The Energy Report: Is Pathfinder Asset Management a hedge fund?
Taylor MacDonald: Well, I think "hedge fund" would be a bit of a misnomer. We tend to invest on the long side, though we can use derivatives and go short. At the moment, we're much more of an investment fund. We originated as a family office set up to manage the assets of one particular client. After growing these assets organically over the last two years and more than doubling them, we finally decided to become a registered fund and initially will bring on friends, family and business associates' funds, perhaps opening the fund up on a much broader basis at some point.
TER: You've been on the sellside as both an analyst and a banker. Now, you pull the trigger to execute trades. Can you tell me the most valuable thing you learned as a banker and as an analyst that informs your practice today on the buyside?
TM: I would say that the most important thing I learned on the sellside is diligence—doing extensive homework on every deal you're evaluating. And that's a process that continues well after you make that investment by continuing to monitor things very closely. I want to keep a short leash on the insider trading and who owns most of the stock. I want to get to know management and look into their histories and do background checks, if necessary. I want to make sure I know every single aspect about the company. That often leads to site visits, bringing in specialists or hiring consultants to evaluate the technical merits of a given project.
TER: As a banker and an analyst, you had an opportunity to look at companies before they became public, so you had to do a lot of original research. Do you find yourself doing that even after a company goes public?
TM: Absolutely. Once a company is public, obviously, that research becomes much easier due to disclosure requirements. But we still go through many of the same processes that I did when I was on the investment banking side.
TER: Based on your extensive research on oil and gas (O&G), what do you see as the future for energy?
TM: In general, we're very bullish on energy. As early as the third quarter of last year (Q310), we pegged oil as one of our key themes for 2011, and we continue to be very bullish on oil for several reasons. First, monetary policy is a key driver. As long as the Federal Reserve keeps printing money and debasing its currency, a falling U.S. dollar is naturally good for all things priced in dollars—especially key commodities like gold, silver and oil. The second thing is supply and demand pressures, which are decidedly positive and support a rising oil price. The supply/demand gap continues to widen, and cheap barrels of oil are becoming increasingly scarce. This leads O&G companies, and by default investors, to go to riskier political jurisdictions to look for unconventional hydrocarbon sources, apply unconventional recovery techniques and find ways to become more efficient in production.
Put these two core drivers against a shaky Middle Eastern and North African political backdrop, and add the situation in Japan, where multiple gigawatts of power are down due to damaged nuclear reactors as well as Japanese refineries all over the east coast, and the result is that they're going to have to get that power somewhere else. The only way to get that is from oil, and perhaps later from liquefied natural gas. All together, it's an extremely bullish outlook for oil going forward; that's our thesis.
TER: You have a few small-cap companies under management; but I see a lot of micro caps, too. Do you have a special strategy for dealing with the marketability of these shares? (Liquidity may be a precarious term to use in companies of this size.)
TM: Overall, I do that by limiting exposure to those less-liquid companies and including certain liquidity requirements within our portfolio. We help to diversify ourselves. Yes, there is added risk because of liquidity concerns but there's also added risk due to the early stage of operations and low valuations of these companies. Therein also lies the opportunity to get a multiple of your original investment back if you play your cards right. We tend to look for things outside of the norm. We like the unconventional plays and seek out what I describe as "innovation and high potential return," as well as companies that have improved efficiency.
TER: What are some examples of unconventional deals with high potential?
TM: Obviously, cheap barrels of oil are scarce in the world today. One name we're very fond of right now is Africa Oil Corp. (TSX.V:AOI), a Lundin company. It's a company that's exploring major basins in Kenya, Somalia, Ethiopia and other African countries. Of late, Africa has been a boon to the oil and gas industry and Africa Oil, itself, is one of the largest landholders in the East African Rift Basin, which is one of the largest underexplored basins in the world. Both Tullow Oil plc (LSE:TLW) and Heritage Oil Corp. (TSX:HOC; LSE:HOIL) are active in the region. AOI, literally, is hunting in elephant country. It's supported by one of the best management teams and suite of shareholders in the business. CEO Keith Hill has a track record of success from Valkyries Petroleum Corp. and Tanganyika Oil Company Ltd, both of which are private. He's built up and sold multiple companies, and now he's on to the next one. I believe investors will be justly rewarded. In terms of sheer geological potential, Africa Oil should be at the top of any speculative investor's list, especially in the oil space.
TER: Do you think of Africa Oil as a conventional play?
TM: It is a conventional play looking in what I would call "unconventional areas." Considering the world is short on cheap barrels of oil, you're going to have to go to new jurisdictions to find them; that's one of our key themes. This is a growing area where you would potentially find billion-barrel pools.
TER: How about other regions that meet your parameters?
