Source: George Mack of The Energy Report (6/23/11)
Companies Mentioned: 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?
Josef Schachter: 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 Administration (EIA) 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 U.S.
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 Arab Spring premium. The other 50% is the hedge and commodity funds.
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 low-$30s.
TER: You use technical analysis quite extensively in your research reports, more than many sellside analysts. What are the charts telling you?
JS: 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.
TER: 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. gasoline?
JS: 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.
TER: Nat gas is quite a bit higher in Europe and Asia. Is there an arbitrage opportunity?
JS: 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 landed costs 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 (LNG) and ship it to Japan due to distance, and it may not be enough of an arbitrage to attract the kind of capital needed.
TER: 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?
JS: 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 instance, 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 producer 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.
TER: 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?
JS: 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. (TSX:TLM) and 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 environmental case.
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.
TER: What are the plays that you're recommending for investors today?
JS: We like companies in Western Canada, where there are multizone liquids-rich natural gas areas. Oil is in some of the plays like the Cardium Formation or the Doe Creek. So, we like companies like Delphi Energy Corp. (TSX:DEE), Vero Energy Inc. (TSX:VRO) and Galleon Energy Inc. (TSX:GO). We also like some Canadian-domiciled companies dealing with international markets like Niko Resources Ltd. (TSX:NKO), 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 with that.
TER: 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?
JS: 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 the dry gas 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.
TER: 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.
JS: 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.
TER: 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?
JS: 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.
TER: 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?
JS: 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 draw attention.
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.
TER: Can the small guys survive?
JS: 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 Duvernay 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 areas before the big boys come in—and where the little guys now just can't compete.
TER: That makes sense. Josef, do you have any further thoughts that you'd like to leave with our readers?
JS: 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.
TER: Great advice. Thank you, Josef.
JS: Thank you.
After a successful investment stewardship at Richardson Greenshields of Canada Limited (RGCL), and the Royal Bank purchase of that firm, Josef 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 Analysts.
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 and Business Edge—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 Talks."
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DISCLOSURE:
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: None.
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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