The Energy Report: What are the key considerations investors should make in evaluating geographical location and political risk in junior exploration and development plays?
James West: Outside of North America, there are a few obvious no-go zones—Russia, China and parts of war-torn Africa. Then again, we did see a great junior success in Kenya with Africa Oil Corp. (AOI:TSX.V), so certain regions in Africa are less risky. Presently in Kenya, I'm watching the progress of Africa Hydrocarbons Inc. (NFK:TSX.V) with interest as the company seeks to emulate Africa Oil's success. Africa Hydrocarbons commenced drilling on its 47.5%-owned Bouhajla Block, located onshore in Tunisia within the productive Pelagian Basin.
Australia carries little or no political risk of expropriation. Terra Nova Energy Ltd. (TGC:TSX.V; TNVMF:OTCPK; GLTN:FSE) is drilling in the Cooper Basin in Australia. Initial production wells that Chevron Corp. (CVX:NYSE) drilled in that basin are pumping 2,000 barrels per day (Mbbl/d). And investors will do well to concentrate on Canada and the United States—there is just so much profitable activity going on in the shale space and in legacy wells and oil field redevelopment.
It's actually Beach Energy Ltd. (BPT:ASX) that made the initial discoveries in the Cooper Basin, and is now flowing in excess of 10,000 barrels oil equivalent per day (boe/d). Chevron has farmed into two exploration permits owned by Beach Energy, but is a minority holder and non-operator.
TER: Are there any places where the political risk outweighs any potential payoffs?
JW: If a government is already inclined toward resource nationalization, then potential success does not really matter. A nationalized firm is going to lose it all, or see its assets tied up in international courts for years.
TER: Which countries in South America are safe?
JW: I am not too keen to invest in Argentina, even though there are Canada-listed TSX juniors producing oil there and at this point it is safe. I am nervous about the long-term political security of Argentina. But in Colombia, on the other hand, the trend is toward stability. Several companies doing business in Colombia are producing and exporting oil without incident. PetroAmerica Oil Corp. (PTA:TSX) is having great success. And Peru, Chile and, to a lesser extent, Brazil are very safe. Ecuador and Venezuela are at the opposite end of that spectrum. Those two countries are no-go zones.
TER: What type of challenge does a junior explorer need to overcome in a politically safe but geographically extreme region like the Yukon?
JW: Typically, the challenge for juniors in the far north is freezing temperatures, especially north of the Arctic Circle. But in the southwestern Yukon where, for example, companies like EFLO Energy Inc. (EFLO:OTCQB) operate, the weather is not so frigid. The challenge there is the snow pack. There are places where you cannot go with heavy equipment until the land is frozen over. That is the case in other Canadian regions, too. But those types of challenges to oil and gas exploration are not insurmountable. The oil sands in northwestern Alberta and northeastern British Columbia are a testament to that. Regardless of the challenges posed by extreme weather, the oils sands support one of the largest oil and gas production infrastructures to be found anywhere.
TER: Do drillers in difficult geographical locations tend to rely on service companies more heavily?
JW: Generally, the service companies are deployed at the same ratio. Local service companies have expertise relevant to the local weather patterns and the associated terrestrial challenges. So companies gravitate toward local firms for early-stage geophysics, but then when it comes to drilling deep, expensive wells, they gravitate toward the multinationals—companies like Baker Hughes Inc. (BHI:NYSE), Schlumberger Ltd. (SLB:NYSE), etc.
TER: You mentioned EFLO Energy. Could you give us a profile on that name?
JW: EFLO Energy has an interest in the Kotaneelee gas field in the Yukon, which is where Apache Corp. (APA:NYSE) recently announced a discovery hole with astounding flow rates. The potential size of the reservoir is over 30 billion cubic feet. It is proximal to where Apache is working on a very large land position with gas processing infrastructure. EFLO is well situated to take advantage of working one of the largest, but as yet undeveloped, gas fields in the world: the Kotaneelee.
TER: What is the situation with the share price of EFLO Energy?
JW: EFLO has held up well—between $1.40 and $2.60 during the last year. It's at $1.50 right now, but that is a reflection of the fact that it has not been drilling much of late. The company is currently focused on building its executive team. Once it starts to drill and develop the oil and gas field, its share price will most likely improve. If it makes a decent-size discovery, it will be a very attractive takeout candidate for a foreign national oil company. China's national oil companies are showing great interest in Canadian companies with large gas reserves.
