The Energy Report: Petroleum prices are largely set by the world market because the product is easily transported via tankers, but natural gas is still regionally priced. Could the development of more liquefied natural gas (LNG) plants in North America affect gas prices?
Ryan Galloway: If more LNG facilities come online in key areas, that will help to reduce regional differentials from excess regional supply. For example, the Kitimat project would be extremely helpful for Montney and Horn River gas in Northeast British Columbia/Northwest Alberta. But a broad, rapid, North America-wide increase in gas prices would still be tricky. A gradual price uptick paired with more stability and reduced differentials is far more likely. Over the last few years, a lot of the North American producers have managed to bring down costs and focus on liquids-rich gas plays, and they're doing OK despite low gas prices.
TER: Does the U.S. shale gas production threaten gas producers in Canada?
RG: A lot of that impact has already been felt. U.S. shale gas production really started to accelerate in 2008. Last summer, major gas price lows triggered a lot of "release valves," including coal-to-gas switching. At peak times, we saw 8–10 billion cubic feet per day (Bcf/d) in incremental demand. There has been more industrial demand growth as well. If prices do start to decline, that should create enough marginal demand to avoid shutting out gas producers. On the flip side, if gas prices rally quite hard, we could see a reversal on that coal-to-gas situation. Longer term, I see fairly stable prices and a gradual uptick, but I don't see the Canadians getting shut out.
TER: Which oil and gas companies could benefit from an increase in prices?
RG: All of the oil and gas companies benefit quite nicely. But for the gas-weighted players I have under coverage, I like Crocotta Energy Inc. (CTA:TSX). Crocotta is a lean and mean gas producer with $56/barrel of oil equivalent ($5–6/boe) total costs and netbacks around $20/boe despite having a 65% gas weighting. It has also grown production about 300% since 2010. In addition to core acreage at Edson, it has a very solid position in the Montney with over 35 net sections where we should see a lot more development in H2/13. A lot of its wells boast 100+% internal rates of return, so if gas pricing improves, a lot of these could go from being good assets to fantastic assets.
Bellatrix Exploration Ltd. (BXE:TSX) is another large, gas-weighted player, also about 65–70% gas. It should see positive support to cash flow (est. at $1.69/share) going forward if pricing improves. What people forget about Bellatrix is its significant Duvernay acreage. It has over 300 potential future wells in the Duvernay needing a $3.5B investment. There's massive potential for Bellatrix on its Duvernay acreage in the event of a gradual improvement to gas prices.
Outside my coverage, I also like Yoho Resources Inc. (YO:TSX.V). It's a junior that's also leveraged to the Duvernay and Montney. It is an early mover in Duvernay and partners with Exxon Mobil Corp. (XOM:NYSE) and Trilogy Energy Corp. (TET:TSX).
TER: Bellatrix Exploration's website describes its strategy as "drilling, development and targeted acquisition." Does it have the balance sheet to support this strategy?
RG: We see Bellatrix having an all-in, net debt position around $260 million ($260M) at the end of 2013. We see that as very manageable at just over 1x exit cash flow rates. It definitely has the cash flow to support a level of debt to continue drilling. With its latest Korean joint venture, Bellatrix also got access to third-party capital, bringing in about $150M from the Koreans to accelerate Cardium development.
TER: How is the company handling the fast growth it has experienced since 2009?
RG: Bellatrix has done it pretty intelligently. In 2012, in advance of this production, the company talked about getting infrastructure in place. That included an 18-kilometer pipeline across the North Saskatchewan River to get access to a couple of plants in the area—the Alder Flats shallow-cut plant, where there's about 15 million cubic feet per day (15 MMcf/d) capacity, and the Keyera Facilities Income Fund (KEY.UN:TSX) Minnehik Buck Lake plant, which has about 100 MMcf/d unused capacity. A lot of that infrastructure is in place to allow it to grow this production quickly. It is also optimizing its efficiency by doing more pad drilling.
TER: Are the gas producers expecting to maximize their returns in the wholesale gas market or in LNG?
RG: It's a bit of a mix. Given that U.S. and Canadian production is around 77 Bcf/d currently, there won't be enough LNG offtake for that. The producers will benefit indirectly from LNG sales operated by other majors. LNG is extremely capital intensive, so the bigger guys will be involved and have some of the option value. Regionally, smaller players will benefit indirectly from the pricing on the wholesale market.
