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Keith Schaefer: Oil and Gas in 2010

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Keith Schaefer "If gas stays in the $5–$6 range, that's what I would call purgatory," says Oil & Gas Investments Bulletin writer Keith Schaefer, adding "and anything less than that would just be hell." Learn about new technologies that are greatly increasing the amount of recoverable oil in the world and find out why Keith warns investors to be very, very selective, particularly in Canadian natural gas stocks in this exclusive interview with The Energy Report.

"If gas stays in the $5–$6 range, that's what I would call purgatory," says Oil & Gas Investments Bulletin writer Keith Schaefer, adding "and anything less than that would just be hell." Learn about new technologies that are greatly increasing the amount of recoverable oil in the world and find out why Keith warns investors to be very, very selective, particularly in Canadian natural gas stocks in this exclusive interview with The Energy Report.

The Energy Report: Let's start with your big-picture take on natural gas because that's one that seems to be retaining a low-price profile. People are talking about the high level storage, the improvements in production, the decrease in the cost of taking the gas out. What's your view of what's happening in those markets?

Keith Schaefer: I think that in 2010, natural gas is going to have what I call a 'purgatory pricing environment,' where it's going to be low enough that most companies will not make money, but a few of the really low-cost producers will. If gas stays in the $5 to $6 range, that's what I would call purgatory and anything less than that would just be hell. You're looking at a situation where the all-in costs for natural gas production in North America is still around $6 to $6.50 per MCF. When the price is below that, few producers are making money.

So investors have to be very, very selective, particularly in Canadian stocks because these companies, for the most part, have high debt levels, higher pipeline costs and a higher Canadian dollar. So it's going to be very difficult in particular for the Canadian juniors to give any real profits to investors, I think, over the next year.

Having said that, there are a couple of very powerful forces that are bullish for natural gas. The decline rates on these new shale gas plays that are so prolific, are quite high. These gas wells start off with great production, but then they die off very quickly.

We're already seeing a slight increase in demand for gas. And there are a lot of people calling for gas to be quite a bit higher in the second half of 2010 because the decline rates are so high and demand is coming back. It was reported that for the first time in a year, gas demand was actually up in October and November of '09. A lot of utilities started using natural gas to generate electricity, so it's happening.

TER: So is the increase in demand mostly from switching from other sources of electrical inputs or is it from consumers?

KS: No, it's not from consumers. It's almost exclusively from utilities.

TER: So if the utilities are switching over to natural gas, there is some hope that it will deplete some of these supplies, and by the end 2010 that will be a point where production becomes more important and, in theory, the price goes up.

KS: Yes. And, of course, if natural gas is going to be going higher towards late 2010, natural gas stocks are going to start pricing that six months in advance.

TER: So from an investor point of view, the purgatory you referred to earlier really is in Q1, '10.

KS: Q1, '10 to Q2, '10, yes, but there's no real crystal ball for natural gas. There are some very strong upholding forces between well decline rates, which is bullish for gas and the huge new supplies that are out there with all the shale gas, which are bearish. So it will be interesting to see which one of those two ends up beating the other at some point in 2010, and whether prices go higher or lower.

TER: So there's still almost a pivot point. We just don't know which way it's going to go.

KS: If I had to guess, I'd say it's going to stay lower. But you're already seeing very high declines in gas production in Canada and from the Gulf of Mexico, so you've got two very important sources there for the U.S. where the decline rates are fairly significant. Of course, they're being bounced off by all the U.S. shale gas plays that are in production now.

TER: Do you see any input in natural gas prices in North America coming in from imported Liquefied Natural Gas (LNG)?

KS: No, I don't see LNG being a factor in the North American market for at least a couple of years. Right now Asian countries are starting to suck up every bit of LNG they can find. You're seeing them not only taking tankers that are out sitting in the oceans right now, but they’re also doing deals around the world to secure supplies, whether it's China, India, Japan or Korea, spending billions of dollars in places like the new Gorgon Field off Australia. They're committing billions of dollars to get LNG to Asia. I think that is going to keep a real whopping supply of LNG off of North America for at least a couple of years.

TER: Do you see any scenarios where natural gas in North America will be exported to Asia to meet that increase in demand?

KS: If Alberta is not thinking about getting a LNG export terminal on the west coast of Canada, they should be. If U.S. demand does not pick significantly, the U.S. will not need much Canadian gas for a couple years. And you're already seeing that.