TM: Well, another one finding new barrels in underexplored regions is Tag Oil Ltd. (TSX.V:TAO). It's a junior O&G exploration company that we've been invested in for some time. TAG is focused solely on New Zealand's North Island, and it's been growing conventional production in the Taranaki Basin, which now is at 700 barrels per day and growing rapidly. Planned optimization in 2011 should allow for simultaneous production at all eight of its wells, doubling production. Also recently announced is a new discovery in the same basin at its Broadside location where two successful wells have been drilled. But what we find truly interesting is its exploration permits on the East Coast that cover what could be one of the most intriguing oil-shale regions yet discovered, potentially 12.65 billion barrels of original oil in place. Even if just a sliver of this could be extractable, it still represents considerable potential. TAG is expected to make strides toward the end of this year to see what these shales could have, but you're backstopped by current and growing production from its conventional leases in the Taranaki Basin.
TER: Well, TAG gives you some diversification into a more stable region.
TM: Yes, indeed; and following on TAG's success is a company I would suggest investors' put on their radar screens. We already own it privately, and the IPO is coming next month. It's called New Zealand Energy Corp. The company will be coming out at a considerable valuation discount to TAG. While it has no production presently, it has five times more acreage than TAG in the Taranaki Basin and will be aggressively developing these acres for conventional production. Beyond that, it also will boast roughly the same—if not more—acreage covering potential shale plays in the East Coast Basin.
TER: Approximately what market cap are we talking about here when it opens?
TM: We're probably talking somewhere between $150 and $200 million for New Zealand Energy Corp.
TER: Wow. Any others?
TM: There are two companies I really like that are more about improving efficiency at proven basins and proven areas. One of the companies is PRD Energy Inc. (TSX.V:PRD). We've owned it for awhile and continue to be buyers. The company is headed up by CEO Michael Greenwood, who is the former chief financial officer of Canaccord Financial Inc. (TSX:CF). It's also run by Chief Operating Officer and former Mission Oil & Gas Senior Executive Mark Hornett, who is one of the best operators I know. They originally set the company up to go after gas assets in North America, but the business model didn't work due to low gas prices. So, now the company is on the verge of signing several deals in Europe where it intends to go into old, previously discovered pools that were under-exploited using older technologies. PRD will use modern technologies, such as horizontal drilling and down-hole stimulation to boost recoveries and turn old shut-in wells into gushers. We expect announcements on these earn-in agreements imminently and that the company will be operational in 2011.
TER: And the other company?
TM: East West Petroleum Corp. (TSX.V:EW). It's a relatively new international O&G junior focused on applying new technologies to enhance recoveries from existing conventional oil resources and commercializing unconventional sources of hydrocarbons. The core of the company's business plan is to form strategic alliances with holders of both conventional and unconventional assets. It has a strategic partnership with Kuwait Energy Company where East West is earning into a significant asset portfolio with enhanced recovery and unconventional opportunities. Its management team has a phenomenal track record and includes Dr. Marc Bustin, who was a cofounder of the recently sold Cuadrilla Resources. The team also includes President and CEO Greg Renwick, who has extensive experience in the Middle East and was with Dana Gas (ADX:DANA) and the Honorable Herb Dhaliwal, former minister of energy for Canada. This company is well positioned; it's got a market cap of under $60 million, more than $30 million in cash and no debt. Management has told me that they expect to exit 2011 with 1,500–2,000 barrels of oil equivalent per day of attributable production.
TER: East West has sold off about 25% over the past three months. Was that due to instability in the Middle East?
TM: Some of that could be instability in the Middle East. The people I've spoken with are actually operating in Egypt, and it's just business as usual for them for the most part. I think a lot of that is because of its association with Kuwait Energy Corp. Keep in mind, Kuwait Energy Corp. has assets all over the world and it's going to be working with East West on a lot of them. So, I don't see as much risk as some people do here. This is a wildly undervalued company.
TER: The market cap is at a sweet spot in the $50M–$60M range. It doesn't take a lot of investment capital to double that stock price.
TM: Exactly, especially if the company's able to put out the production numbers it's forecasting.
TER: You've got this extremely bullish picture on energy and oil, particularly now, and you've just outlined your reasons. Companies that service the exploration and production industry also might benefit. Which E&Ps do you like?