TER: Can geography make a big difference in a company’s profitability? Can a company like Sterling Resources Ltd. (SLG:TSX.V) take advantage of the European desire to free itself from dependence on Russian natural gas because of its location in Western Europe and Romania?
RG: Yes. Sterling Resources has quite a good gas-weighted portfolio, especially in the U.K. as well as in Romania. That should really help it in terms of its ability to take advantage of high European gas prices. In the U.K., for example, we've seen prices as high as $11 per thousand cubic feet ($11/Mcf) on some forward contracts. Sterling's core asset is an offshore asset called Breagh, set to come online this August. That will add about 45–54 MMcf/d net. That will make Sterling hugely leveraged to high U.K. natural gas prices. Going forward, Romania is a big deal for Sterling as well, where they have a lot of discoveries offshore. In late 2013 and 2014, the company plans to conduct additional exploration and appraisal to help prove what it's quoting as a "gas hub" around existing discoveries known as Ana and Doina. You can put together those two offshore-Romania gas discoveries with numerous other prospects in the area, build gas infrastructure and then pipe that onshore.
The nice thing is that historically, Romania has had price regulation that keep gas prices in the high $3/Mcf range, but as a member of the European Union (EU), it has been getting a bit of pressure to allow free-market pricing to prevail. Laws passed very recently are going to put pricing toward the $10/Mcf range by 2018 and probably sooner on the industrial side. Prices there are set to increase rapidly, and there are good gas discoveries and additional prospects to appraise and explore in offshore Romania. The issue for Sterling is just prioritizing which ones it wants to go after first.
TER: Palliser Oil & Gas Corp. (PXL:TSX.V) ships an increasing percentage of its heavy oil by rail. Is its operating efficiency enough to offset the premium it pays for that?
RG: Absolutely. Palliser is a heavy oil producer and we've seen fairly large differentials on heavy oil this year. While Palliser hasn't disclosed figures on what kind of incremental benefit it gets from rail, we're estimating that depending on the differentials it is experiencing, it could get between $6–15/barrel ($6–15/bbl) in improved netbacks. Even a small change to that netback is quite material to the overall cash flow for the company. Other heavy-oil operators have needed to get additional equipment on some of their oil batteries to reduce the amount of water in their oil to meet rail specifications, but Palliser actually installed a lot of that equipment in the first place, which helped the company save money in the long run.
TER: When the Whiting refinery comes online, how will that affect Palliser's share price?
RG: Whiting is fairly important for heavy oil producers because that upgrade will increase the capacity for heavy crude, currently around 20% of its throughput, up to 85%. That will bring on about 420 thousand barrels per day, which should help to alleviate some of the oil differential we're seeing between heavy and lighter blends in Alberta. It should help to improve cash flows for the company, and hopefully share price appreciation will follow.
TER: Is Iona Energy Inc.'s (INA:TSX.V) focus on the North Sea permanent, or is it just a springboard to future expansion elsewhere?
RG: Management at Iona is well experienced in the U.K. North Sea. Neill Carson and Brad Gunn, Iona's CEO and CFO, were also founders of Ithaca Energy Inc. (IAE:TSX), another successful offshore U.K. player, and the rest of the management team is very experienced in U.K. offshore. It makes sense for them to go after the assets that they know, and they've done a good job of it so far.
Iona's game plan in the past has been to secure smaller fields that have been ignored by the larger players, and do this at discounted costs, and then get them developed and tied back into existing facilities. This minimizes its infrastructure risk and minimizes delays associated with building new infrastructure. So we see it continuing with a U.K. focus for the foreseeable future.
The key asset it just acquired, Huntington, is likely going to be onstream imminently. Then it is going to continue with U.K. development of an asset called Orlando, which should bring on about 7,500 barrels per day oil net in late 2014, Kells in 2015 and then another asset called West Wick to follow. I see Iona advancing with quite a good pipeline of development-oriented assets in the U.K. for the next few years. What I like about Iona is that, by 2014, it could be putting out nearly $0.90/share in cash flow versus where it's currently trading, around $0.68/share. This could be a story that really takes off again.