For example, our Canadian declines are down about 7 1/2% this year, but our exports to the U.S. are down almost 20%. So the difference in that is that gas has gone into Canadian storage and that's really depressed our natural gas prices up here in Canada. Some government ministry people should be thinking long term very quickly and thinking about getting export terminals set up on the west coast of North America, especially in Canada.

TER: Have you heard of anyone starting to discuss that?

KS: Yes. In Kitimat, British Columbia, there's a LNG terminal underway, but it will be at least two to three years minimum.

TER: So, essentially, for 2010–2011, the export of LNG is really not a factor in North America at all, import or export. So we're really looking at supply and demand ratios.

KS: Right. LNG is coming into North America at a very regular pace, but it's no greater pace than what it has been for the last three or four years.

TER: Let's talk about oil. Oil has been bouncing around quite a bit here for over the last 12 months and it seems to be in this tighter trading range, at around US$75 per barrel. As prices come down or as prices go up, we saw a lot of new types of drilling from the shales to tar sands, etc. What's your viewpoint on what will happen with oil prices and how should investors be looking at oil as an investment play?

KS: The oil price is quoted in U.S. dollars and investors see that oil has gone from $50 to $80 in the last six months. But truly, most of that gain is because of the decline in the U.S. dollar. The oil price in most of the world has not changed much at all in the last six months.

In Canada, the price of oil today is very close to what it was in June because the Canadian dollar has basically absorbed that price increase. So when anybody says, oh, the price of oil is so high, it's not that high. The price of oil is about the same as it was in the summer for almost the entire world except for the United States.

Then people say, oh, it has to pull back; it's going to cause a recession. Well, that could be true for the U.S. and, of course, that is 25% of the world's economy, so that will definitely have some impact, but truly I don't see any huge, sustained pullback in oil.

TER: Do you see a situation for explorers and producers of oil? Is this at a price point that they can begin to look at higher-cost exploration or production or does it need to go higher to bring new oil fields on line?

KS: No, it doesn't need to go any higher—$75 is a Goldilocks price. Everybody's happy. The producers are happy, the consumers aren't screaming, governments are getting their royalty checks, so this is not too hot, not too cold; it's just right. It's just a Goldilocks price, which means it probably won't stay there. With the new technologies that are happening, this price has plenty of upside for successful explorers and developers, lots of upside.

TER: You say the Goldilocks price is probably not going to stay there.

KS: The market has a tendency to do what will hurt the most people and right now no one's getting hurt with the price of oil. There are companies making fantastic profits, especially those who are using new technology. They are making fantastic returns at these prices. Again, that's balanced against a lot of the declines that we're seeing in some of the big macro situations.

Now, there are new technologies opening up, huge new formations that weren't accessible to us even three years ago. In the last three years there has been an absolute revolution, transformation of North American oil and gas production. I'm assuming that oil is going to stay at a level where growth will get recognized in the stocks. And for me, over about $60 a barrel, growth will get recognized in the stocks and there's no way that I can see that oil is ever going lower than $60. We'd have to really, really go into a sharp decline. The stimulus packages that the governments of the world are willing to keep going, to me, just guarantee that oil is going to stay above $60 for the foreseeable future.

TER: Do you see it going much above $75 in the first quarter?

KS: There can be lots of spikes. There is a lot of oil in the world available to us right now. It's a question of production bottlenecks. In some cases, there really is peak oil—whether it's Mexico, the U.S., or other places. But for the most part, bottlenecks are production constraints. So in those types of situations, absolutely, you can see some spikes above $80. In the near term, is that going to happen? I would suggest that’s not likely.

TER: But if it stays above $60, which seems to be your bottom level, that's enough profit for people to continue with exploration and production profitably.

KS: The exploration and development will get a lot more selective, but, absolutely. Look at what's happening in the Bakken play in North Dakota and Saskatchewan— as well as what's happening in the Cardium play in Alberta.

The new technologies of 3D seismic, horizontal drilling and multi-stage fracing has opened up these well-known, but previously uneconomic formations, and they've gone from being uneconomic to the most economic. The most profitable oil in Canada right now is coming from the Bakken, which people knew nothing about three years ago. That's how quickly things have changed. It is the most profitable oil in North America right now.

TER: How large is the Bakken? Could it satisfy North American demand?

KS: Right now the U.S. Geological Survey is estimating there's about 4.5 billion barrels of oil there. What's happening is that companies have been able to increase the amount of recoverable oil out of their wells, not just every year—but nearly every quarter. There are improvements in production rates, improvements in the total amount of recoverable oil. So it has the potential to really make a difference for North America, but no, it couldn’t satisfy all the demand here.

