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Kevin Shaw: Carpe Cardium, Kurdistan & the North Sea

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Wellington West Analyst Kevin Shaw lives in Alberta and believes there are few better places to invest than Canada's oil- and gas-rich provinces. But he also sees attractive international opportunities in such places as Kurdistan, the North Sea and Albania. "When you're putting a drill bit into the ground in Kurdistan," he says, "you're. . .'deep-sea fishing.'" In this exclusive interview with The Energy Report, Kevin explains why he's also big on the Cardium, Notikewin, Bakken/Three Forks and the Montney shale plays.

The Energy Report: Last week, the government of Alberta announced that it will reduce oil and gas royalty rates in the province to make them more competitive. You're based in Calgary. What impact will this have on the industry and the oil sands in particular?

Kevin Shaw: For Alberta's oil and gas industry, it's an overall positive move. For the last couple of years, we've been competing in the oil patch against some of our neighbors like Saskatchewan and BC. In Alberta, the regulations were changing every 6–12 months; Alberta didn't have a long-term vision. As a result, small to major companies in the oil patch were pushing their dollars into places that had more attractive fiscal regimes like Saskatchewan and northern BC. Now the government of Alberta has a long-term vision; it has reduced royalty rates and put incentives into some really, attractive technologies on which the industry is focused.

TER: What sort of technologies?

KS: Areas of application like horizontal drilling techniques into more mature oil and gas basins where it's really a recovery-type game to exploit more oil and gas. The government has hit the right spots; it's also stated that nothing will change for three years, so we've got a longer-term vision for our royalty structure, which is what investors, the markets. . .everyone wants to see.

TER: What's the new royalty rate?

KS: There is now a competitive 5% royalty incentive rate in the first 12 months that could extend up to 40+ months, depending on what types of targets are being drilled for oil or gas. Out of the gate, the 5% royalty rate will benefit all Alberta producers. There are a lot of drilling and horizontal resource-play incentives that, in some of the deep shale plays or even the shallower horizontal plays, can be upwards of $1 million per well. That's an incentive for the industry to increase activity in horizontal developments or go after some of the deeper targets—especially targets greater than 2,000 meters below surface. I believe this will bring more focus onto some of the well-known Alberta plays.

TER: What are some of those plays?

KS: The Cardium. It's is a major emerging oil-resource play in Canada. It has companies like PetroBakken Energy Ltd. (TSX:PBN), Daylight Energy Ltd. (TSX:DAY) and ARC Resources Ltd. (TSX:ARX; UN:AET), which are really ramping up and spending significant amounts of cash in the play this year and next. Other emerging mid-caps like Bellatrix Exploration Ltd. (TSX:BXE) and Equal Energy Ltd. (TSX:EQU; NYSE:EQU), two companies that I cover, and even smaller exploration and production (E&P) companies like Midway Energy Ltd. (TSX:MEL) and WestFire Energy Ltd. (TSX:WFE), which I also cover. These companies are going to benefit from the revised royalty regime, especially as horizontal wells extend out deeper into the plays.

Operators big and small are drilling longer, horizontal lateral legs and putting a higher density of fracks into plays like the Cardium or Viking Oil resource plays. Other key ones currently include the Montney and Notikewin gas resource plays, which are big in Alberta and in northeastern BC.

One of the companies I cover that has a huge acreage position in the Montney gas play is Painted Pony Petroleum Ltd. (TSX.V:PPY.A). They're surrounded by Progress Energy Resources Corp. (TSX:PRQ), Husky Energy Inc. (TSX:HSE), Talisman Energy Inc. (TSX:TLM; NYSE:TLM) and Royal Dutch Shell plc (NYSE:RDS-B). Those companies are developing huge reserves in the Montney right in the same neighborhood as Painted Pony, which currently holds ~126 net sections in the heart of the fairway.

To gain exposure to the liquids-rich Notikewin, we believe one of the best companies to own is Bellatrix, which is drilling horizontals that test 10+ mmcf/d with 40 bbl/mmcf liquids (mostly condensate) and receive up to ~$1 million per horizontal in Alberta royalty incentives.

TER: You mentioned companies like Midway and Bellatrix. Has the new royalty legislation caused you to re-evaluate some the companies you follow?

KS: You definitely look at who can benefit from it. Without getting into a lot of details, these types of royalty incentives in Alberta allow you to drill two or three wells and get almost a third or fourth for free. On a deeper well, you can now get over $1 million in incentives. If you drill three wells, you get $3 million. In a lot of these plays, you can drill a well for $3 million or less. The point is oil and gas companies in Alberta will be able to ramp up their drilling programs with the same capital budget as before but drill incrementally more wells.