TER: What about the Peace River Arch region? How does that differ from the Yukon in terms of geographical challenges?
JW: The Peace River Arch is a very mature, sedimentary basin. The geographical challenge is to find any available land left to prospect. The Alberta government has done such a good job of maintaining a database of all of the different pay zones that anybody can go online and effectively prospect for property. Where there is some success, the prices are driven up very quickly because the market instantly reflects demand. So it's very tough to get positions in the Peace River Arch region. There are great barriers to entry for new companies that want to get in, but there are a handful of juniors that are developing production nicely.
TER: Such as?
JW: Aroway Energy Inc. (ARW:TSX.V; ARWJF:OTCQX) is a very successful company that I have followed since 2011. Unfortunately, it is currently suffering from the deflationary effect, which afflicts the entire TSX Venture Exchange (TSX.V). Due to the generally poor performance of mining stocks, its share price halved during the last year. That trend does not look as if it is going to change soon. On the other hand, the TSX.V has been beaten up so badly that there are fantastic bargains available. Aroway is an excellent case in point. The company is producing over 1 Mbbl/d, and it has a great land position. Its share price does not reflect the actual value of the company, and Aroway has substantial cash flow and is growing production on an almost daily basis.
TER: What services companies operate in that region?
JW: There is Enterprise Group Inc. (E:TSX.V), which I started following in 2006. The company recently announced several acquisitions. It has acquired a specialized engineering firm, an underground infrastructure construction company that is generating $12 million ($12M) per year in revenue. The acquisition will give Enterprise 40% of its earnings before income tax, depreciation and amortization (EBITDA) in 2013. Enterprise's business model is to consolidate the oil field services industry in Western Canada. The plan is starting to pay off.
TER: From the investor point of view, what is the best type of corporate structure for a service firm—vertical or horizontal?
JW: Enterprise is integrating horizontally. It is in a position to capitalize on new trends in geophysics. It is able to offer everything to everyone. Companies that are more specialized tend to be boom-and-bust. When things are particularly good in their particular sector, then let the good times roll. But when the public appetite goes in a different direction, then those companies can flounder for years. Enterprise Group is acquiring companies across various subsectors in the oil field services and, thereby, insulating itself against future soft spots in the market.
TER: How is the Enterprise stock price doing?
JW: It is in the $0.70 range. The company has touched a 52-week high about 10 times this year. It has delivered a multiple of 7x. In July a year ago, it was trading at less than $0.20. Now, it's trading up near $0.70, and it is poised to go higher.
TER: You mentioned that Alberta has an online prospecting database. Do other jurisdictions in North America maintain similar databases?
JW: Alberta has always led the oil and gas jurisdictions in preserving data and allowing access to it. That is really smart because it creates maximum demand for a potential hydrocarbon asset. The province's tax base benefits every single Albertan. In contrast, look at Texas, which was ground zero for the development of the oil industry. The rights to oil and gas assets in Texas are controlled by a politicized railroad commission, which is more focused on real estate issues than developing energy assets. In Texas, it is almost impossible to figure out who owns what! If you are looking to acquire legacy data from previous hydrocarbon explorations on certain properties, it is like detective work. You have to chase information backward through courts and property deeds. That makes it almost impossible for a newcomer in Texas to buy properties without acquiring very specialized local expertise. At the end of the day, Texas is just not efficiently maximizing its hydrocarbon wealth on behalf of its tax base. That is not by design, it's just the way the system evolved there.
TER: What about other high-profile drilling jurisdictions, like North Dakota, Wyoming and Nevada?
JW: Each of those jurisdictions is regulated by the by the Bureau of Land Management (BLM). But the Bakken in North Dakota is now rather mature. With the declining price of natural gas and the increasing costs of exploration, there are fewer and fewer entrants knocking on the door. Geographically, there are few incumbents, and they are able to operate and finance continued exploration from production cash flows. The grassroots junior boom in land purchases that was characteristic of 2007-2008 is largely over now because the basins are better defined.
TER: So what is a junior company without land to do? Go abroad?
