The Best Way to Beat Today’s High Costs in Oil and Gas

I'm a big fan of royalty companies. And I want to tell you about a new firm I've found, that's using this time-tested model for stable profits-run by some very successful people with proven track records in the petroleum business.

In fact, this oil and gas royalty company is so new, it hasn't even been fully formed yet-let alone garnered any attention from the wider investment community. But you can still invest in it today through a couple of back-door trading avenues.

More on this company in a moment. But first, what is a royalty company? And why should we be looking at such firms today?

The royalty business model is one of the simplest going. Get into a play early (which usually means low acquisition costs), then wait until deep-pocketed investors come knocking at your door. Let them do all the heavy lifting drilling, completing and paying for wells-and keep a no-risk carried interest.

It's always amazed me that more companies don't pursue this model. Likely because doing so requires two qualities that are relatively rare to find in human beings.

First, foresight. The ability to plunk down cash on an idea that's different, before you have the cerebrum-stroking comfort of seeing other people doing the same thing.

Second, patience. Blaise Pascal said that most people's miseries derive from an inability to sit alone in a quiet room. And being in the royalty business means you may have to sit in empty rooms by yourself for quite some time. Buying a play early could mean waiting months, years, or even decades without seeing any activity. You have to resist both doubt and the knock-on urge to spend your own money proving that you're right.

A No-Risk Petroleum Investment

But for those who can summon up both foresight and patience, the royalty model pays dividends.

Ten years ago, I did very well investing in Panhandle Oil and Gas (NYSE: PHX), which at that time functioned almost entirely as a royalty company. The firm collected checks from wells completed on their extensive land holdings along the U.S. Gulf Coast. With drilling on many of the now-famous plays in this region ramping up at that time, there were a lot of checks to open.

The other great thing I recall about the company was its insulation against costs. The period between 2005 and 2008 saw drilling, completion and operating costs rise significantly. Services were in great demand, so there was a lot of money chasing rigs and the people who worked on them.

Such inflation took a big bite out of profits for conventional producers. Even though commodity prices were generally rising, costs were escalating nearly in step. So margins weren't improving materially.

But Panhandle turned out to be the perfect way to play this tricky situation. Payments on the company's royalty production stream went up with rising oil and gas prices. But the company was unaffected by the costs that were killing other producers. A perfect middle ground.

I see a similar conundrum in the petroleum sector today. A recent report from BMO Capital Markets estimated that oil and gas supply costs-the amount producers pay to find, develop and produce a barrel of oil equivalent, including royalties and taxes-came in at a towering $108.50 per boe in 2012. Up from just over $70 in 2009.      

That means the average E&P is not making any money, all-in, on their production today. Costs are simply too high.

We can see the impact of cost inflation on the performance of individual producers too. I like to look at a metric called the "recycle ratio"-the dollar amount of new reserves added by an E&P in a year divided by the firm's capital spending for the same period. The recycle ratio shows us the reserves value created per dollar spent in the ground-a measure of the effectiveness of a company's deployed capital.

The chart below shows the recycle ratio for one of the best drillers in the business-Occidental Petroleum. As you can see, Oxy did very well in the lower-cost environment that prevailed in 2009 and 2010. Each dollar spent by the company generated over $5 in reserves.

But the performance has been degrading the last two years. To the point where, in 2012, $1 spent generated only $1.17 in reserves. I believe this is evidence that higher costs are cutting into Oxy's profitability-the same way such expenses are reducing the business effectiveness of the entire industry.

The Solution: Get Rid of Costs

In this high-cost environment, royalty companies may well be the best way to go for investors who still want exposure to strong oil prices-as well as potential appreciation in the natural gas price.

The problem is, a lot of investors are thinking similarly. The few royalty plays on the market today are trading at fully-valued levels. Freehold Royalties (TSX: FRU) for example, trades at 14.6x annualized cash generated by the business, based on results from the first half of 2013. Not exactly a screaming buy for a non-growth business, financed by depleting assets.

As I learned with the Panhandle Oil and Gas example mentioned above, when it comes to royalties, the highest-return strategy is to buy holders of royalty interests before their acreage sees a lot of drilling. Doing so, you can position yourself cheaply for growth once cash from future drilling comes rolling in.

The trick is finding companies holding lands within plays that are going to see a lot of activity. And making sure the firm you're buying has a large enough position to be material.

I think I've found one tiny company that succeeds on both of these counts: Australian Canadian Oil Royalties (OTC: AUCAF).

Two New Jerseys Worth of Land

If you've never heard of this junior, don't worry-neither has most of the investing world. It trades in a dusty corner of the obscure U.S. over-the-counter market-usually the haven of penny pump-and-dumps.

But several things point to AUCAF being different. The first thing that jumps out about the company is its land position. The company operates entirely in Australia (the "Canadian" in the name refers to the location of some of the management team). Here, AUCAF holds 10.3 million acres of royalty interest lands-about twice the size of the state of New Jersey. That's in addition to 6.3 million acres of straight-up working interest lands. A truly massive position.

The company currently generates a little cash flow from production on these lands-about $80,000 worth after operating costs for 2012. But it's the growth potential here that's more striking.

Particularly in the Cooper-Eromanga basin of southwest Queensland. The company holds nearly 1.2 million acres in this play. And drilling along trend of late has been very encouraging. Less than twenty kilometres to the south of AUCAF's PEL 444 license, Australian E&P Senex Energy recently tested the Mustang-1 exploration well at 2,500 barrels of oil per day. An extremely good rate for an onshore test. This summer Senex also put into production the nearby Snatcher oil field.

Those aren't the only successful fields nearby. Just kilometres to the west of AUCAF's acreage, Australian major Santos tested wells in the James oil field at over 3,000 barrels per day. This play clearly has potential for significant discoveries.

Something Big Afoot

The biggest reason I find Australian Canadian Royalties so intriguing is that significant industry players have quietly been descending on this unknown company over the past few months.

Just last week, the company conducted a special meeting to vote on a new slate of directors and officers. The incoming group includes some good names. Stewart Gibson, who helped build successful U.K. explorer Sterling Resources (TSX-V: SLG) from 2000 to 2010, when the company jumped from pennies to as high as $4.75. Toby Pierce, former partner with major funding house GMP in London. And Yves Merer, who headed exploration for Shell in places like China, Syria and Iran.

This is not the typical bunch you see getting involved with a tiny, pink sheets-listed oil company. Suggesting that something big may be in the works for AUCAF.

The incoming group has indicated they plan to merge AUCAF with its sister company International TME (Nasdaq: ITME), which holds an interest in the company's Australian properties. This would give the new AUCAF (to reportedly be renamed Chelsea Oil and Gas) more control over the projects. The new company will seek an upgraded listing on the Canadian TSX or high-tier markets in the U.S.-further suggesting the new proprietors have significant things planned.  

The share prices of both AUCAF and ITME have bumped up a little as this restructuring gained steam over the last few months. But both plays are still well into micro-cap territory. Following the proposed amalgamation, Chelsea would have some 64 million shares outstanding-equating to less than a $15 million market cap at AUCAF's current share price. The company has $3 million in debt, giving it an enterprise value of less than $20 million.

We should see results from the recent meeting regarding corporate restructuring soon. If the move does proceed, the projects and the people here could make this the perfect play to profit in today's high-cost oil and gas environment.