TER: If there's more drilling, it stands to reason that some of the drilling companies are good investments.

KS: No question about it. Drillers are definitely going to get busier as activity levels increase. Because of heightened activity levels for horizontal drilling and multi-stage fracks, there's a long wait time to get wells fracture-stimulated because frack equipment is becoming very scarce. It's running around the clock. There's not enough equipment on either side of the border on some of the horizontal plays, which can delay operations in some cases. Frack equipment is becoming a hot commodity. If commodity prices, especially oil, continue to move further or stay in the current range—call it $60–$85—we're going to be very busy as an industry in a lot of these multi-stage frack, horizontal-resource plays. As that happens, we expect that the frack companies are going to be very good investments going forward.

TER: Any specific names?

KS: Trican Well Service Ltd. (TSX:TCW), Calfrac Well Services Ltd. (TSX:CFW) is another one. I don't cover the services as an analyst but those are two. There are lots of other companies, like Schlumberger Ltd. (NYSE:SLB) and Canyon Services Group Inc. (TSX:FRC)—another player that's evolving in the energy services space. It would be one to watch as a smaller entity in the frack business.

TER: In the U.S., the Obama administration ordered a moratorium on offshore oil and gas drilling as a result of the Gulf of Mexico (GOM) oil spill. What's Wellington's take of what's happening in the Gulf?

KS: Overall, it's a tragedy. For the next six months, obviously, the drilling permits have been stopped for the deeper drilling. Approximately 33 deepwater drilling permits were suspended for the next six months, and no further licenses will be issued until the cause of the explosion is known in more detail. My numbers say approximately 9% of U.S. oil production and about 3% of U.S. gas production comes from the deepwater drilling in the GOM. If you look at shallow drilling, the numbers are closer to 30% U.S. oil and 11% gas. Obviously, stopping deepwater drilling for six months will have an impact.

TER: Do you see an outright ban?

KS: No, I don't. Let's face it, offshore development for the energy industry is very important to the global supply and demand picture. Thousands and thousands of offshore well operations have been executed safely and efficiently. Quite honestly, the industry does a very good job of putting the right procedures in place and operates many safely run operations.

TER: What do you recommend investors do with offshore plays in the GOM?

KS: If people, who are currently invest only in GOM-based companies, want to have a portion of their portfolio in the offshore space, there are other places they can direct their money over the next 6–12 months while the GOM gets sorted out and back up and running.

TER: Where are those places?

KS: There's an awful lot of activity going on in UK's North Sea. Companies like Talisman and Nexen Inc. (TSX:NXY; NYSE:NXY), which are starting to ramp up activity there; and even smaller caps I cover that are growing steadily into the mid-cap space, in terms of overall asset base, like Ithaca Energy Inc. (TSX:IAE) and Sterling Resources Ltd. (TSX.V:SLG).

Ithaca is manufacturing oil in the North Sea and has steadily delivered results over the past 12 months, increasing oil production and boosting 2P reserves. And Sterling just started a six-well offshore drilling program with five of those in the North Sea targeting shallow depths (i.e., relatively simplistic operations, yet high impact oil and gas prospects).

There's offshore in Brazil and lots of other places around the world where you can direct money to the offshore side of the business. Many people in the investment world like the offshore space, given it provides exposure to big reserve targets per well and material changes in a stock's market performance overnight.

TER: A recent Wellington West investment presentation deemed Kurdistan "the world's hottest exploration region." Please explain.

KS: Kurdistan has what we would call "mega play" potential. There aren't too many multi-billion barrel areas that have been under-exploited or under-explored. Kurdistan is one of those regions because it hasn't been open for business to oil and gas nations or entities under the different government regimes of the last 20 years. There's huge hydrocarbon potential there, contained within huge seismic structures. That's the attraction to Kurdistan. You've seen companies like Heritage Oil Corp. (TSX:HOC) and Gulf Keystone Petroleum Ltd. (LSE:GKP), the United States Short Oil Fund (NYSE:DNO) and others positioning in Kurdistan, as well as the smaller companies like Vast Exploration Inc. (TSX.V:VST), Longford Energy (TSX.V:LFD), Range Energy Resources Inc. (TSX.V:RGO) and others that are trying to tie up land positions as more and more management teams see the big rewards if you drill into one of these mega, multi-billion barrel discoveries. The discoveries are so big—it is one of the only places in the world you can still get truly "BIG" oil in place.