TER: TAG Oil Ltd. (TAO:TSX.V) website notes that two Canadian independents, Addax Petroleum (AXC:TSX) and Tanganyika Oil Company Ltd. (TYK:TSX.V), were acquired by Chinese majors. Is TAG looking for a buyer?
RG: Everyone is potentially for sale for the right price. What TAG is looking to do in the near term is advance its East Coast shale prospects in New Zealand. It is a massive unconventional oil resource play, and TAG is looking to drill that imminently to see what kind of oil shale potential it has on the East Coast. I think it wants to see how that goes before it even considers selling the company, because there's huge value there. Apache Corp. (APA:NYSE) recently exited the joint venture for reasons unrelated to technical feasibility of the shale. TAG has already gotten other interest from parties that might be looking to establish a new joint venture. But I think TAG wants to see what it has before looking at any other options, because it's pretty confident in the potential of oil shale in New Zealand.
TER: What is TAG's reason for focusing on exploration and production in New Zealand?
RG: New Zealand has conventional production but also huge unconventional potential on the East Coast. So when management was first getting into New Zealand, it had a view that conventional supplies worldwide were approaching a peak and there was a need to look for unconventional resources worldwide. We had started to see horizontal, multistage frack technology in North America. So the expectation was if you could find some interesting assets globally, especially in a politically safe jurisdiction like New Zealand and that is closer to demand centers like Southeast Asia, then you could have potential to develop an unconventional resource base. That's what TAG likes there. The resource assessment it got for East Coast was pointing to 12 billion barrels (12 Bbbl), so it's a huge prize.
TER: Share prices for both TAG and Sterling have fallen over the last year. What makes them strong buys, in your opinion?
RG: First of all, big conventional production is finally arriving. TAG has behind-pipe oil and gas wells that need to be tied in. We've been waiting a little while to get that in place, but we hear that it's ready to rock and roll and move forward with a big production ramp up, currently from around 2 thousand barrels oil equivalent per day (2 Mboe/d) to between 4–6 Mboe/d. Second, TAG is advancing on the East Coast shale with a likely spud date in late April or early May for the first vertical stratigraphic well. So if it sees the oil that it's expecting, that could be absolutely massive for the stock. Once you've drilled a few shale wells to delineate the resource, a large area becomes very prospective for additional shale oil drilling and development.
The last reason that TAG is a strong buy is that this summer it is also likely to be drilling a deep gas condensate prospect called Cardiff. Based on what other operators have seen in the same formation nearby, Cardiff could have the potential to be a 30-MMcf/d producer. There is significant upside to the stock in multiple areas over the next few months.
As for Sterling, it has just raised $63M to improve its financing situation. Sterling still needs to work out a few details on its lending facility to unlock the Breagh cash flow, but I'm confident it can renegotiate the terms successfully. Breagh plus the Romanian assets and the other assets it has in its portfolio should provide additional value going forward. That's why we're pretty positive on Sterling's prospects longer term, now that it has come out of the challenges it had earlier this year.
TER: Any final parting thoughts you'd like to share?
RG: There are good quality domestic names, but at some point, I think the internationals are going to attract interest as well. We've had a very risk-off environment in the past year. That could gradually improve in 2013. With the oil differentials in place, uncertainty on oil pricing in North America from pipeline bottlenecks and the Alberta budget situation adding uncertainty on the royalty and tax side, it's very plausible that you could start to see internationals looking more competitive, with very interesting risk-return profiles.
TER: Ryan, thank you very much for your time today.
RG: Thank you very much.
Ryan Galloway joined Casimir Capital in 2011. He was previously at Wellington West Capital Markets, where he covered domestic and international E&P companies. Prior to Wellington West Capital Markets, he spent six years at Encana with experience in financial reporting, strategic planning, business development and public policy. Galloway holds a Bachelor of Commerce from the University of Alberta and is both a CFA Charterholder and a Certified Management Accountant.
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1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: none.
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3) Ryan Galloway: I or my family own shares of the following companies mentioned in this interview: Bellatrix Exploration and Iona Energy. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Bellatrix Exploration, Iona Energy, Sterling Resources, TAG Oil and Palliser Oil & Gas. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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