JW: For a junior company on the TSX.V, that's a good question. I know of a couple of companies that are electing to go abroad. One of them that we hold in The Midas Letter Opportunity Fund is Rift Basin Resources Corp. (RIF:TSX.V). Its projects in Tunisia are advancing in partnership with another British oil and gas company. It is exploring further in Tunisia and also planning exploration in Gabon. It is assessing an opportunity in Indonesia that could be huge. And, remember, I do not categorically dismiss Argentina—Americas Petrogas Inc. (BOE:TSX.V) is successfully drilling unconventional shale oil and gas wells there. The stock is down to $0.85 from a high in the last year of almost $3. But, again, that's largely a reflection of the ailing TSX.V.
TER: Are there junior opportunities in Brazil?
JW: It is very hard for explorers to compete with the national oil company, Petrobras (PBR:NYSE; PETR3:BOVESPA), which is majority owned by the government of Brazil. The country is really biased toward its own. Brazil is famous for that. Only rarely do outside companies acquire major Brazilian corporations. It is a type of covert resource nationalism, practiced not as a matter of public policy, but as a tacit demonstration of nationalistic attitude.
That said, my biggest winner of 2012 operates in Brazil. Abakan Inc. (ABKI:OTCQB) is building a four-line pipe cladding facility there. It will sell pipe to Petrobras. In fact, it has a joint development agreement with Petrobras, which holds a large percentage of its offshore wells at extremely high pressures. Petrobras pumps high-end hydrogen sulfide, which is extremely corrosive. Therefore, to produce the hydrocarbons economically, Petrobras needs to keep improving its gathering and transmission infrastructure. Abakan is really integral to Petrobras' future going forward, and that is why Petrobras and the government of Brazil are assisting Abakan in acquiring the land and financing to build the pipe manufacturing plant. Abakan's stock price has tripled in the last two years. It is waiting for a full NASDAQ listing. After Brazil, it plans to build an eight-line plant in Indonesia. Currently, its one plant throws off $60M annually in gross revenue, of which 40% is gross margin. It is a great cash maker, and there are a lot of projects in Indonesia and Brazil that will not move forward until the Abakan technologies can be deployed in the field.
TER: Are there any other geographical regions or undervalued exploration or service-oriented companies flying under the radar?
JW: Given the state of equity markets in general in the resource sector, a lot of investors are looking for yield. Our fund is no different. We are planning to invest in Argent Energy Trust (AET.UN:TSX), which is a Toronto-listed company that acquires producing oil and gas assets and distributes their revenue, minus the cost of administration, to the yield holders. Basically, it is averaging 10% annually in yield, and the unit holders are also exposed to a rising share price as the value of the portfolio increases and the company deploys capital to acquire more producers. For an energy-focused yield play, I cannot think of a better one than Argent Energy Trust.
TER: How does Argent manage to do that? Does it pick companies that are doing particularly well, or is it distributing risk over a bell curve?
JW: The key to Argent Energy Trust's strategy is that it exploits foreign asset regulations. It is classified as a foreign asset investment trust. It distributes the income from foreign-producing hydrocarbon assets on a tax-optimized basis to unit holders. Brian Prokop, who is the co-CEO and president, was formerly with Daylight Energy Ltd. He has experience in building and producing oil and gas assets. He's the perfect man in the perfect job! In terms of the tax benefits, approximately 60% return on capital is realized. The U.S. corporate tax on it is under 2%. It is a great way to play for yield in the energy sector.
TER: Any other comers?
JW: Surge Energy Inc. (SGY:TSX) bears watching. It was recently the subject of a bought-deal financing for $300M. It is moving more toward becoming a dividend-paying oil and gas company. That suggests great potential for the share price, as well as for the yield that the company will pay out. If it uses its treasury to acquire producing assets and distributes the proceeds to shareholders, that is far more attractive to me in the near term than a company that is raising capital to look for oil and gas assets when the return on that capital will be much lower.
TER: Thank for your time today, James.
JW: My pleasure, Peter.
James West is publisher and editor of The Midas Letter, an independent capital markets entrepreneur and investor. He has spent more than 20 years working as a corporate finance advisor, corporate development officer, investor relations officer, media relations and business development officer for companies involved in mining, oil and gas, alternative fuels, healthcare, Internet technology, transportation, manufacturing and housing construction.
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1) Peter Byrne 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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