TER: What's the risk?

KS: The risk with Kurdistan continues to be the geopolitical environment between Baghdad and the Kurdistan regional government. At the end of the day, you've got over 35 international oil and gas companies in the area. Many governments around the world are trying to work with Baghdad and the Kurdistan regional government to figure out a proper business "law" to move the oil and gas industry forward. Kurdistan is definitely at a real primitive stage, in terms of having a business system and set of regulations for investment into the area by oil and gas companies. That's the risk right now, but there's a huge prize for the government to resolve this situation. I believe it will get resolved, but it may take some time.

TER: What are some junior E&P companies that you're following in Kurdistan?

KS: I cover Vast and Longford. Vast just spud a well a few weeks ago with Niko Resources Ltd. (TSX: NKO), a large international operator in the area. It's pretty exciting times for Vast right now. Vast has several large structures on their block in Kurdistan. Most of the blocks there are on trend with some of the major producing fields, whether it's Kirkuk or Taq Taq. When you're putting a drill bit into the ground in Kurdistan, you're—what I call—going "deep sea fishing." You're not sure what you're going to hit! Oil and gas has been hit over the last 12–14 months across four different horizons of interest. Whether it's in the Tertiary, Cretaceous, Jurassic or Triassic, there's a lot of hydrocarbon potential to change a company's stock price materially overnight.

Vast is currently drilling three large structures, all of which could easily be 100–350 million barrels. You could hit a 1 billion+ barrels-a-day find like that which Heritage hit not long ago. Other big players in the area that have drilled successful wells like Addax Petroleum Ltd. (TSX.V:SLG), which has now sold; and Gulf Keystone, farther to the north in the Kurdistan region, has hit some big finds. Both Vast and Longford are run by the same management team. The Longford block is a shallow development play that already has a number of vertical wells that were put into the block that did produce or show oil. We believe, Range Energy Resources is the cheapest trading stock in the Kurdistan space, currently, and could have one of the most attractive blocks in all of the Kurdistan region, nestled between the Heritage discovery and the existing multi-billion barrel Taq Taq field.

TER: Congratulations on the success you've had with Bankers Petroleum Ltd. (TSX:BNK), Painted Pony and Arsenal Energy Inc. (TSX:AEI). Of all those companies, what are some common elements that allowed such dramatic appreciation of their respective share prices?

KS: I'm a technical guy—oil and gas engineer/operations—by background. I look for what I call a "manufacturing approach" to a lot of the plays. I like to see legs to the story, in terms of growth in proven and probable reserves (2P). A lot of companies in the oil and gas industry can go out and drill a few wells and press release some pretty big production numbers. At the end of the day, you have to build 2P reserves to build a successful oil and gas company—small or big. Companies like Painted Pony, Arsenal, Bellatrix, Midway, Ithaca and Sterling are all steadily building 2P reserves and increasing shareholder value. Many of these companies are involved in very repeatable-type plays in the oil and gas space. There is minimal geological risk in these plays, as the oil or gas resource is there. It really comes down to recovery and the application of technology for exploitation. They tie up the land, and then use technology—horizontal drilling, multi-stage fracks, etc.—to boost the recovery factor per well. They boost the production rates and focus on depleting the resource per section across their acreage in a very methodical "assembly-line" manufacturing approach. If companies are doing that and you can see that they've got low-risk acreage in front of them, reserve estimators will give them credit for the reserves.

TER: Where does the "manufacturing" come in?

KS: If companies boost recoveries on their assets, they'll continue to what I call "manufacture" oil or gas in the space. The Cardium companies like Bellatrix are doing that very effectively right now. Bakken players like Painted Pony in southeast Saskatchewan continue to do this very effectively and have made a lot of money for shareholders in the last few years with significant growth we believe still ahead of them in very repeatable plays both in the Bakken and in the Montney resource play in northeastern BC.

On our valuation, Arsenal Energy is a very undervalued company—one of the cheapest oil stocks in the entire domestic space. Arsenal has just recently released two very successful North Dakota Bakken horizontal results, with these wells coming in at over 1,000 barrels per day (bpd) gross for initial production rates. You get big reserves from both of those wells, anywhere from 400,000–800,000 barrels in 2P reserve bookings. Arsenal's acreage in North Dakota is very low risk, as it has a number of wells on its property that have been drilled successfully in both the Bakken and emerging Three Forks oil resource plays. Companies like Continental Resources Inc. (NYSE:CLR) and EOG Resources (NYSE:EOG) have been drilling up all around them and de-risked their acreage. NuLoch Resources (TSX.V:NLR-A) is another North Dakota Bakken and Three Forks player to watch, with a huge acreage position (over 100 net sections) in these plays and partnered with larger companies like Baytex Energy Trust (TSX:BTE). When you have companies that have acreage in the right spot and very definable and visible production ramps in a well-known play wherein they have a large inventory of drill-ready locations, the value growth going forward is present. That's why I believe a lot of these companies have, obviously, appreciated over the last year or so.