TER: Do you see additional increases or advances in technology that will allow further recoverability of oil?

KS: Absolutely. Right now, the oil industry is where the Internet was in 1996. These new technologies are coming in and we have not yet seen any bumps in the road in terms of the potential for horizontal drilling and multi-stage tracking. These technologies are now being tweaked and refined by many different players and they're continuing to increase production levels and total recoverable oil.

There are also new technologies that are just coming into the fore now, such as the new microbial technologies that basically allow oil to flow more easily underground; these little microbes can reduce the surface tension of oil and make it flow to the well bore better. A company I currently cover is called Wavefront Technology Solutions Inc. (TSX: WEE-V) They have developed a new technology that pulses water into these oil wells to increase production. They have had huge success doing that. The Mexican government is basically willing to give them a trial on their wells and Mexico is the poster child of peak oil. So there are all kinds of technologies still coming out that are showing they can greatly increase the amount of recoverable oil in the world.

TER: So, technology is influencing your investment decisions in the oilpatch?

KS: Yes. If you look at my article, "How to Invest in Oil and Gas Stocks," the number-one question is—how many barrels of oil is the company producing per day? How much oil are they producing and how quickly are they growing? We talk about their financial position, how many wells they are going to be able to drill, etc.

But, really, the number-one question that I'm looking for—what the real nugget for me is—I want to know if a company's production is done with horizontal drilling, because that technology is really where the big returns are right now. You can still get a good well flow rate with a vertical well. But, really, it's the horizontal wells that get the best valuations, the best oil recoveries, highest flow rates, etc.

So the sweet spot for investors is to go in after the discovery hole, where they say, okay, we've gone in here and we've discovered in this horizontal well, for the sake of argument, let's say, 250 to 300 barrels a day, which is a little bit better than an average well in Canada. Then if they've got a huge land position where they can drill another hundred wells, well, that's just very low-risk growth that almost guarantees the next three years. So that's where I'm spending almost all of my research time.

In offshore plays where you have bigger wells that are foreign international plays, that's a different story. I'm still willing to look at vertical well situations. But certainly here in North America, the number-one criteria is: show me you've hit a well in an area that has a huge undeveloped land position where you can have X years of drilling inventory of horizontal wells.

TER: So what do you look for in international plays?

KS: Size— either big wells or a big field.

If you're investing in international plays, you want them to be going after elephants because your political risk is usually a little higher and infrastructure might not be quite as prevalent as it is here in North America. So you've got all those costs to put in infrastructure, which all the pipelines can cost—for example, Pacific Rubiales (TSX: PRE) has just spent $500 million building a pipeline to take their heavy oil to market. So you need to have a well-funded company.

So then you look at a situation like Colombia, where a company like Petrominerales Ltd. (TSX:PMG), one of my picks, has hit two or three 10,000 barrel-a-day wells. Just for comparison, in Canada the average well is under 80 barrels a day.

TER: In what timeframe did they hit those wells?

KS: In the last two or three years. This year they hit over 10,000 barrels a day in one well, and 6,000 barrels a day in another.

TER: What’s an example of a huge field internationally?

KS: Pacific Rubiales has a huge field in Colombia. Their wells are a bit larger than what we get in Canada, but not that much larger. They might be a couple hundred barrels a day, but they just had a huge field and it was very low-risk drilling. It was my first recommendation for my newsletter and the stock has gone from $2-$16/share this year.

It was the same with Bankers Petroleum Ltd. (TSX/AIM:BNK) in Albania. Their wells don't produce much more than Canada's. But the field is enormous and it's just like shooting fish in a barrel. You just plunk a well down at fairly cheap cost and money flows out. Plunk, swoosh. Plunk, swoosh.

TER: Can you share with our readers some names of producers that you're looking at currently that represent good investment plays for early 2010?

KS: A couple of oil companies that I like are really turning a corner.. One of them is a company called West Energy Ltd. (TSX: WTL). This team has had a chronic low valuation, despite having a great balance sheet and being mostly oil because oil gets a much better valuation than gas does right now. But they bought a new asset and it's fantastic. They're showing the market they know how to operate and they're able to deliver some really good returns from this new property. So the market is in the process now of re-rating them at a higher level. That is one company that I like right now..

There's another company called Painted Pony Petroleum Ltd. (TSX.V: PPY.A) that is not a cheap stock in terms of valuation, but they have a very large undeveloped land position in the most profitable oil producing region in North America, the Bakken. Over the next three to four years, they just get to go “plunk swoosh, plunk swoosh” with a low-risk drilling campaign. Their success rate is 100% and they've got the next three to five years, at least, of drilling locations ready to go. So, as they grow, so will the stock.