TM: We very much look to companies that solve the problems faced by the oil and gas industry. There are two plays we like. The first one is Cortex Business Solutions Inc. (TSX.V:CBX). I spoke about this in my last letter and my first interview with The Energy Report. One area that's largely been overlooked in the O&G business has been invoicing and accounts payable systems. Cortex helps increase efficiency in the business by taking these systems paperless. It sets up a Cortex Network and charges a fee for every document that passes through its system. So, there's no human error and no inefficiency. The company has been building this for awhile and it really wasn't getting any recognition or respect, but then about two years ago, Husky Energy Inc. (TSX:HSE) signed on and mandated that every single one of its +10,000 suppliers had to be part of the Cortex Network or it would no longer do business with them. A number of other major O&G producers came on board, but it wasn't until Murphy Oil Corp. (NYSE:MUR) signed on that Cortex really started to get critical mass.
The last time we spoke, Cortex had only Husky and Murphy Oil. Well, now you've got six other majors who signed on. Those would include Apache Corporation (NYSE:APA) and PetroHunter Energy Corp. (OTCBB:PHUN), Energen Corp. (NYSE:EGN), W&T Offshore Inc. (NYSE:WTI) and others. I'm sure there's a solid pipeline of other majors that are going to be signing onto this system, so each and every hub that you add on will already have suppliers that deal with the other hubs. Now, it's kind of a manifest-destiny scenario for Cortex in my mind. I believe it is about to turn the corner on profitability; and by November or December of this year, we should see that on a recurring revenue basis. I have no doubt that it's going to become an insanely profitable business. Soon, I think you'll see these guys make the leap to other industries, as well, like construction or utilities.
TER: Is a potential customer company required to have a major database system installed, or can Cortex come in and manage a legacy system?
TM: Cortex can absolutely come in and manage a legacy system. It's very easy to sign onto, as well.
TER: I see Cortex down 17% over the past 52 weeks. Does that, in your mind, constitute value?
TM: Yes it does, absolutely. A lot of the speculative froth on the company has subsided and it's become a numbers story. In my view, it's absurd that the share price has drifted the way it has over the last year given all the strides forward the company has made.
TER: You said there was another service provider you liked.
TM: Yes. The other one that I would mention is a company called Ridgeline Energy Services Inc. (TSX.V:RLE),which we've been involved with for a long time now. Initially, it was environmental consulting and soil remediation; but about a year ago, it acquired a technology that uses electricity to separate out any bad stuff in dirty water. It's essentially a water cleaning business. The company decided very quickly that this technology could be used to clean dirty frack water, and there are potential applications for tar sands lakes and steam-assisted gravity drainage operations. The company has put a pilot plant together at a gas-fracking operation in Northern British Columbia, and the first commercial unit is nearing completion; in fact, I was in Las Vegas three weeks ago to check it out.
Water is a key resource, especially in Alberta, and it's actually quite difficult to come by in the volume needed for a fracking operation. Every time you frack a well, you have to drill a disposal well—that costs you upwards of $1M, and then you have to dispose of all this dirty water in the well. Not only that, but you're taking water out of the ecosystem of rivers, lakes and reservoirs. What this technology allows a company to do is take that dirty water out of the frack well, clean it and reuse it in the next well. So, not only are you conserving water but you're stripping the cost out of having to drill a disposal well for every frack well. It's also very interesting that Ridgeline has taken the technology to a tar sands tailing area and was able to separate out pure water.
TER: It sounds like Ridgeline could open up some possibilities for E&Ps to go into areas where communities may not want them now. Do you see that as a distinct possibility?
TM: My vision would be a Ridgeline water truck on every E&P site. But, realistically, the company still has a lot of proving to do. I will say the signs are very encouraging right now.
TER: Taylor, thank you very much.
TM: Thank you, too.
Taylor MacDonald is an associate portfolio manager at Pathfinder Asset Management Ltd., a Vancouver-based family office. He graduated from the Wharton School at the University of Pennsylvania with a BS in economics in 2004. Prior to moving to Pathfinder, he worked in equity research at Raymond James Ltd. in Vancouver, investment banking with Haywood Securities (UK) Ltd. in London, England, and institutional equity sales at RenCap Securities in New York. Taylor has been a CFA Charterholder since 2009 and is a Level II CAIA candidate.
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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) Taylor MacDonald: I personally own shares of the following companies mentioned in this interview: None. I personally am paid by the following companies mentioned in this interview: None.
Taylor MacDonald: Bullish on Unconventional Oil Plays
TICKERS: AOI, APA, CF, CBX, DANA, EW, EGN, HOC; HOIL, HSE, MUR, PHUN, PRD, RLE, TAO, TLW, WTI
Source: George Mack of The Energy Report (4/21/11)
Consumer pain at the pump is a windfall for E&P companies. As old oil and gas fields are exhausted, companies move to new regions where the potential reward may justify the inherent risk. Pathfinder Asset Management Associate Portfolio Manager Taylor MacDonald tells investors where to find new ways to play growing energy demand in this Energy Report exclusive.
The Energy Report: Is Pathfinder Asset Management a hedge fund?