's happening here is that many of
the U.S. refineries, particularly those down in the Gulf of Mexico,
are geared toward heavy oil. You just can't change your refinery at
the flick of a switch and say, "Alright, today we're going to do
light oil. Tomorrow we're going to do heavy oil." When you're a
heavy oil refinery, that's the type of feedstock you need.
The two biggest sources of heavy oil, Mexico and Venezuela, are
in steep decline-Mexico for geological reasons, Venezuela for
political reasons. That means that the heavy oil from Canada is in
hot demand in U.S. refineries. There's a new pipeline being
proposed to take oil from Canada down to the U.S. refineries. Many
heavy oil producers that are used to getting only 50%-60% of the
regular oil price for their products, because it costs so much more
to process them, are now getting 85%-90% of the regular oil price.
Over the last two or three years, there has been a huge increase in
the heavy oil price. What they called a "heavy oil discount" has
gotten much smaller. And the heavy oil in Canada is very shallow,
so it does not cost much to produce. Wells only cost
$300,000-$700,000, versus $3 million-$5 million for a deep light
oil well. So when your costs are low and the price of your product
has gone up a great deal, that's a recipe for profits.
Tell us about some of those companies that are profiting from this
trend in heavy oil.
Well, one of my favorites is a company called
Emerge Oil and Gas Inc. (
, which has lots of heavy oil in Alberta and in Saskatchewan. They
have done a great job securing large land packages that have highly
prospective oil leases. Emerge has been able to deliver good
production growth and will continue to do so over at least the next
Another one that I like is a company called
Rock Energy Inc. (
. CEO Al Bey knows how to secure land positions, and he has a very
good cost-control system in place. Some of their properties are
able to deliver profits of three to seven times the money that Rock
puts into them. For every dollar that they put into the search for
the oil, they're able to return $3-$7 to the shareholders. That's a
fantastic "recycle ratio."
What other things has management done?
They just brought on John Van De Pol as President and CFO. John's
been involved in a couple of winners in the past, has a lot of
experience and does it right. He's very methodical. For a
shareholder, he's exactly the type of guy who gives you a lot of
What are Rock's prospects for growth?
They still have a large undeveloped land package, with a drilling
inventory of at least two to three years ahead of them. They'll be
able to continue to grow production quite strongly. Rock is also
one of the pioneers in using this new radial drilling technology.
They're finding that the amount of oil they can get out of each of
their land sections is increasing quite dramatically, and that's
been a big, big bonus.
Are there any other companies you like in the heavy oil space?
Not too many. Rock and Emerge are two of the best. Another one is
BlackPearl Resources Inc. (
, which has a strong growth profile. Their growth is actually going
to come in chunks. Unlike Emerge and Rock, which are able to drill
a lot of small wells, BlackPearl has slightly larger assets that
take more time and more capital to develop. Their growth is going
to come more in steps and stages, as opposed to the steady growth
that Rock and Emerge will have. But it's a well-respected team, and
the market loves BlackPearl.
They trade at a much higher valuation, for example, than Emerge
does. Its market cap relative to its production is very high. With
almost 300 million shares issued, the company is worth almost $1
billion. For the level of production that it has right now,
BlackPearl is a relatively expensive stock.
BP (NYSE:BP; LSE:BP)
sold most of its Canadian assets to
Apache Corp. (
. Will that create any opportunities in Canada?
I think it's too early to say. But let's consider Apache the
general contractor in a construction job. They are going to
cherry-pick the assets that they really want and sell off the
smaller assets that they don't want. You're going to see a
filtering-down of these assets to smaller companies over the next
year. That should create a pretty big opportunity for the right
team that's able to get a good land position.
What could it do for Apache?
Apache has been spending a lot of money up here, which is
interesting. They're one of the largest gas producers in Canada.
They bought the controlling interest in the LNG (Liquefied Natural
Gas) terminal being built at Kitimat, British Columbia. That gas
will go to Asia, where the price is much better. This is one of the
strategic things Apache has been able to do: basically, set
themselves up as huge land and major infrastructure owners to send
gas overseas, where it gets a much better price.
If Apache had to send this gas down to the U.S., it would not be
very profitable, because it's way up near the Yukon border. And
with Marcellus production coming on-stream, that's really cutting
out a lot of Canadian gas into the States. But if they can keep
that gas producing and send it over to Asia, via the LNG terminal
on Canada's west coast, that could be a huge profit center for
Are there parting thoughts you want to leave us with?
Many natural gas companies are trying to rebrand themselves now as
wet-gas companies, to try to get higher valuations. We're going to
see a lot of that type of talk over the next six months. But I
don't see any sustained pick-up in the gas price for a year. Having
said that, as soon as we get a sign that some of these U.S. shale
plays are going to fizzle quicker than expected, that situation
could change very, very quickly.
Also, we have a special offer exclusively for
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Keith Schaefer of the
Oil & Gas Investments Bulletin
writes on oil and natural gas markets. His newsletter
outlines which TSX-listed energy companies have the ability to
grow, and bring shareholders prosperity. He has a degree in
journalism and has worked for several dailies in Canada, but has
spent the last 15 years assisting public resource companies in
raising exploration and expansion capital.
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1) Brian Sylvester, of
The Energy Report,
conducted this interview. He personally and/or his family own none
of the companies mentioned in this interview.
2) The following companies mentioned in the interview are sponsors
The Energy Report:
3) Keith Schaefer-I personally and/or my family own the following
companies mentioned in this interview: Rock Energy, Angle Energy,
Bellatrix Energy, Vero Energy, Orleans Energy, Cinch Energy,
Canadian Energy Services, Emerge Energy, BlackPearl Resources. I
personally and/or my family am paid by the following companies
mentioned in this interview: None.
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