TER: Their success rate is 100%.

KS: Honestly, that's not unusual anymore.

TER: Because of horizontal drilling?

KS: The drilling, but also the 3-D seismic and the underground mapping. They can see these formations now quite easily and the risk level in exploration has gone way down. That's why I'm surprised you're not seeing a lot more retail interest in oil and gas stocks, because the risk is lower, and the cash flow is higher. There are just so many great new opportunities out there for investors.

TER: Does that mean we may not see the multiples of return that we saw five years ago, or is that value creation still there with lower risk (which sounds like a real sweet spot)?

KS: It is a sweet spot. Yes, valuations are definitely higher now than they were in the past. But again, growth is getting recognized and they're still figuring out ways to get more production out of wells, so the valuations are still increasing.

TER: So we have West Energy, and Painted Pony. Are there any others that you can share with us?

KS: If gas turns around, there's a company called Peyto Energy Trust, (TSX: PEY.UN), which is a very low-cost producer and it also has a growing oil profile in one of the best new plays in Canada, the Cardium. Certainly if people believe in a gas turnaround, that's a very intriguing stock to look into because there's a lot of leverage there with it being such a low cost producer.

TER: Earlier you mentioned Bankers Petroleum and Petrominerales. Have those stocks seen the appropriate appreciation?

KS: Bankers is much like Painted Pony. They're going to increase production very steadily and reliably as they grow the company because the field is huge. It's the largest onshore oil field in Europe, and it's a very low-risk situation. I think both Painted Pony and Bankers are takeover candidates in the next 6 to 12 months. In fact, I'd be surprised if Painted Pony wasn't bought out sooner. They have such a strong land position and the team there, Pat Ward, has done a fantastic job. And, again, with Bankers, President and CEO Abdel F. (Abby) Badwi has a great track record in building these companies and selling them. He sold a company called Rally Energy Corp. (TSX:RAL), which had an oil play in Egypt, so he knows these companies have great management teams.

TER: What about Petrominerales?

KS: I don't know if it'll get bought out or not because it is 66% owned by Petrobank Energy and Resources Ltd. (TSX:PBG), another TSX- listed company. So, again, they have an amazing set of properties in Colombia that bring in huge wells when they're successful. They've shown a great success rate over the last three years.

TER: What's the special offer you have for the oil and gas investments newsletter that you write?

KS: We have a special offer exclusively for Energy Report readers— we're offering a free Oil & Gas Investments Bulletin report, which includes an exclusive stock pick, which I believe has lots of room for growth—despite it having already doubled for my subscribers. As well, we’re offering a 20% discount on current subscription rates, for a limited time only. For more information on this special offer, please visit our website at: Our returns have done very, very well this year and with the annual subscription there is a 60-day money back guarantee.

TER: That sounds good. I noted that in Part 2 of your "How to Invest in Oil and Gas Stocks" there is a summary of the returns for this year by issue and they are impressive.

KS: Yes, if you would like to take a look at these I’ll refer you to the article that is posted on our site: “How To Invest in Oil & Gas Stocks – Part II”

TER: Is there anything else you can share with our readers about investing in oil and gas stocks?

KS: I'll close by saying that right now I'm focused on oily stocks, not gassy stocks. I don't know if and when natural gas is going to turn around, and the cash flow out of the oil stocks is just so much greater. I don't really understand taking a risk on natural gas stocks just yet.

So we've focused on oil stocks with good balance sheets that are really using the new technologies to increase cash flow; that's not hard for investors to figure out. It doesn't take a lot of work for investors to really go out there and find which plays have the best economics. But, like you say, why would they spend any time at all? They should just subscribe and let my research do the work for them.

TER: There we go. I appreciate your time, Keith.

Keith Schaefer, of the Oil & Gas Investments Bulletin, writes on oil and natural gas markets. His newsletter outlines which TSX-listed energy companies have the ability to grow, and bring shareholders prosperity even in these tough times. He has a degree in journalism and has worked for several dailies in Canada, but has spent the last 15 years assisting public resource companies raise exploration and expansion capital.

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1) Karen Roche, of The Energy Report, conducted this interview. She personally and/or her family own none of the companies mentioned in this interview.
2) None of the companies mentioned in the interview are sponsors of The Energy Report.
3) Keith Schaefer—I personally and/or my family own the following companies mentioned in this interview: West, Petrominerales, Bankers, Painted Pony. I personally and/or my family am paid by none of the companies mentioned in this interview.

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