TER: What are some of your strong buys among the domestics?

KS: We've talked about a few of them already. Bellatrix is definitely a strong buy recommendation. It has one of the premier acreage positions in the Cardium play with 81 net sections. It is right alongside the PetroBakkens and Daylights of the world. Bellatrix is one of the most attractive valuations in the Cardium space compared with its peer group. If you reverse engineer the buyout matrix of some of the companies PetroBakken and Daylight have purchased in the Cardium space over the last six months, you get Bellatrix anywhere between $8 and $10 a share. It's trading just over $3 right now.

Bellatrix has a great management team. It's a sizeable entity—over 8,000 bpd right now—and planning to exit the year at around the 10,000-bpd mark. There are hundreds and hundreds of locations in two great repeatable resource plays (i.e., the Cardium), and then the very liquids-rich Notikewin play in Alberta. These wells are drilled for about $3 million each. They test at 10+ mmcf/d and make anywhere from 30–70 barrels per million of liquids, which is mostly all condensate. Even in a low gas price environment, the economics in those plays are hugely supportive at current gas prices due to the couple hundred barrels of condensate/liquids they get with these wells.

TER: Let's continue with the strong buys.

KS: Arsenal is a smaller company than Bellatrix; it is producing about 2,600 bpd now, but it is very heavily weighted toward oil—more than 75% oil. The company really has three different core areas of operation and drilling. Right now, they trade at about half of their net asset value (NAV). I think they are around $0.90 on the recent broader market pullback, and it's trading at about 0.3x its price to cash flow at the end of this year. Arsenal is one of the best buys, valuation-wise; its stock should be well over a dollar.

Painted Pony's current trading price is more than backed up by what I call its Bakken oil "manufacturing" in southeastern Saskatchewan. It's in and around $6 and has over 100 net sections of Bakken acreage, which is over 95% undeveloped. We also believe the company's getting next to no value in its stock price for having one of the best acreage positions in the Montney shale play in northeastern BC. Painted Pony is surrounded by Talisman, Progress, Husky, Shell and others, with 126 net sections in the Montney. Over the last few weeks, it issued a press release on a couple of very successful Montney drill tests on its 100%-owned land; and the company's strategically partnered with Talisman and Progress on some bigger scale developments in the area. Painted Pony is one to watch, especially if gas price appreciates.

Another company in the domestic space and one to watch that just converted from a trust to a corporation is called Equal Energy. The company generates about 9,500 barrels of oil equivalent (boepd) and has several different resource plays in its asset portfolio. Equal has 21+ different oil pools here in Canada; and several of the favorites like the 'Cardium, Viking, Pemiscot and Dina light oil plays." It's just starting to drill some of growth areas and has already had some solid initial successes. The company, which rebranded officially as of June, is under new management; and management has done a great job of paying down over $150 million of debt so far to reposition this sizeable producer as a newly focused, emerging "mid cap." It's just coming out of the gate to start drilling its first series of horizontal wells; so that's one to watch.

TER: Any thoughts you'd like to leave us with?

KS: I see lots of room for growth in the energy side of the business. At some point, I see gas prices coming back to more of our cost basis on the North American side, call it $6–$7. As the gas price appreciates, you're going to see that a lot of stocks—both in the small- and mid-cap space—have a lot of torque to them. As the industries continue to put horizontal technology to bear, there's going to be significant growth in the oil plays domestically and internationally. It's a good place to be for investors—there's a lot of money to be made both domestically and internationally with oil prices over $60 a barrel.

TER: Thanks so much for speaking with us today, Kevin.

Kevin Shaw has extensive industry experience, including engineering, operations and management positions with Imperial Oil Resources, Trimox Energy Inc. and Colt Worley Parsons. Mr. Shaw has a B.Sc. in Mechanical Engineering with a minor in Petroleum; and an MBA from the Haskayne School of Business at the University of Calgary.

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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Vast Exploration and Royal Dutch Shell.
3) Kevin Shaw: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.

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